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Based on our research, which includes factory visits and discussions with customers, competitors, and government officials, as well as examinations of Chinese financial filings, we think that China Agritech does not have a currently functioning business generating anything close to $100 million in revenue. We’re very confident that the company is a scam.
We have put together a report discussing our research, which can be downloaded here: CAGC Research Report
Our report features the following highlights:
- Despite a $230 million market capitalization and claims of $119 million revenue in 2010, our factory visits revealed that Agritech’s manufacturing facilities are currently all idle and only one out of its four factories produced anything at all in 2010. We visited each Agritech facility and found each one idle and highly unlikely to produce significant amounts of fertilizer.
- Even though it has raised over $70 million in capital since 2005, Agritech appears to have acquired only several million dollars worth of capital equipment. By contrast, it has paid its two founders at least $4 million in rental fees and real estate purchases during that time.
- Companies Agritech claims as clients, such as the big state-owned fertilizer company Sinochem, deny having any contracts with Agritech. Sinochem has told us that it does not sell any Agritech products.
- Agritech’s stated suppliers cannot be found in any directory under possible Chinese names that would correspond to the transliterated names or under the alphabetic names. They do not appear on industry lists of companies making humic acid or ingredients for organic fertilizers.
- Revenue, profit and fixed assets reported to the Chinese government are 10x, 5x and 3x lower than the figures reported to the Securities and Exchange Commission.
- Agritech’s CFO has been involved in two listed companies before Agritech in which he personally collected seven-figure sums while the companies went to zero. Another Seeking Alpha analyst has written on this previously (here and here). Insiders have sold over $2.5 million worth of stock over the past 12 months.
We discuss highlights of the report below.
Factories are Idle, Distribution Centers Cannot Be Identified, and Products are Nowhere to Be Found
After visiting Agritech’s reported manufacturing facilities in Beijing, Anhui, Xinjiang, and Harbin, we found virtually no manufacturing underway. Pictures are available in our report. The single exception was the facility in Pinggu County on the outskirts of Beijing, where the plant was not in operation on the Friday when we visited but local people told us that it has sporadically produced some liquid fertilizer over the last year. Plants in Bengbu, Anhui (supposedly the largest), Harbin, and Xinjiang were completely shuttered.
The Harbin facility – supposedly a major manufacturing facility for the $100 million revenue business – had a sign hanging on the gates last summer reading “this factory is for sale.”
Although the company has announced 21 regional distribution centers, we have not been able to locate any. In May 2010, Agritech issued over 1.4 million new shares, raising just under $19 million for the construction of distribution centers. But we have not been able to find evidence that any distribution centers were actually built.
We attempted at some length to purchase at least one bottle of the Agritech product but were disappointed. Fertilizer distributors listed on a popular industry website did not carry Agritech product. We looked for the addresses of retail locations. Then we tried buying online via the popular site Taobao or an agricultural products site, with no luck. Then, we telephoned the company. We asked for retail locations, but the staff member who answered the phone said that they could only fill our order directly. We explained that we wanted one bottle as a sample before making a bigger order. She said that the company is able to fulfill only wholesale orders. When we persisted, the staff member said that a distributor would be passing through our area, Beijing, the following week and would drop off a sample, but that did not happen. When we called the number for the “distributor” the following week, the phone was unanswered.
Non-Existent Customer Relationships And Mysterious Suppliers
Last month, Agritech announced that the company had previously renewed a “contract supplying organic liquid compound fertilizers to Sinochem, China’s largest fertilizer distributor. The sales contract is worth RMB 61 million (approximately $9 million) and the Company will also continue to supply Sinochem with organic granular compound fertilizer under another existing contract.” We spoke with a manager at Sinochem and he told us that Sinochem has no contract with Agritech and in fact has never bought or sold organic liquid fertilizers.
The companies that Agritech lists in its corporate materials as suppliers of raw materials, including Harbin Haiheng Chemical Distribution Co., Beijing Zhongxin Chemical Development Co., and Shenzhen Hongchou Technology Co., cannot be found in any directory under possible Chinese names that would correspond to the transliterated names or under the alphabetic names. No companies with names resembling these appear on industry lists of companies making humic acid or ingredients for “green” fertilizers. In fact, we speculate that the companies, if they ever existed, form an outdated supplier list, since at least three of Agritech’s four factories are closed down.
For example, Agritech lists a supplier they call “Beijing Zhongxin Chemical Development Company.” No such company exists, although there is one in Beijing called “Beijing Zhongxin Trading Company” listed on the Internet. However, when we called the Beijing operator for directory assistance, she could find no such company listed in the active directory. We gave her the phone number listed on the Internet site (010-66067374) and asked her to do a “reverse look-up” of the number. She advised us that this is a number for a public phone booth, not a legitimate business phone number. All other searches for the suppliers mentioned in the 10K filing were futile.
Agritech gives no information about customers or distributors in the two most recent 10Ks; we had to go back three years to find the names of any such companies. We decided to contact each of the companies mentioned in that three-year-old 10K. We could verify only one of the names – Sinochem, which had already told us they do not do business with Agritech. We were not able to find active businesses with active phone numbers for any of the other supposed customers listed by Agritech.
