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Managing Director w/ a multi-bb China-focused PE fund Living in China/HK for 10+ years Speak/read/write Mandarin
  • ADY: The Milk Has Gone Bad 1 comment
    Apr 8, 2011 7:50 AM | about stocks: ADY, CHBT, CCME, CBEH, KEYP, DGWIY, DYP, AMCN, BORN, CAAS, HEAT, DEER, HRBN, PUDA, SCOK, SEED, WATG, CSKI, CEAI, SYUT
    sa: chinadebunker
    chinadebunker@yahoo.com

    Highlights

    The situation is far worse than many envision…

    • ADY seems to have grossly misled US investors with its claims of superior product quality.  Serious safety and quality allegations have recently arisen in the PRC press. ADY’s ‘high quality’ and ‘reputable brand’ pitch appears questionable. It looks as though the company takes similar shortcuts as other PRC competitors.
    • SAIC and SEC-reported financial accounts do not remotely track.  Audited PRC financials filed with the State Administration for Industry and Commerce (NYSE:SAIC) indicate that ADY is grossly overstating its profitability and cash in its SEC filings.  These discrepancies raise even more doubts (beyond those raised by Deloitte in the most recent 10-K) about ADY’s ability to continue as a going concern. 
    • Sequoia, the ‘smart money’, has already bailed on ADY – does an insider’s abrupt exit usually portend good news? 
    • The infant formula market is already highly competitive and the operating/strategic challenges faced by ADY are only increasing -- ADY has not and cannot keep up.  PRC market leader (and direct ADY competitor) Beijngmate recently secured final CSRC approval to execute a RMB 1.8 billion new share offering. ADY ranks nearly dead last in market share, and is small and highly indebted player in a capital intensive business.
    • Investors should only accord only a conservative liquidation value to ADY’s common stock, i.e. less than $1 USD – the company is, or soon will be, insolvent; ADR holders stand to recover very little, if anything, should the company enter or be forced into receivership.

    Maggots in the Milk

    ADY has misled investors with its claims of superior product quality

    ADY has consistently defined its key advantage as offering superior quality product quality vs. other brands.  Sourcing milk from Heilongjiang province, if you are to believe management’s claims, confers some advantage (although many dairy brands source there; including competitors such as Beiyinmei).  Management describes in its filings its milk handling process which ensures quality and freshness. This is nothing more than a misdirection ploy directed as investors who don’t really have access to meaningful PRC market intelligence -- ADY has no operational results to tout, so it instead encourages the naïve to focus on its better milk and alleged market share.

    But PRC Chinese media sources reveal a story starkly at odds with the official company line. ADY appears to be currently facing very serious product safety allegations:

    • On February 24th local media outlets reported that a customer found maggots in Feihe product (http://news.e23.cn/Content/baby/2011-02-24/201122400178.html). Rather than address the concern in a constructive manner – i.e. report the matter to ADY corporate for formal investigation and possibly recall -- the local distributor alladegedly offered only a new box of infant formula as compensation – unbelievable? The individual alleging the tainted product, a Ms. Zhang, seems to think so and is quoted in the article as intending to pursue legal action against ADY
    • Allegations that ADY encourages product expiration date modification/tampering amongst distributors have been reported in the People’s Daily (not known for its loose standards or sensational reporting; shipin.people.com.cn/GB/9388707.html). The article cites authorized distributor sources as claiming that ADY required them to purchase date stamping machine for 500 RMB/unit in order to alter expiration dates on expired or soon-to-expire goods

    Post-melamine scandal PRC consumers are extremely sensitive to product safety concerns, especially when it comes to their children. These Chinese language articles would seem to indicate ADY does not enjoy the sterling reputation and superior product that it claims, on the contrary. ADY faces serious quality issues and takes similar shortcuts as its maligned PRC competitors, which is why the domestic PRC infant formula marketplace is largely dominated by multinational brands (people of means actually import their formula from abroad, that’s the level of mistrust).  According to PRC equity analysts (specifically Chinese language equity research by Sinolink Securites (国金证券所; a respected local shop who covers the dairy sector) ADY already ranks nearly dead last in the infant formula space -- there is little wonder why.


