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This SeekingAlpha article sent a wave of anger and accusation of market manipulation across the long shareholder world of Yongye--a reverse merger Chinese small cap that makes fertilizer.

I thought it was mild and made good points about the company. Most everyone else thinks the author is maliciously driving the stock down

I bought one of these bad boys a few years ago and it was a pos that is near zero--Bodisen Biotech a fertilizer company. So I thought I would look at Yongye and see what was up.

I never read these 10Ks without wondering how much is fiction and loosely audited. There is no doubt by these numbers Yongye is a manic grower with decent returns However, there has been a great deal of speculation about inflated revenue reported in the US that does not match Chinese filings. Some of these companies say this is standard practice and they don't need to match. I have not figured out why they bother filing in China if this is the case. Of course being a US listed company gives them access to all kinds of capital not available in China.

The Birth of Yongye

As with most reverse merger recapitalizations, the birth of Yongye is a mess and convoluted.

Yongye started in 2006 in Nevada under the guise of a self-tanning product that had no product but did have the valuable commodity of a way to circumvent an IPO and become a company in a shell no one was using. It was known as Golden Tan.

I would call this the hermit crab gambit

Most frequently hermit crabs use the shells of sea snails (although the shells of bivalves and scaphopods and even hollow pieces of wood and stone are used by some species

Having the shell is great but no money comes with a shell.

For money you need a core of investors and that was Fullmax organized in 2007 in the friendly Virgin Islands. Fullmax had shareholders who held shares presumably in exchange for money.

Shareholders in the investment company [AKA Fullmax] exchanged these shares for shares in a wholly owned subsidiary called Asia Standard Oil. Asia Standard Oil [ASO] is no doubt a nod to John Paul Getty and also their shell roots in suntan oil.

Shares in ASO gave shareholders rights to the heart of the matter and that was the indirect subsidiary called Yongye Nonfeng Biotechnology company. At this point there were 11.4 million shares outstanding . Fullmax became a wholly-owned subsidiary of Yongye Nongfeng and the group of Fullmax shareholders owned 84.7% of the company. The empty shell became the listed Yongye and that was the reverse merger recapitalization.

Fullmax had acquired some small assets from a Zishen Wi [now CEO and 5% beneficial owner of Yongye]enterprise called Inner Mongolia Yongye Biotechnology. These were very small and generated small amounts of revenue. There was a 2,000 ton capable plant transferred to the new company that did $13 million in revenue in 2007 and only $3 million in 2006.

In 2007, ASO and Inner Mongolia Yongye [Wi] joined forces to form the Yongye Nonfeng. ASO owned 99.5% and Inner Mongolia owned 0.5%. Inner Mongolia was as it happens almost completely owned by the now CEO Zishen Wi. Inner Mongolia was not any part of the structure previously. Inner Mongolia was formed in 2003 as a fertilizer company. It seems to have had a very small manufacturing plant. They made around $13 million in 2007. The split became 5% Wi and 95% ASO after 2007. In 2008 it again reverted to 0.5% and 99.5% and after the 2009 plant acquisition, Wi again returned to 5% ownership.

Yongye went from zero manufacturing employees in 2008 to 207 in 2009. Out of a total of 399 employees in 2009, 63 were administrators—16%. Seems a little top-heavy in management and light in worker bees for the increase in revenue. Revenue more than tripled and plant capacity quintupled.

In order to become fully operational, the company sold 6.1 million shares to finance restructuring of these assets. They had to buy land and buildings to turn the 2,000 ton plant into a 10,000 ton plant and they had to buy the fertilizer license in the Yongye name. Until they got the license Zishen Wi and his company manufactured fertilizer for Yongye.

To give Yongye their first plant that was capable of 10,000 tons, they spent the proceeds from the 11 million initial shares and sold an additional 6.1 million shares.

In 2007, ASO and Inner Mongolia Yongye [Wi] joined forces to form the Yongye Nonfeng. ASO owned 99.5% and Inner Mongolia owned 0.5%. Inner Mongolia was as it happens almost completely owned by the now CEO Zishen Wi. Inner Mongolia was not any part of the structure previously. Inner Mongolia was formed in 2003 as a fertilizer company. It seems to have had a very small manufacturing plant. They made around $13 million in 2007.

