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Rising concerns over food security, the shrinking of available arable land and increasing populations have brought agricultural investments back into the limelight. Globally, investments in agriculture are required to increase output and productivity. This includes the production of fertilizers and agrochemicals, farm machinery and high-performance seed (by breeding of genetic engineering), but also the farming operations themselves.

For the equity investor who wants to become a part-owner in a farm, the choice has been rather limited. While diversified investments in agriculture are possible via exchange-traded funds such as CRBA, MOO, PAGG, DBA, RJI or RJA, which cover a wide range of larger agriculture-related public companies or commodities, most of these do not contain any farming operations.

The recent IPO of Adecoagro (NYSE:AGRO) has made investments in South American farmland accessible, which was also possible previously via the ADRs of Cresud (NASDAQ:CRESY). Other farms listed on U.S. exchanges include the secretive JG Boswell company (OTCPK:BWEL), which has a market capitalization of nearly $1 billion but is tightly-held and thinly-traded.

The last decade saw a large amount of IPOs of eastern European farming operations, with very mixed results. Companies such as Firstfarms, Black Earth Farming (OTC:BLERF),and Landkom (OTC:LKNTF) went public but have mostly failed to reward their shareholders. The very high valuations at which those stocks were issued as well as the financial crisis that hit shortly afterwards certainly played their part in this sorry state of affairs, although the managements of these companies have certainly their part in the blame. Recently, Ivolga (allegedly the world’s largest farm with 1.5 million hectares of land) came under duress and is negotiating with RBS to avoid bankruptcy and foreclosure.

Like with any other company, it is not just the business area that makes a company successful, but the people behind it. I would like to take this opportunity to highlight a Chinese company with ongoing success, Chaoda Modern Agriculture (OTCPK:CMGHF). Its success is based on operational excellence and financial discipline, and I think the market is not giving enough credit to its excellent track record.

A successful vegetable farm

The probability is high that American readers are very familiar with the Green Giant brand for vegetables owned by General Mills (NYSE:GIS). I expect that only a minority of you will have heard of Chaoda before, although it is truly a vegetable giant in its own right. And I am not only talking about the name of the company (Chaoda is written with the characters 超and 大 in Chinese which stand for “super” or “exceeding”, and “large”, thus giving it the meaning of “super-huge” or “gigantic”). Chaoda’s operation is very impressive in the context of a fragmented agricultural base in China. As of June 2010, it was had a production base of 664,225 Mu (a Chinese surface unit equivalent to 1/15th of a hectare or 0.1647 acres) which is equivalent to a surface of 443 km². About 75% of the surface is used for the cultivation of vegetables, the rest being fruit orchards, tea plantations or livestock land.

Chaoda has continually expanded its production base area over the past decade. The total surface has grown about sixfold from 8,000 ha in 2002 to over 44,000 ha currently. Chaoda aims to increase the total production area even further in the coming years. In addition to the 714,933 Mu of production area at the end of 2010, the company has a further 300,000 Mu of total land reserve for crop farming (some 45% of the current production base), and the company is planning to expand the production base area at a rate of 25-30% per year over the next three years. Just look at the chart below to see the impressive growth in land, a growth that can be projected into the future as per the company’s land reserve and expansion plans.

[Click all to enlarge]

production base
The crop harvested on Chaoda’s cultivated land has kept pace with the increase in acreage. The volume of crops sold has increased with a CAGR of 24% in the years 2002-2010. Last year, Chaoda sold an impressive 2.8 million tons of vegetables. That’s approximately the amount of coffee beans that Brazil, the largest coffee producing country, harvested last year.

total crop
The growth in production has been commensurate with the growth in cultivated surface, as Chaoda has managed (and invested heavily) to keep the yield of its land stable at a high level. Vegetables are typically harvested three times a year, which is also Chaoda’s average. The yield per harvest has been stable at around 28 tonnes per hectare over the past years. The evolution of the yields over the past years is given in the graph below, along with a comparison of the five-year average yields of Germany, France and the U.S. for vegetables. Chaoda can be proud of its track record, as its harvest volume exceeds those of France and the U.S. by some margin.

crop yields
I wanted to show these data points first to make you realize how efficiently Chaoda has been operating. It has been growing its production base and production like clockwork while maintaining an excellent yield on its production base.