SAIC Filings Show Dramatically Lower Revenue, Profit and Fixed Assets than SEC Filings
Below are CAGC revenues, profit and fixed assets reported to the Chinese government for the year 2009 in every subsidiary we were able to trace — including the Beijing subsidiary, which is mysteriously unreported by the company. We were able to review CAGC’s results from its companies in Anhui, Beijing, Heilongjiang, and Xinjiang. The branch company in Chongqing, we were told by government sources, does not keep a separate P&L but instead records its revenue through its parent company. We did not find a record of a Xinjiang branch company.
Gross revenue, profit and fixed assets reported to the government in these companies for 2009 was as follows:
|Subsidiary Name||2009 Gross Revenue (RMB)||Profit (Loss) (RMB)||Fixed Asset Value (RMB)|
|Harbin Pacific Dragon Liquid Compound Fertilizer Co.||580,000||(7,000)||1 million|
|Agritech Fertilizer Company (Beijing)||46.65 million||7.61 million||10.95 million|
|Anhui Agritech Agricultural Development Co. Ltd.||530,000||(94,000)||2.73 million|
|Xinjiang Agritech Agricultural Resources Co. Ltd.||3.82 million||(250,000)||20,000|
|Totals Reported to SAIC (in RMB)||51.58 million||7.259 million||14.7 million|
|Totals Reported to SAIC (in USD)||$7.58 million||$1.067 million||$2.16 million|
|Numbers reported to the SEC||$76.13 million||$5.69 million||$5.98 million|
|SEC figures as a multiple of SAIC||10x higher||5x higher||3x higher|
Below are further notes on China Agritech’s SAIC filings:
- The Harbin company, Pacific Dragon, has cumulative losses since 1994 of over 4 million RMB. None of its 2009 revenue was actually received but all was entered into “accounts receivable.” Meanwhile, the debt-to-asset ratio is 98%. There were no sales expenses at all, only administrative expenses. In short, the 2009 audit report on CAGC’s Harbin company shows a relatively worthless company.
- The Anhui facility has generated losses every year since its establishment in 2006. By the end of 2009, it had lost 3.89 million RMB. The company had zero cash on its books.
- The Xinjiang company reports zero fixed assets, meaning that it owns no equipment for production. Moreover, its 75% parent is the Anhui company, yet the Anhui company never reported making the required investment in the Xinjiang subsidiary.
- The Beijing facility has licensed registered capital of $20 million, but by the end of 2009 had received 88 million RMB, so only more than half of the legally required amount. But despite the missing capital, half of the registered capital was still sitting in the account in cash in 2009, indicating that the company had not purchased much, if any, equipment.
Humic Acid Fertilizer Manufacturing is a Low-Margin Business
We visited one of China’s largest manufacturers of pure humic acid, a factory that produces 2,000 tons of humic acid per year. 2,000 tons of humic acid can yield about 75,000 tons of fertilizers. Currently earning 10,300 RMB per ton of humic acid, this company estimates 20 million RMB in gross revenues for the current year, or about $3 million. The managers believe that, if they can use all their production for their own end product, they may be able to triple revenues. Even these optimistic estimates, however, would not bring the company anywhere close to the revenues claimed by Agritech. Not permitted to expand production and concerned that its existing outdated equipment may have to be replaced, this company is now shifting to manufacture blended fertilizers under its own brand in order to extract more value from the existing facility.
As market prospects for humic acid have dwindled, China Agritech, China Green Agriculture, and other producers of natural fertilizers have been driven into compounds, where the admixture of chemical fertilizers adds volume and market acceptance.
The problem is that compounds earn slim or negative margins. In 2008, the compound fertilizer production volume showed negative growth, as raw materials prices soared and farmers limited consumption to manage their costs. According to the China National Chemical Industry Information Center (CNCIC), China’s production capacity for compound fertilizers in 2008 was 200 million tons per year, while actual production was only 50 million tons. Product prices are essentially determined by the input costs plus 1-3%. That means manufacturers of compounds, if they produce at all, are doing so at razor-thin margins. Given that Agritech claims to produce 200,000 tons of granular compounds against 13,000 tons of higher-margin liquid compound fertilizers, a 28.5% EBITDA margin in 2009 should be viewed as a feat of magic by large competitors like Sinofert (HKG: 297). In 2009, Sinofert sold about 1.01 million tons of granular compounds. The company’s EBITDA margin in 2009 was negative. Although only 20% of Sinofert’s revenues is derived from its own manufacturing rather than agency sale of compounds, margins are similar on that side of the business.
Faced with industrial fragmentation and losses, China’s government agencies in 2008-2009 issued policies designed to consolidate the industry, shutter high-cost manufacturers, and convey expansion capital and other benefits to large producers. Lower prices of nitrogen in 2009 bolstered production of compounds to about 55,000 tons, often at a small profit. But small producers and newcomers like Agritech were not able to obtain production licenses for compounds. Local government officials told us that Agritech had not obtained licenses for manufacturing compounds in any of its facilities and was restricted to making liquid compounds at the facility in Beijing. A government official in charge of regulating a part of Agritech’s business and who was very familiar with the company estimated that, nationwide in 2010, Agritech did not have more than 50 million RMB in revenues.