    Substantial Difference between Official SAIC-Reported PRC Audit vs. SEC Reported Figures

    Apologists will seek to explain away these differences by offering the standard litany of ill-informed defenses. Common sense explanations should readily address any extant differential. Should there exist any remaining and non-attributable difference, something is definitely wrong. Alternatively, apply some simple logic. On whom is the company more likely to pull a fast one on? The local SAIC and SAT, both of whom are intimately aware of the business, and in constant close-touch contact with it –or- the SEC and public investors, 8000 miles away, dimly aware of prevailing market/operating realities, relying chiefly upon disclosures and the diligence of auditors? Going one step further, cheating PRC authorities risks severe, proximate and immediate criminal consequences. An unfortunate, but common, view amongst a certain breed of the guys standing behind PRC-based USA-listed small and micro-cap stocks is simply: what can the SEC really do to me? As a practical matter this way of thinking is not too far off the mark, at least in so far as they are concerned. These are not generally individuals with any meaningful ties to the States, nor do they typically have any US-based assets which might be imperiled. In fact even if a judgment were entered against them in a DE or UT court, then what’s the worst they will face? It would certainly not have any effect in China. The reality is that most PRC residents could happily do without another trip to the USA and comfortably live out the rest of their lives in China (on your money).

    To this section’s point: I have obtained copies of ADY’s 2008 and 2009 SAIC-filed audit reports.  These were prepared by ADY’s PRC auditor, Anlian, and submitted to local authorities (under pain of, once again, criminal prosecution for willing misrepresentation). Here are some summary highlights; complete analysis will follow as soon as I have time:

    • Revenues roughly correspond in 2008 and 2009, but this is where the similarity largely ends…
    • 2009 SAIC audit reports shows loss of ~133mm RMB, 2009 SEC accounts show a profit of $19.6m (~133mm RMB) – I checked it twice, the accurate SAIC numbers seemingly invert the +/-…
    • 2009 SAIC audit shows a year end cash balance of 121mm RMB, 2009 SEC accounts show a cash balance of 328mm RMB – cash is cash, or maybe it’s not when it’s not there?
    • SAIC accounts show an increase in accounts payable from 21mm RMB to 624mm RMB over the 2008-->2009 period; SEC accounts show a modest increase of less than 35mm RMB over the same period – how’s that for sustainable growth?  Clearly ADY’s financial position is perilous and the working capital deficit is much greater than it lets on its SEC filings.  No wonder Sequoia is running…
    • Divergence between 2009 SAIC and SEC total assets figures is suspicious and raises questions around where all this money is going; in the SEC accounts assets total nearly 3bb RMB, whilst in the SAIC accounts less than half of this figure, 1.4bb RMB, is shown; with only 188mm under the fixed assets accounts and 121mm as cash, the majority of the remainder of assets are accounted for under somewhat dubious receivable and accrued expense entries…
    • With the company’s awful track record for delivering returns on equity one must wonder what is really going on here, money seemingly only flows out, but never in…
    • These are non-trivial differences which demand ADY audit committee attention; Deloitte’s ‘only a little bit dirty’ audit opinion is no doubt a product of their recent CCME misadventure -- I personally believe we are going to see more and more of these coming for PRC-based companies; this discrepancy demands immediate clarification…

    Don’t take my word on any of this, here are the SAIC audit report filings, review with a Chinese speaker and form your own opinion: http://www.scribd.com/doc/52531161

    I encourage those of you who would try to explain away the SAIC and SEC differentials to step back and critically examine at some Chinese companies whose SAIC and SEC accounts failed to reconcile. It is a star-studded cast: RINO, CCME, CEU, CBEH….need I go on?