Yongye Nonfeng was incorporated in 2008

In September 2009, Inner Mongolia [Wi] sold their Shengmingsu plant to Yongye Nongfeng. This was apparently another holding of Inner Mongolia and Wi and not part of any of the Yongye Nongfeng structuring. It was a Wi owned entity outside of the merger and joint venture. It is unclear what the profitability is.

The price was a satisfying $16 million—mostly goodwill. After the transaction he became 5% shareholder as he received equity as part of payment. I can't divine why the ownership ratios were changed pre-acquisition. Maybe he does not want more than 5%

Here is how it worked:

In order to fund the acquisition, Yongye went to the usual well and issued a whole lot of shares –6.073 million [26 million outstanding end of 2007] for 23% increase in shares outstanding.

The acquisition itself was a bit ugly with a small amount of tangible property sold and a huge amount of goodwill paid.

Wi collected $16 million. As CEO and part owner of Yongye, this could be construed as conflict of interest. The plant brought the total plant count up to two. Capacity went from 10,000 tons to 35,000 tons of plant fertilizer and from 1,000 tons of animal supplements to 11,000 tons.

Consideration Fair value
Cash $4,692,265
4.5% equity interest in Yongye Nongfeng 11,830,000
Total consideration $16,522,265

The tangible property was valued at $2.4 million, land use was $4.2 million and goodwill was $10 million.

- Buildings $1,443,489 30 years
- Machinery and equipment 577,191 10 years
- Vehicles 351,161 10 years
- Office equipment and furniture 13,280 5 years
Total PP&E 2,385,121
Land use right 4,188,750 48 years
Goodwill 9,948,394
Total consideration $16,522,265

That was Yongye as of the first part of 2010—two manufacturing facilities with the capacity to make 35,000 tons of fertilizer and 11,000 tons of animal supplements.

Most of the organization benefited Zishen Wi. He had the Inner Mongolia holdings and at least two of the manufacturing plants that ended up in the final Yongye. He was paid millions and ended up a 5% owner. He quite likely planned the move from private PRC company to publicly traded company to give him access to capital. That’s not necessarily bad. He saw personal enrichment from the string of deals at shareholder expense. The dilution required to make the purchase of property, plant and equipment from him has been substantial.

Share issues

in millions

Balance Jan 2008 4,960
Stock issued to Fullmax 11,444
For cash 4/17/08 6,496
For cash 9/8/08 6,073
Warrants 687

Balance Dec 2008 26,760
For cash 5/8/09 5,834
For cash 12/22/09 8,000
For cash 12/31/09 1,200
Warrants 2,738

Balance Dec 2009 44,532
Issued for customer list 3,600
Options 55

Balance Dec 2010 48,187

Wi received at least part of the funds from both the Fullmax exchange and from the September 2008 issue. Yongye paid Wi again after sales of shares for the second plant Shengmingsu. Cash paid was $4.7 million and he was given $11.8 million in shares bringing his stake back to 5% ownership after a reduction in May 2008 down to 0.5% for unknown reasons. The fact it seems to anticipate the next sale to him suggests it might have been done because of the pending sale to Yongye.

In May 2008, upon the agreement among Inner Mongolia Yongye, ASO and Yongye Nongfeng, the ownership of Yongye Nongfeng was revised, pursuant to which Inner Mongolia Yongye and ASO became 0.5% and 99.5% equity interest owner of Yongye Nongfeng, respectively.

In October 2009, the Company completed the Acquisition. The consideration paid for the Acquisition consisted of cash of $4.7 million and 4.5% equity interests in Yongye Nongfeng. After the Acquisition, Inner Mongolia Yongye and ASO became 5% and 95% equity interest owner of Yongye Nongfeng, respectively.

There is little doubt shareholders are being diluted as Yongye uses shares every time it needs to raise cash. The number of shares has nearly doubled in 3 years. This equity financing is expensive. They have taken on small amounts of debt but appear to be unable to get reasonably good debt financing. If they continue this method of finance, shareholders will continue to see their shares undergo dilution.

