China Minzhong Food Corporation

[freedom]

I am very surprised that China Minzhong can have 40+% gross profit margin given that in China, with 40% margin, a lot of players would come already with not high barrier to entry(farmland? cheap almost every where in China if you are connected; harvest vegetables? not exactly rocket science).

[Nick]

I am very surprised that China Minzhong can have 40+% gross profit margin given that in China, with 40% margin, a lot of players would come already with not high barrier to entry(farmland? cheap almost every where in China if you are connected; harvest vegetables? not exactly rocket science).

Why use margin ? Should be using return on equity. Farmland cannot use debt to buy. Must use 100% equity - who have access to equity to raise > RMB 100 mil ? I guess only listed companies and SOEs.

[freedom]

I am very surprised that China Minzhong can have 40+% gross profit margin given that in China, with 40% margin, a lot of players would come already with not high barrier to entry(farmland? cheap almost every where in China if you are connected; harvest vegetables? not exactly rocket science).

Why use margin ? Should be using return on equity. Farmland cannot use debt to buy. Must use 100% equity - who have access to equity to raise > RMB 100 mil ? I guess only listed companies and SOEs.

China is flooded with liquidity from years of success in exports in the private sectors, not just in SOEs. with 20% gross margin, a lot of money will enter already, 40%? the market would be crowded like hell.

[Nick]

I am very surprised that China Minzhong can have 40+% gross profit margin given that in China, with 40% margin, a lot of players would come already with not high barrier to entry(farmland? cheap almost every where in China if you are connected; harvest vegetables? not exactly rocket science).

Why use margin ? Should be using return on equity. Farmland cannot use debt to buy. Must use 100% equity - who have access to equity to raise > RMB 100 mil ? I guess only listed companies and SOEs.

China is flooded with liquidity from years of success in exports in the private sectors, not just in SOEs. with 20% gross margin, a lot of money will enter already, 40%? the market would be crowded like hell.

Margins don't mean anything. REITs have 80% margin - who wants it ? Margin just mean how effective you can covert the revenue to profit. Would the revenue generated be sufficient to cover the cost of investment over the 20 year lease ? That's the question. One natural disaster, one famine, one poor harvest and you are dead if you lack scale. Essentially, scale is necessary. Moreover, you need to invest money and time to develop processing plants and products which can meet international quality test. I don't think many would be willing to cough up > RMB 500 million to join in. Makes more sense to buy properties where ROE > 100% with leverage. Why invest so much for just 20% ROE on a good year !

[freedom]

I am very surprised that China Minzhong can have 40+% gross profit margin given that in China, with 40% margin, a lot of players would come already with not high barrier to entry(farmland? cheap almost every where in China if you are connected; harvest vegetables? not exactly rocket science).

Why use margin ? Should be using return on equity. Farmland cannot use debt to buy. Must use 100% equity - who have access to equity to raise > RMB 100 mil ? I guess only listed companies and SOEs.

China is flooded with liquidity from years of success in exports in the private sectors, not just in SOEs. with 20% gross margin, a lot of money will enter already, 40%? the market would be crowded like hell.

Margins don't mean anything. REITs have 80% margin - who wants it ? Margin just mean how effective you can covert the revenue to profit. Would the revenue generated be sufficient to cover the cost of investment over the 20 year lease ? That's the question. One natural disaster, one famine, one poor harvest and you are dead if you lack scale. Essentially, scale is necessary. Moreover, you need to invest money and time to develop processing plants and products which can meet international quality test. I don't think many would be willing to cough up > RMB 500 million to join in. Makes more sense to buy properties where ROE > 100% with leverage. Why invest so much for just 20% ROE on a good year !

if there is cheap liquidity, gross margin and economy of scale are the only things matter. ROE? cheap liquidity could lift ROE to above 50% with great gross margin and economy of scale.

CMZ's vegetable sale, has great gross margin of 40%. economy of scale? key products of CMZ include broccoli, tomato, celery, garlic, such common vegetables. you can easily scale up the production/sales. after all everybody has to eat vegetables, there's a huge market.

during the ship building boom of 2007, hundreds of shipyards were established. Most of them are private shipyard. There are quite a number of large, private shipyards. Ship building is not an industry you can expect fast return.

The fact is that, China has too much liquidity, just there is not good enough investment which has good profit margin. SMEs complain they are not getting loan easily because they do not have good gross margin and economy of scale to service the loan, why would anyone lend money to them?

with great gross margin and ability to scale up production/sales, there definitely is enough liquidity for the industry.

[VestedInterest]

Feel very tempted to go into this one again but somehow, gut feel is that it would be a big gamble. Price movement does not reflect the numbers and ratios. It has dropped too much too fast even in this poor market condition. GIC and/or Temasek owning is no basis for confidence (am thinking of Chinasun Biochem and all the other coy that were duds).
Moreover there are so many 'safer' counters around now with moats to boast too. Must not forget Sun Tzu's art of investing- must take on an enemy only if you are sure of winning. If price continues its fall next week, then it doesn't bode well for the stock. Will mull over this one...

