Agfeed Industries: An Early Chinese Pork Play

Considerable interest has been generated on Seeking Alpha on how to capitalize on China’s shortage of pork, leading to suggestions of investment in Smithfield Food’s (SFD) to Zhongpin (ZHNP), a meatpacker and retailer. However, there may be another play that takes advantage of the increase in pork demand without the risk of higher pig prices that Zhongpin (ZHNP) might experience which could dampen its revenue growth.

On August 29, Agfeed Industries (FEED) commenced NASDAQ trading under its new symbol, FEED. Given China’s pork demand, I am profiling the company as a potential investment opportunity .

The profile is drawn from news reports, Agfeed’s website and the company’s SEC filings from 2006-2007.

History

Agfeed Industries' initial business subsidiary, Nanchang Best, was founded in 1995 as a Chinese animal nutrition company by its current CEO. In October, 2006, by reverse merger, it became a Nevada corporation, and acquired a second Chinese animal nutrition company that same month. In December, 2006, FEED acquired a third Chinese company for about $1.1 million. These three subsidiaries form Agfeed’s current operations.

Business

Agfeed researches, produces, and sells feeds for the Chinese livestock industry, primarily in 10 provinces of eastern China. It operates three subsidiaries: Nanchang Best located in the province of Jiangxi, Shanghai Best in Shanghai City, and Guangxi Huijie in the province of Guangxi. The three produce blended and pre-mix feeds for the pork, poultry, and cattle industries. The largest business segment is swine feed and approximately 10% of revenues are generated by poultry feeds.

Industry and Market

China's animal feed market was valued at approximately $40 billion in 2006 according to China Feed Industry Association. It is expected to be a $50 billion industry by 2010. The Annual Report on China’s Feed Industry, published by the Chinese government, estimates that the market for premium baby pig feed is approximately $3.8 billion per year.

The June 07 Chinese consumer price index report announced that food costs increased by 15.4% YTD primarily due to a pig shortage. Given the resulting higher pork prices, Agfeed’s baby piglet products are in high demand, especially as farmers begin breeding for Chinese New Years pork demand. Almost half of Agfeed’s 1H 07 revenue was generated from its 1Q 07 introduced pre-mix feeds designed for piglets that reduces their growth cycle time from birth to market weight by up to seven months, a key to increasing pork availability and alleviating Chinese food price inflation.

Management

Every member of Agfeed’s management team has an advanced degree in either Business, Accounting, or Animal Nutrition. The Board Chairman Songyan Li, Ph.D, has his doctorate in animal nutrition. The CEO, Mr. Junhong Xiong, who founded Agfeed’s predecessor, Nanchang Best, has degrees in animal nutrition and business and 15 years experience in the industry. The Agfeed website details the rest of the management team.

Governance

In addition to its Chairman and CEO, Agfeed has three independent board members with extensive experience in Chinese and U.S. business, the U.S. securities industry, and in animal nutrition. John J. Egan, Jr., was former Chairman of the Philadelphia Stock Exchange (1998-2003). Mr. Masucci has over 45 years of experience in financial, accounting, manufacturing, and distribution management. Since 1991, Mr. Masucci also has served as Chairman and principal of Montgomery Capital Advisors which provides guidance to clients in strategic and operational planning. The third new member, Dr. Lixiang Zhang, Ph.D., is a leading expert in animal nutritional science and management consulting in China. In 2005, he was named a Top Ten Enterprise Strategist and in 2004, a Top Ten Best Management Consulting Expert by the Chinese Government.

Additionally, Agfeed has two technical advisors, Mr. Nicholas Giordano, CPA, another former CEO the Philadelphia Stock Exchange [PHLX] from 1981 through 1997. He also served as Chairman of the Stock Clearing Corporation of Philadelphia and Philadelphia Depository Trust Company. Bud Harmon, PhD, is an Emeritus Professor of Purdue University where he was the Head of Animal Science Department. Previously he was Director of Swine Research for Purina Inc. Since 2000, Dr. Harmon has visited China more than ten times as Chief Scientist of USDA Emerging Market Program. He has worked with the swine and feed industries in 15 provinces across China.

Strategy

Agfeed has primarily engaged in five business development activities detailed further below, adding new products, expansion of franchise and wholesaler sales networks, growth by acquisition, and entering into a future planned international joint venture. Additionally, an Agfeed strategic objective was to list on NASDAQ.

If successful in business acquisition, integration, and creation of operational synergies and efficiencies, then Agfeed has strong corporate potential as a consolidator of the fractured Chinese animal nutrition industry. According to Agfeed’s 10K, a recent China Animal Feed Industry Development Report stated the blended feed market for pork was approximately $12 and $14 billion for 2004 and 2005, respectively. The largest player in the market has approximately a 7% market share, and forty companies share the top 33% of the market. From 2000 to 2005, blended feed sales have grown at an average annual rate of 4.5%.

In 2005, the pre-mix swine feed market in China totaled $1.45 billion and contained over 2,500 companies. From 2000 to 2005 pre-mix swine feed industry sales grew at an average annual rate of 14.3%. There is no single dominant market participant, with the largest player in the market realizing only 1.2% market share.

From this synopsis, it seems Agfeed has a significant opportunity to create a national presence and capitalize on consolidation of other animal nutrition companies by acquisition. It also has strategic opportunity to add new products, geographic coverage, and create additional production capacity to enable it to achieve its targeted 20% profit margin and revenue growth.

