I had a chance to talk with the CFO of Emerald Dairy (EMDY.OB) Shu Kaneko on the ride out to the new Emerald Dairy factory 3.5 hours outside of Harbin. Emerald Dairy has had a few tough years with 0 growth in revenues and warrant non cash adjustments that have pushed down the net income. With the most recent hormone scandal with Synutra, the powdered milk industry in China is also facing recent pressure on safety standards. That being said, Emerald Dairy seems to have interesting prospects.
Zack: What is the background of the company?
Shu: We had $45 million sales in 09 with completely maxed out capacity. Since we were unable to expand capacity in 09, our revenues did not grow, which looked bad to investors. In addition, we had a large warrant charge that essentially wiped out our GAAP net income for the year. Going forward we are very confident in the future of our company. We have our new factory coming online in September which should more than double sales. Our original factory has a total capacity to do $45 million in revenues, this new factory will give us the capacity to make $95 million in revenues.
We sell to 20 out of 30 provinces. In the top 5 provinces, there are international brands, Synutra, and American Dairy that we do not like to compete with. In the bottom 5 provinces, we do not go because population density is not high enough. So the middle is our sweet spot. We target the bottom of the market with tier 3 and 4 cities.
Zack: What is the direction of the company in the next 3-5 years?
Shu: First we are focused on getting our current factory online. We believe this will ramp up in 8-12 months. Once this production line reaches 70% capacity, we will begin the construction of the other line, line c, which is located in the same factory. When line c is at full capacity we will make $150 million in revenue with 18-20 million in net income.
Due to economies of scale, the margins should go up as we build more production lines.
My 5 year goal for the company would be $500 million in sales with higher margins between 17-20%. Our current market cap is around $37 million. With the b line completed, we should do $13-14million in OCF. When line c is added we should make $20mm in OCF. Hopefully by that point we will be on the AMEX. Ideally, our strategy would be to raise money at 10x P/E and buy companies at 3-4x P/E. We will be very cautious with acquisitions, however, as we do not want to buy too many subsidiaries because they could damage the brand if something goes wrong. There are lots of acquisition candidates, about 50 smaller companies in this space in China.
Zack: What is currently going on in the industry?
Shu: There are 4 US listed companies and 40-50 total companies in china. Many smaller companies are being pushed out because of government regulation. They don’t have the capital to upgrade equipment and are forced out of the business. There are 40 cities in Tier 2, 60 in tier 3, and 500 in tier 4, currently we are only in 120. The industry is growing at a 20% pace with 16 million newborn babies which is 5x more than in the US. The Total infant product formula is half of the US, so based on that math to be even the market in china would have to increase 10x. Our penetration rate is only 20% of tier 2 –tier 4 cities. Based on that, we don’t even have to take others market share, we just need to grab 7-8% of the growing pie.
Zack: What do you think of the industry risk?
Shu: There is a real problem in terms of scandals pushing down valuations. Also, as careful as we are with quality control, there is always a chance we could have an issues as well. This is the biggest risk we perceive in our industry.
Zack: What is going on with the current factory?
Shu: For line b the building is done, line b is basically done and we need to add line c next year depending on how fast we can ramp up line b. We hope in 9-12 months to reach 100% capacity for line b.
The new factory is in Hailun city. The company is currently generating around 30-40% pretax roc on these buildings? In terms of capex, the first phase was about $22 million which will generate about $7 million in OCF. The second phase only requires, $14 million since the building and land are shared, but we need to purchase additional equipment. So the average cost for the two lines is about $18 million, with $7 million in cash flow generated from each. $36 million total investment for $100 million revenues. So $14-16 in FCF with a payback period of about 3 years.
Zack: What do you think of your competitors? ADY? SYUT?
Shu: Synutra has great management. They acquired companies very rapidly and have been successful with their rollup strategy. I think the hormone accusations will blow over and are relatively unimportant as babies can get sick from many things other than milk.
American Dairy predicted .19 and ended up losing money which is not good for the company. I think they spent too much money advertising and not enough money on developing their sales channels and sales force. I still think they are a good company with a strong brand and should do well over the long term.
Zack: What capital do you anticipate having to raise in the future?
What is going on with your auditors?
We are looking to get bigger auditors, in the process of uplifting to amex. Right now otcbb will upgrade auditors to the top 10.
What is the insider and institutional ownership?
Shu: The insider ownership is 42% for our CEO. John Winfield and Jag multi investments both own about 5%.
What are your competitive advantages?
Shu: We feel that our business model is our biggest competitive advantage. Our competitors generally cover tier 1-tier 4 and sell through a big wholesaler, reseller, and retailer, so there are usually 2-3 layers of middlemen. Since we go to only Tier 3-4 cities, we find distributor that sells to supermarkets. Se we sell product at same price as our competitors, but give the supermarket substantially higher margins on the sales. This gives the supermarkets more incentive to sell our products.
Zack: Why don’t the large companies copy your model?
Shu: Once a company has the distribution structure it is hard to change it. Our biggest customer is 2% of sales because we use smaller distributors. With ADY and SYUT, many of their distributors are very large. They cannot get rid of 10-15% customers to get 2% customers, it would not make business sense, and therefore it does not make sense for them to make the switch into our business model.
What is you’re A/R like?
Shu: We have low A/R as our customers have 60 days to pay, in addition, some customers pay up front.
Disclosure: Long EMDY