Investors in Yongye International (NASDAQ:YONG) initially cheered the company's 4th quarter results released last week. The company beat expectations on revenues and earnings, and the stock initially traded higher. However, Yongye shares soon reversed, closing last week sharply lower despite the upbeat earnings announcement. Why the dour mood?
Behind the pleasing top-line results lurk several significant problems that raise red flags about the company's operations and profitability. The first of these issues is a seemingly impossible figure reported in Yongye's 10-k released last week:
Sales from Hebei increased 428% period over period in the second half year of 2010 and 111% year over year during the year of 2010.
Sales from Hebei were 20 million in 2008, and 29 million in 2009, and 61 million in 2010. So how could sales have soared 428% in the second-half of 2010 versus the second-half of 2009? It seemed impossible, however further research found that sales had first dropped sharply, making the 428% increase less impressive. In the 3rd quarter of 2007, the Hebei distributor bought $583k of product, in 3rd quarter of 2008, it bought $11.8M of product (a 2000% increase), in 3rd quarter 2009, it only $3.7M of product (a more than 60% decline), then in 3rd quarter 2010, Hebei's sub-distributors bought somewhere close to 428% more than $3.7M from Yongye's newly-acquired provincial level distributor (exact number unavailable; Yongye doesn't seem to have reported it).
I can understand some volatility in distribution ordering, however, this level of fluctuation is inconsistent with Yongye's reported network of retail stores. A retail model should result in steadily rising sales (note that since I used the same quarter's data for each year, seasonal demand changes are not an acceptable explanation), not wild swings in distribution from year to year. A 60% year over year decline in Hebei sales (2009 to 2008) does not make sense given the company's retail model. Other provinces including Inner Mongolia and Xinjiang had bizarre changes in sales volume inconsistent with the steadily-rising top line revenue growth Yongye International has reported.
Unfortunately, in some past reports (such as the 10Q for Q1 of 2009), the company only identified customers as "Customer A", "Customer B", etc. making it difficult to track quarter-by-quarter sales by province due to the fact that Yongye also appears to have changed distributors' customer labels between reports. While I can assume, for example, that Customer A in the Q1 2009 report is Hebei, I cannot be sure as it appears that Hebei was also Customer B at some points. After Q3 of 2009, Yongye seems to have quit releasing sales data by province on a quarterly basis, making it nearly impossible to check whether its reported sales growth is realistic.
Why would the company not release this information? One reason would be to obscure the fact that the company's sales apparently wildly fluctuate among distributors with huge spikes and large declines that cannot be explained due to seasonality. This brings into question the quality of Yongye's earnings. If their distributors sometimes order great quantities and other times hardly anything, it is hard to make solid projections about future earnings and cash flow. This could explain the company's unwillingness to offer a dividend, its need to raise so much more capital in 2009, and its surging accounts receivables and inventories. Yongye's distribution network remains a great mystery to its investors. Yongye should return to its old practice of reporting sales by province quarterly and also explain the reasons why its sales to specific distributors used to (still do?) swing so violently from quarter to quarter and year to year.
Another glaring problem is that the company doesn't seem to have enough employees. I highlighted this problem in my first article about Yongye. The problem has become worse since then, as Yongye's employee base increased by a scant 13 employees from the end of 2009 to the end of 2010. Additionally, the company has an unbelievably low number of sales & support staff given its tremendous growth in branded stores. The 2009 Yongye 10-K stated that:
We overlay this sales and support network on top of our store and distributor network in a way that our sales and support staff are project managers who oversee three to ten stores each depending upon their region and capability level.
Note this point: project managers oversee three to ten stores each. At the end of 2008, Yongye had roughly 1,125 branded stores and 153 employees and 65 sales & support staff employees. Therefore, at the end of 2008, there were 17 stores per sales & support staff employee. As you can see, Yongye's 2009 10-K appears inaccurate. However, the discrepancy steadily gets worse, moving from possibly just an error to something worse. At the end of 2009, Yongye had roughly 9,110 stores and 100 sales & support staff employees. Thus in 2009, there were 91 stores per sales & support staff employees.
At the end of 2010, the company had roughly 24,036 stores and only 114 sales & support staff. Thus, at the end of 2010, there were 211 stores per sales & support staff employee. This is a far cry from the 3 to 10 stores per project manager that Yongye told us was company policy just two years ago. Has Yongye radically transformed its sales & support methods? Can each of the 24,036 stores be productive given that each project manager now has to deal with more than 200 individual stores rather than the 17 they had to manage at the end of 2008? Or is it possible that many of the 24,036 stores simply don't exist, as was the case when China Biotics (OTC:CHBT) inflated its store count drastically? At best, it would seem that Yongye has radically overhauled their sales & marketing methods to no longer focus on individual farmer education and support without notifying investors of the change.
Another interesting question is how the company managed to double revenues in 2010 vs. 2009 while reducing the size of its manufacturing staff. Here is what the company's 10-K states:
The number of manufacturing staffs from 2009 to 2010 decreased by 18 employees, which were mostly contract employee. As we usually hire the contractors in manufacturing function for cost saving from 2010, these contractors would be dismissed during the winter time when our operation is in a relative low season.
While something may have been lost in translation, this explanation doesn't make sense. The company should need more manufacturing employees to produce twice as much revenue. The explanation that contractors are dismissed in the winter fails to shed light on the situation since the 10-K is filed at the same time each year. Thus the end of 2009 employee count should also reflect the fact that it was winter.
The company is also stonewalling investors who want to verify the company's customer base. The company has refused to release the location of the company's branded stores, and it has also chose not to name any of the company's distributors. When I spoke with CFO Sam Yu, he told me that the company knew the location of the stores but that the company wouldn't disclose them for competitive reasons. He said the important thing was that farmers could find the stores.