[weijian]

I am very surprised that China Minzhong can have 40+% gross profit margin given that in China, with 40% margin, a lot of players would come already with not high barrier to entry(farmland? cheap almost every where in China if you are connected; harvest vegetables? not exactly rocket science).

the high profit margin is explained by the fact that china's farmland is fragmented. It seems like big players like Chaoda was able to consolidate them, cut the middle men and provide the economies of scale to sell them overseas - this might explain the good GPM. Apparently, CMZ is 1 of the later folks who join on this 'full integrated vege grower/processer/exporter' bandwagon..

of course, no high profit margins will last forever as more and more folks join onto it..

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Feel very tempted to go into this one again but somehow, gut feel is that it would be a big gamble. Price movement does not reflect the numbers and ratios. It has dropped too much too fast even in this poor market condition. GIC and/or Temasek owning is no basis for confidence (am thinking of Chinasun Biochem and all the other coy that were duds).
Moreover there are so many 'safer' counters around now with moats to boast too. Must not forget Sun Tzu's art of investing- must take on an enemy only if you are sure of winning. If price continues its fall next week, then it doesn't bode well for the stock. Will mull over this one...

haha..CMZ is indeed a risky proposition. Besides Sun Tzu, do not try to forget Warren Buffett's rule - be fearful when others are greedy, and greedy when others are fearful'

[touzi]

Feel very tempted to go into this one again but somehow, gut feel is that it would be a big gamble. Price movement does not reflect the numbers and ratios. It has dropped too much too fast even in this poor market condition. GIC and/or Temasek owning is no basis for confidence (am thinking of Chinasun Biochem and all the other coy that were duds).
Moreover there are so many 'safer' counters around now with moats to boast too. Must not forget Sun Tzu's art of investing- must take on an enemy only if you are sure of winning. If price continues its fall next week, then it doesn't bode well for the stock. Will mull over this one...

haha..CMZ is indeed a risky proposition. Besides Sun Tzu, do not try to forget Warren Buffett's rule - be fearful when others are greedy, and greedy when others are fearful'

Would you be able to explain why you think CMZ at its current price is a risky proposition compared to other companies? As for me, I think it is a good business since urbanization and education is going to result in less land and workers in the farming business. Is this a case of a good business reaching a fair price? Is the risk associated with farming higher than other businesses? Every business seems to face some risk of having a disruption to its supply chain.

[weijian]

Would you be able to explain why you think CMZ at its current price is a risky proposition compared to other companies? As for me, I think it is a good business since urbanization and education is going to result in less land and workers in the farming business. Is this a case of a good business reaching a fair price? Is the risk associated with farming higher than other businesses? Every business seems to face some risk of having a disruption to its supply chain.

i guess with the recent debacle at Chaoda coupled with the S chip scandals over the last 2 years, the risk is in the sense that CMZ could turn out to be a fraud or have bad corporate governance. When that happens, no amt of 'growth prospects, competitive moats etc' or healthy balance sheet/great margins' matter anymore...

[weijian]

The FAQ portion of CMZ AR2011...It does provide such insights but do take it with a pinch of salt as usual...

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(1) Please describe the farmland leasing model for your upstream fresh vegetables
cultivation.
a. All agricultural farmland in PRC is owned by the government and individual farmers only possess the farming
rights to the farmland they are allocated.
b. The operating of our owned cultivation bases involves the collective leasing of farming rights (from the farmers)
through the respective village committees. The Group will typically enter into lease agreements for ten years so
as to lock in the lease cost and fully realize the investment made on land improvements (eg. roads, irrigation and
drainages) on the farmlands.
c. Farmers will be given an upfront one-off payment for the lease and be paid monthly wages for the part-time labour
they provide on the farmland.

(2) Why is the PRC government supportive of large-scale farming?
a. On the back of population growth and increasing urbanization, food security is an increasingly concern for the PRC
government. Large-scale farming by corporations or collective enterprises typically comes with higher productivity
and more stable supplies, which will help alleviate the food security issues.
b. With the growing rural-urban income gap in China, the government is also obliged to raise the livelihood of the
farmers. This objective is achieved with large scale farming when corporations pay farmers for both the leasing
of the farming rights and the farming labour. The sums received by the farmers are usually in excess of what they
were earning previously when they manage their own farmland.

(3) Why would the farmers want to lease farmland (or farming rights) to you?
a. Individual farmers are very dependent on weather and market factors for the yield on their farmland. Vegetable
price fluctuations and weather calamities could potentially wipe out the bulk of their income for the year.
b. Farmers who lease out their farming rights to us will receive both rental income and wages for the part time
labour they provide on the farmland. This is easily about two to three times compared to what they were earning
previously.
c. The villages which we target tend to have most of the able-bodied men and women already migrated to the cities
to work. The older folks left in the villages are staying back mainly because of lifestyle reasons and are typically
more laid back. Most of the time, they will prefer to get some stable income by leasing out the farmland and by
providing some part-time labour.