Self-Dealing and Fundraising
China Agritech has been active in the capital markets since going public, completing three significant private placements and a fourth secondary public offering since 2005. In total, the company has raised more than $70 million. Yet SAIC filings show that the company had no more than $2 million of fixed assets since 2009. Even according to SEC filings, the book value of its fixed assets were only $8.3 million at the end of the third quarter 2010.
Rodman & Renshaw handled the public offering in April 2010 of 1.24 million shares of CAGC stock, raising almost $19 million. The money was intended for the buildout of distribution centers, Agritech said. But the company by summer 2010 had still not received production permits for granular fertilizer, while demand for liquid fertilizers was limited. We have not been able to identify any distribution centers that were built with the share proceeds.
While the capital raises have not been re-invested in productive manufacturing capacity, company insiders have profited handsomely from CAGC. Real estate companies owned by founders Chang Yu and/or Teng Xiaorong have earned at least $4 million from China Agritech since 2004. Since its reverse merger, Agritech has been renting certain of its Harbin and Beijing premises from its founders, with the rent cost totaling more than $500,000 annually over the past few years. The premises are mostly empty. Agritech has also purchased real estate from its founders. Last August, the company paid Ms. Teng $1.49 million to purchase 750 square meters of office space in Beijing from her.
Share sales have been an even more lucrative form of monetizing their involvement with CAGC for insiders. Over the past twelve months, at least 200,000 registered insider shares have been sold by Ms. Teng, CFO Gareth Tang, and officer Zhu Mingfang (Steve Zhu) for a value exceeding $2.5 million.
Our careful examination of China Agritech’s business indicates that along all parameters, Agritech has grossly inflated its revenue, failed to account for tens of millions of investor dollars, and now has virtually no product in the market. We believe this company should not be listed on NASDAQ. Fundamentally, CAGC is worth no more than the $2-per-share cash that is still in the company’s accounts – if insiders don’t empty it first.
Disclosure: We have short positions in the stock of CAGC
Over the past several years, we have seen increasing instances where Chinese companies have sought acquisition targets abroad. In 2005, Lenovo Group bought the hardware computer business of International Business Machines for $1.8bn, while the Chinese automaker Geely recently purchased the German icon Volvo also for $1.8 billion. We’ve seen numerous minority investments by Chinese companies, often in the resource sector. Aluminum giant Chinalco (also known as Aluminum Corp of China Ltd) bought a 12% stake in Anglo-Australian miner Rio Tinto in 2008 while CNOOC (“China National Offshore Oil Corp”) paid $2.2bn to Chesapeake Energy earlier this month for a one-third interest in its South Texas oil and natural gas shale project.
In most of these cases, the implied investment rationale has been China’s desire to either expand its global reach or to gain access to much needed natural resources. Return on capital considerations can sometimes take a backseat to other concerns, such as fulfilling certain broader economic goals that the Chinese government hopes to achieve through the acquisitions. In all of the above cases, the acquirers are partly state-owned.
In October, however, we saw the potential for a different sort of acquisition involving a Chinese suitor and a foreign target. In late September, Bright Food, a Chinese food conglomerate, announced that it was in exclusive talks to buy private equity-owned United Biscuits in an acquisition that would likely exceed $2 billion in value.
United Biscuits sells and manufactures a variety of packaged food products, including McVitie’s, Carr’s crackers, Jaffa Cakes, Hula Hoops, etc. Its history dates as far back as 1948 when two Scottish family businesses, McVitie & Price and MacFarlane Lang, merged their operations. Bright Food, on the other hand, is a majority state-owned Chinese enterprise with more than $5 billion revenue and a wide network of retail outlets in China.
The merger talks have since fallen apart, as was reported by the Wall Street Journal earlier this week. But if Bright Food had moved forward with the purchase, the transaction could have represented a seminal event within the universe of Chinese cross-border M&A. Whereas many prior acquisitions featured Chinese companies expanding abroad or gaining access to natural resources, a Bright Foods acquisition would have been an instance of a Chinese company attempting to take foreign brands and better integrating them into the Chinese market. Rather than trying to increase its business reach outside of China, Bright Foods would be using United Biscuits to accelerate its growth within China, via foreign brands rather than domestic ones. It would have been an example of a Chinese conglomerate attempting to use its local expertise to provide a better end-market for foreign goods.
The food sector in China has been benefiting from many of the same macroeconomic growth trends that we’ve seen in other Chinese sectors. Whether the industry is steel or chemicals or cell phones, China has been a more attractive place to sell one’s goods than most end markets in the developed world. Rapid GDP growth has meant that chocolates and biscuits are selling at a faster pace in China than in other countries. To take Coca-Cola for instance, unit case volume growth in China was 16% in 2009, compared to -2% in the United States. Yum! Brands is seeing a resurgence in its sales and share price, mainly because more than 40% of its sales are now in China, and those sales grew 20% in the most recent quarter.
Yet the problem for many midsize foreign manufacturers is that they haven’t been able to gain a foothold in China as successfully as some of their stronger global competitors. United Biscuits may very well be one of those brands. While Yum! and Coca Cola have the financial and operational resources to become dominant players in emerging markets, smaller outfits like United Biscuits often do not.
