High on the Hog: An Interview with Zhongpin's Senior Management

| About: Zhongpin Inc. (HOGS)

Only certified processors will be able to slaughter hogs under new government regulations that take effect from the start of August. Nasdaq-listed Zhongpin Inc (NASDAQ:HOGS), the seventh largest meat processor in China, is among those poised to benefit from the new rules. The China Perspective talks to executive vice president Ben Baoke about the company’s position in the market and its plans for the future.

Where is Zhongpin ranked in terms of China’s pork production sector?

The company is the seventh largest meat processor in China in terms of 2007 sales revenue. Out of these top seven processors, three focus on poultry products. Zhongpin’s product mix consists of over 270 unique products, including chilled pork, frozen pork, pig by-products, prepared meats and fruits and vegetables, among which chilled and frozen pork accounts for the majority of total capacity as well as total revenue. The company operates ten processing plants in Henan, Heilongjiang and Sichuan provinces and in the Economic Development Zone in Tianjin City. It distributes its pork products through an experienced sales team and a large network of agents in 24 provinces, including four cities with special legal status.

Tell us more about your key products.

Chilled pork is chilled – but not frozen – between 32°F (0°C) and 39.2°F (4°C) immediately after it is cut and packed and thereafter maintained at that temperature during storage and transportation. This serves to preserve the freshness and quality of the meat; chilled pork has better taste and more nutrition than frozen pork and room-temperature pork.

Frozen pork is frozen at -31°F (-35°C) to -40°F (-40°C) for 48 hours, after which it is stored or transported at a constant temperature of between -0.4°F (-18°C) to -13°F (-25°C). Customers include processing companies, food distributors, wholesalers and exporters. Processed pork, also named prepared meat, is ready-to-eat food, such as sausages, ham and Chinese cured hams.

Which segments have the strongest growth potential?

Among these three kinds, chilled pork leads the industry and will remain the focus of our product mix as it accounted for over 51% of total sales in 1Q 2008. The gross margin of chilled pork is relatively stable and surging hog prices can be easily transferred to customers. Our state-of-the-art vertically integrated supply chain, as well as our advanced knowledge in producing these kinds of products, justifies the company’s recent expansion plan, which will increase capacity by 150,000 metric tons to 471,560 metric tons on an annual basis until year end 2008, excluding the contribution from our OEMs. Over 60% of the added capacity will be dedicated to chilled pork production.

Additionally, advances in refrigerating storage techniques and the stronger presence of supermarkets in China are boosting consumption of low temperature prepared meat products. This market is less competitive than high-temperature prepared meat foods. We are also building a new facility in Changge City to produce 28,800 metric tons of prepared meats. Once completed in September 2008, the new plant will increase our prepared meats capacity to 54,000 metric tons per year.

Can you tell us more about your distribution network?

The company has established distribution networks in 24 provinces including four cities with special legal status, covering key target markets in the north, east, south and southern midlands of the PRC. Zhongpin has also formed strategic partnerships with leading supermarket chains in the PRC. As of March 31, 2008, the company had developed a robust retail network comprising 114 showcase stores, 929 “branded” retail stores and 1,903 supermarket counters. In addition, the company also exports products to the European Union, Southeast Asia, Russia and South Africa.

Where do you see the most potential for growth in the near future?

The company bases its production in Henan, Sichuan, Tianjin and Heilongjiang provinces, most of which are large agricultural provinces and have large bases of hogs and piglets feeding. Henan province, where the major facilities are located, as well as its adjoining provinces, are anticipated to be China’s fastest growing market in the future. Approximately one-third of China’s population lives in this so-called Greater Central China area, which indicates a huge market for pork consumption. Retail industry development and life-style advances in recent years will facilitate the recognition and popularity of low temperature meat in this area.

Do you export your products and, if so, where to? What effect does the ongoing poor perception of the safety of Chinese food have on your exports?

We export products to the European Union, Eastern Europe, Russia and South Africa, which accounted for 2.1% of total revenues in the first quarter of 2008. Zhongpin is known for its high quality products and we meet global standards of quality. We apply strict quality control standard throughout our production, no matter if it is for export or domestic market. Our customers include the PRC-based subsidiaries of many well-known multinational corporations, which should demonstrate that our quality has met or exceeded international standards. Both our domestic and overseas customers have strong confidence in our product quality.

New pork processing industry regulations take effect at the start of August. How will these affect your company?

We view this as a positive for Zhongpin as the new regulations will definitely speed up the modernization of the pork processing industry in China and encourage the transition from the traditional wet market to modern “dry” market processing. We expect that some processors who cannot meet the national standard will eventually leave the industry and consumers will have better access to safer and healthier pork products. As a leading meat and food processing company that utilizes state-of-the-art equipment and advanced technology in our production, we believe the new regulation will enable us to seize opportunities for further expansion and increase our market share, especially in second and third-tier cities

Pork prices have been extremely volatile in China over the last few years. What impact has this had on your profitability and what are your expectations for the near future?

Actually, the tight hog supply relaxed in the second quarter, resulting in reduced hog prices. Reduced cost pressures relieved meat processors from raising sales prices and, therefore, pork prices will remain relatively stable if there are no significant unexpected events. Since the company’s major products, chilled and frozen pork, have a stable gross margin, our bottom line will not deviate far from management estimations in the future.

What are those estimates?

The management expects to achieve a gross margin of 12.6% to 13% as reported in the Company’s guidance for the year 2008. We have not released our guidance for 2009.

When do you expect to complete your new factories, and how will this increase your total production capacity?

The new factory in Luoyang City had already started production at the end of June and the Shangqiu plant will begin operations by the end of the fourth quarter of 2008. These two plants will increase our capacity of chilled and frozen pork to 471,560 metric tons, excluding outsourcing from OEMs, equivalent to a 42% year-over-year growth rate.

In September 2008, a new facility in Changge City with 28,800 metric tons of prepared meat will start production, which indicates our capacity will increase 114% to 54,000 metric tons per year after completion. Our annual production capacity of fruit and vegetables will increase by 114% to 56,280 metric tons when a facility in Changge comes on-line by the end of this year.

How much do you source from your OEM partners?

Our OEM partners have the capacity to produce 37,440 metric tons of chilled and frozen pork per year. However, since the fourth quarter of 2007, we have stopped outsourcing from our OEM partner as our own production facilities came on-line gradually.

Fruits and vegetables make up a very small percentage of your sales. Is this a legacy business or something you hope to significantly expand in hopes of becoming a real revenue driver?

Given the seasonality of the fruit and vegetable business it helps us increase the utilization rate and operating efficiency of our cooling storage and cold-chain system. This diversifies our product portfolio and provides some raw materials for certain prepared meat products, which contain both meats and vegetables. It also strengthens our relationship with the government and local farming community. For example, last year we received a grant for $1.2 million from the central government for our new pollution-free fruit and vegetables processing facility, which we are building in Changge. It will come on-line by the end of this year. Once completed, our production capacity in this product line will increase by 114%. However, it will remain a small percentage of our total revenue.

Lastly, going forward what are the key areas management is most focused on in terms of growing the business?

We are at the critical forefront of industry modernization and consolidation. We will certainly focus on expanding our production capacity, improving our utilization rate and ultimately increasing our market share in this highly-fragmented industry. Through our aggressive marketing campaign, we strive to increase our “Zhongpin” brand awareness and build customer loyalty. We also believe in growth through product innovation, for example pig by-product deep-processing and new lines of prepared meat products. These products represent higher added value to the consumers, bringing in more profit for the company and more value for our shareholders.

Stock position: None.