Business Execution 2006-2007 YTD

To date, Agfeed has:

1) Successfully consolidated its acquisition of Guangxi Huijie into its operations,

2) Created 300 of 500 of its planned franchise feed stores,

3) Added wholesale distributors to its commercial feed sales force,

4) Completed two private equity placements which generated over 9 million in cash for future development,

5) Added three independent board members with considerable finance and market securities and animal nutrition expertise,

6) Got Agfeed listed on NASDAQ,

7) Introduced new products that are in high demand.

8) Achieved a 20% profit margin for this last quarter, a stated corporate goal.

It seems management and corporate governance, through demonstrated strategic and operational business execution, are capable of building the company into a larger enterprise with higher revenue and market value.

Financial Performance

Revenue and Net Income:

Agfeed’s 2006 consolidated revenues were $8,594,876 for the twelve months ended December 31, 2006, an increase of $983,031 or 12.9%, compared to $7,611,845 for 2005. FEED’s net income for 2006 was $1,175,280 compared to $560,706 for the twelve month period ended December 31, 2005, an increase of $614,574 or 110%. In 2006, Agfeed realized .07 EPS.

FEED’s business execution is evident in its 2007 YTD results. As of June 30, the company had achieved $11.86 million in revenues and $2.24 million in net income, a 183.5% gain in revenues and a 332% increase in net income over the first six months operations of 2006. Moreover, net income for 1H 07 was more than double reported for FY 2006, and is .09 EPS YTD.

Liquidity and Debt:

As of June 30, Agfeed had about $9.2 million in cash. It had used approximately $1.3 million in the last quarters operations, however $620,000 of that was for a good faith deposit on an acquisition, which if due diligence is satisfactory, will close in 2007. About $1 million has been used to pay loans that financed the December, 2006 acquisition.

Agfeed carries $1.8 million in 4 bank loans, of which about $750,000 matures in 2007 and the remainder in 2008. The company believes it will fund 2H 07 operations, product expansions, and debt repayment from its operating revenues, and net proceeds from already completed two private placements. Additionally, Agfeed is budgeting $3 million from those proceeds for a potential 2008 acquisition.

Outlook:

Agfeed management states it expects to achieve approximately $36 million in revenue in 2007 with estimated net income of $7.2 million. If realized, it would represent a 400% increase in revenue and 600% increase in net income over 2006.

Given performance to date, it seems possible the company will fall short of its revenue target, but is likely to realize $32-35 million. It holds a better probability of achieving its net income objective of $7.2 million.

Future Business Development

1) New products: Agfeed continues to invest in new animal feed product development such as its 2007 introduction of Arubao Series of blended feeds for piglets.

2) Sales Network Expansion: In January 2007, Agfeed decided to create a network of 500 franchise chain stores to sell its products throughout China. By August 10, over 300 franchise stores have already opened to serve small farmers in 10 Chinese provinces. Additionally, the company plans to expand its wholesale dealer network from 500 to a 1,200 by year end 2007 to sell products to commercial-sized pig farms across China.

3) 2007 acquisitions: Agfeed has already deposited $620,000 to acquire an animal feed company in 2007, for which it is currently conducting due diligence. If the company meets expectations, the transaction is expected to close in 2007.

4) A 2008 acquisition: Agfeed has already budgeted $3 million from its private placement proceeds to make another acquisition in 2008.

5) International Joint Venture: Management is in talks to create an international joint venture, perhaps in 2007, if not 2008.

Share Performance and Price Projections

With the issuance of its initial 8 million shares, reverse stock acquisition, and 2:1 share dividend in fall 2006, Agfeed began 2007, with 24 million shares issued, trading at $2.01. Share dilution has occurred as a result of private placements, with a total of 27 million currently listed. Outstanding shares are substantially held by company management, board, and private investors, including Apollo Management. As a result, management’s interests are aligned with the investors since Agfeed’s officers and directors hold 29% of the existing issued stock.

As of Sept. 6, the stock traded as high as $9.00, and currently traded at $7.12 this morning, a 354% gain YTD. However, these gains have been made on thin volumes, with a daily volume average of 7,260 shares since its open on NASDAQ.

Investing in Agfeed does come with risks, a factor to consider for a stock currently trading at a 61.16 P/E. One should read the latest FEED 10Q for the management list of investment risks.

On an EPS basis, the company reported $.04 for 2005, $.07 for 2006, and $.09 for 1H 07, of which $.06 was reported of the last quarter. If estimated for FY 2007, it is possible Agfeed will report EPS between $.20 to .28, substantially more than double reported for 2006.

Given the company’s revenue growth, acquisition prospects, expanded sales network, and implied commitment from management to not pursue a strategy of stock dilution to finance growth into 2008, the stock has potential for further increases in value and price on an F/PE basis. While management has not provided guidance for 2008, it seems reasonable Agfeed will double revenues and income in 2008 over 2007, to an EPS of $.40 to $.56. Assuming a 20x to 30x earnings for 2008, the 1 year target price seems to have a potential trading range between $8.00 to $16.00, based upon either a conservative or aggressive growth model. Given its business achievement to date, a moderately aggressive assumption would have the stock trading at $12 per share by 3Q08.

Given the overall strategic position of the company, its management strength and strong governance and advisor teams, and given the high and increasing market demand for its piglet and swine feed products, the company seems to be an interesting investment opportunity in China’s animal nutrition industry.

Disclosure: Author is a shareholder based upon the long term growth prospects of FEED.