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ZhongPin: No Fraud at All, Target Price $40

|Includes:Zhongpin Inc. (HOGS)
ZhongPin: No Fraud at All, Target Price $40
 
Zhongpin was close at $6.74 with a trailing PE of 3.6, a forward PE of 2.76, PEG ratio of 0.23 (Source: Yahoo Finance http://finance.yahoo.com/q/ks?s=HOGS+Key+Statistics), as a fast-growing Chinese Food company, this such a low price tells us only one thing, like CER, GEO ,Jefferies and some individulals stated, it is a fraud.
Is that a fraud for Zhongpin? Absolutely Not and it will deserve the 20X PE at a target price of $40.
There are 2 focus articals to elaborate how Zhongpin ‘could’ be fraudulent, let me summarize them and try to dig into those allegations to see how poor those ‘researches’ are.
1)      CER: Zhongpin: Where Are the Pigs?
·         Zhongpin claims it purchases 1.1mil hogs from large breeding farms in Henan annually, but the farms say only 81,000, 93% less than Zhongpin’s reported figures.
·         The company claims more than 1,200 retail stores in major cities in Henan, but detailed checks in all five cities failed to find more than 83.
·         Zhongpin claims to sell through more than 2,000 supermarkets nationwide. But in Henan, Zhongpin’s most important market, only 51 supermarkets were found to carry Zhongpin brand products.
·         Evidence collected indicates slaughterhouse output is insufficient to sustain reported totals, and based on anecdotal evidence could well be only 50% of reported output.
 
2)      GEO: Overstated Income, Excessive Capex and Deceptive SAIC Filings
·         Overstatement of SEC net income vs. SAIC filings by nearly 500% in 2009.
·         GEO estimates 2010 net income of $10-20 million vs. $58 million reported to the SEC.
·         Deliberate manipulation of SAIC filings.
·         Likely diversion of almost $150 million of reported capex.
·         Inconsistent trends between inventories and sales.
·         Repeated capital raisings, despite assurances to investors that none were needed.
·         Capex concerns already noted by Roth Capital resulting in downgrade.
I do not want to spend more time on the CER article, it doubts on the no. of stores and pigs based on things like ‘but in Henan,51 supermarkets were found to carry Zhongpin brand products’, how many days has the author been in Henan Province and did he/she know how big it is? Since the CER’s allegations are full of shit, just ignoring it by now.
Let us focus on the GEO’s big findings, it used some data, graph, looked relative professionally; as you really looked into those findings, they are wildly guess only and all the conclusions are wrong. The GEO’s findings covered 3 items:
1)Capex is much higher than peers’, noted by Roth Capital, Jefferies as well;
2) Overstated net income compared with SAIC filings all the time;
3)Repeated capital raisings
WHAT IS THE AVERAGE CAPEX PER TON IN PORK INDUSTRY?
We take a look at the Capex from GEO in a glance first:
Table 3 - Capex per Ton - HOGS vs. Peers
Company - Year
Capex per Ton
People's Food - 2005 (Source: 2005 People's Food Annual Report)*
$262
China Yurun - 2008/2009 (Source: Dec. 2010 Jefferies Report, pg. 8)**
$338
Shuanghui - 2008/2009 (Source: Dec. 2010 Jefferies Report, pg. 8)**
$328
HOGS 2006 - 2010 (Source: HOGS Annual Reports)
$682
HOGS 2011 - 2012 Est.
$515 (based on Table 4 Total)
Source: GEO
Table 4 - Zhongpin Planned Capacity Increases - 2011/2012 cost per ton**
 
