Yongye's Cost Discrepancy

| About: Yongye International (YONG)

A cost analysis of Yongye International, Inc. (NASDAQ:YONG) focusing on its animal nutrient product shows that the company's filings with the U.S. Securities and Exchange Commission (SEC) are self-contradictory. Specifically, shipments and product costs as stated in the audited annual reports cannot be reconciled with claims about product content, material costs, and gross margins.

In short, Yongye's disclosures imply that its animal nutrient product, selling at about $6,000/ton, is 40% fulvic acid that costs about $40,000/ton, resulting in the absurd inference that this very profitable product sells at a gross loss of at least $10,000/ton.


According to Yongye's SEC filings, the company sells two products - a crop nutrient product (sometimes referred to as a plant nutrient product) and an animal nutrient product [pages 5 and F-9, FY2011 10K filed 2012/03/15]. The crop product is a "brown liquid," while the animal product is a "grey particle [sic] and powder" [Product Standard, Exhibit 10.6, 8K filed 2008/04/22].

However, the "major production processes for [the] crop and animal nutrient products are identical" [page 13, FY2011 10K filed 2012/03/15]. The "core compound" of both products is "fulvic acid" extracted from "humic acid," which is in turn derived from coal, so manufacturing primarily involves the extraction of fulvic acid and then blending it with other ingredients [page 12, FY2011 10K filed 2012/03/15].

Yongye states that the extraction and blending processes and the final composition formulas of its products are based on its two patents [page 12, FY2011 10K filed 2012/03/15]. Both the crop product patent [CN 100383093, SIPO] and the animal product patent [CN 1951208, SIPO] do indeed specify identical manufacturing steps and input materials for the extraction process from coal to concentrated "FA," or 黄腐植酸 (translated by Yongye as "fulvic acid" in the English version of the IMARSTB assessment posted on its web site). The patents also quantify the fulvic acid content in the final products - about 5% ( ≥ 50g/L) of weight for the crop product, and about 40% (35-45%) of weight for the animal product.

In December last year, an article published on Seeking Alpha questioned Yongye's reported product costs. It estimated that the company's disclosures imply about $50,000/ton (about $2,500 for about 50 kg) cost of the fulvic acid component of the crop product. It then showed, using readily-available online prices for humic/fulvic acid, that Yongye was likely overstating its fulvic acid cost by a factor of up to 50x in its financial reports in order to mask inflated revenues and justify its low cash balances. In its response, Yongye did not refute the article's cost estimate - instead, Yongye emphasized that its products contain "high-grade" fulvic acid that somehow required expensive "top-quality" input material, humic acid, in large quantities [Q. 27, Yongye's Investor Relations FAQ].

However, that explanation appears to contradict Yongye's own patents which list low-grade coal and commodity chemicals as the inputs in the steps of fulvic acid extraction and therefore imply low cost of manufacturing. In fact, the IMARSTB assessment, cited as an authoritative source in Yongye's annual report [page 4, FY2011 10K filed 2012/03/15], praises Yongye's low-cost technological approach to fulvic acid production that has finally enabled "manufacturing effective fulvic acid at reasonable price."

To further address Yongye's response, this cost analysis extends the work presented in the December article. Rather than relying on external public sources (such as raw material prices in China and Yongye's government fertilizer license), it is based exclusively on Yongye's own filings with the SEC. Any additional public information, such as patent texts or statements made on earnings calls or in the FAQ section of Yongye's Investor Relations site, is only used to clarify and confirm the specific claims in the SEC filings. By focusing on the fulvic acid content and the reported cost of its product, the analysis demonstrates that Yongye's own official disclosures are mutually incompatible.

Yongye's SEC filings cannot be reconciled

By examining a set of four disclosure pieces in Yongye's SEC filings, it can be shown that the animal product is both profitable and unprofitable. The implication, therefore, is that those disclosures (and the SEC filings that contain them) are mutually inconsistent and cannot be relied upon. The analysis is organized in two parts. The first part lists and describes the disclosures that cover reported shipments (in dollars and tons) by product and overall product cost, amount of fulvic acid in the two products, overall humic (fulvic) acid cost, and gross margin by product.

The second part shows the seven simple calculation steps that use the numbers in those disclosures to arrive at the above conclusion - once the overall unit cost ($/ton) of fulvic acid is obtained in the first three calculation steps, then it is straightforward to show that just the fulvic acid component of the animal product exceeds its selling price.