    Sequoia: A Bad Deal from the Beginning

    A brief summary of the history

    • 8.2009 subscription netted Sequoia 2.1mm shares @ $30/share
    • Performance targets required ADY to achieve certain unspecified 2009 and 2010 income targets, if these were missed Sequoia would be entitled to an additional 525k shares
    • The subscription also included a 3-yr European put option where Sequoia would be able to put back all shares arising under the subscription @ $31.20/share if post-8.2012 15-day ADY trading average below $39
    • The wheels obviously came off quite quickly: pursuant to the 8.2009 agreement (before the ink had dried) on 3.29.2010 ADY issued the 525k shares to Sequoia for the nominal consideration of 1 USD -- obviously the company failed to meet the undisclosed 2009 operating target it had just signed up for
    • Then, just this February, a full1 1/2 years in advance of the put’s trigger date, ADY disclosed that it had entered into a redemption agreement with Sequoia where all of Sequoia’s outstanding shares shall be re-purchased at 24 USD/share (a substantial discount to the amount which it was contractually entitled)
    • This ‘make good’ redemption totaling $65mm USD shall take place over the next three quarters in equal installments (the 1st 15.75mm USD batch should have been settled just a few days ago on 3.31.2011)

    ADY’s sordid past is something of an open secret amongst China-specialist investors (not USA-based arm chair analysts, nor University of Southeastern Iowa college finance majors popping off – people who actually have some idea of what they are talking about). Several major  funds evaluated the opportunity back around the time of Sequoia’s investment -- all passed. Feedback from those involved is uniformly negative. The common refrain: ‘revenue fabrication’ which extended to ‘both quality and volume’. Rumor has is that Sequoia realized the books were cooked only shortly after making their investment, and began looking for the door. The quick investmentàredemption fact pattern (which is not at all Sequoia’s modus operandii for its China portfolio) seems congruent with such an account.

    The real story behind Sequoia’s apparent misstep is clear enough in hindsight. Around the time of the melamine scandal ADY held what appeared to be an enviable position: it had maintained a secure product supply chain and was thus, in theory, poised to achieve substantial market share gains by exploiting upon the missteps of its larger and better financed competitors. Instead of capitalizing upon the mistakes of its competitors and extending its own brand, poaching share, going up market, etc. ADY instead opted for an easier route. Rather than spend money on branding/marketing/distribution it ADY elected to sell product to Hangzhou-based Beingmate (贝因美).   For those of you unfamiliar with Beijngmate, they are the major player in PRC baby food and, now, infant formula (ranked amongst the top-3 of all local/international brands by Sinolink Securites in a 2.2011 dairy industry coverage piece); they operate baby/infant-focused retail shops all over China and offer a full line of own-branded kids clothing, nutrition products, et cetera all things baby. Just last month, March 2011, the CSRC approved Beijngmate to raise 1.8bb RMB in an A-share share offering. The IPO should happen quite soon.

    It would appear that Sequoia drank the ADY kool-aid and based its investment consideration around some mistaken idea of the business. In their defense, post-melamine scandal ADY seemed ideally situated, growth in its own-branded product sales via capturing share from other local players should have been a no-brainer and would likely yield lasting advantage/gains. In retrospect it is now clear that Sequoia vastly over-estimated the worth of ADY’s business by probably failing to understand the true nature of revenues. Contract manufacturing generally help build a franchise. In failing to extend its own brand when the opportunity presented itself ADY had effectively mortgaged its own future.  With myopic focus on juicing numbers (via OEM manufacture) ADY traded future growth for a nominally high multiple fund raise. Along with this raise came unrealistic performance targets and onerous terms, thus locking ADY into a short-term strategy and wasting its temporary advantage in pursuit of ratchet targets. Squandering its ‘safe producer’ status, ADY’s managers effectively catapulted Beingmate into the big leagues and set into motion the competitive forces which now conspire to destroy the company – namely, Beingmate. The reported YoY 2009-->2010 revenue decline points to the beginning of the end.

     Companies get involved in RTOs for all sorts of reasons; in China these typically follow a set pattern. Owners/managers with little financial sophistication (i.e. no concept of what a warrant is) are duped into a no-fuss IPO by sweet talking local hustlers. USA-based ‘China expert’ ‘bankers’ (who don’t understand the concept, let alone the practice, of due diligence) aid and abet fundraising by foisting shares off upon unsuspecting retail investors and the occasional ill-informed institution, who, not themselves entirely innocent, often assume they’ll just flip out on the ensuing run up. When you come right down to it, multiple parties are complicit and all guilty of adopting a ‘greater fool’ investment approach (i.e. there will always be some sucker dumber than me). The ADY case is unique only in that is was able to lure major institutions into the game, each conferring additional legitimacy to and further perpetuating a broken business model.

