Seeking Alpha
Long/short equity, growth, value, contrarian
Profile| Send Message|
( followers)
In the past couple of years, hundreds of small Chinese companies entered the U.S. capital market by way of reverse mergers. However, the lack of quality among these companies in general has created a negative perception that they are risky plays. Given that most reverse-merger stocks start as microcaps, it is indeed quite easy to understand why this is so.

One the other hand, the elites within this group have performed extremely well and often made their way straight into major U.S. stock exchanges. Savvy investors have been able to profit handsomely from these superb reverse-merger Chinese issues. Just take a look at China 3C Group (CHCG.OB). Since I wrote about it in mid January at $4 per share, this stock has almost doubled by now. When counting from last October’s intraday low of $1.08, this stock has multiplied by more than 700%. The company is aiming to be listed in a major U.S. exchange by the end of the year.

Right, CHCG investors have made a bunch. But clearly the easy money has been made. So your question is who would be the next CHCG. That was my question too. And after a little study, I think I have cornered a candidate.

Before you read on, remember that you should take this as nothing more than a lead for your further study. Whether it could be the next CHCG, you, not me, should be the judge. Moreover, the term “next CHCG” can mean different things to different people. In particular, if you are expecting a 700+% multiplication in less than a year that certainly is too far away from what I could promise. You won’t find that type of savvy in me!

The Company and Its CEO

With that said, here is my vote: China Yingxia International, Inc. (OTC:CYXI).

cyxi company headquarter This nutraceutical company (inset is company headquarter) has been able to capitalize on the vast Chinese population’s crave for health food. Its major product lines include solid foods and liquid drinks or alike that are based on soybean, millet, cactus and organic rice (which meets government-endorsed “green food” standards). These products are sold in the form of powder, tablets, meals, salads, chocolates, energy bars, milks, or other drinks. They can be served as regular meals, nutritional supplement, weight-loss diet, disease prevention or treatment diet, etc.

Besides these major product lines, CYXI also sells air purifiers, water purifiers, cosmetic products, and various NestleTM products (chocolates, instant meals, coffees).

CEO (and CFO) Mrs. Yingxia Jiao is a nurse-turned entrepreneur. She was a top-ranking nurse and then Union chief in a hospital she worked for more than twenty years. In 1998 she abandoned her medical career and founded Harbin Yingxia Group, now a wholly-owned subsidiary of CYXI.

Partly helped by her healthcare experience and academic and family background in Chinese medicine, her enterprise quickly learned how to make health food products that are liked by Chinese consumers. The success has earned Yingxia Group and Mrs. Jiao herself numerous awards and recognitions on the national and provincial levels. It has also won her several leadership positions in several provincial associations.

Most recently, Mrs. Jiao became one of the ten entrepreneurs who won the 2006 “Child of the Earth” award granted by the Chinese Ministry of Agriculture. This award honors entrepreneurs whose success has greatly benefited the rural communities.

As of the end of 2006, the company sold a total of 186 products. These products are distributed and sold through regional distribution centers and franchise stores. Franchise stores are further categorized as either flagship stores (large and standalone) or retail outlets (small or stores-in-stores). As of the end of 2006, the company had a total of 500 stores consisting of 18 distribution centers, 42 flagship stores, and 440 retail outlets. Only 60 of the stores were owned by the company, the balance being owned by franchisees.

Why It Can Be the Next Champion

CYXI could be the next CHCG simply because of the similarity in growth trajectory between the two.

Recall that CHCG had 150 stores-in-stores in FY 05, 800 in FY 06, 1200 (projected) in FY 07, and finally 4000 stores (projected) in FY 2010? CYXI had 73 stores on Aug. 1 2006, 500 by the end of 2006, is projected to have over 1000 by the end of FY 07, and over 5000 stores by the end of FY 09!

There are definitely obvious differences between CHCG and CYXI. CHCG owns its stores, while CYXI mostly does not. CHCG sells electronics, while CYXI sells health food products. But these differences should have impact mainly on the sales volume rather than growth rate.

A less obvious but important difference between the two is that CYXI’s products sell at a much higher gross margin of 50+% vs. CHCG’s below 20%.

Industry Background

A lot of investors shy away from nutraceutical companies. You do not have to join them, at least not in this case. Behind CYXI’s phenomenal growth is China’s immense health food market, which is slated to grow at an annual clip of 17% through 2015 when the market size will reach some $32B.

The Chinese have a deep-rooted culture of believing in “medicine and food from a common source.” They have a tradition of eating “medical meals” to strengthen health. Nowadays, one can easily find Chinese web sites that recommend recipes and cooking techniques for medical meals. In recent years, the Ministry of Health has even begun to set standards on what crops or plants (mostly traditional Chinese medicines) are appropriate for consumption as both food and medicine.

As such, it is fair to say that there is a strong cultural driving force for the growth of the Chinese health food industry.

Although CYXI’s health food products appear more food biased than medicine biased compared to their traditional Chinese medical meal/food counterparts, the fact they look closer to the regular food products might make them even better absorbed by the market in the end.