That is where Bright Foods can come in. Bright Foods is a leading provider of numerous Chinese foodstuffs, such as Da Bai Tu candy and various milk and yoghurt brands. The company can use its local competencies and distribution network within China to bring United Biscuits’ products to Chinese retailers. Foreign products often receive warm receptions from Chinese consumers, who may view them as more high-end than domestic products. Some domestic food producers have faced scandal due to low quality products, including Bright Foods’ own Bright Dairy & Food Co., which was among the more than 20 milk producers implicated in a 2008 scandal in which the industrial chemical melamine was added to milk powder that killed at least six children and sickened nearly 300,000 others.
Although talks between Bright Foods and United Biscuits appear to have collapsed, the Chinese conglomerate’s initial interest may be a harbinger of things to come. From a business perspective, Chinese firms could realize value by taking midsize yet reputable foreign brands, especially ones that lack ambitious multinational parents, and effectively introducing them to Chinese end markets.
In my last article, I discussed some of the general industry-level factors that make the three state-owned Chinese telecom operators, China Mobile (CHL), China Unicom (CHU) and China Telecom (CHA), potentially good investments. In this article, I’ll elaborate on the specifics of each company, as well as some concluding remarks on which of them may be the most attractive. I’ll focus on China Mobile and China Unicom, but also briefly touch upon China Telecom.
China Mobile is the leading wireless telecom in China and the largest wireless company in the world by subscribers. The company went public in 1997, with operations initially concentrated in Guangdong and Zhejiang provinces. Between 1998 and 2004, the company acquired numerous mobile operations from the government, ultimately expanding its reach to all of China’s 31 provinces. The company has 522 million subscribers, $210 billion in revenue and $215 billion market cap.
Below are summary financials for China Mobile. I’ve converted all figures to US dollars.
Over the past decade, the company has been the principal beneficiary of China’s rapidly increasing wireless usage. Wireless penetration has steadily risen from approximately 10% in 2000 to approximately 60% today. With market share of about 80% and ARPU that is nearly double China Unicom’s, CHL has enjoyed strong growth.
The question, however, is how CHL will fare going forward. As part of the industry-wide restructuring in 2008, China Unicom was granted WCDMA technology, which is the most mature 3G wireless technology out of the Chinese telecoms. WCDMA capability has played a part, for instance, in allowing China Unicom to win exclusive rights to the IPhone. China Telecom’s CDMA platform is also a more advanced technology than China Mobile’s.
Both China Telecom and China Unicom have been making heavy investments in their wireless business following the industry restructuring, and are certain to become a more viable competitive threat to China Mobile in the future. Government initiatives aimed at leveling the playing field, such as number portability, will also eat into CHL’s competitive position.
Nevertheless, China Mobile will continue to have a bright future given the general growth of the mobile sector in China, and the three-operator competitive landscape. In 2011, many telecoms in the world will be transitioning to the next generation of wireless networks, and CHL will likely be a frontrunner in upgrading to “Long Term Evolution”, or LTE technology, as it transitions its network to 4G infrastructure.
Furthermore, CHL’s management, operational infrastructure and brand identity are several notches above that of China Unicom and China Telecom. Even though its technology may be lagging when compared to CHU or CHA, at least until CHL upgrades to 4G, the company can compensate for that through strong operational execution. Indeed, the slowdown in China Mobile’s metrics have not been dramatic so far. In the most recent quarter, CHL’s revenue still grew 8% year-over-year, and its subscriber count rose 3% compared to the prior quarter.
China Mobile trades at a relatively low valuation, at about 12x 2010 P/E and 4.7x 2010 EV/EBITDA.
China Unicom is the second largest wireless operator and second largest fixed wireline operator in China. The mobile operations were begun in 2000, and steadily grew through acquisitions in subsequent years. The fixed wireline operations operated in the form of China Netcom prior to 2008, when the industry-wide restructuring pushed China Unicom and China Netcom to merge. As of 12/31/09, China Unicom had 148 million mobile subscribers, $11 billion in mobile revenue and $12 billion in fixed-line revenue. Its market cap is approximately $35b.
Below are summary financials for China Unicom. I’ve converted all figures to US dollars.
China Unicom’s historical financials are not very meaningful, because the company changed materially as part of the 2008 industry restructuring. The company was granted a WCDMA license by the government, which is a more advanced technology than the TD-CDMA or CDMA2000 licenses operated by China Mobile and China Telecom, respectively.
The company is currently undertaking high expenditures in both capex and marketing in order to build out its WCDMA network and strengthen its brand identity. The company’s former GSM technology was viewed as low-quality by consumers, and the company is in the process of re-branding itself as a higher-end operator.
The most attractive part of the China Unicom story is that it has underperformed so much historically that its future is bound to be brighter than its past. Its ARPU and minutes of use per subscriber has historically been nearly half of China Mobile’s. It controlled only 13% of the Chinese mobile market in 2009, compared to 79% for China Mobile. With its new WCDMA license, its exclusive rights to the IPhone, its high capex spend, and government policies designed to help CHU at the expense of CHL, China Unicom is poised to improve its profitability and competitive position.
