Largely immune to the West
A slowdown in demand from the West and an appreciating yuan won’t derail Minzhong’s earnings growth much, we believe. There are no signs of a slowdown in export demand so far. The company also has the flexibility to switch to fulfilling orders from South America at short notice. Management did this successfully in 2009. Its cost advantage is also unlikely to be eroded as ASPs for key crops are 20-50% those of European comparables.
Ready for next phase of growth
Its recently launched processing facility at Putian built at a cost of
Rmb1.1bn and sits on 282mu of land will triple Minzhong’s processing capacity. This new facility is expected to support processing volume for the next five years. Our previous farmland-expansion assumptions were too aggressive and we have reduced them from 30,000mu to 15,000mu for FY13-14, costing an estimated Rmb360m a year. With increased processing capacity, capex needs should be lower. Expected FY12 cash flow of Rmb700m and a net gearing of 0.07x should comfortably fund its coming growth.
Cheap
We change our valuation, now pegging our TP to 6x P/E, the stock’s average in its short listing history rather than the broad FTSE China Index. Its closest competitor China Green’s 5-year average P/E is 11x. Minzhong is cheap at 3.2x forward P/E against a 3-year EPS CAGR of 31%. Continued strong earnings growth, and a switch to a Big-4 auditor, should catalyse the stock, in our opinion.
Entering next phase of growth
1. LARGELY IMMUNE TO TROUBLES IN THE WEST
1.1 Euro-zone slowdown not hurting so far
Management expects higher yoy export orders in FY12, with 1Q12 earnings of Rmb93.1m (+ 78% yoy) underpinning its optimism. We expect the earnings momentum to remain strong. Europe comprises about 1/3 of its sales. Still, management has decided to be prudent in farmland expansion this year, cutting its plans from 30,000mu during IPO in Apr 10 to 15,000mu.
1.2 Take a leaf from 2009
Minzhong took more orders from South America in 2009 to balance out lower demand from Europe. This was evident in a 275% spike in brined Champignon mushroom sales. South American customers prefer brined products. We expect management to do the same this time round to counter any euro-zone slowdown. Its new processing facility at Putian will improve its ability to fulfil such orders at short notice.
1.3 Yuan appreciation won’t erode cost advantage
An appreciating yuan against the US$ (+4%) and euro (+9%) since the beginning of the year is not likely to erase its cost advantage. We understand that Minzhong can sell at 20-50% of Europe’s ASPs for crops such as Champignon mushrooms, capsicums, and German chives. Its competitiveness stems from cheaper labour and land, and more conducive weather which allows for more harvests for certain crops.
However, yuan appreciation has also rendered certain crops such as celeries no longer profitable. It is also one of the forces behind Minzhong’s decision to pursue higher-value crops where a cost advantage still exists.
2. READY FOR FURTHER GROWTH
2.1 Processing capacity tripled
Minzhong’s new Putian processing plant built at an estimated Rmb1.1bn sits on 287mu of land. Processing capacity is estimated to be 210,000 tonnes, 3x the volume processed in FY10-11. This should support its expansion in the next five years. The new plant will give Minzhong the flexibility to switch between various processing methods (air-drying, freeze drying, brining, fresh packing, individually quick frozen) at short notice, enabling it to capitalise on demand opportunities that crop up in different regions. Management has accelerated the construction of this plant so that it can be on time for the peak season in 2Q 12 and expects full utilisation within three years.
2.2 No direct impact from VAT tax removal for vegetable distribution
FY11 S&D expense of Rmb56m comprised only 3% of revenue with trucking expenses making up a small portion. Near term, the removal of the VAT tax will have minimal impact on its earnings. This move is part of a broader slew of initiatives by the Chinese government to contain price inflation. Other initiatives include subsidies for farming-related expenditures. The measures are encouraging as they should encourage vegetable supply growth.
3. FINANCIALS
3.1 Paring down farmland expansion
We were previously too aggressive with our farmland-expansion estimates. We have pared these down from 30,000 mu for FY13-14 to 15,000 mu, in line with guidance. This reduces our FY13-14 earnings forecasts by 14-16%.
3.2 To be financed internally
We estimate that it would cost Rmb10,000 to acquire the operating lease for 1mu of farm land. Management typically spends another Rmb14,000 per mu to improve the land , such as on irrigation and road infrastructure. This results in capex of Rmb24k per mu of new farmland. FY12 operating cash flow is estimated at about Rmb744m which should comfortably finance its expected Rmb660m of FY12 capex (Rmb360m for farmland expansion and Rmb300m for the remainder of the new processing plant). Net gearing at 0.07x in 1Q12 should give management the headroom to take on more debt as well.
3.3 Gross margins may decline
We estimate that gross margins may decline to 40.4% and 39.6% in FY12, and FY13 from 41.5% in FY11 from additional depreciation expense from the Putian processing plant. Economies of scale won’t accrue overnight. However, this is a conservative assumption as the increase in depreciation expense may be offset by higher sales of better-margin black fungus and King oyster mushroom crops.
3.4 Market concerns unfounded
The stock tanked by 27% in the early half of Dec 11, possibly due to its competitor’s credit downgrade by Moody’s. The latter’s debt was downgraded twice from Ba3 to Caa1 in two weeks. Jitters over its ability to pay creditors spilt over to Minzhong, whose cash balance is Rmb67m vs. Rmb302m of short- term debt.
We aren’t worried yet as:
1) 1Q is a low season; and
2) its short-term debt is due for re-financing only at the end of this year. Cash balances should be replenished after the 2Q-3Q peak. The market may have come to the same conclusion, as the stock has clawed back part of its losses.
4. VALUATION AND RECOMMENDATION
4.1 Outperform
We maintain our Outperform and TP. Previously, our TP was pegged to the FTSE China Index. Now, we apply 6x P/E, the stock’s average in its short trading history rather than the broad FTSE China index. We think this is conservative given that our TP is at a 45% discount to China Green’s 5-year average P/E of 11x before the Chaoda scandal.
At 0.8x P/BV, 3.2x forward P/E and a 31% 3-year EPS CAGR, Minzhong appears cheap. We see catalysts from continued strong earnings momentum and a switch to a Big-4 auditor.
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