In a subsequent event outside the 2010 10K, Yongye has somewhat inexplicably decided to branch out into mining. They have paid Wuchan Shuntong Humic Acid the substantial sum of $35 million for merely the right to explore and produce the coal resources located near their other facilities in Hohhot Mongolia. Yongye has no expertise or equipment for establishing a mining operation and has not processed coal into fulvic acid as it has always bought this raw ingredient.

In addition to the $35 million, they will now have to set up a mining operation—presumably open pit. The machinery is not inexpensive and the infrastructure will have to be built. That would include buildings, conveyers, roads among others. The $35 million for this vertical integration is the tip of the proverbial iceberg. This will be a capital-intensive undertaking and it is unknown whether the investment will actually produce reasonable returns. There is no cost/reward analysis. There is only the catch phrase—vertical integration—that may be expensive over the long haul. The fulvic acid they buy allows 53%-56% margins which is reasonably good. I am skeptical owning their own coal is going to improve that and the capital expense will no doubt come at shareholder’s expense.

If the new plant opened in August has been built to include coal processing, then it is an expense in anticipation of an event that is nowhere near completion and capable of providing raw material and that will drag on returns until they begin production. So far they do not even have mineral rights or productive coal beds identified.

This new third facility produces 20,000 tons of fertilizer and 10,000 tons of animal supplement and will produce the humic/fulvic acid required if they complete the mining expansion.

From the company:

If we are not able to obtain the government approvals to complete the coal resources project, our vertical integration strategy could fail and we need to take back the prepayment from Wuchan Shuntong.

We are still in the process of securing government approvals to complete this deal. If we are not able to obtain the government approvals on the Mineral Rights, our vertical integration strategy could fail. Another risk is that if we are not able to obtain the government approvals on Mineral Rights, we need to take back the prepayment to Wuchuan Shuntong amounting to $34.2 million, and litigation may be necessary. Moreover, the supply of lignite coal to Inner Mongolia Yongye Fumin Biotechnology Co., Ltd (“Yongye Fumin”)’s manufacturing facility will be dependent upon lignite coal availability in the market. If we are unable to obtain adequate quantities of lignite coal at economically viable prices which meet our specifications, our financial condition and results of operation could be adversely affected.

The third facility

On July 20, 2010, Yongye Nongfeng set up a wholly owned subsidiary in Wuchuan County, Inner Mongolia Yongye Fumin Biotechnology using $14,731,880 to build the manufacturing facility located in Wuchuan County, near the lignite coal resources project. Yongye Fumin has annual production capacity of 20,000 tons of plant fertilizer and 10,000 tons of animal supplement. Yongye Fumin will expand the production capacity for fulvic acid based liquid and powder nutrient compounds, and produce humic acid using lignite coal. The construction of the production plant of Yongye Fumin was completed in the fourth quarter of 2010.

Over the past 9 months Yongye has been on an extraordinarily big spending spree

In June 2010, they acquired the customer list from the provincial level distributor in Hebei Province. To pay for it they issued 3.6 million shares and paid $3.0 million in cash. The total was $25 million, the benefits dubious. It merely took out a provincial distributor and made Yongye responsible for increased distribution activity on store-by-store level in the province. There are no figures on what it cost to engage the distributor, but it is going to cost more to send sales reps to individual stores. The company claims it improved gross margins in 2010. However, operating margins normalized decreased. If the sales force needs to be beefed up, we might expect to see margins fail to increase and possibly contract

The total comes in around $74 million. I have not seen a discussion of the funding for the mining enterprise. I am assuming it will be sales of shares. The other activities were done with cash from shares. Cash in 2010 dropped from $65 million to $41 million yoy. We will not see the damage to equity or the balance sheet from the March payment until the end of the quarter is discussed. Something to look for.

With the high levels of acquisitions and building, there has been no positive free cash flow In fact CFFO has also been negative until 2010. Inventories and accounts receivable are eating up a lot of cash.

A few numbers
The SeekingAlpha article raised a storm of invective and accusations of market manipulation. I thought he had some good points and that the piece was mild compared to real short attacks I have read.

One of the author’s points was reduction in manufacturing staff even as production and revenue grow. Can they really be this efficient?

The other trend is the small additions to sales in light of the documented store increases and wider distribution. Add to the sales burden, the removal of the distributor they bought out and it becomes even more difficult to see how they can cover more territory with only a 12% increase in sales staff.