That said, it’s unclear just how much CHU’s operating metrics will improve. Part of the problem with China Unicom is poor management. Not only is the company tackling a difficult acquisition, given that its 2008 merger with China Netcom was a merger of equals amongst two poorly-run state-owned enterprises, but the company has a more centralized, bureaucratic management structure when compared with China Mobile. As well, the company’s WCDMA technology represents a small portion of the firm’s overall revenue, and is projected to remain small in 2011. As of June 2010, WCDMA represented 5% of CHU’s total mobile subscribers and is likely going to remain at 10% to 20% of CHU’s wireless subscribers in 2011. Given that global wireless operators are likely going to transition to 4G technology in 2011-2013, CHU’s WCDMA advantage is unlikely to transform the Chinese mobile landscape over the long-term.
The company currently trades at a high valuation. At 13x 2011 EV/EBITDA, much of the company’s turnaround appears to be already priced in. The stock’s valuation is inflated partly because the company has A shares traded in Shanghai, where valuations are artificially propped due to the fact that China restricts domestic investors from investing outside of China.
Last, we have China Telecom. China Telecom is predominantly a fixed wireline telecom, but is looking to transition to its new wireless operations, given the secular decline of the wireline sector. The company entered the wireless business via the 2008 industry restructuring, when it acquired the CDMA assets of China Unicom. CHA went public in 2002 and proceeded to acquire numerous wireline telecom assets from the government throughout 2002 to 2008. As of 12/31/09, China Telecom had 57m mobile subscribers, $31b in revenue and its market cap is approximately $43b.
Like China Unicom, the company’s historical financials are not a reliable predictor of its future performance, given its lack of wireless operations prior to 2008. CHA is suffering a predictable decline in its wireline business, and its future performance will depend on its ability to offset that decline with growth in its mobile segment. Also like China Unicom, it’s attempting to brand itself as a high-end wireless provider, given that its CDMA technology is in certain ways stronger than China Mobile’s. The company is hoping to begin selling a CDMA-based iPhone in 2011. Finally, the company is growing from a small base, and favorable government policies and rising customer acceptance of its brand and technology should help China Telecom steal market share from China Mobile.
In terms of its fixed line business, the company is attempting to use broadband growth to offset the decline in voice customers.
Financials for China Telecom are below:
From a valuation perspective, China Telecom trades at a discount to China Unicom, at a 2011 EV/EBITDA multiple of 4.2x and 2011 P/E of 16x.
In my prior article, I argued that the secular growth in wireless / broadband usage in China and the 3-operator dynamics of the Chinese telecom sector provides a favorable backdrop for CHL, CHU and CHA. In this article, I’ve provided more details on each of the major telecoms. From a valuation perspective, CHL and CHA appear reasonably priced, while CHU’s valuation remains somewhat optimistic about its ability to grow rapidly in the coming years.
From a long-term perspective, a basket approach to the telecom sector would allow investors to benefit from the overall growth and reasonable valuations of the industry, without having to determine which of the three telecoms will emerge strongest over the coming years. Alternatively, an investor could bypass CHU due to its lofty valuation, and just invest in both CHA and CHL, or simply choose one. None of these three companies are going away, and all are likely to grow steadily over the long-term. I’ve chosen CHL as my vehicle to benefit from the China telecom story, but the underyling thesis has more to do with secular tailwinds than a belief that one of the three players will prove triumphant over the others.
Disclosure: Long CHL
Few investment themes are as obvious today as the long-term secular growth story of China. The gap between standards of living in China versus the rest of the world, combined with the hard work of the Chinese people and growth-oriented government policies of the government, mean that the next century is almost certain to belong to China.
Unfortunately, the Chinese growth story isn’t necessarily conducive to successful investing. Competition is cutthroat in China, and chronic overcapacity has fueled low returns on capital and low margins for many companies. An inability for Chinese residents to invest outside of China has led to perpetually overvalued Chinese stock markets. For companies that list on non-Chinese exchanges, promising stocks like EDU already have excessive optimism priced into their valuation multiples. Some of the others have been exposed as frauds, as has been common practice on Seeking Alpha.
Nevertheless, there are still effective ways to play the China growth story. One of them is by investing in Chinese telecoms. Three companies dominate China’s telecommunications industry, and all have ADRs available for US investors: China Mobile (CHL), China Unicom (CHU) and China Telecom (CHA).
Chinese telecoms benefit from rapidly increasing wireless and broadband usage within China, and the nature of the telecommunications sector protects the incumbent operators from cutthroat competition. As well, the telecoms are available at reasonable valuations, allowing patient, long-term investors to potentially benefit from the long-term rise in telecom usage in China.
A variety of macro trends makes the Chinese telecom story an attractive one.
First, the percentage of Chinese residents who own cell phones remains low in China relative to developed countries. Mobile “penetration” stood at about 56% at the end of 2009, compared to nearly 100% in the United States and 120% in European countries like Germany and the UK (in countries that feature a high proportion of prepaid plans, as opposed to the United States’ general preference for postpaid plans, we often see penetration rates higher than 100% because some users own two or more SIM cards). China also lags behind numerous developing countries, such as Russia (penetration rate above 120%) or Mexico (penetration rate above 75%). While subscriber growth will certainly slow down in the coming years, saturation within the Chinese wireless market is at least several years away, which offers the three Chinese telecoms an ever-increasing pie to share amongst themselves.
