China Organic Agriculture's Recent Moves Bring Up New Questions

I've written quite a lot about China Organic Agriculture (CNOA.OB) and despite the fact that I do like the stock, I haven't found it in me to put money into the company. For while CNOA is growing at an amazing clip, two things keep bothering me:

1) Its recent management shuffle resulting in a company without a CEO; and
2) The fact that all it does is produce organic rice, and nothing else.

Well, news in the last two days have directly addressed those fears. First, the company appointed Mr. Changqing Xu as CEO. In the past five years, Mr. Xu was the CEO of Hubei Tianjin, a food distributor, and has been involved with rice production and improving grain quality. Then Wednesday, the company announced that it is in the process of acquiring Huiming Trading, a food transportation company. This is a larger company than CNOA, as is clear when we compare their revenues:

2006 - CNOA: $0.1m versus Huiming: $40m
First half 2007 - CNOA: $6.4m versus Huiming: $24m

Of course, this was before CNOA's explosive growth starting in Q3 2007, and the company is currently projecting sales of $45m for FY 2007. In other words, CNOA is more than doubling its revenues through this acquisition.What about net income? We do know that Huiming earned a net of $2.6m in the first six months of this year, giving it a net margin of approx. 11%. Compare this to CNOA's projected FY 2007 net margin of more than 30%.

So therein lies one new worry. The proforma net margin of the combined entity would be much lower than now, and without details of the dilution involved with the acquisition, signs are pointing to it being non-accretive. Assuming a 50% dilution, I'm now estimating the fully-diluted proforma FY 2007 EPS of the combined entity to be $0.19. Compare this to the recently announced expectation that the company will earn $0.29 per share this year.

But there's an even bigger worry, and that has to do with the core identity of the company itself. It is quite clear that Huiming does not just transport organic foods. So can the company still be called China Organic Agriculture? Isn't CNOA's investment thesis closely intertwined with its organic strategy? Have investors bought one company only to realize that they have ended up with another? With these questions and uncertainties at hand, it is not surprising that the shares dropped by more than 23% on 12/12. This is a company with good fundamentals, but I suspect it needs to formulate its strategy with greater care.

My Position: None.

Comments

[Shanghai Advisor]

I respect OTC Player posts and thank him however I think he might have made a mistake in the revenue figures for CNOA. It's FY 07 revenues are about equal to Huiming Trading. Also Huiming is more than just transportation they also process and trade and allow CNOA to diversify into wheat and soybeans and cereal. Here's some financial from 10-K

CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDING DECEMBER 31, 2007 AND 2006

12/31/2007 12/31/2006
------------ ------------
Sales, net $ 44,500,003 9,002,345

Cost of sales 29,382,399 5,210,575
------------ ------------
Gross profit 15,117,604 3,791,770

Selling, general and administrative expenses 1,556,350 364,500
------------ ------------
Income from operations 13,561,254 3,427,270