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No. of Recommendations: 34
China Green Agriculture started life as Discovery Technologies held by Michael Friess CEO and another shareholder Sanford Weiss. They held 80% of the stock and there were 18,000 shares outstanding. This was the listable shell that could be morphed into China Green. There is no money in a shell. For that you need investors and a legal holding company.

In August 2007 the China Green Holding co acquired TechTeam from Tao Li who is the CEO. There were three shareholders putting the money up in the holding company that bought Tao Li’s Techteam. That became the ongoing business that was renamed China Green.

There were two reverse splits and Friess and Weiss were cashed out for $550K and 111K shares and seats on the board. They made Tao Li CEO. He ended up with around 7 million shares after transfers from the 95% original investor. His pay out for TechTeam is not discussed in the 10Ks but he is on record as saying he received only shares. There were 10 million shares exchanged to create the original 3 shareholders in CGA.

The original issue of shares to three investors used in the reverse merger share exchange created the nut of cash that made all this magic possible. As always, it’s about the money and there is a lot to be made by a few individuals in these RTOs. Tao Li did OK taking TechTeam public with a substantial share grant and the three original investors owned stock in a company that did well for a year or two and they appear to have mostly cashed out leaving Tao Li as a 35% owner of CGA.

Yinshing David To (95.1%), Paul Hickey (2.45%) and Greg Freihofner (2.45%) were the 3 investors. Most of To’s stock was transferred to Li in the form of call options taken out of escrow. To is no longer a major shareholder. I don’t how much he made but he had more than 6 million shares initially.

Part of the unsavory part of the reverse merger was a large infusion of cash in the form of a PIPE—private investment in a public equity. PIPEs are dilutive and those chickens came home to roost as the PIPE was converted to shares in 2009—over 6 million shares were added to the share count. PIPEs in and of themselves have a use and may provide financing when other avenues are closed. What I find questionable is the use of the cash.

Tao Li says he did not receive any compensation other than shares but in reading the terms of the PIPEs it sounds like TechTeam shareholders received cash.

After the consummation of the transaction contemplated by the Share Exchange Agreement and a simultaneous private placement[PIPE] of $20,519,255 on December 26, 2007 (the “Private Placement”), Techteam received the Techteam Purchase Price on January 2, 2008 paid by Green New Jersey by using part of the Private Placement proceeds to Techteam’s shareholders.

To me that translates into the PIPE cash was in part used to pay the price for TechTeam. Cash may well have ended up in the bank to run the business. However, it sounds like part went to TechTeam shareholders and Li was the biggest shareholder. It’s difficult to tell from the passage whether shareholders received cash as part of the purchase price.

Regardless, shares jumped from 12 million to 24 million in 2009 and 6 million of that was PIPEs redemption and a part of the cash from the PIPEs may have gone to Li.

CGA went through some glory days hitting near $18 per share in 2009. Since then it has been a slow downward drift to around $7 today

It has dropped 60% from highs at $18.

It is part of the freshman class of reverse mergers from China that have proved to be a minefield for investors.

This one does not look extraordinarily bad compared to others in the class like RINO,CCME and FUQI. CGA has made some blunders especially in the PR department and communicating with the public. They may survive, but they are turning into a different company than the fast-growing smallcap investors bought into a couple of years ago. Ironically the move to more conventional fertilizers may make them a better company if they survive the transition.

CGA is one of the microcap/smallcap Chinese RTOs that are into fertilizer. There are three that are in the spotlight—Yongye, China Green Agriculture and China Agritech. So far, only China Agritech may be on the verge of implosion—trading was halted in March:

In late February, public relations outfit Grayling waded into a battle between short sellers and a client, Chinese fertilizer company China Agritech. Account executive Kevin Theiss wrote to Australian hedge-fund manager and blogger John Hempton, who is short China Agritech and has raised questions about the company, saying, "We have collected evidence that your allegations are groundless." He then raised the specter of legal action.
Weeks later, China Agritech dumped its auditor, Ernst & Young Hua Ming, after the accountants called for "an independent investigation." China Agritech also announced the resignation from its board of Zheng "Anne" Wang, a director with Carlyle Group, the company's largest outside shareholder. The stock has since been suspended on Nasdaq. Tough to put a positive spin on that.

Yongye has some challenges and questionable company practices detailed elsewhere by me. I am still not a buyer of CGA although they look more solid and believable than YONG. CGA has made some questionable left turns into new businesses that are not satisfactorily explained and there are accounting questions I am unable to resolve since I have no access to Chinese documents.

The Chinese fertilizer companies mentioned above specialize in an organic product that comes from weathered coal. That becomes humic acid and then through a base/acid organic chemistry reaction it crystallizes into a proprietary Fulvic acid that becomes the base for around 160 fertlizer blends that these companies sell

The coal is cheap—less than $50 per ton
The humic acid is pretty cheap if the company starts there[as Yongye does] ranging from $100-$300 per ton

The companies start with humic acid [either from coal as GGA does or buys the humic acid like YONG]and put their spin on crystallizing it into fulvic acid.