Second, the Chinese market does not suffer from an excessive number of operators undercutting one another in order to steal market share. Different countries can have dramatically different competitive landscapes, depending on the number of mobile operators. In some countries like Pakistan or India, there are 5-7 different wireless providers all vying for consumers’ attention. Invariably, excessive competition prevents the operators from enjoying attractive margins and returns on capital, as each operator undercuts its competitors in order to maintain market share. In other countries, such as Tunisia or Colombia, a smaller set of 2-3 operators dominate the wireless market, and are able to grow subscribers while still maintaining pricing power and high profit margins.
As well, because wireless operators must spend large capital expenditures in initial years to build out their networks, it can be relatively tough for a new operator to break into a maturing mobile sector. Despite the high returns on capital that Tunisian and Colombian operators may enjoy, it would be relatively risky for a new operator to enter that market, given the high up-front capex investments that would be necessary.
In China, it’s unlikely that a new competitor tries to break into the telecom sector currently controlled by China Mobile (CHL), China Unicom (CHU) and China Telecom (CHA). First, the industry is mature enough such that a new entrant would find it risky to begin building out a wireless network from scratch. Second, the Chinese government is highly interested in keeping the Chinese telecommunications sector out of foreign hands. CHL, CHU and CHA are all majority owned by the Chinese government. China’s desire to control the media and limit political freedom necessitates that the country control the major providers of broadband and wireless communications in the country.
It’s also instructive to examine the telecommunications restructuring that the Chinese government undertook in 2008. The goal of the industry restructuring was to create a reasonably competitive telecom sector. When China was accepted to the World Trade Organization in 2001, the WTO stipulated that the country open up its telecom sector to foreign entrants after a “transitional” period. Yet China has no desire to see foreigners get a foothold in its telecom sector, and a key solution is to make its telecoms sufficiently competitive as to ward away potential entrants.
The 2008 restructuring attempted to do just that. Specifically, it tried to create a telecom industry comprised of three dominant, efficiently run telecom giants. The government pushed the two telecoms China Unicom and China Netcom to merge, resulting in a company that had both wireless and fixed wireline businesses. It also pushed China Unicom to sell one of its wireless platforms to China Telecom, allowing China Telecom, which was the country’s strongest wireline provider at the time, to become both a wireless and wireline provider. Finally, the government pushed China Mobile to purchase a small fixed wireline operator, and also enacted certain policies to help China Unicom and China Telecom to better compete with China Mobile. For instance, China Unicom was granted more advanced 3G wireless technology with which to build out its newest network. Prior to the restructuring, China Mobile was the clear dominant player in the wireless market, with more than 80% of mobile market share. Analysts predict that China Mobile will steadily lose market share to China Unicom and China Telecom as a result of the government policies, as well as the small base from which CHU and CHA are building their wireless operations.
For our purposes, the key takeaway is that we now have three major players in the Chinese telecom sector which are all state-owned and have been carefully positioned by the government to become the dominant players within Chinese telecom. We can rest assured that the Chinese market will not result in overcompetition. Certainly, we should expect China Mobile’s margins to decline as it loses some of its previously monopolistic pricing power. But from a long-term perspective, the telecom providers should be able to co-exist reasonably well, and be able to mutually share the benefits of rapidly increasing wireless and broadband usage in China.
In the next article, I’ll take a deeper dive into each of the three companies, with more in-depth discussions on valuations, technologies, and growth profiles of CHL, CHU and CHA.
In a previous post, I discussed how Yum! Brands (YUM) was a viable way for U.S. investors to allocate capital towards the China and emerging markets growth story without stepping out of their comfort zones. In this article, I’m going to take that topic one step further and look at three other stocks that benefit from a similar theme: consumer companies with easily identifiable products that have developed relatively high exposures to Asia and emerging markets.
The investment thesis is relatively simple. In all cases, the companies highlighted are consumer product companies that have developed leading products over the course of decades. To transform themselves from stodgy large caps to attractive growth stories, the companies have made a concerted effort to replicate their proven business models in emerging markets, exporting not only their products, but also their marketing and distribution knowhow.
I selected my three sample companies from scouring a few websites and research reports on companies with high exposures to emerging markets. In particular, Chris Sholto Heaton has a nice list in this article.
Mead Johnson Nutrition
Mead Johnson Nutrition (MJN) sells nutritional products for infants and children, including infant formula and children’s nutritional products. Its Enfa family of brands comprised more than three-quarters of sales in 2009 and is the world’s leading franchise in pediatric nutrition. Founded in 1905, the company became a leading producer of infant formula throughout the early part of the century and was purchased by Bristol Myers Squibb in 1967. In 2009, the company split off from BMS via an IPO and split-off, and is now an independent public company.
MJN operates through two reportable segments: (i) Asia/Latin America and (ii) North America/Europe. Below are statistics for the last three fiscal years for MJN:
As we can see, MJN’s emerging market sales and operating income comprise 58% and 60% of the total company’s operating results, respectively. Asia/Latin America sales grew 24% in 2008 and 7% in 2009, while Asia/Latin America EBIT grew 27% and 25% in each of the last two years. Like the other companies profiled in this post, MJN is taking proven consumer products and replicating their marketing and sales infrastructure in emerging markets. The company’s attractive growth profile was featured in Third Point’s quarterly letter here. Unfortunately for investors, the company’s growth profile has been recognized by the market. The business trades at a steep 29x P/E multiple, and much of the business’s growth, as well as its potential to be a takeover target, has been priced into the stock.
