American Dairy: Seeing Unrecognizable Value

| About: Feihe International, (ADY)

In a recent edition of Value Investor Insight, Jim Shircliff of River Road Asset Management explained why he sees unrecognizable value in American Dairy (NYSE:ADY). Key excerpts follow:

Turning to some specific ideas, describe the investment case for the misleadingly named American Dairy [ADY].

JS: We came across this company four years ago just by looking at Yahoo Finance for dairy-related businesses, which we’d had success with in the past.

We hadn’t heard of it, but in doing our research we became convinced it was an interesting growth play on China, where it is a premium producer of powdered infant formula under the Feihe brand. It’s run by Leng You-Bin, who took it over when the Chinese government privatized the company in 1997.

Our basic premise with ADY was and is that as China becomes somewhat more Westernized in its consumption habits, there is tremendous growth upside for the company as the market for infant formula expands. Today Chinese per-capita consumption of baby formula is just 30% of not only what it is in the U.S., but also versus the levels in Hong Kong and Taiwan. The overall Chinese market, currently around $5.5 billion, is expected to hit $12 billion by 2014. Any loosening of the one-child-per-family rule would expand the market even faster.

One thing we obviously didn’t expect – but which has been a big boon for the company – is the melamine scandal that hit most of its competitors last year. ADY was one of the few companies not implicated in the crisis, a function of it controlling its own production rather than buying milk from brokers who had tainted their supplies with melamine in order for the milk to appear thick and rich in protein during testing.

As competitors either halted distribution or went out of business, ADY saw big increases in market share, revenue and profits. In this year’s first quarter, revenues were up nearly 200% and earnings per share nearly quadrupled, to $1.55 per share. The stock responded accordingly, going from below $7 in September of last year to high as $44 in June.

As is often the case, the market overdid it and seemed to assume the gains in the first quarter would all be permanent. We never assumed that, so we started cutting our position back quite a bit over $38. That was a good thing because when the company earlier this month tried to dampen down expectations for the rest of 2009, the stock got slammed.

With the shares now at $27.80, what expectations do you have from here?

JS: We still believe the overall growth story is intact. With the Feihe brand now even more highly regarded, the company is looking to expand beyond the secondand third-tier Chinese cities in which it has traditionally been strongest.

From the scandal they’ve seen their market share go from around 2% to 7%, and while all of that gain won’t be permanent, we expect a decent portion of it will be. Overall, it’s not a stretch to expect revenues and profits to grow 15-20% per year from here.

We’re looking for the company to earn around $4 per share in 2010, with cash flow per share coming in above $5. Because of the attractiveness of the market and the company’s specific growth prospects, we’re comfortable using a 9x cash-flow multiple. That gives us an estimated absolute value in the mid $40s.

What are the biggest risks?

JS: We’ll be watching the level of marketing spending closely as they look to expand distribution into bigger cities.

We’re happy the company has a new auditor, Grant Thornton, but there could be some risk of accounting issues arising from that change. There’s also the political risk of being in China, but one could make the argument that policies there are going in a more positive direction than we’re seeing here in the U.S.

We’ve been to China to see management and the company’s facilities and came away impressed. We think this is a rare inexpensive play on the growing affluence of Chinese consumers. You won’t see our portfolio packed with this type of thing, but it’s an attractive addition to the mix.