By Dan France, GeoInvesting Contributor
A Tale of Two Recent Chinese Small Cap IPOs
The performance of two recent Chinese small cap IPOs last summer peaked my interest. Two solid companies with strong fundamentals and outstanding growth prospects recently came to market and both stocks initially declined following the IPO and then churned sideways for extended periods before finally coming to life.
The first of the two to go public in June was New China Borun (BORN), a producer of edible alcohol that is used in China’s national drink, baijiu. BORN was priced in a volatile market at $7.00, well below its original targeted price range of $12 to $14. BORN frustrated its IPO investors by trading on low volume and with little price movement after the offering. I researched BORN and published an article on it as the stock was starting to stir at the end of July. Since then the stock has been “discovered” by Investor’s Business Daily among others and has rallied strongly recently reaching $18 in active trading.
Since BORN’s saga unfolded, Tianli Agritech's (OINK) completed its IPO on July 21 at $6.00 and the share price initially plunged to below $4.00 during the first week of trading. The trading pattern since then has been eerily similar to BORN’s. Volume until recently has been almost nonexistent and the share price churned sideways just under $4.00.
One curiosity I noted with both OINK and BORN was that during the darkest days of low volume and investor indifference it seemed both stocks consistently had bids with size below the market and few shares offered at the ask price. It appears both stocks were quietly and patiently accumulated as discouraged IPO players gave up the ghost and sold at deep discounts to true value. Now the pigs in OINK’s pens are stirring and the shares have rallied on increasing volume from around $3.70 three weeks ago to $5.96 on October 15, just under its IPO price.
Could OINK be the next BORN?
OINK is in the business of breeding, raising and selling hogs for meat and as breeders for its own use and for other hog farmers in the PRC. The company entered the hog breeding and production business in 2005 when it built its first hog farm. OINK currently operates nine hog farms with annual production capacity of approximately 110,000 hogs. Capacity will increase to 130,000 hogs once the ninth farm reaches capacity by the end of calendar 2010.
The company also invests in research and development activities focusing on animal nutrition and health. One of the greatest challenges to the hog production industry is the growing variety and variability of swine diseases. Many hog farmers manage these diseases with antibiotics including the use of such drugs in their premix feed without regard to whether a particular hog requires treatment.
OINK has set itself apart from the competition by developing a proprietary premix feed for use in its hogs that contains no antibiotics. OINK adds live microbes to its swine feed that results in better absorption of the feed and a generally healthier intestinal system than would exist without the use of beneficial bacteria. Greater absorption reduces waste and feed costs by 10%-12%. The industry’s typical feed cost per hog is $117 for meat hogs and $51 for breeders. OINK’s costs are around $104 for meat hogs and $45 for breeders giving the company a competitive costing advantage. And, drug free hogs are preferred and valued by OINK’s customers, government regulators and informed consumers.
China’s Demand for Pork
China is the world’s largest hog producing and pork consuming country. China accounted for nearly half of the world’s pork production and consumption for the past five years. Chinese per capita pork consumption is among the highest in the world and pork is China’s most popular meat accounting for 65% of Chinese meat consumption. The Chinese consume over 600 million pigs a year.
China’s Hog Industry in Transition
China’s hog industry is transitioning from a large number of small farms to larger, more commercial farms. Hog production in China has historically been dominated by backyard farms that sell 5-10 hogs per year to small farms that sell less than 100 hogs annually. In fact, farms that sell less than 100 hogs per year account for 75% of the hog farms operating and produce approximately 33% of the hogs sold annually in China. Farms that produce 100 to 500 and 500 to 1,000 hogs per year account for 33% and 19%, respectively, of the hogs sold in China each year. Larger farms that sell more than 3,000 hogs per year account for the remaining 15% of annual hog sales.
The Chinese hog industry is ripe for consolidation and the Chinese government is “encouraging” or more appropriately stated pushing the move to larger and more sophisticated commercial farms. In 2009, the Chinese government gave over $750 million in subsidies to invest in larger farms, to subsidize high-quality breeding swine, and incentives for large hog-producing counties. Such subsidies are accelerating the shift toward larger farms such as OINK’s that benefit disproportionately from the incentives.
OINK’s Growth Opportunities
The transition of the hog industry in China from smaller independent farms to larger commercial producers together with government incentives puts the wind at OINK’s back as it moves to deploy the $10 million net proceeds raised in its recent IPO. Opportunities for growth include:
- Build New or Expand Existing Farms: To date OINK has built its own capacity.
- Acquire Other Producers: OINK can acquire the assets of other producers and upgrade the facilities and operations to its standards. The government is pressing less sophisticated commercial producers to either sell their operations to larger producers or shut down. The company estimates it can acquire other producers at bargain prices and intends to do so in the future. For example, a 20,000 hog farm can be acquired for around $2.5 million. It would take around six months and $500,000 cap ex to upgrade and transition the acquired farm to OINK’s standards. A 20,000 hog farm would generate annual revenues of around $4.2 million with 45% gross margins based on current market prices for hogs.