Incremental Capacity (000s Tons)
Capex
(millions)
Capex per Ton
Taizhou, Jiangsu Province
130
$63
$484
Changchun, Jilin Province
125
$61.5
$492
Tangshan
102
$49
$480
Tianjin
36
$21
$583
Changge, Henan Province
100
$58.5
$585
Totals
493
$254
$515
**Source: June 30, 2011 Annual Report by GEO
The first thing here is the capital expense per tons is widely different by segments in meat industry. There are 4 major products: chilled meat, frozen meat, low temperature meat product (LTMP) and high temperature meat product (HLMP), the first 2 products are mostly produced by the slaughtering line then go with being chilled or frozen; and the last 2 are produced on different lines. As the company claims it has a capacity in upsteam business like to slaughter 100M heads (75,000 tons), the cost could be widely different due to the proportion of its product being chilled or frozen. Jefferies report quoted by GEO does not distinguish all the differences.
The 2nd thing, most important point here, the data from Jefferies and GEO are widely wrong. Here is Peers’ Capex / Tons:
THE CAPEX/TONS FOR PREPARED PORK
SHUANGHUI: n Shuanghui 2010 Annual report Page 34:
Invest 172 Million RMB (26 MM) on a prepared pork project of the 120 tons per day (43.8 K tons) which means $595 per tons.
This is almost the same with Zhongpin’s Tianjin’s project of 36,000 tons with cap of 21MM,
LTMP/HTMP Project
Incremental Capacity (000s Tons)
Capex
(millions)
Capex per Ton
Shuanghui:
44
$26
$595
Zhongpin
36
$21
$583
Source: annual reports
That is average cost / ton for prepared pork is around $590; Zhongpin has 308,000 tons capacity built and in progress, which needs the cap of around 182 MM.
THE CAPEX/TONS FOR CHILLED/FROZEN PORK
The No.5 brand ‘DELISI’ was IPOed in earlier 2010 for one project of capacity of 200M heads (approximately 150,000 TONS) annually with cap of 189 MM RMB (USD30MM ), $200/ton, half with chilled and half with frozen pork.
The average cost of 100M heads slaughter line with all chilled and frozen products is around 130 MM RMB currently in China (this is most popular average industry cost per tons for chilled and frozen pork), which means the average cost is $275/tons; this amount will be different among different cities due to the different land right use cost.
Zhongpin has the capacity of 838780 tons both built and in process, which needs Caps between 167MM to 230 MM. Zhongpin states they invest the most efficient plant (their plants has the highest utilization rate at 77%, so assume the total cpaex for upstream business is 230MM.
The total invest Capex is $ 412 MM; compared with total funds from the raising activities $432, there is no obvious difference.
Table 5 - Zhongpin Capital Raising Activity - 2006 to 2011
Raise Type
2006
2007
2008
2009
2010
2011
Cumulative
Combined
Equity (net long term debt, millions $)
23
63
0
57
0
66
209
$432*
Debt (net long term debt, millions $)
0
12
43
32
49
87
223
Source: GEO
The 3rd point with Jefferies data is that the Shuanghui and People`s food are focusing on the downstream businees, also Shuanghui buys most of products from its parent company so that the products in tons were not produced by itself. THEY ARE NOT COMPARABLE AT ALL AS A WHOLE COMPANY.
The CapEx in Zhongpin is reasonable and in line with peers, the doubt from GEO is because they are lack of the common sense in pork industry.
IS THE NET INCOME OVERSTATED?
GEO states: revenues between PRC and SEC filings are in line that is good; no need to prove how the revenue makes sense by comparing with peers. So how about the gross margin or net income?
Let us take a look what UBS was saying on Aug 15, 2011:
The margin gross for Shuanghui is based on the consolidation between Shuanghui and its parent company; the gross margin for Zhongpin is in the middle of the first 5 brands, which corresponds to its sales ranking.
As we breakdown all the sales into chilled, frozen, LTMP (low temperature meat product) and HTMP (high temperature meat product), we will find all the gross margin by segment among each company are all in the line as well.
Provided the revenue and gross margin are reasonable, for a simply business like pork,
it is pretty straight forward to get the net income, which was easiest part for audit firm.
 
Source: UBS Investment Research date: 20110815
DRINK BLOOD by Repeated capital raisings?
Somehow! The capital raise for one company which has PEG of 0.26 is supposed to be repeated. The only thing is that the management should be shy to state that and also need to consider raising the funds from other market, like China or Hong Kong.
Valuation:
Now we take a breath to recall what the logic for `if fraud`: the revenue is OK, the capital expense is OK, the gross margin is OK by compared with peers; the net income is OK derived from above OKs.
What else for lower valuation? Excuse of shorters. Can you image the floats of one stock was shorted by 1/3 based on analysis like GEO and others’?
I do not either want to spend too much time on the valuation, the EPS estimation from most analysts are pretty close, like range $1.84-$2.01; I am pretty optimistic with the EPS of 2011, the brand 1 and 2 company, Shuanghui and Yurun are experiencing the food safty issue now, Shuanghui reported a loss in 2nd quarter and Yurun will have this negative impact since the 3rd quarter; Zhongpin will beat the analyst’s esitmaiton in the 2nd half of 2011, I will say it like at least $2.1.
How much PE ratio will you give it if there is no any fraud concern for one Chinese food company? I will give it 20, so the target price for me is $40, I dare not say it will be reached in 6 months or 36 months, because the price is not based on ‘valuation’, is based on ‘supply/demand’, the shorters absolutely can dump it to $5 or even lower if they ‘create’ the ‘demand’ in such a circumstance of shorting China.


Disclosure: I am long HOGS.
Stocks: HOGS