“ Dreams can be beautiful, but reality can be cruel.” – Yongye CEO Wu Zishen
Investors think they've found a dream stock in the apparently cheap shares of Yongye International (YONG). A closer look, however, reveals an odd and peculiar story of a company with a murky past and an uncertain future.
Long a staple of Hollywood movies, the story is familiar. An unknown, previously failed businessman finds redemption in a miracle product and fashions a remarkable business around it, disproving the doubting critics every step of the way.
At Yongye, you have the opportunity to invest in just such a story, as Mr. Zishen has been transformed from a rather ordinary man with an undistinguished resume into a visionary man who is now leading a company that is allegedly more than doubling its revenues every year with a game-changing fertilizer additive.
The Yongye story's central character is the charismatic, nearly-messianic figure of CEO Wu Zishen. The China Daily newspaper reported that Mr. Zishen was driven into the agriculture industry after a moving experience:
“Once my colleagues and I were carrying out an investigation in Tongliao, a city in Inner Mongolia, and a sandstorm blew up," Wu said. "We went to the house of a local farmer for shelter. I was shocked at what I witnessed. "The family of five only had two pairs of trousers to wear and their miserable life was something that I had only read about in textbooks. I used to think the poverty of Chinese farmers might be down to laziness but at that moment I realized it was mostly generated by irresistible natural disasters. I resolved to do something for them."
The result of this was the founding of a company that planned to, along with building a resort and 3-star hotel, do something to help China's farmers. At first, Yongye floundered as Zishen's plans backfired. He admits that his overeagerness to operate a big company led to capital shortages. The resort fell by the wayside, but due to the fortuitous donation of a secret blend for a fertilizer, things turned around.
China Daily reported that,
Wu said. "And, I especially appreciated the senior expert who shared with me the formula of Shengmingsu, which he devoted 40 years of his life to creating."
Shengmingsu for plants is a patent-pending chemical that stabilizes and helps mix fulvic acid with nutrients such as nitrogen, phosphorus, potassium, boron and zinc. It is able to boost their yield by 10 to 35 percent and also shorten harvest times by 15 to 20 days. The acid can be extracted from brown coal.”
Using this donated formula for Shengmingsu (Chinese for “life essential”), Yongye began to grow. The company was able to launch as a bulletin board stock in 2007, not exactly a reputable start to its American reputation. However, the company has since upgraded to the NASDAQ market, and with revenues and profits allegedly doubling every year since, it appears the company has been performing well. However, as the stock of Yongye has gone nowhere .
As the company has more than doubled in size over the past 18 months, its share price has actually fallen. This disconnect between the company's rosy reported financials and the sagging stock price has made the company appear to be a great value. The company trades at a 7 trailing PE, a forward PE of 4 and an absurdly low PEG ratio of 0.2. On paper, this appears to be the value play of a lifetime!
But is it too good to be true? Unlike, say, RINO International (GM:RINO), there's no smoking gun here to say that the company is misstating anything. However, the deeper one looks, the more one wonders what's going on.
Let's start with the story that investors have been drawn to.
The company claims its innovative Shengmingsu is a unique product that provides tremendous value to farmers. I'll let the near-messianic CEO Zishen weigh in:
"If you invest 40 yuan in one mu [a fraction of an acre] of land, I promise you can earn more than 400 yuan, but in reality it is likely to be 3,000 to 4,000 yuan; If you invest 100 to 200 yuan in a cow, I promise you can earn 2,000 yuan and it might exceed 10,000 yuan," Wu said.
Incredible stuff, eh? Invest 40 yuan and get back 3,000-4,000 yuan? Amazing! It's no wonder Shengmingsu sells so well.
Or, could it be that Wu is either lying or simply way too optimistic? The company's Shengmingsu allegedly helps to mix fulvic acid with the normal stuff in fertilizer, such as nitrogen, potassium, and zinc to increase the plant's ability to use the fertilizer. This in turn is supposed to increase yields of fields by at least 30%, thus translating to 100fold returns for farmers, according to Wu Zishen. I don't understand the math, but I do get the concept – fulvic acid makes for successful crops and greater returns.
But there are at least two problems. One, fulvic acid is a commodity product. Yongye cited numerous competitors making similar products when it IPOed several years ago, and cited difficult to quantify intangibles such as relations with its customers as reasons why it would perform better than competitors making nearly the same product. Regardless, even Yongye admits it is making a commoditized product. By nature, these sorts of products typically have low profit margins, not the sorts of sky-high margins that have driven Yongye's frenetic expansion.