List of disclosures

1. Reported shipments and product cost

Table 1 lists sales in dollars and tons by product as well as overall product costs and gross margins, as disclosed in Yongye's 10K filings.

Table 1. Shipments and costs

Table 1. Shipments and costsClick to enlarge

* Note that the animal product shipment reported for 2008 (6 tons) is clearly false - the number appears understated by a factor of 100x, as detailed elsewhere.

2. Fulvic acid content of Yongye's products

The amount of fulvic acid in Yongye's crop or animal product, or the weight of fulvic acid in a ton of each product, can be estimated by examining the specification forms in the "Product Standard" exhibit from Yongye's JV cooperation agreement [Exhibit 10.6, 8K filed 2008/04/22] (note that prior to a restructuring in 2009, the products were manufactured by Yongye's JV partner using the same equipment and processes [page 9, FY2011 10K filed 2012/03/15]).

According to the form titled "ShengMingSu for Plants," the crop product contains ≥ 50 g/L "water-soluble humic acid." Yongye's Investor Relations FAQ page clarifies that the company uses the terms "fulvic acid" and "water soluble humic acid" interchangeably [Q. 27, Yongye's Investor Relations FAQ]. One liter of the crop product is about 1 kg since the product is mostly water, therefore, there are about 0.050 tons of fulvic acid in a ton of crop product, or, in other words, fulvic acid accounts for about 5% of the crop product weight.

According to the form titled "ShengMingSu for Animal," the animal product contains ≥ 40-60% "Humic acid (calculate [sic] by butt [that is, volume])." The wording is rather suspect, given that the "core compound" in both products is supposed to be fulvic acid extracted from humic acid (see the background section above). However, the Chinese term for "fulvic acid" in Yongye's patents, 黄腐植酸, also translates as "yellow humic acid" in English.

The percent of volume should be similar to the percent of weight given the high content of the fulvic acid in the product. In fact, as noted in the background section, the animal product patent explicitly specifies fulvic acid content of 35%-45% of weight. So, there are about 0.4 tons of fulvic acid in a ton of animal product, equivalent to about 40% fulvic acid content.

3. Fulvic acid cost as share of overall product cost

According to Yongye's communication with the SEC, humic acid accounts for over 50% of the cost of goods sold. Since Yongye's finished products actually contain fulvic acid extracted from humic acid, rather than "raw" humic acid (see the background section above), fulvic acid accounts for over 50% of Yongye's cost of goods sold.

Note that according to Yongye's 10K filing, starting in 2011 the company has been "able to extract humic acid and fulvic acid in-house from lignite coal and no longer rely on humic acid from intermediaries" [page 12, FY2011 10K filed 2012/03/15]. However, despite the estimated 20%-30% profit margin for its previous humic acid supplier, the humic acid cost (and, therefore, fulvic acid cost) remained over 50% of overall product cost (cost of goods) as late as the third quarter of 2011 - the disclosure is dated 2011/07/21.

4. Similar gross margins

Yongye does not report gross margins for the crop and animal product separately on periodic basis, but did disclose contract prices (paid to its manufacturing JV partner, essentially equivalent to product costs) and the corresponding selling prices in effect prior to the 2009 restructuring [page 10, 8K/A filed 2010/01/04]. Those prices (in RMB, per "case" of product) are shown in Table 2. Note that the product cost numbers in the table include not just the "raw material and supplemental material fee" but also a "non-predictable fee" of 10% of cost, and a "manufacturing overhead fee" of 30% and 15% of cost, respectively [Breakdown of Fees, Exhibit 10.6, 8K filed 2008/04/22], indicating a room for some gross margin improvement upon restructuring, but the improvement would have been roughly similar for both products.

Table 2. Gross margin prior to restructuring

Table 2. Gross margin prior to restructuring

In fact, after the restructuring process was completed, Yongye's CFO confirmed on an earnings call in 2010 that the gross margin for the two products have remained similar [23min:00secs, FQ1 2010 earnings call dated 2010/05/14]:

Q: Could you please break out the gross margin for your [crop] product vs animal product?

A: The margins are very similar for those two products.

Q: So both had 50%- ... 56%...?