I took issue with the Yongye strategy to vertically integrate and buy rights to coal development when the ingredients are so cheap and plentiful. Why buy the cow as the saying goes? The costs of infrastructure or hiring mining equipment are high in the face of such cheap ingredients. Yongye paid $35 million just for the rights to unproved undeveloped reserves of coal. They have yet to even obtain mineral rights or begin assaying it for coal development.

From the CEO

…..weathered coals constituted only 0.37 per cent of the Company’s raw material costs. That figure is accurate, and it represents the particularly low price of weathered coal, which is a waste product of coal mining companies. While it is a valuable source of humic acid for CGA, coal miners are happy to get rid of it, hence the low price.

I think we have a failure to communicate on this percentage from the CEO. At 0.37% it is too low to constitute any part of the product. What I think he meant was 37%. That would fit with the cost of humic/fulvic acid and the gross margins. It is an extremely low cost item making up almost 40% of the product. That gives these companies great gross margins

China Green is smarter and realizes just how dirt cheap the materials are. They have said they will look for possible interests in phosphate production, which makes a certain amount of sense.

Wrong turns and left turns

Chinese RTOs have been under the gun -- some deservedly so and others may be innocent bystanders. I have not yet made up my mind which CGA is.

Part of the attack has been from research companies and individuals citing references to mismatches between financial filings in China called SAIC documents and the SEC filings we are familiar with.

The CEO has said in print in a PR statement that it is standard procedure for Chinese companies to fudge the SAIC numbers in an effort to keep competition from gaining an advantage.

Given this focus, Chinese companies, particularly small or middle size companies, do not file all of their financial information in order to avoid disclosing their operating metrics to competitors, suppliers and customers. To suggest, as the J Capital report does, that a discrepancy here reflects any wrongdoing or misinformation is both false and misleading.

This of course is ludicrous if the company files 10Ks and 10Qs. The competition certainly has the capacity to follow CGA through the SEC documents. There should be no discrepancies and if there are I would consider it fraudulent and wonder if the SAIC numbers or the 10K numbers or neither is believable and reliable. That needs resolution. Getting the SAIC filings is more problematic. Translating them adds a layer of difficulty. The SAIC filings are similar to the 10Ks with income statements and balance sheets.

There has been some enrichment of insiders at the expense of shareholders. Share dilution is significant.

Yongye diluted shares to an even greater extent and a lot of it was to acquire property that had questionable value from the CEO. CGA until recently has been restrained in its expansion, but Tao Li has been given generous options grants as well as other key employees and managers.

From Li:

As the founder of CGA, I was issued 3,156,808 “make good” shares and 6,535,675 call option shares in December 2007, which were recorded properly as part of the purchase price under the reverse merger but not a compensation expense at the time of its issuance. All these shares, according to the “make good” escrow agreement and call option agreement, represent a return of shares in compliance with China’s laws and regulations. I gave up my controlling equity interest in Shaanxi TechTeam Jinong, which is now a wholly owned subsidiary of CGA, without receiving any compensation. These shares formed my only consideration in the disposal of my controlling entity which had revenue and net income of $15.1 million and $6.9 million, respectively, in the year ended June 30, 2007.

Li has sold millions of dollars worth of shares over the years.

Li has also been a related party in rent paid for office space and as a major shareholder in King

Tao Li also owned the office space he then leased to CGA for $19,266 per year for 800 square meters[8,000SF] Additional office space of 3,600 SF is leased from the CEO for $4,000 per year.

One final slightly unsavory transaction is between Tao Li’s Kingtone Information [KONE}company where is the principal shareholder and CEO. CGA has contracted for two jobs. One was a drip irrigation service and installation at a cost of $586K. The second job involved automating the production line. That was a $760K job. Altogether between 2008-2009 that is $1.46 million in work for Li’s other company. Total revenue for KONE was $11 million in 2009—CGA provided a bit more than 10% of revenue for KONE if the revenue was recognized in 2009 at completion of the job.

These things do not involve huge sums of money,but whenever management is on both sides of a deal, shareholders do not always get the best deal. The business begins to take on the flavor of being incorporated for management’s benefit. Tao Li has not caused as much damage as the CEO of Yongye.

How is the fertilizer business?

That is a very good question. In previous shareholder letters, Li has been upbeat about the seemingly limitless demand for humic acid based fertilizer. This is not a mainstream product. It is for poor and damaged soil and enables plants to grow better but does not necessarily take the place of the more commonly used nitrogen, phosphate and potassium [NPK]fertilizers. They are expensive and worldwide dominance of this product in the market appears unlikely.

Yongye was recently downgraded by Roth, seeing slowing sales and demand and decreased adoption by farmers.

In a somewhat shady questionable report by J Capital Research, the same issues were raised. The J Capital report has just enough real fact to assume there is a kernel of truth, but I do not see much more than an attempt to short CGA beyond that. They do claim to have contacted distributors and stores in China and have names and dates and if their research can be believed, the outlook for humic acid products is not one of unlimited growth

Normally I might discount a source like J Capital except for Tao Li’s abrupt about face and entry into low margin standard fertilizers.

