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It Is Time To Have Some Sino Agro Food

|Includes: Sino Agro Food, Inc. (SIAF)

Summary

- SIAF is trading at a deep discount with a margin of safety of 87.6%

- Recent carve-out of its fishery division and may lead to a correction in its stock price

Company overview and business model

Sino Agro Food Inc. (OTCQX:SIAF) is a Nevada-based agriculture technology and natural food holding company with a capitalization of $80 million, currently traded on the U.S. OTC market and the Merkur Market in Oslo. The Company's operation is located in Mainland China; it develops and operats cattle farms and fisheries, produces organic fertilizer, grows dragon fruit flowers and immortal vegetables, markets and trades relevant products, and operates restaurants. The Company has recently carved out the fishery division and established an independent company - Tri-Way Industry Ltd, with SIAF owning 36.7% of its equity. The Company is striving to establish a "farm to plate" strategy through vertical integration. At this point, the Company's main operations are cattle farms and fisheries. Its main business strategy is to form joint ventures with Chinese investors, leverage its technology and know-how to develop aquaculture and agriculture farms, and then acquire equity stakes in developed farms per the terms specified upfront in joint ventures. Such a business model has likely been shaped by the tax and business policies established by the Chinese authority for foreign companies such as SIAF. The Company owns several patented technologies, mainly "A Power Technology" for on-land indoor fish farming. Its fishery division (now Tri-way) is currently operating the largest indoor fish farm in the world. For more details, please refer to its most recent 10-K.

Competitive advantages

The Company's main advantage lies in its "expertise and know how in specific agriculture and aquaculture technologies." In particular, it owns the "patented and proven technology" for indoor fish farming. The Company has, however, been struggling in obtaining capital required for its rapidly expanding operations. In contrast, its competitors in China are much larger and can deploy large amounts of capital for new investment opportunities.

Operating and financial results

The Company (excluding its fishery division) is in a good shape, operationally and financially speaking, but the growth has stalled due to a variety of reasons. It has a total revenue of $343, $344, $299 million and a net income of $65, $74, and $85 million in 2016, 2015, and 2014, respectively. In the last three years, the revenue grew on average 6.2% per year but the net income decreased by 13.5% per year, indicating its declining profitability. These were primarily due to a large decline in cattle and beef prices as China lifted the beef import ban in 2015, and the wet weather condition in the last several years that has impacted the plantation division. In the last two years, the average return on asset and common equity is 17.0% and 14.2% respectively, with a current ratio of 13.0, quick ratio 7.3, long term debt to equity 5.1%, and interest coverage ratio 17.8.

The fishery division (now Tri-way), which was carved out in October 2016, has been in a transitional phase but has a huge growth potential in the foreseeable future if it can raise enough capital to support its expansion. Its total revenue and net income in 2016, 2015, and 2014 are $61, $85, $106 million and $15, $17, and $28 million, respectively. These declines are due to the ongoing renovations of its Fish Farm 1 and Prawn Farm 1 and 2. The construction work is still in progress in Prawn Farm 3 and 4, which are expected to produce 200,000 metric tons of prawns by 2026. To put this in context, the existing Prawn Farm 1 and 2 have a total capacity of about 2,400 metric tons. According to the Company's disclosure, Tri-way has a total value of $340 million and SIAF has $125 million of its equity (36.7%).

Intrinsic value

A residual income model results in a value of $32.0 per share, with $20.6 from the current SIAF operation and $11.4 from SIAF's interest in Tri-way, representing a margin of safety of 87.6% (the Company is trading at $3.95, the opening price on 04/17/2017). A discounted cash flow approach leads to the same numbers. A number of assumptions are made in valuing the current SIAF operation.

