IPO Analysis: Agria's Valuation Seems Way Off

On October 29, Bill Simpson wrote an analysis of Agria Corporation (GRO). The company priced its initial public offering of 17,150,000 American Depositary Shares (ADSs) at $16.50 per ADS. November 7 the stock fell 26.9 percent in its market debut. It closed November 9 at $12.70.

The text of Mr. Simpson's original writeup follows:

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Agria Corporation plans to offer 19.7 ADSs (assuming over-allotments) at a range of $14.50-$16.50. Insiders will be selling 5.5 million ADS in the ipo. Credit Suisse is lead managing the deal, HSBC, Piper Jaffray and CIBC are co-managing. Post-ipo GRO will have 65.5 million ADS equivalent shares outstanding for a market cap of $1.02 billion on a $15.50 pricing. IPO proceeds will be used to fund capital expenditures, for R&D and for general corporate purposes.

An entity co-controlled by Chairman of the Board and CEO Guanglin Lai and Director Zhaohua Qian will own 60% of GRO post-ipo.

From the prospectus:

We are a fast-growing China-based agri-solutions provider engaged in research and development, production and sale of upstream agricultural products.

Yes, yet another China ipo. GRO sells corn seeds, sheep breeding products, and seedling products. Corn seeds account for 48% of revenues, sheep breeding products 40% and seedling products 12%. Gross margins for each segments are: corn seeds 41%, sheep breeding products 73% and seedling products 79%.

GRO has access to 27,000 acres of farmland in seven provinces of China, of which approximately 23,000 acres are used for production of corn seeds, approximately 3,700 acres are used for sheep farming and breeding activities and the remainder are used for seedling production and research and development activities. Note that GRO does not own their own farmland, as apparently they are legally prohibited to own farmland. Instead they rely for the most part on contractual agreements with village collectives.

GRO owns 17,000 sheep and sells frozen sheep semen, sheep embryos and breeder sheep. Through the first six months of 2007, GRO sold approximately 14,400 tonnes of corn seeds, 10.6 million straws of frozen sheep semen, 4,980 sheep embryos, 1,760 breeder sheep, 14,400 Primalights III hybrid sheep and a total of 11.6 million seedlings. Seedling products predominantly include blackberry, raspberry, date and pine bark seedlings.

Sector - China's agricultural sector is growing; note, however, the growth has lagged China GDP growth in recent years. The agricultural sector accounts for 10% of China's GDP and has grown 8% average annually the past five years. China is the world's second largest corn producer accounting for 19% of worldwide-corn production. China has the largest sheep flock in the world at an estimated 171 million sheep.

Financials

$2 per share in cash post-ipo, no debt.
3 X's book value on a pricing of $15.50.

While corn seed still accounts for 45%-50% of revenues, corn seed revenues have been stagnant for 2 1/2 years now. Revenue growth has been driven by sheep breeding revenues and seedling products. Annual revenues have been: 2004 - $20 million; 2005 - $50 million; 2006 - $60 million; 2007 - on pace for $65 million. GRO has been profitable since 2002.

Note that revenues are seasonal with the June and December quarters annually being the strongest. As GRO sells barely any corn feed in the September quarter, that Q is by far the weakest. Expect a seasonally weak report when GRO releases their 9/30/07 quarterly earnings report.

2007 - Revenues appear on pace for $65 million, a 5%-10% increase over 2006. Gross margins should be 57%. GRO has very little operational expense as they contract with village collectives for most of the work, which is factored into gross margins. Actually looking at the strong gross margins here for GRO, I'd think these village collectives might want to consider adjusting their contracts! Operating expense ratio is just 6%. Operating margins should be 51%. Tax rate thus far has been 0%. However, it appears going forward GRO's tax rate on earnings will be in the 10% range, so we'll plug that percentage into 2007 earnings. 46% net margins, earnings per share of $0.45-$0.50. On a pricing of $15.50 GRO would trade 33 X's 2007 earnings.

Conclusion - $1+ billion market cap for a farmings operation that will book $65 million in 2007 revenues, just 10% higher than 2006? The net margins here are strong, but just 10% top line growth and nearly 14 X's revenues for an agricultural operation that has village collectives producing corn seed, sheep and seedlings for them seems awfully excessive. China ipos have been pretty hot in 2007 and we've seen a number of good ones. GRO looks fine as a company, but the valuation here seems way off. Most of the high multiple, highly successful China appears have been sector leaders benefiting directly from the urbanization and growing affluence of the middle class in China. While one could make a tangential case that GRO benefits from the growing China individual's affluence, it is still not a direct link.

This is a pass for me, as I've no interest in paying for a $1+ billion cap agricultural operation with $65 million in revenues. In range, this seems like a very lofty price to pay for an operation responsible for producing corn seed, various sheep breeding products and seedlings. Pass in range for me.