China Agritech (CAGC) is a China-based producer of organic fertilizers, both in liquid and granular form. On first glance, their operating results appear impressive, with strong top and bottom-line growth. However, when one engages in deep analysis of their financial statements, a number of serious red flags become apparent, one of which I will be discussing today.
Management is the cornerstone of every business, the foundation upon which the entire credibility of a company is built. No matter how good a product, if a company’s management is not committed to increasing shareholder value, ultimately the stock will perform poorly. I believe that CAGC possesses corrupt management, one argument for which I will present using 100% publicly available information.
CAGC does not own the buildings in which it operates manufacturing facilities. It could have owned some, if the majority shareholders CEO Yu Chang and director Xiao Rong Teng had vended these assets into the company when it went public via RTO, but they did not to do that. Instead, they decided to keep the fixed assets for themselves and CAGC occupied these spaces entering into inflated related-party leases.
As stated in Note 19 of the 2009 10-K:
Pacific Dragon has entered into a tenancy agreement with a related party, Yinlong Industrial Co. Ltd. (“Yinlong”), the former minority shareholder previously holding 10% equity interest in Pacific Dragon, to lease two factory plants and one office building with a total floor area of 7,018 sq. meters for a term of 10 years from January 1, 2004 to January 1, 2014 at an annual rent of RMB 1,200,000 (equivalent to $144,578). The tenancy agreement was revised by increasing the annual rent to RMB 3,600,000 (equivalent to $518,940) effective from July 1, 2005. Yinlong is owned and controlled by Mr. Yu Chang and Ms. Xiaorong Teng, who are both directors of the Company.
On July 2, 2007, Beijing Agritech entered into a tenancy agreement with Ms. Xiaorong Teng (a director of the Company) to lease an office with a total floor area of 780 sq. meters for a term of 5 years from February 1, 2007 to February 1, 2012 at an annual rent of RMB 492,000 (equivalent to approximately $70,922) effective from July 2, 2007.
Leases in China are legally binding agreements, the terms of which cannot be changed without consent from both parties. So, for their 7,018 sq. M facilities in Harbin, Pacific Dragon (CAGC’s operating subsidiary), decided to enter into a 10-year tenancy agreement with an annual rent of 1.2M RMB per year in January of 2004; yet just 18-months after signing, CAGC consented to the rate on this 10-year tenancy agreement arbitrarily being tripled by their landlord? What could possibly justify such an increase? The timing of the lease amendment may indicate that it has something to do with the fact that CAGC became a public US-listed company via an RTO arrangement on February 3, 2005.
The new lease rate works out to 513 RMB or approximately $76.33 per sq. M ($7.08/sq.ft.) per year on the whole facility. The landlords Mr. Chang and Ms. Teng are earning a very high lease rate on the space considering this is an industrial facility in Harbin, China. More to the point, this is number is highly inconsistent with the rent of CAGC’s other production facilities - Anhui excluded, but that will be addressed in further detail later.
According to the 2009 10-K, on their production facility in Chongqing, CAGC pays 112,440 RMB or 105 RMB per sq. M per year for a 1,074 sq. M facility. In Xinjiang, CAGC pays 300,000 RMB or 96 RMB per sq. M per year for a 3,110 sq. M facility. On its liquid fertilizer facility in Beijing, CAGC pays 600,000 RMB or 134 RMB per sq. Mper year for a 4,485 sq. M facility. For the Beijing Granular Factory/R&D center, they pay 650,004 RMB or 145 RMB per sq. M per year for a 4,485 sq. M facility. What could possibly be so different about the Harbin manufacturing facility such that they are paying 513 RMB per sq. M per year? One key difference is that this building is owned by CEO Yu Chang and current director, the former COO Xiao Rong Teng. It appears that the company is transferring shareholder funds to insiders via leases at significantly above-market rates.
Further examination of the notes in the 2009 10-K reveal Mr. Chang and Ms. Teng are making even more in their role as landlords than one might originally assume based on the language used in the disclosure. If you were to simply add the amounts in Note 19 of 3.6M RMB and 492K RMB together, you’d arrive at a yearly rent of 4.1M RMB or approximately $610K in annual expense. But if you take a closer look at Note 22 about operating leases in the 2009 10-K, you will read the following:
The Company incurred rent expense of $1,134,047 and $888,460 related to the leases with related parties disclosed in Note 19 for the years ended December 31, 2009 and 2008, respectively.
This is almost double the rate that is mentioned in Note 19. If we back out the $219,718 in 2009’s capital commitments for the purchase of organic granular compound fertilizer’s production facilities that are mentioned in Note 20 of the 2008 10-K, we are left with $915,223 for 2009, still 50% higher than what is revealed in Note 19. Examination of Note 22 of the 2009 10-K reveals that the operating leases are designed for maximum payment in 2009. It seems as though in 2009 CAGC may actually have paid north of $10/sq. ft. for industrial leasing space in Harbin, China.
Keep the following information in mind. According to this report by multinational leasing agent DTZ as of Q2 2010, the average Grade A commercial office rental rate in Beijing is about $275 per sq. M per year.
The Harbin facility is not the only place where CAGC’s leasing structure looks highly suspicious. Let’s look at CAGC’s rental expenses at their Anhui facility located in Bengbu (alt. spelling Bangfu, Bengfu, Bangbu), a tier-3 city of 3.5 million in Anhui province. Although not leased through a declared related party, the situation here looks highly suspect. According to the 10-K from 2008, the original lease of the Anhui facility was signed in 2006 as a 3-year lease. The rent here was 160k RMB per year for 1338 sq. M in 2008, or about 120 RMB per sq. M per year;consistent with the rent paid on their other non-related party facilities.
In 2009 when it came due to renegotiate lease, CAGC also expanded the footprint of the factory, so one might expect that to lease more space would cost more in total. But the rental rate paid at this location increased astronomically. According to the 2009 10-K, they are now paying approximately 3M RMB per year for a 3400 sq. M facility, or 892 RMB per sq. M per year. This represents an increase of 640% in the rental rate. It works out to $131 per sq. M per year, or $12.17/sq. ft., approximately 50% of the price of Grade A commercial office space in Beijing. But this is not remotely close to Grade A commercial real estate in Beijing, this is industrial real estate in a tier-3 Chinese city. What about this particular location can possibly justify CAGC not only staying put, but expanding the footprint of the facility when it is subject to an 640% increase in the lease rate?
Readers may know a little something about the rates for industrial leasing in your own neighborhoods. For those that do not, I challenge you to do a search for the cost of leasing industrial real estate in your own city and see if the prices paid by CAGC make sense to you considering the locations of the factories. You will find that these prices are not cheap by European or North American standards, much less that of tier-2 and tier-3 cities in China.
In conclusion, management needs to answer some serious questions as to why the rate being paid on the Anhui facility is so far out of line with what seems to be the prevailing rate for industrial real estate in China of between 100-150 RMB per year per sq. M. What is perhaps more troubling is that the related-party leasing transactions reveal that CAGC common shareholders are on the wrong side of a serious conflict of interest between Yu Chang as the CEO of CAGC and as the 85% owner of Yinlong.
Disclosure: Author is short CAGC