The other problem is that fulvic acid just doesn't work, according to highly respected Western research institutions. I could write for pages citing studies, but in the interest of not boring you all, I'll only cite one. UC-Davis released a report printed in 2010 by the reputable HortScience journal documents the latest research in humic acids (fulvic acid is simply a water-soluble portion of a humic acid). In the report titled, “Humic Substances Generally Ineffective in Improving Vegetable Crop Nutrient Uptake or Productivity,” the authors wrote (emphasis added),
Field trials were conducted in 2008 and 2009 evaluating the effects of pre-transplant soil application of HA at 1.1 or 3.4 kgha–1 a.i. on growth, nutrient uptake, and fruit yield of processing tomato (Lycopersicon esculentum Mill.). In neither year was macro- or micronutrient uptake increased with HA. Similarly, there was no significant HA effect on plant dry mass accumulation or fruit yield. We conclude that, at typical commercial application rates in representative field soils, HA is unlikely to significantly improve vegetable crop nutrient uptake or productivity.
While I could not find a single Western study to support the use of humic or fulvic acids in increasing crop productivity, I did find several university scholars who referred to these soil additives as “snake oil.” In my opinion, it is probable that the company is grossly overstating the abilities of its product. Like many traditional Chinese medicines, fulvic acid has a lot of internet hype, particularly in alternative medicine circles, but almost no scientific backing. Bulls will point to unverifiable pictures such as those that can be found here as “proof” that Shengmingsu works.
However, I cook Mexican food often enough to tell you with 95% confidence that the pepper on the left at the linked page is a Jalapeño while the pepper on the right is an Anaheim pepper. These pictures, and other such “evidence”, do little to convince one of Shengmingsu's efficacy. Regardless, if you believe Shengmingsu is effective, you are trusting anecdotal evidence over scientific evidence. Sometimes science gets it wrong, but it's not a bet usually worth taking. Lots of dubious companies have tricked investors over the year with “technological miracles” whose science just didn't work. Shengmingsu, and other such fulvic and humic acid products, are likely to be ineffective.
However, Yongye could be a good investment even if its product isn't particularly effective. Many companies have survived for years selling things that many people claim are “snake oils” such as Mannatech (MTEX) and their line of unproven glyco-nutrient based products. As long as the products you make sell, it doesn't really matter if your marketing claims are accurate.
But the rest of the Yongye story also fails to compute. The company claims to have had a mere 200 stores when it went public in 2007. Now, it claims to have somewhere in the neighborhood of 20,000! How is such rapid growth possible? Even more implausibly, the company has only grown from 265 employees in mid-2008 to 399 today, even though it has since opened almost 20,000 stores, rapidly grown production of its products, and its revenue during this span has gone from $13 million to $196 million. (You can find the exhaustive Yongye report I gathered these figures from here.)
It isn't impossible, I guess, to increase revenues from $13 million to $196 million while only increasing your workforce by 50%. But it's highly implausible. How on earth could you open 20,000 stores, more than 40 each day, with only 399 workers? Are you familiar with any other companies that can grow so rapidly without hiring more workers? I'm not. I highly doubt the company is truly generating $196 million a year in revenue from its alleged 20,000 stores with only 399 employees. That just doesn't pass the sniff test.
There are other concerns. For one, Yongye has a dubious corporate ownership structure. According to Yongye's website, Yongye International of Nevada owns all of Fullmax Pacific Ltd. (BVI), which in turn owns Asia Standard Oil Ltd. (HK), which owns 99.5% of Inner Mongolia Yongye Biotechnology Ltd. Very little is returned by Google searches of each layer of this corporate onion. However, the striking resemblance to the corporate pyramid at the fraud-stricken RINO International – with a Nevada corporation also at its apex and another shell company in the British Virgin Islands under that one -- is alarming. If all is good and well at Yongye, why the obtuse ownership structure?
Also, accounts receivables were surging, growing ten-fold between 2009 and third quarter fiscal 2010 according to retired CPA Marty Chilberg. The company also had a period of 4 consecutive years of negative cash flow until the company announced a spectacular reversal in January of 2011 with cash flow suddenly turning wildly positive and accounts receivables dropping by 2/3rds. With YONG giving consumers six months to pay (a dangerous and highly unusual practice), swings in accounts receivables are to be expected, but it is still a dangerous sign. The fact that the company had been hemorrhaging money consistently for years is also concerning in the face of its allegedly high profit margins and net income. Where'd all the cash go? (Some of it went to buy a customer list at an absurdly high premium – but that's a different story for a different blog post – and that doesn't explain most of the missing cash.)
While there is no smoking gun at YONG, there are many good reasons to doubt the story. The company's flagship product probably doesn't work. Even if its product is effective, it is still a commodity good that should not generate outsized profit margins. Yongye is unlikely to have been able to open 20,000 stores and generate 8-fold revenue growth in the past few years while hiring such a scant number of employees. Its corporate structure is unnecessarily complex and opaque. And its cash flow and accounts receivables raise yet more questions. When the story appears too good to be true, step aside. There are much better value plays out there than Yongye International. I doubt this corporate drama will have a Hollywood ending.