     Sequoia probably based its investment consideration on some mistaken assumptions around ADY’s growth prospects and sustainability. But, in point of fact, with their investment structured as it was, the relative health/success of the underlying business did not really matter. Sequoia’s $63mm was injected as ‘temporary equity’ (whatever that means), under what amounts to a sort of ‘heads we win, tails you lose’ arrangement which is actually a convertible bond not ‘temporary equity’. More than an innocent misnomer, this sleight of accounting hand allowed the company to maintain a seemingly healthy balance sheet while continuing to invest in foolish projects -- in effect sowing the seeds of its eventual demise. To be clear, the $63mm ‘temporary equity’ investment was and is debt, and it should have been accounted for as such from the beginning.

     Contrary to ADY’s claims that the Sequoia redemption will improve its capital structure, theses payouts, should they proceed as agreed, will very likely set ADY into a ‘death spiral’ (decreasing investment, decreasing advertising = decreasing sales, diminished distribution; compounded and accelerated by competitors ramping up). It seems that at this point ADY’s last remaining chance of survival would be to re-visit the Sequoia agreement and seek to modify its terms to effect some sort of debtà equity swap -- otherwise these four quarterly payouts totaling 65mm USD will surely kill the business. At this point the decreasing stock price and deteriorating operating and market fundamentals all but rule out any sort of PIPE or ‘replacement’ convertible bond, so forget that.


    Competition Stiff and Only Getting Stiffer

    The impact of Beijngmate’s impending IPO should not to be underestimated. After deployed the billions raised will substantially compound ADY’s already existing disadvantages of small scale, lack of brand equity and inadequate advertising spend. In addition to Beingmate, others are entering the fray. Rumor has it that a another major operator in northern China is about to close a major multi-hundred mm USD round anchored by a major bulge investment bank’s private equity outfit.

     When you come right down to it Fast Moving Consumer Goods is a money game – it’s all about advertising. P&G, Nestle et al. succeed not only by offering superior product, but by outspending any emerging competitors by a substantial margin (or, more correctly, % of revenue).  It requires significant capital to create a leading consumer goods brand, and substantial continued investment to maintain it.  Only the most well run and best capitalized companies stand any chance of success.  With the major multi-nationals and gigantic PRC dairies actively pursuing ADY’s core market how does the company stand a chance? Already the self-perpetuating cycle of marketing spendàshare increaseàprofit increaseàincreased marketing spend has relegated ADY to also-ran status.  ADY does not have the investment dollars to compete, and thus its share/revenues/profitability will likely continue to erode.

     Ask your PRC friends about the many of the famous brands they grew up with which have now all but disappeared. Well-funded household brands get wiped out in China a matter of a few years by free spending marketing-savvy multi-nationals and aggressive local FMCG players.  What takes 20 years to unfold in America transpires in less than 2 in China. How can a minor player with a barely established brand and virtually no advertising budget compete?


    ADY is Worth Liquidation Value at Best, 10% of Zero is Still Zero

    Given its long history of negative cash flow, it is clear that ADY’s brand and distribution is not creating any value for shareholders -- the only real value should theoretically be found in its hard assets.  If you take the SEC financials to be true, then the equity value of the company at December 31, 2010 was $162 million.  Subtract from this $65 million for Sequoia, you get to a valuation of $97 million, which would equate to $4.35 per share if you assume the assets are worth full value and/or are actually there.  However, the company’s history of goodwill impairments and loss on disposal of biological assets would indicate that its assets are carried above their actual value.  The company states in its 2010 10-K, “Substantial doubt about our ability to continue as a going concern could affect our relationships with suppliers or customers. In accordance with generally accepted accounting principles in the US, our balance sheet generally states the book value of our assets, which does not necessarily represent the value that could be realized from the assets if we could not continue as a going concern.” In liquidation it is nearly certain that the assets of the company would obviously command far lower than book value. 

     Going one step further: the above scenario only roughly describes an idealized USA-type wind-up works and assumes the SEC accounts are true – both big assumptions. In China bankruptcies tend to more of a free for all slug fest, and the SEC accounts would not be at all relevant. Should ADY enter judicial administration (as per PRC bankruptcy law, there is no Chapter 11-type option) the starting point for the appraisal/audit of the company would be the latest PRC-audited SAIC-submitted accounts (as these generally, according to my experience the administrator often finds these to be overstates). The eventual asset auction value will be at likely a 20-30% discount to an already haircut SAIC accounts book net asset value. You do the math, it’s far darker than the SEC accounts scenario as far as common holders would be concerned.