- Long run growth rate: 3%

- Required rate of return: 13.6% (risk free rate 4.5%, market risk premium 7.3% using a historical risk premium of 5% and a country risk premium of 2.3% based on Damodaran's data for 2016, beta 1.24 based on Russell 2000 in the last 7 years - the actual beta of SIAF is negative and does not reflect its risk)

- Volume growth: cattle and beef 10% in Years 1-5, 5% in Years 6-10, and 3% thereafter; organic fertilizer 5%, 5%, and 3%; planation 5%, 3%, and 3%; corporate consulting services 20%, 10% and 3% (based on historical trends and the Company's projections)

- Price growth: cattle and beef -5% in Years 1-5 and 0% thereafter; organic fertilizer 3% in Years 1-5, and 0% thereafter; plantation -2% in Years 1-5 and 0% thereafter (based on historical trends)

- Income tax: 0% in Years 1-5, 15% in Years 6-10, and 25% thereafter

The assumptions for valuing Tri-way are as follows

- Long run growth rate: 3%

- Required rate of return: 13.6%

- Base year income: the average of the last three years

- Income growth rate: 60% in Years 1-5, 8% in Years 6-10, and 3% thereafter (based on the assumption that the production will reach 60,000 metric tons of prawns by 2021; the Company projects it will reach 100,000 metric tons by 2021)

- Income tax: 0% in Years 1-5, 15% in Years 6-10, and 25% thereafter

Using P/E or P/S or P/B ratios, we can reach similar conclusions. Assuming a P/E ratio of 10, P/S 1.5, P/B 1.5, SIAF has a value of $35.1, $38.6, and $57.3 per share, respectively.

Company risk

The commodity nature of agriculture products makes the market very competitive and this is no exception to SIAF, but the Company has managed surprisingly well after the authority lifted the ban on beef imports in 2015. The Company responded quickly by reducing local cattle production but increased the processing of imported beef so that the total revenue from the cattle and beef processing division did not decline much. This suggests that the Company does not have high operating leverage, meaning a high fixed cost in its production, which is beneficial in a rapidly changing market.

Its ability to obtain sufficient capital is another challenge for the Company and it has potential risk of diluting existing shares. The Company had a 9.9-for-1 reverse stock split in 2014. And in the last three years, the number of common shares increased by about one third from 16 million to 21 million. With the carve-out of the fishery division, the demand for capital has reduced greatly but it depends on whether and when the Company will have another carve-out.

Tax policy changes will impose a significant burden on the Company. At the moment, the Company does not pay any income taxes. The corporate tax in China is 25% and if the Company is subject to this tax rate, it will lose about 20% of its value.

Trading mentality and catalysts

The stock is trading at 1.4 times of its 2016 earnings and there are some reasons for that. First, the Company's revenue growth has stalled and its profitability has declined since 2015. Second, it has a history of diluting existing shares. Also, the Company is operating in China, which may be easily mistaken as a fraud. Another possible reason is related to the corporate governance. The CEO owns 11% of common shares but he has 62% of voting power.

Nevertheless, the situation is likely to change in the foreseeable future and it is a good entry point now to own some shares. The likely game changer will be the carve-out of the fishery division, which will be traded on a senior exchange and have a better governance structure. Tri-way is better positioned to raise capital needed for its expansion. There is still a possibility that the value materialized in Tri-way may not flow to SIAF if the dominant reason for the current depressed stock price is SIAF's corporate governance. However, if the stocks of the two companies can be easily exchanged, arbitrage opportunities will align the prices. The likely side effect of the carve-out is that it reduces the pressure on the Company to raise a huge amount of capital that often leads to share dilution. The Company is contemplating additional carve-outs but it does not provide a timetable. Further, as the beef price to stabilizes, SIAF's growth in cattle rearing and beef processing will likely resume. At the time of this writing, I believe it is a good entry point to buy some SIAF shares.

Disclosure: I am/we are long SIAF.

Additional disclosure: Investors have to do their own due diligence or seek professional advice before making any investment decisions. I have no business or financial relationship with any of the companies mentioned in this article; neither do I receive any compensation for writing this article.