A: Yeah, same range, 55%... Animal - a little bit lower, but not very different.

Detailed calculation steps

The actual calculations performed here cover only year 2011, but the results are similar for prior years (except for 2008, due to the misreported tons of animal product tons shipped)

1. Cost of fulvic acid

The implied fulvic acid cost is at least $80 million in year 2011, calculated from the product cost in Disclosure 1 by applying the 50% (or higher) fulvic acid share of product cost from Disclosure 3 { $162 million x 50% }.

2. Tons of fulvic acid in shipments

Yongye's 2011 reported shipments contain a total of about 2,000 tons of fulvic acid (about 1,700 tons of fulvic acid in the crop product and about 300 tons of fulvic acid in the animal product), calculated from the respective tons in Disclosure 1 and applying the respective fulvic acid content (percentages) from Disclosure 2 { 33,179 tons x 5% + 683 tons x 40% }.

3. Cost of a ton of fulvic acid

Implied fulvic acid cost in year 2011 is over $40,000/ton, calculated by dividing the dollar cost from Step 1 and the tons from Step 2 { $80 million / 2,000 tons }

4. Cost of fulvic acid in a ton of animal product

Over $16,000, calculated by combining the result in Step 3 with the claim in Disclosure 2 that there is about 0.4 tons of fulvic acid content in a ton of animal product { $40,000/ton x 0.4 tons }.

5. Average selling price for animal product

About $6,000/ton, calculated by dividing the animal product sales by the tons shipped from Disclosure 1 { $4.2 million / 683 tons }.

6. Animal product cost per ton

About $3,000/ton, which is the number that results in the 50% gross margin from Disclosure 4 given the ASP from Step 5 { (1-50%) x $6,000/ton }.

7. Contradiction: animal product gross profit cannot be both negative and positive

A ton of animal product sells for about $6,000/ton, per Step 5, but just the fulvic acid in it costs over $16,000, per Step 4, resulting in a severely negative gross loss of over $10,000 for each ton of animal product shipped. On the other hand, each ton of animal product shipped brings a gross profit of about $3,000, per Step 6. As a result, the calculations based on the numbers in Yongye's disclosures end up in a contradiction - the animal product is unprofitable and profitable at the same time. Therefore, Yongye's disclosures cannot all be correct.

Can the cost discrepancy be explained away?

One could blame the discrepancy on mistranslation and argue that the animal product uses some kind of other, cheaper fulvic acid, and therefore its cost could be considerably lower. Or, in other words, 0.40 tons of fulvic acid in the animal product could cost considerably less than 0.05 tons of the "cheaper" fulvic acid in the crop product. However, that would contradict Yongye's claim that the fulvic acid in both products is manufactured using identical processes. Moreover, the exact same term, 黄腐植酸 (fulvic acid), is used in both patents to describe the core product ingredient, and the patents also list identical steps and materials in the extraction and refining from coal (or humic acid) to concentrated fulvic acid. And, yes, the content label on the actual animal product packaging explicitly states "黄腐植酸 ≥ 40%."

Alternatively one could argue that Yongye simply made an inadvertent mistake in one of it disclosures, but that the rest are correct. For example, if the animal product is not 40% fulvic acid, then all the other three pieces of disclosures can be reconciled. However, that would mean that Yongye's actual product labeling is false and that Yongye is not producing the animal product according to its patented formula (thus, violating another disclosure in its SEC filings - see the background section). Or if the humic acid is less than 50% of Yongye's cost of goods sold, then the remaining three disclosures can be reconciled, but that would mean that Yongye intentionally misled the SEC in its written response to a direct question.

Lastly, if the gross margins of both products are not similar, then a highly-profitable crop product, constituting 99% of revenues (see Table 1), can offset the loss from the animal product, and the other three disclosures can be reconciled again, but that would mean that Yongye's CFO intentionally misled investors on an earnings call in his response to a direct question by an analyst.

Finally, one could dismiss the disclosure discrepancy as immaterial since the animal product now accounts for just 1% of revenues. It would also explain why the discrepancy has remained unnoticed for years. However, the differential between the $10,000 gross loss and the $3,000 gross profit in Step 7 is $13,000, so the potential impact of about $9 million { $13,000 x 683 tons } on income from operations appears material given than Yongye reported $106 million income from operations in 2011.

Disclosure: I am short YONG.