Colgate, the world’s 51st most widely recognized brand as ranked by Interbrand, is a global leader in oral care, personal care (soap, shampoo, deodorant, etc.), home care (Ajax, Murphy’s Oil Soap), and pet nutrition. Here is Colgate’s geographic segment breakdown:
Colgate’s emerging market exposure is relatively strong. Asia, Africa and Latin America accounted for 53% of the company’s 2009 sales (excluding pet nutrition), up from 49% in 2007, and for 56% of the company’s 2009 operating income (excluding pet nutrition), compared to 50% in 2007. Operating income has been benefiting from improving margins in the Greater Asia / Africa region. The Company’s end markets are not growing quite as fast as YUM or MJN, but still at a healthy clip. Recent quarterly results were disappointing partly due to the impact of foreign exchange in their Latin American and Europe/South Pacific operations. At 18x P/E, the company appears relatively attractive as a bet on emerging market growth.
Nike, the world’s 26th most widely recognized brand as ranked by Interbrand, designs, develops and markets high quality footwear, apparel, equipment, and accessory products. Nike has a burgeoning emerging markets presence, but its exposure to fast-growing economies in Asia and Latin America remains materially behind the likes of YUM, MJN and Colgate. Below is its revenue and EBIT breakdown by geographic end market:
As we can see, the United States, Europe and Japan represent 70% of sales, which makes Nike still a company that predominantly caters to developed markets. That’s unfortunate, because growth has been mainly coming from China and emerging markets (excluding central/eastern europe), where sales grew a combined 10% in 2009 and 15% in 2008. Operating profit in China and emerging markets grew a combined 23% in 2009 and 24% in 2008.
Over time, Nike’s emerging markets presence will overtake its Western operations, similar to what we’ve seen with YUM and MJN. The company’s current valuation is at 21x P/E, which doesn’t immediately jump out as either overly cheap or expensive.
Finally, here are the geographic segment metrics for YUM:
Unfortunately, we can’t quite tell what portion of YUM’s sales and EBIT come from emerging markets because YUM lumps Europe, Australia and Canada with the likes of Brazil and Mexico in its “International” division. But a good estimate is that 40% to 50% of sales and profit come from fast-growing emerging economies. YUM has the highest China exposure out of the companies I’ve examined in this post, and out of any large U.S.-based consumer company I’ve been able to find. At a 22x P/E, the stock appears reasonably valued. An investment in YUM may not generate quick returns, but the company is a sound long-term investment if emerging markets, and particularly China, continue to outpace the developed world.
The power of China’s economy is something that every investor is going to have to deal with, regardless of whether one is interested in investing in China or not. In the following post, I’ve compiled some of important charts demonstrating the growth China has experienced in recent decades, as well as how the economy is changing.
In particular, I look at whether the factors often cited for China’s growth are likely to continue fueling the economy’s rapid expansion, or whether new drivers will need to emerge.
The first chart that we’ll examine is one depicting historical Gross National Product:
China’s GNP growth is daunting. But the above chart doesn’t necessarily tell us how fast China’s economy is expanding on a yearly basis. So our next chart of year-over-year GDP growth rates might help put China’s growth into perspective a bit better:
Investing in an economy that’s growing at a minimum of 6% per year is like shooting fish in a barrel. One of the primary sources of China’s strength isn’t great ingenuity, but rather a tremendous population. This chart shows how China’s population has been growing:
Unlike our chart on China’s gross national product, this chart is surprisingly not growing at an exponential rate. It isn’t compounding the way our first chart did. This is likely the result of both China’s one child policy as well as cultural and demographic changes encouraging less population growth. As a result, mere population growth will not be enough to sustain China’s economic growth rates.
With GDP/GNP rising and population growth slowing, we can guess that per capita metrics are also improving. A big part of this is the well documented migration of rural agricultural workers into the cities. Is this migration continuing at an exponential rate or is migration slowing? The chart below shows urban employment in China:
This chart shows us that the flow of migrants to the city has been somewhat constant over time, meaning the migration rate is slowing.
If GDP/GNP is growing exponentially, city populations are growing linearly, and the population is growing at a slower and slower rate, then wages must be increasing. The following chart shows us how wages have changed over the last decade:
The upward trend is obvious, and the sawtooth pattern is caused by seasonal changes in demand for labor as a result of Chinese holiday seasons. Social rights issues aside, it can be gathered from the chart above that quality of life is improving in China. It’s hard to believe that the Chinese people could be making 2-3 times more than they were making just a decade ago and not be enjoying some of the fruits of their labor. Unfortunately, Chinese residents aren’t fully capturing the higher standard of living that the increase in wages and GDP growth would imply. That’s because of China’s monetary policy, which is causing headline news weekly. The chart below shows how inflation has affected China:
Government policy to keep the Renminbi cheap relative to the US dollar and other global currencies has resulted in significant inflation which has historically come in waves. It doubled from 1978 to 1989, then again from 1991 to 1996. It looks like another wave is about to begin. The good news for China is that this keeps unemployment low as Chinese labor remains cheap and “competitive”. The bad news for China is that this reduces the value of China’s savings. All those decades of hard work slowly evaporate as inflation chips away at purchasing power.
