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16-05-2012, 02:09 PM
weijian Wrote:(4) My guess is that the numbers used in FY11 ppt for FY10 for 'processed veg' and 'fresh produce' were stripped of the contributions from 'mushroom pores' and 'others'. In FY2010 ppt, both ('mushroom pores' and 'others') were consolidated in 'fresh produce' and 'processed veg' respectively. Hence this explains the discrepancy.
Hi weijian, thanks for the audit. I double checked the numbers myself and reached out to the company for verification, and yes, what you said is correct. They have changed the definitions of the categories because the mushroom spores command very low margins compared to their other fresh vegetables so they decided to carve it out.
Under processed food, they have also carved out the lower margin individually quick frozen ("IQF") products from other higher margin processed vegetables. They did not elaborate what these other higher margin processed vegetables were.
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IMHO, the risks involved in investing in China Minzhong's business model are numerous and pertinent.
(1a) Will they be able to continue securing new farmland to expand production? This seems pretty dependent on the wishes of the Fujian authorities.
(1b) How much will the farmland cost? Already, costs of land leases have almost doubled from RMB 6,000 per mu in 2007 to RMB 10,000 per mu in 2011. Current land use rights carried on books likely understate replacement costs.
(2) Labour costs have also risen substantially in China over the same period of time. This would likely increase the replacement costs of the factors of production. Thus, land improvement costs and operating lease payments carried on books also likely understate replacement costs. We know for example that land improvement costs have risen from RMB 8,000 per mu in 2007 to RMB 14,000 per mu in 2011 (company's estimates).
(3) The government has intervened before in the prices of vegetables to keep costs of living low for the masses. Clearly, China Minzhong is not a price setter.
(4) One would expect exported goods to command a higher margin, given the total cost of production and shipping to Europe is still 30% - 50% of the same costs that European farmers would incur to produce the same good. Yet, the company has reiterated its desire to ramp up sales to the Chinese domestic market and to achieve a 50-50 split between domestic and export markets. I sense pressure here from the Chinese government to support the local market. Again, this signals a lack of flexibility to pursue profits.
(5) The company has very very very favourable tax rates from the government. Perhaps this is in return for the company's support of the domestic market. Without the tax exemptions, effective tax rates would be 25% instead of the current 13%. How long will this last?
(6) Even in many other growth industries, companies usually pay a nominal sum of dividends. This practice is good in many ways. It shows people that the money is there. It enforces discipline in making budgets and capital projections. It reminds managers of the company's profit-making purpose.
There are companies out there who have tripled their revenues and quadrupled their profits in 8 years, through acquisitions and regular capex, and still pay dividends year in and year out. Dividends may fluctuate, but they are generally commensurate with the overall growth trend. China Minzhong has refused to pay a dividend in pursuit of growth. If there are truly concerned about long term corporate governance and being stewards of capital, shouldn't they pare back expectations (their own and all external stakeholders') and opt for a slower growth rate? If you can only double instead of tripling your production in 4 years, I'm sure investors will still be very happy.
So all in all, what does this mean for the valuation of the company? For one, current reported net profits bear depreciation costs that are significantly lower than what can be expected going forward. Whether or not prices can rise to fully compensate for that is unclear and, in my opinion, unlikely. A valuation exercise for CMZ should thus carry a larger than usual margin of safety in my opinion.
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I have wondered about the position of the Chinese government on these agricultural companies. Why would they allow full tax exemption on the sales of fresh produce? Is this the best way to keep prices low and affordable for the masses? Let's list out the ways to keep prices low:
(1) Set a price ceiling
(2) Subsidize factors of production
(3) Tax breaks
(If you have more suggestions, please do share.)
Out of these three options, (3) is probably the most palatable since the costs are not immediate, and can be more easily removed. However, it does represent a cost to the government. It is just that this cost is in the loss of future cash flows rather than a present disbursement of cash.
Taking a step back, it might also not be a bad idea to allow the privatization of such capital-intensive industries that (a) serve mainly local markets and (b) have a wide impact on society. The government can indirectly influence its operational objectives while sending the bill for expansion to foreign investors. But what is good for the Chinese government and its people may not necessarily be good for investors. A lack of dividend for example, casts doubt over when investors will see the returns on their investment.