That seemed reasonable, however the company also refuses to name any of its distributors. It simply lists them as Customer A, Customer B, Customer C, and so on. This, of course, makes it very hard to verify the company's sales, since neither its store locations nor distributors are publicly available. As noted above, there are questions about the quality and reliability of these sales streams, and so presenting investors with merely a list that goes "Customer A, Customer B, Customer C, etc." does little to allay these concerns.
To add the opacity, Yongye has also not disclosed the name of the customer that ran the Hebei distribution company. Yongye purchased the customer list from this distributor in June 2010, but the seller identified him or herself. This is an apparent violation of SEC rules, which require the disclosure of the name of any owner of more than 5% of Yongye's outstanding shares. The Hebei distributor received 3.6 million shares of Yongye stock, and there are less than 50 million outstanding Yongye shares. Thus, the Hebei distributor would seem to need to reveal him or herself as a 5% owner in Yongye.
Why might the company be so reticent to disclose the name of any of its distributors, including the Hebei distributor? Simple: there is a chance that the Yongye International's customers are related parties. Here is Yongye International's corporate structure, as stated in its 2011 10-K.
Inner Mongolia Yongye Nongfeng Biotechnology Co., Ltd. is the operating company that produces the profits that are supposed to accrue to Yongye International shareholders. However, the company is frequently referred to as the "Yongye Group", including in the award that Yongye International claimed that it won in this press release Monday.
The Yongye Group logo appears on the Inner Mongolia Yongye Biotechnology website (link here), and not on the Yongye International website. Inner Mongolia Yongye Biotechnology owns a 5% stake in Yongye Nongfeng (Yongye International's operating company), but it appears to be an entirely seperate company whose website states that besides Shengmingsu, other key products include eco-tourism and the company's 3-star Monogolian-themed hotel. However, Inner Mongolia Yongye Biotechnology and Yongyeng Nongfeng share many of the same key personnel including corporate finance advisor Larry Gilmore and chairman Zishen Wu, and they also share the same corporate address.
Furthermore, in the conference call following Yongye's most recent earnings release, CFO Mr. Yu stated that CEO Mr. Wu is also head of the Yongye Group, and that the Yongye Group is introducing new products in the agriculture industry that are seperate from Yongye International's products. It would seem to be a glaring conflict of interest for a CEO to run two companies that compete directly with each other. Mr. Yu stated that the CEO Mr. Wu spent 95% of his time on Yongye International's affairs rather than the Yongye Group's affairs -- however, this is hard to believe since the Yongye Group operates so many different businesses including agriculture products, eco-tourism, and hotels that would seem to require a good deal of management attention.
It is unclear what corporate relation Inner Mongolia Yongye Biotechology (possessors of the Yongye Group logo), and Yongye International share with each other today given that Yongye Nongfeng was supposed to have acquired the Shengmingsu production facilities from Inner Mongolia Yongye Biotechnology in 2008. Yongye International's 2010 10-K stated that Inner Mongolia Yongye Biotechnology was no longer supplying finished products (Shengmingsu) to Yongye Nongfeng:
Upon Yongye Nongfeng obtaining its own fertilizer license, the Agreement [with Inner Mongolia Yongye Biotechnology] was terminated in July, 2009.
Is Inner Mongolia Yongye Biotechnology operating the distribution network for Yongye International's Yongye Nongfeng operating subsidiary? If not, then what is Inner Mongolia Yongye Biotechnology's relation to Shengmingsu? Shengmngsu is still listed as a product on Inner Mongolia Yongye Biotechnology's website (and the website has been updated in 2011, so stale information is an unlikely explanation.)
This seemingly great conflict of interest between the Yongye Group and Yongye International (Yongye Nongfeng) is a major red flag. In addition, it's suspicious that Yongye International refuses to disclose any names of its distributors including the name of the Hebei distributor it purchased the customer list from in 2010 who owns more than a 5% stake in Yongye International. I understand the company does not wish to disclose information that could benefit competitors. There is no reason that disclosing the Hebei distributor should harm the company, however, since that acquistion is already completed. In addition Yongye may be violating SEC reporting requirements.
In addition to the apparent violation of the rule that 5% owners of company stock must disclose themselves, Yongye also appears to be in violation of this piece of SEC Regulation S-K:
The dependence of the segment upon a single customer, or a few customers, the loss of any one or more of which would have a material adverse effect on the segment. The name of any customer and its relationship, if any, with the registrant or its subsidiaries shall be disclosed if sales to the customer by one or more segments are made in an aggregate amount equal to 10 percent or more of the registrant's consolidated revenues and the loss of such customer would have a material adverse effect on the registrant and its subsidiaries taken as a whole.
Yongye International has multiple customers which account for more than 10% of its revenues -- simply listing them as "Customer A", Customer B", etc.would seem to fail to meet the SEC's requirement to list the name of these customers. Yongye International needs to do something to prove it is credible, particularly since it declined to implement a dividend or share buyback after last quarter's better-than-expected earnings.
In a time when Chinese companies are being questioned in the wake of various scandals that have engulfed Rino International (OTC:RINO), China MediaExpress Holdings (OTCPK:CCME) and direct fertilizer-sector competitor China Agritech (OTCPK:CAGC), Yongye cannot afford to run such an opaque business with such glaring conflicts of interest. It must provide verifiable proof of independent customers, explain the relations between Inner Mongolia Yongye Biotechnology (Yongye Group) and Yongye Nongfeng, clarify the mystifying lack of employees for such a reportedly large business, and explain why sales to provincial-level distributors fluctuate so wildly.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.