By way of introduction I run a small hedge fund specializing in small-cap contrarian ideas. Like you, I read about the high profile allegations and eventual admissions of fraud by several US-listed small-cap Chinese firms. As an investor who has made a career primarily from investing in “penalty box” stocks I became intrigued with the mass selloff in the sector and began to do some work. I met with several Chinese management teams and reached an early conclusion that most do not have a fundamental understanding of how the US capital markets function or what a typical US institutional investor expects from a publically traded company management team. I also learned through doing the work that there are some US-listed small-cap Chinese companies with extremely favorable investment attributes which simply do not sync up with the sector throwaway valuations evident today. One of those companies is Yuhe International Inc (NASDAQ:YUII).
I had the privilege of spending two weeks in China earlier this month as part of Roth’s 6th Annual China Tour. In those two weeks and 5,000 miles of planes, trains and automobiles, I met with twelve companies – on their turf. Aside from the normal extensive due diligence one would expect with company visits , I came away having noticed some general traits consistent among the founders of these small-cap companies, which I think is important. First, size matters. Status as a founder seems to grow as a firm’s revenues and (interestingly) number of employees increase. Earnings per share, higher cash flows, lower share counts, higher stock prices – they are all nice but not at the top of the list when it comes to what seems to be most important. Second, the Big Guy is the Big Guy. Especially in these smaller companies, the founder is quite often involved in any and all aspects of the company. You will see this in small companies in the US as well but in China there seems to be more votes of One . Third, the founder is the single largest shareholder in the company and often owns between 25% - 45% of the shares outstanding. Surprizingly, very few or none of the remaining key employees own shares. With US-listed small-cap Chinese companies, stock options or even restriced shares are seldom used and I can see why. They are simply too complicated; what would work much better would be cash bonus programs linked to the price of the company's stock. Fourth, the founder is almost always the smartest person in the room. They are very well respected in their communities and trade associations and in meeting several founders it's easy to see how they have ended up in the positions they are in. I came away from the trip with a strong hunch that the primary reason management teams do not seem to understand the workings of either the US capital markets or US institutional investors is that feedback and education on this topic gets lost in translation (very few founders speak English), or more likely simply lost, before it gets to the top. Fifth, and most important to my belief that there is real money to be made in select US-listed small-cap Chinese equities, is that the founder cares very much about success as a public company in the US capital markets and, if not there already, will very quickly get down the learning curve of how to regain investor confidence and in turn create shareholder value. These guys are not used to being in the penalty box and I believe the old era of business as usual for these companies is about to change.
Picture yourself holding a crate of strawberries in front of you, shoulder width. Now instead of strawberries you have 102 screaming one-day old chicks looking up at you. Now picture hundreds and hundreds of crates with screaming one-day old chicks. Welcome to Yuhe International Inc (YUII), the largest chicken breeder in China. The company is headquartered in Weifang, Shandong Province, about 275 miles southeast of Beijing. YUII is a direct play on China’s increasingly affluent consumer demand for more protein in their diet. Chicken today represents approximately 20% of protein sources in China but that number is growing rapidly. Moreover, the amount of corn required to breed an equivalent amount of chicken versus pork is about 50% less and if you are of the belief as I am that rising food costs are here to stay, chicken economics look pretty good.
Last year YUII sold 146 million day old broilers at an average cost of RMB $2.97 per bird, gross margins of 35.9%, operating margins of 29.0% and earnings per share of $1.15. The company has 28 breeder farms (soon to be 43) in operation and three hatchery houses (#4 is under construction), enough capacity when fully built out and upgraded to YUII standards to produce nearly 260 million day old broilers this year and 400 million in 2012. Equally important, YUII generated $17.4 million in operating cash flow in 2010 and that will grow substantially in 2011. I am not going to share with you my estimates for what the company will earn in 2011 and 2012, nor what I believe they will do with all that cash they will generate; that work stays for the benefit of aAd Capital investors. Do your own work and I think you will conclude YUII has the potential for significant earnings growth in the future. I walked away from my day at YUII impressed with the level of “manufacturing” sophistication and quality control. Their incubation process is highly modernized and their German equipment manufacturer is the most respected in the industry. Every parent breeder is vaccinated with 10+ types of vaccinations and because of this YUII can guarantee a 98% survival rate which in turn leads to YUII’s positioning as the premium player commanding premium pricing.
