by Nathan Slaughter
It's pretty simple really.
You sell products, you bring in revenue. Subtract whatever cash was spent on those products (cost of goods sold) and you have gross profit. The larger the gross profit, the more earnings are left over once all the other day-to-day expenses are paid.
For many companies, the cost of goods sold can really eat into the bottom line. Think of the mountains of grains and sugar that cereal maker Kellogg's (NYSE: K) has to procure. The company took in $12.6 billion in revenue last year, but spent more than $7.2 billion (57%) on raw ingredients that went into all those boxes of Rice Krispies and Frosted Flakes.
Even firms with smaller budgets have to cope with volatile price fluctuations or shipment delays that can create havoc on production schedules.
But one upstart Chinese company has decided to cut out the middleman almost entirely.
Yongye International (Nasdaq: YONG) is an up-and-coming player in the green agriculture movement. The firm sells organic crop nutrients and animal feed supplements derived from lignite coal. Lignite coal is the most expensive input in the firm's business model, accounting for about 50% of its production costs.
So rather than continue paying a fat mark-up to its suppliers, Yongye bypassed them entirely by buying its own lignite coal mine earlier this year. It also just cut the ribbon on a new manufacturing facility right next door to the mine, which will soon be rolling out 30,000 tons of plant and animal nutrient each year.
This vertical integration will have a dramatic impact on Yongye's profitability -- much like a lemonade salesman planting a grove of lemon trees in his backyard.
Management doesn't give us any specifics, but a +15% to +20% expansion in gross margins is reasonable. With sales already soaring, earnings should soar even more in the near future. Not that the Yongye needs any help in that department. Revenue doubled from $46 million to nearly $90 million last quarter, which helped net income quadruple to $24 million, or $0.54 per share.
Of course, numbers are just numbers -- it's the catalysts driving them that matter.
In a recent article about the wheat shortages in Russia, I mentioned that there will be an estimated 1.1 billion more mouths to feed by the end of the decade. That kind of population growth is what is partly fueling surging commodity prices. [Read the article here]
And in this case, Yongye is in an enviable position because many of those mouths will be in China.
The firm's Shengmingsu brand nutrients are proven to shorten harvest times and boost crop yields, enabling farmers to get the most productivity out of their land. Cucumber output, for example, can rise as much as +22% -- and get to market nearly two weeks earlier.
Most of China's rural farmers rely heavily on local stores for supplies, and Yongye is making the most out of this distribution channel. The firm negotiates with these independently-owned stores to prominently display (and push) the Shengmingsu brand. By the end of 2010, Yongye will have converted 23,000 stores, a powerful +152% increase for the year. And the company is just now spreading its footprint outside its core territory in the Hebei region of northern China.
Yongye's shares, at $8, are trading at just 15 times trailing earnings, fine for a slow-moving giant, but highly enticing for a young company that's delivering racy triple-digit earnings growth. The stock can be had for a PEG ratio of just 0.2 -- one of the most discounted valuations you'll find.
Looking ahead, the company has several big-picture factors working in its favor, not the least of which is the fact that Chinese growers, which have just one-third as much arable land as other countries per-capita, must feed one-fifth of the world's population.
I see the shares climbing above the $10 mark in the next 12 months, which would represent gains of +25% or more from current levels -- and even more in the long-run.
Disclosure: Neither Nathan Slaughter nor StreetAuthority, LLC hold positions in any securities mentioned in this article.