China-Biotics: DuPont's Next Acquisition Target?

 |  Includes: CHBT, DD, DNSOF
by: Sean Wright
For those of us invested in China-Biotics (OTC:CHBT), there was some very good news on Monday, namely, that the number one player in the probiotics industry, Danisco (OTC:DNSOF), agreed to be bought by DuPont (NYSE:DD) in a $6.3 billion deal. Normally when a competitor gets bought at a much higher valuation, a whole industry tends to move up in valuation. For this reason, for example, Chr. Hansen, Danisco’s competitor, opened over 6 DKK higher on Monday. It is a tribute to just how little the stock market understands China-Biotics that it did not trade up on the news, especially given the history between CHBT and Danisco. Rarely have I seen a situation where market perception and reality are so markedly different than with China-Biotics. As the reader can see below, the difference between the current valuation and objective instrinsic value is massive. That discrepancy provides a great investment opportunity.

At the Investor Day on September 20th, Mr. Song, the CEO of CHBT, announced in his closing speech that he had a close relationship with the CEO of Danisco China, and that they were going to have a meeting on September 30th to discuss strategic cooperation. On the November 9th earnings call, I asked Mr. Song about the meeting with Danisco. He said this was sort of a trade secret and he could not comment without speaking with Danisco, but he was willing to give a hint. He said it was a strategic partnership discussion, and people very high up from the headquarters, including the vice president in charge of production as well as the China CEO were there. I heard from another investor who talked with the company that approximately 30 people from Danisco showed up at China-Biotic’s Qingpu plant.

We know that Danisco has a strong position in the bulk probiotics market in China, but no local production and that it imports all of its product. We know that CHBT has the largest stand-alone probiotics facility in the world and is the only Chinese player with the ability to produce bulk probiotics at the same quality standard as Danisco and Chr. Hansen. We also know that CHBT’s bulk business is growing very quickly, now with over 50 customers, and taking market share from Danisco and Chr. Hansen.

So what should we make of all of this? My conclusion is that Danisco probably wants CHBT to OEM its product and sell it in China. That is probably its intent, but I am thinking Danisco is probably also interested in purchasing CHBT. The problem with these type of JV discussions, especially with a competitor, is that they are difficult. Your competitor gets knowledge of all of your proprietary products (in this case knowledge of proprietary probiotic strains) and might even find out more about your customer relationships and pricing. How do you agree not to compete? Can customer relationships be managed in a way to avoid competition? As soon as the customer finds out that the Danisco product came from China-Biotics, it would have an incentive to buy directly from China-Biotics because its prices are lower. These are reasons why it is just cleaner in the end to buy your competitor rather than start some sort of joint venture relationship, and I am sure this is evident to both parties here.

Danisco knows it needs to be on the ground in China, and it knows it needs a local manufacturing base. China is after all the world’s fastest growing economy and is home to 1.3 billion persons of which 90% are lactose intolerant and need probiotics in order to consume dairy protein comfortably. The potential is huge. Dairy consumption is taking off in China as wealth grows and probiotics should be a fantastic growth business for at least the next decade. But it takes a long time to set up a new plant, test it, ensure its safety, and get all the GMP and other certifications necessary. It took several years for CHBT to build the Qingpu facility. Further, this is a very specialized field with a limited number of people that actually know how to develop new probiotics strains, produce them in large quantities of even quality, and ensure their survivability through delivery. It’s a very technical product. If you’re Danisco, you know you can’t staff the entire plant with Danish expats, so you’ve got to hire locals, but how can you find the best local talent when it all works for CHBT? These are again more reasons why it makes more sense to buy, rather than rent, your competitor.

My guess is that the discussions with Danisco will continue, but might be interrupted temporarily while management works on merger integration issues. However, once these are resolved, I would expect them to continue in full force. After all, what do you do when you’ve gone from being a CEO to a divisional CEO at a firm like DuPont? You’ve got to show growth and expand your fiefdom in order to keep your job and your standing in the organization. You want your division to be the best performing, not the worst performing division. The easiest way to grow your business fast is through acquisitions, not greenfielding new plants. Where do you want to expand to get growth? China. Danisco was already adequately capitalized, but now as a part of DuPont it has a virtually unlimited war chest. Acquisitions of companies like China-Biotics don’t make the headlines for a company like DuPont with a $45 billion market cap, but they do add meaningfully to earnings growth.

What’s CHBT Worth?
Below I show the multiples of comparable companies in the probiotics industry and the implied price per share of CHBT if it were to trade at industry average multiples. In addition, I show the implied price of CHBT if it were to trade at the Danisco transaction multiples. As I prepared this comp table, Danisco was trading at the DKK 657 / share vs. the deal price of DKK 655 / share, so the Danisco multiples are not only a comparable company multiples but also comparable transaction multiples. As the reader can see, the comparable company multiples imply that CHBT should trade in the $50 - $65 per share range. The Danisco multiples imply that CHBT should trade in the $40 - $70 range. Consider though that CHBT is growing faster than any other company in this industry and is trading at the lowest multiple. A rational argument could be made that it should trade at the highest multiple. If CHBT had come public through an IPO recently, it would be a hot Chinese growth stock trading at 30x earnings. Arbitrage plays this good are rare finds. CHBT provides an exceptional combination of growth and value. I am very much looking forward to the coming earnings release. The longer Danisco or Chr. Hansen waits to buy this company, the more expensive the deal will be because the growth will not stop.

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A Final Word
I have heard a lot of people say, “I know CHBT is great company, but it was attacked by the shorts, so I am not going to invest because it might get attacked again.” Well, if you have done your work and know your investment, you can appreciate that a lower price provides a better buying opportunity. Secondly, if you are a fund manager and worried about your drawdown risk, the real risk you run is that your co-shareholders are all weak hands who will sell at the first sign of trouble. For this reason, the Chinese stocks that have been attacked are actually the safest investments because all the weak hands have been flushed out. So if you’re on the sidelines and worried that you might lose money on CHBT, while I can’t promise that you won’t lose money, I can tell you the weak hands are gone by now. They left in September when the stock was $4-$5 cheaper than it is now. The lead shorts covered ages ago and left their followers to get burned eventually. Stay tuned for great growth in the next quarter and the next year, and if that’s not enough, maybe a buyout offer from DuPont.

Disclosure: I am long CHBT.