If the macro story is sound, and the business economics are compelling, why in the world is YUII stock trading at $5.45, or just under 5x trailing earnings with significant growth still to come? YUII is a reverse-merger company, and was not subject to as intense a due diligence process had they originated as an IPO. The 10-K (http://www.yuhepoultry.com/newEbiz1/EbizPortalFG/portal/html/sec.html) describes their offshore holding structure which, while commonly used by foreign investors with operations in China, introduces an additional degree of complexity. So yes, the business structure is complex but the business itself is simple. Their business is predominantly a cash business which makes auditing more difficult than say for a hog producer selling to supermarkets. Co-founder & CEO Zhentao Gao will at times act as the banker on weekends in order to facilitate business with the same farmers who have done business with him for nearly 20 years. Local lenders to YUII, perhaps in the best position to understand how the business works, performed extensive due diligence and continue to lend money to the company; additionally, the last two sellers to YUII performed extensive due diligence and decided to take YUII stock at $10 a share, well above where the stock was trading at the time of the acquisition announcements.
Let’s discuss the coming auditor upgrade because this issue is very much front and center in the minds of investors. When US-listed small-cap Chinese frauds began appearing the US institutional investor response was “You need to be audited by a big four auditor if we are to have any confidence in your historical financial representations.” Last year YUII spent approximately $150,000 in auditor fees. Six months ago the estimated new audit fee in going with a big four was about $700,000. Given the surge in demand for big four services, that estimate is now more like $1.2 million and the wait time to engage a big four auditor has also lengthened considerably. Please remember, YUII sells chicks; they don’t have a lot of SKUs nor do they have a wide variety of input costs. The company has not made a decision yet or at least not broadcast their decision to the world (not a great strategy in continuing their relationship with their current auditor) but I certainly hope they don’t go to a big four auditor. I can think of several reputable auditors outside of the big four and much better ways to deploy that incremental million dollar spend.
I have done my work and I certainly have been wrong before. But I have been there and seen for myself their business. I have listened to farmers who buy their product and distributors who sell their product. I have looked Mr. Gao in the eye and shook hands with the feeling that although I do not speak the language we were communicating very directly. I like companies with favorable revenue tailwinds, sustainable business models, glowing customer recommendations, and management teams who reach a point where they say “Enough. We are better than you think we are. Watch us.” The company now has a market cap of $110 million and an enterprise value of only $88 million. Comparables listed in Hong Kong trade at multiples as much as 4 to 5 times higher than YUII today. If you do the math, it really isn’t that difficult to conceive YUII being a $300 million dollar plus enterprise value company sometime in 2012. I believe you will begin to see more primary research published by the sell-side as well as efforts to educate and demand more from Chinese management teams in working with their investor base. Upcoming Chinese investor conferences being held by Piper Jaffray and Oppenheimer in May and Global Hunter in July all will have or are considering closed door founders coaching sessions. Should the messages coming from US-listed small-cap managements begin to change, I have two words for you: Multiple. Expansion.
I have three other long ideas I hope to share with you in the future. They also have favorable revenue tailwinds, sustainable business models, glowing customer recommendations and managements that are ready to step up. But for now, let’s see how this plays out. Thanks for your consideration.
DISCLOSURE: We are long YUII shares.
Disclosure: I am long YUII.
Additional disclosure: final revision! monday, may 2nd 9:00am pdt thanks Dan Wimsatt 858 427 1437 office or Meredith Hooke 848 427 1434