It is easy for an investor to get stuck looking at daily forex fluctuations, or the latest headline GDP growth rates. But occasionally looking at these important charts over the course of decades puts things into perspective.
It’s fairly clear that the next decade will witness more rapid growth in emerging markets as compared with developed countries. Numerous factors are contributing to this, including increased urbanization, lower labor and production costs, underlevered economies relative to U.S. and Europe (Brazil and Mexico, in particular, have relatively low private and public market debt-to-GDP ratios), etc.
Countries like China, India and Brazil will not only continue to benefit from export-oriented growth, but are also increasingly reinvesting their export dollars in their own consumption, fueling strong growth for their own domestic end markets.
Yet while it’s obvious that emerging markets will feature higher growth, that doesn’t necessarily translate into obvious investment options. Many U.S. investors aren’t comfortable investing in foreign companies, given different norms for corporate governance and corporate disclosure, and an inability to vet foreign products or industry trends as easily as one can investigate U.S.-based products, trends or companies.
As a result, one of the more conservative ways to place a bet on emerging market growth is by betting on U.S. or European companies that are expanding rapidly in emerging markets. Particularly attractive are consumer-oriented companies that are taking proven business models from developed countries and replicating them abroad. Examples like Coca Cola, Colgate, and Procter & Gamble come to mind, as well as retailers like Wal-Mart or Tesco. These companies can use their best-in-class operating techniques and low-cost production positions to expand quickly and efficiently in new foreign markets.
For U.S. investors, these sorts of stocks can provide opportunities to benefit from emerging market growth without having to invest in companies outside of one’s comfort zone.
In this post, I’ll profile one multinational that has done a first-rate job at taking its proven U.S.-based business model, and fanatically copied it throughout the developing world, particularly in China: Yum! Brands (YUM).
Yum! is one of the largest quick-service restaurant operators in the world, operating such household fast food restaurants as Kentucky Fried Chicken, Pizza Hut, Taco Bell, Long John Silver’s, A&W and other smaller banners. Spun out of PepsiCo in 1997, Yum! has mainly grown organically, and has completed no major acquisitions since its spinoff.
For our purposes, we’re most interested in documenting the company’s transformation from a peddler of age-old American icons 10 years ago to one of the most aggressive global fast food operators in developing markets today. In 1997, the company’s international units accounted for 24% of the company’s total sales and 22% of operating profit. In 2009, international operations accounted for 59% of sales and 63% of operating profit. YUM’s focus on global expansion has converted it from a predominantly U.S. fast food chain to a predominantly non-U.S. operator.
The company’s expansion in China has been particular impressive. Below are some stats about the company’s Chinese operations:
As we can see, the company’s units have more than doubled since 2004. Its operating profit has tripled. Although I don’t provide any statistics here on their return on invested capital, it’s fairly obvious that the return on the company’s investments in China have been tremendous. To see a restaurant business growing EBIT at a 25% CAGR when it’s spending only 50% to 75% of EBIT on capital expenditures is nothing short of phenomenal.
Below are metrics on the non-China international operations:
While not as impressive as the China metrics, the non-China international operations have also performed well over the past 5+ years. It’s important to note that these international operations include Australia, UK, Canada and Japan, which are relatively mature compared to countries like China, India, Brazil, Vietnam, etc. So we can’t necessarily see the degree to which YUM has achieved the same level of success in other emerging markets as it has in China.
One reason to be excited about a company like YUM! is its potential for growth in developing countries not just during the next few years, but over the next 10-20 years. Below is a chart that compares the population per YUM! restaurant in developed markets as compared with the population per YUM! restaurant in emerging markets.
Naturally, many rural areas of developing countries may be unsuitable for a KFC or Pizza Hut, but the above chart nevertheless demonstrates the tremendous room for growth for YUM’s banners.
Focus on China
In the most recent quarter, China accounted for 34% of sales and 31% of operating profit. This makes YUM one of the most levered U.S.-based consumer companies to China. YUM is the leading foreign fast food operator in China, with its 2,800 restaurants nearly double the 1,200 units of McDonald’s. YUM’s Pizza Hut banner is the #3 operator in China. The Company’s chief of operations in China is also now YUM’s Vice Chairman.
The company’s growth in China has not been without its bumps; for instance, YUM’s China same-store sales experienced negative trends in 2005 and 2006 due to an ingredient supply issue and an Avian Flu outbreak. But over the long-term, the company’s focus on becoming a dominant restaurant chain in China has essentially transformed the company from what would have been a stodgy, cash-generating, dividend stock to a global growth story.
With YUM’s promising long-term growth trajectory, it’s no surprise that Bill Ackman at Pershing Square recently disclosed a position in the company. The company’s future will be determined by emerging market growth, as opposed to what happens with the U.S. economy. At 22x P/E, YUM trades at a premium to many other fast food chains, but the premium seems justified and the stock is not particularly expensive. For investors looking to diversify their investments out of the United States, YUM! is a viable option.
Disclosure: Long YUM