(4) Do you find the leasing of farmland (or farming rights) getting increasingly
competitive in today’s environment?
a. As of today, the corporations and the large scale collective enterprises account for less than 2% of total vegetable
production in China, with the remaining 98% are still dominated by individual farmers. As such, there is still a lot
of room for us to expand.
b. So far, we have not entered into competitive bidding with our peers for land leases. Most of the time, our contacts
with the village committees for farmland leasing is done by way of invitation through the local mayors who are
looking to raise the standards of living of the farmers in their area.
c. Our status as a “National Leading Dragon Head Enterprise” in China since 2002, has also placed us on the priority
lists of the local governments.

(5) Are you generally a beneficiary of food inflation?
a. Yes, we are. While the prices of our processed vegetables have already been contracted before the cultivation
season, we get to reap extraordinary profits on our fresh vegetables.
b. On the other hand, our integrated business model helps to cushion us if vegetable prices were to fall in a market
down cycle. As far as our working capital allows, we will process the excess fresh vegetables, keep them as
inventories (which are good for three years) in our warehouses and sell them again when prices rebound the
following year.

(6) Is the PRC government likely to put any price controls on vegetables?
We do not foresee the PRC government placing direct price controls on vegetables for the following reasons:
a. One of the key objectives of the PRC government for the agriculture sector is to raise the livelihood of the farmers.
By placing price caps on vegetables amidst an inflationary environment, the government will be directly hurting
the farmers’ incomes and be in conflict with their policy goals.
b. There are an estimated 700 million farmers and few hundred types of vegetable species in China. Any form of price
restrictions (which need consistent monitoring) will be an arduous task with the many points of sales and large product
variety.
c. The government has however clamped down on speculative activities on vegetable prices. In addition, they have also
implemented measures which are targeted at lowering the production and distribution costs so as to ease inflation
pressures.

(7) Are your high margins sustainable?
We have many competitive advantages (in terms of cultivation techniques, economy of scale and distribution network)
over the individual farmers who contribute more than 98% of vegetable production under China’s agricultural landscape.
The aggregate large volume contributions from the lower-yield production of small farmers have helped to ensure the
sustainability of our margins. Besides having the expertise to grow higher value crops, some of the things which we do
differently from individual farmers include:
a. Having land improvement infrastructure (eg. drainage and irrigation systems) on our cultivation bases. With
only small plots of land to manage, individual farmers do not have the incentives and resources to do much land
improvement, hence making their land (and yield) very susceptible to weather conditions.
b. The use of imported seeds which enhances the yield. Due to the lack of resources and accessibility to bigger
suppliers, individual farmers typically use local seeds.
c. Unlike the individual farmers, we do not sow the seeds directly onto the ground, in the hope that all the seeds will
germinate. Instead, we will first nurture the seeds in the nurseries and upon germination, the seedlings will be
planted on the farmland, hence optimizing the available space on the farmland and ensuring appropriate spacing
between individual crops for them to grow optimally.

(8) What cost pressures are you seeing in the near term?
a. We expect the lease costs of farmland to be on the uptrend, underpinned by the ongoing food inflation trends.
However, the lease costs have already locked in for our existing farmland for the rest of the tenure (average of
about seven to eight years remaining).
b. Our raw materials comprise mainly of fertilizers and seeds. Fertilizer costs are correlated to international oil
prices, the rise of which is a main contributor to food inflation. As most of our seeds are imported from overseas
(purchases denominated in USD), its absolute costs in RMB is on the decline.

(9) What are the major risks and challenges in your business and how do you overcome
them?
a. RMB appreciation. While most of our key products (eg. champignon mushrooms, German chives, etc.) are still
very price competitive compared to the local suppliers in Europe and US, the continuing appreciation of the RMB
implies that these products will slowly lose their price competitiveness. While the short term strategy to protect our
margins is to price in RMB appreciation in our contracts and sell our processed vegetables to export distributors
based in the PRC (sales denominated in RMB), the long term strategy will be to continuously shift towards higher
value products.
b. Weather risks. It is known in the agriculture sector that any adverse changes in weather patterns could potentially
affect the farmland yield. To mitigate this, we generally choose to lease farmland only in premium locations (away
from drought or flood prone zones) and construct land improvement infrastructure (in the form of roads, irrigation
and drainage systems) to better shelter us against any weather adversities. As a further protection, we also have
escape clauses in our contracts with customers in the event that we are unable to deliver our products due to
Acts of God.
c. Redevelopment risks. While this has not happened before in our operating history, there could be a possibility that
the local government could rezone certain farmland areas for commercial or industrial developments. To mitigate
this risk, we generally choose farmland that is at least 2 hours drive from the city centre (or 1 hour drive away
if it is located in a mountainous region), so that any chances of redevelopment during our ten years of tenure is
almost negligible.
d. Managerial talent. With increasing urbanization in the PRC, it is getting more difficult to find qualified farmland
supervisors who are willing to relocate and reside in the rural villages all year round. To manage this, we have
started (1) scholarships for undergraduates pursuing agriculture or food processing degrees (2) internships for
undergraduates (so that we have a first choice of talent) (3) tying up with local agriculture bureaus to second
agriculturists to our plantations.