After repeated failed attempts to elevate itself from its second-tier dairy company status in China, Feihe International Inc. (ticker: ADY) is now in a dire financial situation. The company is losing market share in its core milk powder market. Recent management missteps have destroyed a key strategic operating segment which we believe will drastically reduce ADY's ability to compete effectively in China dairy market and to raise substantial doubt about ADY's ability to continue as a going concern. Our valuation analysis reached a price target for ADY of $1.75, 72.5% lower from yesterday's close price of $6.35.
· Upstream (i.e. dairy farms) ownership and management represents the new paradigm shift in China's modern dairy industry that has been forced to become increasingly quality driven. US private equity firm KKR's $150 million investment in Chinese dairy farms and Mengniu Dairy's recent talks of acquiring China's largest raw milk producer China Modern Dairy Holdings (a pure play dairy farm company) are just two examples highlighting China dairy industry's urgent push to secure quality raw milk supply in the aftermath of the tainted milk scandals. Unfortunately for ADY, it inability to compete and manage effectively in this key area has forced ADY to sell its dairy farms which are considered long-term core competence for most domestic Chinese dairy companies, leading to a very bleak future for ADY in our opinion.
· To avoid working capital deficiency ADY was forced to sell valuable assets including the strategically important dairy farms. Successive missteps in strategic and investment decisions by management have drained the company's cash position to a scant $2.6 million by the end of Q2 2012. It now has $52.6 million of near-term debt obligations due, including $46.7 million of short-term bank loans that mature between August 30, 2012 and December 31, 2012.
· If ADY cannot "milk" growth even in the Year of the Dragon, then next year the Year of the Snake will certainly bite ADY's bottom line deeply. We expect ADY to experience negative revenue growth and significant operating losses as infant formula sales begin to "normalize" in 2013.
· ADY is losing market share in its milk powder business - its primary revenue stream. In a growing overall market, ADY's first six-month 2012 milk powder sales in quantity actually decreased by 458,000Kg YoY to 9.9 million Kg from 10.4 million Kg.
· ADY's gross margins and earnings are much lower when adjustments are made to measure pure operating performance. ADY's extraordinarily high above-industry gross margins can be shown to be inflated once proper adjustments are made to better categorize its costs and expenses. When normalized for government subsidies, ADY's 2Q12 adjusted net income shows a YoY decrease of 55.4% versus a company reported 11.5% increase in net income.
· Three different auditors in less than two years, CFO and VP Finance both unqualified for US GAAP, and self-admitted material weakness in its internal control over financial reporting expose US investors to high financial accounting risk. Yesterday's after-market announcement of an ADY board member's resignation is just another sign of ADY's weak and unstable corporate governance.
· We expect negative top line and bottom line growth and significant cash flow problem for ADY starting in 2013 if not sooner as ADY faces heavy financial burden and core structural challenges ahead. Our comparative valuation analysis reached a price target for ADY of $1.75, 72.5% lower from yesterday's closing price of $6.35.