     More problematic for common equity holders, PRC bankruptcies follow a common pattern. Management sees the end in sight before minority equity holders or creditors. They typically begin blowing money out the door and/or establishing friends/cronies as ‘creditors’. At some point when the company defaults on a principal/interest/other payment (whether real or fictitious), then the bank/’creditor’ immediately secures a court-endorsed charge over all of the assets (even if the claim only accounts for a small portion of the frozen assets; relatively simple to do). The local government will quickly (through the local court) appoint a bankruptcy management team to ‘work out’ the situation (read: take over the business before management strips the remaining assets and they are left facing hundreds of angry workers). A feeding frenzy ensues amongst local players, connected-guys, real estate speculators, competitors, et al., even the Non-Bank Financial Institution arm of the local government often gets in on the game (which never makes for a fair outcome, as these guys effectively control the local court) -- and all jockey for position. Eventually what remains of the assets gets sold in a rigged auction, first workers/employees claims, then secured credits, then  unsecured claims are settled – equity holders are, in the vast majority of cases, left with absolutely nothing. This whole process will, mind you, likely take two+ years if all goes smoothly, much longer if there are problems (as there often are). I have witnessed this process from both sides of the table.  It always ends tears for minority equity holders. Interestingly and tellingly, it is often original majority equity holders who end up (through an ‘unrelated’ proxy of course) back in control of the business they ran into the ground. These are China rules.

     On a separate but equally critical point, ADY shareholders should not overestimate the generosity of PRC banks. They are only generous with  state owned enterprises, and even these not as much lately.  All other companies risk immediate acceleration of debts if a single payment is missed, or if the bank manager doesn’t like the way things smell – it does not matter what the loan agreement says.  Based on consultations with senior officials in PRC banks it seems highly questionable as to whether or not ADY will be able to extend/roll over its existing credit facilities going forward. In other words the bottom could fall out of this business very quickly.

     Summary

    • Serious product safety concerns call into question ADY’s ability to continue selling its largest infant formula product.  ADY has misled US investors regarding superior product quality.
    • SAIC and SEC accounts do not remotely comport, the differences in key line items are sizeable and indicate that the financial picture of ADY is likely far worse than the management is letting on.
    • The ‘smart money’ has already made its exit; Sequoia is not stupid, nor are they known to leave any money on the table. Settling for recovery of only their initial investment means something is terribly wrong.  In agreeing to redeem Sequoia’s investment as ADY has, it has not only put the itself on a probably path towards bankruptcy; but, perversely given the real common equity nature of Sequoia’ investment, it has also established for Sequoia a preferential claim on assets as ahead of other common shareholders. So not only has ADY accelerated its own implosion, it has given Sequoia a preferred position to collect whatever pieces are left after the business collapses.
    • ADY is losing the battle against large multinationals and big PRC dairies in what is a fiercely competitive market.  It has no competitive advantages, neither in funding, size, distribution, product quality, nor branding.   ADY is clearly a sinking ship.  Absent a miracle equity raise, which would be massively dilutive to existing shareholders, the company is approaching a death spiral.
    • In terms of valuation, ADY does not have any going concern value. Looking at the common as a distressed gamble one might accord a $1/share value, but no more than this amount. It is important to remember that common minority shareholders will likely come away empty handed as the major assets of value are already encumbered by ADY’s lenders and preferred creditors. 

    What’s Next

    • I’ve put this brief note together on the fly, but you can look forward to additional and in-depth analysis covering ADY’s accounts, tax (mis)reporting, competitive and strategic challenges, etc.
    • If you are interested in receiving direct copies of future analysis please shoot me an email at chinadebunker@yahoo.com to get on my distribution list – I have 30+ Chinese businesses on my immediate radar which are as bad or worse than ADY.
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  • Value Investor Today
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    I've seen both sides of the argument. Yours is the most compelling. Nicely done.
    13 Sep 2011, 05:16 AM Reply Like
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