- Grow Production Organically: OINK’s management has been very prudent with respect to the hog population at the company’s farms. Currently, management considers 20,000 hogs to be the optimal population at the average farm compared to as many as 40,000 hogs at maximum capacity. The lesser hog population avoids overcrowding and promotes healthier (and happier?) stock. As management gains operating experience and the business matures there is potential to increase the hog population at existing farms and grow the business organically.
Meat and Breeder Hogs - These Little Piggies Went to Market
OINK sells meat hogs and breeder hogs. 28% of sales for the six months ended June 30, 2010, were breeder hogs and 72% meat hogs. When possible the company prefers to sell breeder hogs. That’s because the margin generated from the sale of breeder hogs is higher than meat hogs. The average selling price (“ASP”) of breeder hogs in QII 2010 was $325 with a 57% gross margin. In contrast, the ASP for meat hogs in QII was $168 generating a 34% margin. Breeder hogs cost less to produce because they weigh 110 lbs. when sold vs. 220 lbs. for meat hogs. The breeders therefore consume less resources than meat hogs.
Breeder Hogs for OINK’s Own Use – These Little Piggies Stayed Home
OINK retains some breeders for their own stock. Breeder hogs consist of purebreds and certain crossbreeds that display favorable genetic breeding traits. A sow is able to have a litter every seven months and produce around 22 piglets a year. Around 5,000 breeders are therefore required to maintain current annual production levels at 110,000 hogs. The productive life of a sow ranges from three to four years. The company capitalizes the cost of raising the hog to maturity and carries it as biological assets on the balance sheet. The costs are amortized over three years.
OINK Trading at 5X Likely 2010 EPS
Using OINK’s most recent trailing quarters as my guide I expect the company’s calendar year 2010 EPS to be around $.95 vs. guidance of $.74 ($.47 achieved as of June 30, 2010). Further, I think $1.30 in 2011 is a reasonable estimate. If my projections are in line with actual performance OINK is currently trading at around 5X likely 2010 EPS and less than 4X what we can reasonably expect EPS to be in 2011. Factors that could materially impact 2010 and 2011 earnings include:
- The actual market price for OINK’s meat and breeder hogs. In the last four quarters the ASP range for breeder hogs was $229 to $325 ($325 in QII) and $157 to $203 ($168 in QII) for meat hogs. We know from recent industry press information that meat hog prices have recovered from the lows in July to around $185 during the second half of September. We also know that quality breeding sows are in short supply. Pork prices should reach their seasonal peaks during QIV 2010 and maintain those levels in QI 2011.
- How and how quickly management deploys proceeds from OINK’s IPO.
- The mix of breeder and meat hogs sold.
- Organic growth at existing farms.
- Possible secondary offering to raise additional capital. Management has shown a prudent and methodical approach to expanding operations. I believe the proceeds from the recent IPO will be deployed sequentially rather than all at once so I don’t think an equity raise is likely until at least the middle of 2011 when the share price should be significantly higher mitigating possible dilution for existing shareholders. Keep in mind that the company does have access to bank credit and cash flows from operations are strong. Both of those factors should grow over time so an equity raise may or may not be necessary depending on the opportunities available and circumstances in the future.
A Make Good Agreement with Teeth
Investors should take note of and be comforted by management’s commitment to growing shareholder value. The company’s Chairman/CEO and CFO have committed personal shares in a make good agreement. Under the agreement if the company does not generate after tax earnings of at least $.74 per share for 2010 the executives will cause to have cancelled a sufficient number of their shares necessary to ensure the EPS target is attained. Based on my research the executives have nothing to worry about but nevertheless it displays a firm commitment by management to protect the interests of all shareholders.
On the Ground Due Diligence
Geo Investing is working with OINK’s US representative to schedule an onsite visit with management in China. That meeting should take place within the next month. Geo will report the results of their on the ground due diligence after that meeting takes place.
Where Do OINK’s Shares Go Next?
Nobody has a crystal ball or the ability to predict share prices in the short run especially for a stock with a small public float. OINK does, however, display the fundamentals, financial performance and has the operating assets, cash resources and management needed to capitalize on the business opportunity it has in the largest pork producing and consuming country in the world. Given the government’s commitment to consolidating the pork producing industry by pushing production more and more toward larger commercial producers and the concerns about the adequacy and safety of the country’s food supplies, OINK is well positioned to do extremely well and the price of its shares should follow. Recent activity in OINK’s shares just might indicate it is on its way to becoming the next BORN. We could all drink to that!
To see GeoInvesting's initial thoughts on the OINK story please go here.
Disclosure: Author is long OINK, BORN at time of article; The GeoTeam also has a short-term trading position on OINK.