China Yingxia: Private Placement, Smaller Franchises Dampen Bullishness

Aug.27.07 | About: China Yingxia (CYXI)

China Yingxia International (OTC:CYXI) released its Q2 earnings recently. Before the earnings release, the company also completed two rounds of sales of common shares to a total of 23 private investors. So I think this is a good time to share some of my new thoughts on this company with my readers.

The company has delivered a solid quarter with revenue growth of 59.8% and net income growth of 20.9%. Revenue and net income for the quarter were $5.2M and $2.5M, respectively. But of course, what´s of real interest to us is what lies ahead.

Overall, the company's growth picture for the next few years still seems to be quite good. The company still stands by its projection of 1000 franchise stores by the end of this year and over 5000 by the end of 2009.

The company needs to add 500 franchise stores in the year to make the target of 1000. It has already added 150 stores in the first half, bringing the total to 650 at the end of second quarter. With 350 more stores to add for the second half, starting in Q3 the management is rolling out an incentive program for existing franchisees to bring in new franchisees. Franchisees who introduce new franchisees will be given 10% of commission. Besides, on the 28th of each month the company will be holding a franchisee recruiting campaign.

However, it should be noted that the first 75 franchisee stores introduced before 2006 still accounted for 44% of revenue for the first half of 2007. In comparison, the 425 stores added in 2006 contributed only 36% while the 150 new stores added this year accounted for only 11%. Simple math should tell you that, on a per-store basis, the original 75 stores (introduced before 2006) outsell the 575 stores added since 2006 by a factor of 7.18 to 1.

Admittedly, the new stores added since 2006 need time to ramp up to full sales capacity. But common sense tells me that this would only be able to explain a small fraction of the 7.18 to 1 disparity. The bulk of the disparity has to be from some type of inherent superiority of the original 75 stores. I figured this must be due to the store size difference.

A follow-up call to the company indeed confirmed this. The original 75 stores are mostly at the provincial or regional level. The newer stores are generally smaller, sometimes even family-operated stores. What this means is that we cannot expect revenue growth to be proportional to store growth.

Another implication of the generally smaller stores is that not all of the stores will survive. Note that the revenue percentages of the franchise stores listed above added up only to 91%. The balance 9% was contributed by inactive stores, those which have failed to endure. Consistent with the revenue percentages, the company expects the franchisee retention rate to remain above 90%. The franchisee retention rate is the percentage of active stores, i.e., those who place reorders within three months.

From 2007 through 2009, the company projects revenues of $15M, $22.784M, and $32.385M, respectively. On a year-over-year basis, the revenue growth would be 78.6%, 51.9%, and 42.1% for 2007, 2008 and 2009, respectively.

In my previous post, I noted that due to the contribution from their new organic functional rice W3660 (for renal and diabetic patients), the company´s revenue is likely to surpass $20M this year. I know you might be taking issue with this prediction now. However, when you assume Q3´s revenue to be just the same as Q2's (company has anticipated Q3 to be slightly higher than Q2) and Q4's revenue the same as last year's Q4, you arrive at a whole-year revenue of $15.2M.

Then the company has reiterated the revenue potential from W3660 rice to be about $10M. So it was obvious to me the $15M projection has not accounted for much of the W3660 contribution. A call to the company's Chief Accountant Mr. Chen confirmed this. He was trying to be conservative and has only put $1.04M of revenue contribution from W3660 in the 2007 estimate.

(By the way, I always have a high respect for conservative accountants like Mr. Chen.)

Since the W3660 rice will be harvested in November, there remains a possibility part of the sales will occur in early 2008. But barring a natural mishap or disaster, it still appears to me $20M remains a realistic target for the present year.

Gross margin was 55.68% for Q2 and 54.88% for the first six months. Despite the negative impact from some of the lower-margin products (mainly personal-care and NestleTM products) introduced in the second half of 2006 and earlier this year, it should be clear from these numbers that the overall gross margin remains quite impressive. The company expects the W3660 rice and soybean milk and yogurt products (to come in the second half) to have higher margins compared to the aforementioned lower-margin products.

CEO Mrs. Yingxia Jiao also revealed that they are eyeing a pharmaceutical company and a drink company as acquisition targets. This is an indication that the company is seriously implementing its strategy of diversifying its product portfolio, as mentioned in one of my previous posts.

In terms of overall growth picture, the generally smaller size of the new franchise stores has slightly dampened my bullishness on this company. But by and large the company still appears to be on track, at least for the next couple of years.

However, a big turn-off to many individual investors is the company´s recent two rounds of private placement, which sold 10.725M shares of common stock. The shares were sold at $1 per share; besides each common share also comes with half a share of warrant with exercise price of $1.5 or $2. The shares alone represent a 31.9% of dilution; and if all the warrants are exercised the dilution is as much as 47.9%.

To me this is stunning and overdone. The company should have considered other financing options, for example, a loan from major Chinese banks, issuing bonds, negotiating a better term, or taking the financing in steps, and so forth.

I totally disagree with Mr. Alan Sheinwald's argument (on the Q2 conference call) of the stock offering being the cleanest form of financing for small companies, and the benefit of allowing institutional investors to participate in the company´s growth. But obviously it does not really matter what I think or say. Isn't Mr. Sheinwald's argument indeed the philosophy behind the so-called Private Investments in Public Equity [PIPES] these days?

As an individual investor though, I do not call this PIPES. Instead I call it BBF, or Big-Bath Financing. Whatever you call it, individual investors should always bear in mind that this is indeed one of the major risks investing in small companies, particularly those listed on OTC BB!

Disclosure: I do not have a position on CYXI as of this writing. This writing is not a recommendation to buy or sell CYXI shares.