Feihe International (NYSE: ADY) is a leading producer and distributor of milk powder, soybean milk powder, and related dairy products in China. The stock price is not far away from a five-year low of $6.31 touched after the company reported its disastrous $24 million second quarter operating loss last year:
Fear surrounding the prior operating losses and high debt levels caused many investors to doubt that ADY will survive. However, we find ADY has a large asset base that is substantially undervalued on its books. Many of the assets are either not essential to their core business or amount to excess production capacity that can be easily sold. Selling these assets allows ADY to raise cash to pay down debt without affecting sales and actually boosting earnings, as we will show. Following the asset sales, ADY can easily refinance the remaining debt. The rapidly improving balance sheet, combined with strong earnings in 2011 and growing market share, prompted us to buy ADY at these depressed levels.
Recent sale of diary farms could improve bottom line and lower company’s leverage
ADY has two sources for their milk—small local dairy farms and its own dairy farms. Its contracts with numerous small dairy farms collectively give them access to 200,000 cows. Given that each cow can produce 4 tons of milk per year (stated in their SEC filings), total supply is around 800,000 tons per year. ADY’s own dairy farms, Gannan and Kedong, have a combined 17,000 Australian Holstein cows and a total milk production capacity of 140,000 tons per year. The company only sources about 30% of its milk from its own farms that are in fact not essential to the core milk powder production business. ADY built its farms in 2007 primarily to promote quality and brand image by designing them to state of the art international standards.
Unfortunately, dairy farming is a difficult asset-intensive business with fairly low returns. In 2010, ADY experienced substantially higher accounting losses on the disposal of under-producing cows from its farms. ADY lost $10.7 million in 2010 disposing of cows versus $1.7 million in 2009. Cows are also rapidly depreciated on the books, a fact that further contributes to net losses in this business.
In the difficult 2010 environment, the two dairy farms contributed 62% of ADY’s net loss while its core milk powder production business was actually profitable. For the six months ended June 30, 2011, the dairy farms segment contributed less than 3% of total net income. Selling the continuously underperforming farms appears to make good sense.
Furthermore, selling the farms would not significantly impact quality, as the company explained in its Q2 2010 earnings conference call. ADY collects milk from local farms through its own milk collection stations using its own equipment to test and control the quality of the milk. Government quality checks that have failed in the past have been expanded.
On August 1, 2011, ADY announced it entered into an equity purchase agreement with a local company to sell its two dairy farms for a total purchase price of approximately $131.8 million. The aggregate purchase price includes approximately $17.8 million in cash and $114 million payable in raw milk over the next 6 quarters. The dairy farm land is pledged to ADY as security for the exclusive raw milk supply agreement.
The sale of the two farms generates $17.8 million of immediate cash without affecting ADY’s core profit generating milk powder business. Since it is an equity sale the buyer will assume the farms’ debts as well. At the end of June 2010 ADY had around $18.7 million long-term debt attached to the farms that will now be eliminated. Interest expense could be reduced by around $1.2 million per year. More importantly, the elimination of biological assets will greatly reduce depreciation and disposal losses. In the first half of 2011, ADY incurred $3.5 million in depreciation of biological assets and a loss of $2.4 million on disposal of biological assets, a total savings of $5.9 million that can go straight to the bottom line.
Looking forward, management intends to focus more on producing better products and gaining more market share.
Combined with the cost savings, the company’s bottom line will greatly improve. Altogether, the increased earnings and cash flow drastically improve ADY’s liquidity. It is rare that we find a Chinese company that seems to be truly looking after shareholders’ interests and focusing on the bottom line and liquidity. Furthermore, ADY’s share count is actually being reduced by 2.6 million from 19.65 million to 17.05 million after factoring in the full redemption of Sequoia’s preferred shares, another huge boost to earnings.
Excess milk powder production capacity can be sold to further improve liquidity
ADY has 7 production and packaging facilities with an aggregate milk powder production of 1950 tons/day. Since the acquisition of its production facilities, ADY has considerably invested in remodeling and expansion of their production capacity. However, according to management, capacity utilization is only about 60%. ADY could raise significantly more cash by selling one or two of its excess facilities without affecting its production target.
Some of the milk production facilities are geographically and strategically very desirable to other dairy companies. The expanded and remodeled plants will likely sell for prices far above book value. Just one or two sales could allow ADY to repay its current liabilities in 2011 and eliminate the going concern risk.
Good access to credit facilities to roll over debt
ADY is one of the largest private companies in Heilongjiang province and enjoys many privileges from its good relations with local governments and banks. For such companies, carrying and rolling over large amounts of short-term debt is easy. ADY can easily draw on their $72 million unutilized credit lines (as of December 31st, 2010), obtain additional short-term loans on demand or roll over existing debt.
Management’s effort to improve operations and grow market share
Management has made major strides at moving ADY in the right direction. They have taken various actions to conserve cash, procure financing and improve liquidity, by actively working on reducing working capital deficits, through measures such as improving sales, accelerating collections and strengthening control on operating expenditures. They successfully closed unprofitable retail points and focused on areas with higher profits. These actions have resulted in the company’s last two quarters’ positive performance. According to recent market research by CIC, ADY was able to improve the market share of its key product sequentially and year-over-year. The market share has increased from 4.0% in March to 4.7% in June.
ADY reaffirmed its public guidance for $290 million in revenue and $22-24 million in net income for 2011. After the recent diary farm sales, we estimate ADY could easily beat on the bottom line due to interest, depreciation and operating expense savings discussed in this report. ADY’s share count is actually being reduced by 2.6 million from 19.65 million to 17.05 million after factoring in the full redemption of Sequoia’s preferred shares. Based on the current share price, the market cap of the company is only $111 million, less than 5x this year’s projected earnings. This distressed valuation should begin to improve as investors and analysts realize ADY’s greatly improving operational and financial performance.
A desirable and possible acquisition target
Lastly, ADY has resources that are very attractive to potential acquirers. Again, their newly expanded and remodeled production facilities are strategically located near milk farms. They have an extensive distribution network of over 80,000 retail points of sale, with a strong focus on China’s northern provinces and 2nd and 3rd tier cities, making them an attractive takeover target for multinationals seeking to expand their presence beyond China’s coastal and 1st tier cities.
Many Chinese companies we have shorted in the past focused on fabricating earnings to show continuous hockey stick growth, unnecessarily diluting their shareholders, leveraging their balance sheets and investing the proceeds in real estate or some other unrelated venture where only the insiders stand to benefit. ADY appears to be doing just the opposite.
How many other Chinese companies can you think of that have announced large asset sales, significantly reduced their shares outstanding, begun eliminating much of their leverage and gained real market share with earnings rebounding? We are buying ADY “powdered milk” at these levels. So is the Hillbilly Housewife.