The social component

The growth and operational success of Chaoda has a political dimension. China needs an efficient and large producer of vegetables to feed its growing urban population. Rising food prices are a concern for politicians in countries where a large part of the population has a relatively low income. The government has thus to strike a balance between the necessity of having a large and efficient profit-oriented producer to meet ever-increasing demand for fresh produce and its desire to keep citizens happy with affordable prices. Let’s look at the average selling price per kilogram that Chaoda realized for its vegetables:

average selling price

For a country with an official inflation rate averaging 4-5% per year, the selling price of Chaoda’s vegetables hardly budged over the last years. The company sold its crop at about 2.45 RMB per kilogram in the last five years. Along with increasing its investments in new production, that’s the price Chaoda has to pay for its government support. This does however not at all impair Chaoda’s profitability.

Before that, let me just briefly come back to the selling prices of Chaoda’s vegetables and compare them to prices in the US. Vegetable prices are generally very volatile individually and depend heavily on the type of produce. The average price per kg is thus inherently dependent on the weighting of the individual crops. A 2008 survey by Nielsen for different crop types that can be found on the USDA website has analyzed the average prices for different types of vegetables (see picture below, taken from the report). The prices (converted into RMB/kg at the 2008 exchange rate) range from 7.25 RMB/kg for Potatoes, to 60.71 RMB/kg for sliced Mushrooms. This means Chaoda’s produce is being sold at one-third of the price of even the cheapest fresh vegetable type in the US.

us vegetable prices 2008
The Government says Xie Xie (thank you)

The first thing that struck me when I looked at Chaoda’s P&L statement was how the gross profit nearly completely translated into net profit. Chaoda has consistently achieved net profit margins above 50% over the last decade – this is not something you would expect from a vegetable producer. Contrast that to the 2% net margin of Bonduelle.

This is partly due to heavy government support for agricultural companies in general, and Chaoda in particular. The PRC government has granted an incredibly friendly tax break to Chaoda which means it is virtually paying no taxes. These are the relevant lines from Chaoda’s annual report (emphasis mine):

According to the PRC tax law and its interpretation rules (the “PRC Tax Law”), enterprises that engage in qualifying agricultural business are eligible for certain tax benefits, including full enterprise income tax exemption or half reduction of enterprise income tax on profits derived from such business. Fuzhou Chaoda Agriculture Development Company Limited, the Group’s principal subsidiary and other PRC subsidiaries engaged in qualifying agricultural business, which include growing and sales of crops and breeding and sales of livestock, are entitled to full exemption of enterprise income tax.

Next to its size, operational efficiency and financial prudence (the company is nearly debt-free), this is a key advantage for Chaoda. Like many other Chinese companies, the holding company is incorporated in Bermuda, which is also not known for its high corporate tax rates.

Conservative and growing

The next picture shows some key financial ratios of the company over the last decade. As one can see, all ratios have remained quite stable, and they show a great operational success. Even with nearly zero leverage (some bonds were issued in 2005 and 2006 to finance expansion, but are now repaid), Chaoda has on average produced a return on equity of 21% and net profit margins above 50%.

selected financial ratios
With stable and high profit margins and return on equity, the growing land base has produced profit and revenue growth. As the next graph shows, Chaoda’s revenues have grown to nearly 7bn RMB in 2010, and net profit was 3.7bn RMB, all with stable and rather low average selling prices. Assuming the land bank increases as predicted by 25% per year for the next three years, and prices and profit margins remain stable, net profit could double and reach 7.2bn RMB in 2014 – that’s nearly 70% of its current market capitalization.

revenues, profits, margins
Bringing new fields into production requires large investments in agricultural infrastructure. You can’t just plant seeds on new land and expect the kind of yields that Chaoda achieves. Chaoda has large capital expenditures which will remain high in the coming years – the company has invested and will invest big sums into irrigation systems, land upgrading, agricultural equipment, greenhouses, fertilizers and production and distribution systems.