I have noted an outsized number of management compared to workers. It seems to take quite a team to manage so few employees. That number keeps increasing and is up 17.5% from 2009 to 2010-- does not seem efficient.

Category 2010 2009
Admin 74 63
Manufacturing 189 207
Research & Development 35 29
Sales & Support 114 100
Total 412 399

Stores served went from 9,110 in 2009 to 24,036 in 2010. The SA author commented on how a sales staff not growing fast can cover so much more territory. Yes, they rely in provincial distributors [barring Hebei] but the increase in workload cannot be inconsequential. They have to take orders, invoice deliver send support materials etc. The 15,000 unit increase has to be stressing their structure. If nothing else Yongye needs to oversee increasing numbers of distributors.

2010 2009
AR/revenue 12.2% 6.3%
Inv/Revenue 30.8% 42.9%

DSO 27.5 16.6
DIO 207.7 249.0

As I comment elsewhere, a DSO of 27.5 days is not consistent with a 180-day credit cycle. Inventory does not move fast considering they should be able to efficiently match production to distributor needs with only two plants to oversee. I have not matched it to peers yet. Maybe it is the standard.

When I originally started with this I was only interested in the margins as they compare to China Green. China Green has unbelievably high margins that none of the competitors come close to matching. It makes me disbelieve CGA. These margins are close to CAGC and don’t vary a great deal. The 2009 dip is due to a noncash decrease in value of warrants

2010 2009 2008
gross 56% 53% 52%
operating 29% 8% 32%
net 24% 2% 30%

Normalized 2008 shows 31% operating margin and 22% net margin. CGA has been double.

Currently, we typically provide up to six months credit terms to our key distributors and ask for all others to make cash payments upfront or upon delivery.

ROIC is 24% and WACC 11%. Returns are creating value.

As of December 31, 2010, there were approximately 35 active stockholders. That seems hard to believe as this recommendation was made to two newsletters with tens of thousands of subscribers.

There is one large shareholder that remains a mystery. She was a 25% shareholder and has been diluted down to 17%. She is an individual, but is called Full Alliance. Her name is Zhong Xingmei and she lives in Hong Kong. Through most of the early offerings she took large blocks of shares and is now a little over 7 million. She was consistently granted the right to place shares in escrow and if the company did not meet certain milestones she could refuse them and put them to other shareholders. She is your very large business partner if you are a fellow shareholder. I don’t know who she is.

The positive returns on invested capital are a plus.

Continuously issuing equity is working as a means of finance so far. As a shareholder, I would hope the business really is undergoing sustainable growth so the dilution is offset with ongoing growth. There are nearly 600 competitors selling this type of product.

I would definitely want to see how the Chinese filing compare to the SEC documents. Yong does not have a big 4 auditor. They employ Moore Stephens. Moore Stephens gets a lot of work from reverse mergers and has been implicated in at least one fraudulent filing

From Barron’s:

Hedge funds would seem to want to ensure that their portfolio companies hire only the sharpest auditors. Yet one after another of the reverse-merger companies hire the same small firms that certified the financials of companies that came to grief.
Dozens have hired Frazer Frost, the successor firm to Moore Stephens Wurth Frazer & Torbet. Moore Stephens, a Los Angeles auditor, gave clean audit opinions in 2004-05 to China Energy Savings Technology. Doubts about the balance sheet caused the SEC to suspend trading in 2006 and eventually file a fraud suit against the company, which is now defunct

I have some questions about receivables—they seem to good to be true considering the company gives their best and biggest distributors 180 credit terms. The DSO works out to be 27.5 days. Are the cash accounts impacting DSO that heavily? They would be smaller accounts.

The incursion into mining and processing is going to be expensive Draglines and shovels are high-ticket items. Joy Global and Bucyrus now CAT do not sell cheaply. They may be able to find used. Infrastructure will be expensive. Financing should be interesting. Just getting the right to explore and develop was $35 million. This will be a very capital-intensive venture and their cash flow will not pay much of it. They will need massive amounts of equity or perhaps debt. If so, I would look for returns on capital to decline and margins to contract as the expenses hit the P&L and balance sheet. The margins savings are going to likely be a long time realizing. This activity is well outside their circle of competence.

I am not a buyer but hope I can remember to look in on them to see how this all works out.
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