Competitive Advantages

Besides capitalizing on the “medicine and food from a common source” culture, CYXI has strived to differentiate its products through intellectual properties and R&D initiatives.

The company currently holds three patents on nutritional supplements, weight-loss supplements, and cactus based nutritional drinks, respectively, all set to expire in year 2024.

The company’s research capability also includes a post-doctoral station.

The company has developed its manufacturing processes either internally or through international and domestic collaboration efforts. It has forged ties with an Australian company and several Chinese universities and the Chinese Academy of Agriculture.

These collaboration efforts have borne fruits from time to time. Early this year CYXI has just secured an exclusive right to commercialize a technology for producing a special kind of rice suited for renal patients and diabetics. It is this type of uniquely high tech products that will enable the company to maintain pricing power and avoid margin erosion in a fiercely competitive environment. Management seems to have a clear understanding about this.

These measures allow CYXI to differentiate itself in a highly fragmented industry with no clear leaders. This industry has more than 3000 players. But now CYXI falls into the top 1.45% companies having net assets in excess of $15M. Furthermore, the aforementioned franchise expansion plan is likely to allow CYXI to stand out among the top 1.45% elites.

As its domestic footprint expands, CYXI also has plans to diversify its product portfolio and enter international markets. The company has identified the following industries to diversify into: cosmetics, biomedicine, chemicals and agriculture. It also sees this as a way to increase investment returns. For international markets, the company will target Southeast Asia, Russia, and Middle East first before attempting more mature markets.

Financial Highlights

CYXI has a solid balance sheet that has no long-term liabilities and intangible assets of any sort. With a very low level of leverage, equity accounted for 92.6% of the total assets as of end of Q1. And the current ratio was a healthy 3.75.

For FY 06, inventory turned over every 61.6 days and A/R (accounts receivable) turned over every 14.7 days, giving rise to a full operating cycle of about 76 days. Obviously this company has good overall financial health.

Revenue for FY 06 grew by 35.85% to $8.4M. Earnings growth was largely distorted by a huge amount of tax credit and one-time expense associated with last year’s reverse-merger deal. But the net income grew by 190% to $5.34M. And the corresponding ROE was 32.8%. Today’s (Monday 7/9/07) market close of $2.45 trades at a paltry P/E of 7.4 against FY 06 earnings (EPS=$0.33)!

To fairly assess last year’s financial performance, however, I have removed the impact of both tax credit and reverse-merger expense. Moreover, I have also assumed that the company was provisioning income taxes at its regular rate of 33% for both FY 06 and FY 05. This resulted in an adjusted net income of $2.14M and $1.83M for FY 06 and FY 05, respectively. After this adjustment, net income grew by 16.7% at an ROE of 14.6% (against adjusted average equity). The adjusted EPS for FY 06 is now $0.12; and the same market close of $2.45 now corresponds to a P/E of about 19.7.

So the “real numbers” for FY 06 were not exactly spectacular. But to see the whole picture of CYXI’s business fundamentals the following needs to be noted.

1. Adjusted earnings (in FY 06) grew slower than revenue mainly because of heavy discount of new products to gain market awareness (along with the fact that there was no R&D expenditures in 2005). CYXI introduced 104 new products to the market in FY 06.

2. As one can see from the store expansion initiative mentioned above, FY 06 marked the beginning of a fast multi-year business expansion period. “Real earnings” in such years inevitably understates underlying business fundamentals.

Similarly, the valuation ratios (e.g. P/E) in such years inevitably portrait a pricier stock than actually is. Take CHCG as an example. Even at last October’s intraday low of $1.08 a share, the P/E against previous fiscal year’s (FY 05) earnings was 27. Now even after the stock has multiplied by more than 700%, the P/E ratio is still only 32 against FY 06’s EPS. Furthermore, forward P/E is actually only 14.3 to 15.4 based on company’s projected EPS for FY 07.

3. The income tax benefits for Chinese companies who qualify as a foreign-owned entity are for real, huge and long lasting.

Look at CYXI itself. By way of a reverse merger, it has not only gained access to the U.S. capital market but also secured seven years of special tax benefits. Income taxes for the four years 2004 through 2007 are exempted completely. For the three ensuing years, 2008 through 2010, the company is entitled to a 50% reduction in tax rate.

Essentially the company is using the tax dollars (or RMBs) given back by the government as capital for business expansion. This enables the company to enjoy great investment return during a transition period when organic growth is still unfolding and needs time to find its way to the bottom line. As seen above, in FY 06 the company essentially used that free capital to boost ROE from an otherwise low 14.6% to a high 32.8%.

4. We are seeing the power of franchise business model at work with CYXI. In this model franchisees commit capital on the stores, while both the franchiser (OTC:CYXI) and the franchisees reap the benefit. Franchisees own and operate the franchise stores and become the franchiser’s customers and partners.

Owing to the power of this business model, CYXI will only need to (1) invest in production capacity, and (2) increase SG&A to acquire and maintain franchisees. The company has made significant capital investment in new plants and equipments in recent years (particularly in FY 06). This will help moderate the capital requirements in the next few years.