These are required expenditures to bring new land into production and integrate the new production in the existing distribution system. So far, Chaoda has been able to finance its expansion mainly by its operating cash flow. It has issued senior notes in 2005 and a convertible bond in 2006. Both of these liabilities have been extinguished in the past two years. Other minor shortfalls have been covered by equity issues or credit lines, which have remained small compared to the overall size of the company. The picture below shows the components of cash flow (operating, investing, financing) over the last decade.

cash flow analysis
As can be seen, the outflow of cash for investments has increased over the years, but so has the cash inflow from operations. The large amounts the company is planning to invest over the next years seem to be a concern for analysts, with Jake Lynch from Macquarie even being quoted as “we have no idea where the money is going”. I am respectfully questioning this opinion, in light of the company’s past achievements and its expansion plans.

Invest or Return ?

“It is our belief that shareholders should demand of their management either a normal payout of earnings (…) or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per-share earnings”
B. Graham, The Intelligent Investor, Chap.19

The question of whether it is better to reinvest a dollar into the business or distributing it do the business owners is usually best answered with the return that this dollar achieves when reinvested. If the shareholders can achieve better returns by other investments, or if incremental investment into the business does not increase returns, it is usually better to return money to shareholders.

I think shareholders should not be too concerned over Chaoda’s investment plans. Chaoda has already heavily invested in its growth in the past, and the results achieved have confirmed these investments were indeed profitable. Just look at the growth in book value per share over the last decade:



Albeit small, Chaoda has also paid a dividend to shareholders over all these years. Including dividends, the per-share book value of Chaoda has increased over 22% per year in 2002-2010. While the growth in book value has not been as high over the last year, the long-term track record is more than satisfying. Given these numbers, the valuation given to Chaoda’s stock by the market is remarkable."

A thirsty stock

"If you own a farm and you have a drought once every 10 years, you don't mark down the value of your farm 30% the year of the drought." Warren Buffett

Current headlines in the agricultural sector highlight the severe drought that China is currently facing. While the drought is mainly concentrated in the wheat-growing northern part of China (away from Chaoda’s production bases which are mainly in the south-east), it seems Mr. Market did not heed Warren Buffett’s advice. In fact it marked the value of the farm down even further, by over 50%. One year ago, Chaoda was trading at 9.45 Hong Kong dollars (HKD), today the stock is traded around 4 HKD, and Chaoda has paid dividends in between as well.

stock price
What is the current valuation of Chaoda? At 4 HKD and with 3.12bn shares in issue, the market values the company at 12.5bn HKD or 10.5bn RMB. That is a little more than half the book value (net assets) of the company, and only three times last year’s earnings and 1.5 times last year’s revenues (and remember the company has a 50% net margin!). The cash on the balance sheet alone makes up 30% of the market capitalization – and this is a company with an equity ratio exceeding 90%. At the current price, the operating cash flow of around 3.3bn RMB provides a yield of about 16% on the equity. This value even goes up to 19% if the 13.5% equity stake in Asian Citrus (OTC:ACTFF) (worth around 1.3bn RMB at the current share price, and not contributing to operating cash flow) is backed out.

Price to 2011 H1 Book value

0.6

Price to 2010 FY Earnings

2.9

Price to 2010 FY Revenues

1.5

2011 H1 operating cash flow yield

15.7%

2011 H1 operating cash flow yield,
excluding Asian Citrus stake at market value

19.3%

Dividend yield

1.5%

The market obviously believes that Chaoda will grow no more, and all its current investments are useless. While it is certainly true that China is building a lot of overcapacity in many sectors, the growing of vegetables does not really strike me as an area where overcapacity is a looming problem. With international concerns over food supplies, a lot of potential domestic overcapacity will probably still find many happy buyers abroad.

Chaoda’s largest shareholder is the founder and chairman, Mr. Kwok Ho. He holds around 20% of the shares, aligning his interests with other shareholders. His commitment to the company, along with the prudent and conservative balance sheet (over 90% equity ratio, 3bn RMB in cash) give me great confidence that buying shares in Chaoda at around 4 HKD is an investment with very little downside, but tremendous upside potential. I am happy to buy this green giant for the price of an ugly dwarf.

Source: Chaoda Modern Agriculture: A Green Giant for the Price of a Dwarf?

Additional disclosure: I am long H-shares of Chaoda Modern Agriculture (Ticker 0682 in Hong Kong)