The great combination of immense growth, savings from income taxes and avoidance of franchise store capital together should help the company maintain a decent level of ROC and ROE (ROC=ROE when there is no debt) in the next few years. In a simple model I built, ROE would dip to below 20% in FY 07 and FY 08 from last year’s 32.8% for two reasons.

1. The huge amount of retroactive tax credit enjoyed in FY 06 is now absent.
2. The capital expenditures in the past will now find its way into amortization expense.

But in FY 09 ROE would ramp up to about the FY 06 level. In 2010 ROE would even shoot past 40% level. After 2010 when the regular tax rate of 33% comes back, ROE would still remain in the 20% to 40% range, depending on gross margin and growth rate attainable at that point.

My model assumed that it would take three years for a new franchise store to get up to full sales capability. And it did not go beyond 2012 due to the impaired visibility in the distant future. But roughly speaking, it seems reasonable to conclude that ROE will stay at respectable levels for the next 5 or so years, thanks mainly to the combined effects of enduring tax benefits and the great growth being engineered by the management.

Of course, a model is just a model, nothing more. So you can be sure CYXI’s actual financial performance in the next few years will differ from whatever my model says. But the key point is that CYXI would be able to maintain a decent ROE even when the time comes for the income tax benefit to go away completely.

Thus, CYXI’s growth is likely to be accompanied by an ROC that is much higher than the cost of capital (for the foreseeable future). And that is the kind of growth that will create (rather than destroy) value for the enterprise and shareholders.

Weak Link

If you ask anyone who has studied this company about what he/she dislikes about it, he/she is very likely to tell you that it is the company’s “loans to related parties.” What we are talking about here is the management’s practice to extend loans to a few privileged franchisees to cover the startup cost of new franchise stores. These loans are interest free, unsecured, and have no fixed repayment dates.

So far the company has been successful in collecting these loans in less than a year. But it is understandable why investors frown on this liberal loan practice.

Fortunately, as mentioned previously, this company had a very efficient A/R turnover cycle of only 14.7 days as of FY06. And as of 3/31/2007, A/R totaled only $1,464. This effectively leaves a good buffer for any possible bad debt on the “loans to related parties.” Besides, in view of the company’s past success in collecting those related-party loans, I do not see this as a red flag or alarming issue.

However, I do view this loan practice as a weak link over the long run. What the management could do in the future is to partner with a financial institution to offer financing to qualifying franchisees. In doing so, all qualifying franchisees (not just the selected few) would have access to capital. And when franchisees have easier access to capital CYXI would be able to expand faster. It can also focus on its core competence without being bogged down in chasing the debtors. Financial institutions would also reap profit from this partnership. In the end everybody benefits and CYXI would have turned a weak link into strength.

Possible Low Market Correlation

As this bull market ages, I’m getting more alert to a severe correction or outright bear market. So, besides building cash positions, I tend to be in stocks that I think likely to have a low market correlation.

It appears to me that stocks that have experienced spectacular gains are likely to be vulnerable to major declines should a major market correction strike. Take CHCG as an example. It has multiplied 700+% in nine months. In recent months its swings are getting wider (making it a perfect trading stock), particularly following the massive insider divestiture (9. 625M shares or 18% of shares outstanding sold by two beneficial owners) two months ago. Judging from its down swings, it would not surprise me if it falls back to the $4 level in the event of a major market correction in the near future.

In contrast, I would expect a similar adverse market condition to have a much less impact on microcaps that have solid fundamentals but have yet to capture widespread attention, like CYXI. High-quality microcaps generally are not highly correlated with the general market and over time often produce superior returns.

Cautionary Remarks

1. This article represents only my personal opinion. The reader should not use it as sole basis for making buying or selling decisions. He/she should understand the risks involved. An incomplete list of risks follows.

2. The validity of the opinions expressed herein depends on if CYXI can fulfill its expansion projection in the next few years. Nobody can guarantee that will be the case. Only time can tell.

3. The prediction of a respectable level of ROC/ROE sustainable over the next 5 or so years are based on the assumption there is no severe erosion of gross margin due to cutthroat competitions. The model also did not consider the impact of economic cycle, loss of competitive advantages, and other catastrophes.

4. Microcaps are usually thinly traded, causing difficulty to buying and selling at desirable prices. CYXI is no exception.

5. As with many other microcaps (particularly other reverse-merger Chinese issues), the insiders own a majority and controlling stake in the company. That means outside investors virtually have no say in any of the company’s business decisions. Management’s interest might not be aligned with yours and they can make decisions that might hurt your interest. For CYXI, insiders (mainly Mrs. Jiao’s family and relatives) own 61.45% of the company.

Conclusion

CYXI appears to be on the road to exceptional growth for the next few years. Judging from its franchise based business model, the fantastic growth is likely to be accompanied by high ROE and ROC sustainable over the next five or so years. There is a great potential it will be the next champion in the reverse-merger Chinese microcap space.

Disclosure: As of this writing the author owns CYXI but not CHCG.

CYXI 1-yr chart

CYXI

Source: China Yingxia International: The Next Chinese Microcap Champion?