In a recent letter to shareholders discussing the Gufeng acquisition, he alludes to a limited growth future for humic acid and explains his acquisition of Gufeng as a necessary diversification.

This normally would not strike me as an odd business move, but in the case of CGA, they will take an enormous hit to margins. The future of humic acid must look dim indeed for the company to need to sacrifice margins for revenue growth.

A few numbers

Since margins are a topic of interest—here are a few.

The company has 3 years of filings as CGA. Margins are high and in fact, operating margins are so good they have been accused of cooking the books to get the results.

I looked at the administrative and selling costs. They are low. From the 10K all the appropriate items are included.

They have 21 marketing employees accounted for in sales
They have 121 local sales and support people
There are 25 district managers

Altogether they now have 586 full-time employees:

160 are employed by Jinong,
47 are employed by Jintai [produce and flowers],
16 are employed by Yuxing

333 are employed by Gufeng and 30 are employed by Tianjuyuan

Gufeng can be ignored for purposes of looking at historic operating costs.

The fertilizer business alone had only 160 employees and is nearly 88% of the business [2010]. The greenhouse business is negligible for the purposes of this discussion

Considering YONG has 412 employees and that includes a very high number in administrative at 74[would increase operating costs] and 114 in sales and support then it is possible that CGA could be running leaner in operations. It is difficult to know with any certainty that the numbers are reliable

On to margins.


2010 2009 2008
gross 59% 58% 57%
operating 48% 49% 41%
net 41% 41% 34%

YONG’s margins for comparison

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

YONG normalized 2008 shows 31% operating margin and 22% net margin.

Notice that gross margins are fairly close company to company in spite of the fact CGA starts with coal and YONG starts with humic acid.

Quarterly margins CGA

12/10 9/10 6/10 3/10 12/09
gross 39% 33% 56% 60% 61%
operating 22% 24% 44% 46% 49%
net 18% 20% 37% 40% 42%

It is clear what a big hit Gufeng was to margins after acquisition in July 2010. Gufeng has become 53% or so of revenue so these impacts on margins are here to stay and may worsen if humic acid loses ground. This was a drastic step and I can’t help but think that it was done to be assured of staying alive in the fertilizer business.

As far as SG&A is concerned, CGA had SG&A at 12% of revenue in 2010 and YONG was 26%.

One metric I have been interested in with these companies is utilization. Yongye flagged this for me as they consistently underutilize their capacity and yet turn in astounding revenue numbers and have an ROIC of 24%.YONG was at 51% utilization in 2008 and is now at 41%. In spite of overcapacity, they keep buying facilities from the CEO and have recently constructed a third plant. There is some question whether they will grow into these plants fast enough to keep returns high if humic acid has indeed hit the wall. The CEO was well-compensated from the sale of the second facility and the third does not appear to have been profitable for insiders but details are lacking

CGA on the other hand has kept capacity in line with production and for 2008 and 2009 were close to 100%. This changed in 2010 as they built 30,000 tons capacity[issued 5 million shares] opened in 12/09. They are now at 40% and that does not include Gufeng. This does not look like a good way to invest capex if the market is slowing.

The measures of utilization are somewhat cruder than I would like and use the stated capacity and the reported tons produced. I would have preferred to use manufacturing facility square footage and production but those metrics are not available across companies. It would be similar to sales per SF for retailers.

The last things to mention are working capital and cash flow.

Cash flow and working capital

Fertilizer sales are a rather notoriously cyclical business. There are of course heavy sales in the spring and summer and some difficulty collecting payments until the crops are in. Both YONG and CGA sell to distributors that sell either to sub-distributors or retail stores. CGA does not make mention of credit terms. YONG says they give their best distributors 6 months to pay. Their 5 major distributors were 56% of revenue in 2010. CGA says no distributor is more than 1% of revenue.

Imagine my surprise when YONG’s days sales outstanding came in at 27 days [averaged] and 44.5 days if the 2010 receivables are not averaged.

They must be doing a cash on delivery with the other 44% to get this result or perhaps their customers are not using the 6-months credit line. That does seem unlikely.

CGA has more believable DSOs at 109 days in 2010. That changed dramatically to 38 days after the acquisition in July. Since Gufeng’s books are not open, I don’t know what they were running on their own.

YONG’s movement of inventory is slower at 208 days in 2010. It was 249 days in 2009. Seems like a slow turn for a product that should be flying off the shelves in the spring and does not need a lot of back stock sitting on the shelves in the winter

CGAs DIO was 194 days in 2010 and decreased to 126 in the last quarter after the acquisition of Gufeng

Both companies have low cash flow.

I look for CFFO/net to exceed “1” telling me that the company is making good choices using working capital.

We saw high numbers in DSO and DIO—YONG somewhat worse than CGA. Here is how that ratio looks

2010 2009 2008
Yongye 0.31 -0.88 -0.77
CGA 0.57 0.50 1.17

A negative means negative CFFO.

Neither is doing a stellar job creating value out of inventory and receivables as measured by CFFO. The edge does go to CGA.

Final metric is ROIC. It actually is not bad. The company has made no acquisitions & carries no goodwill. The ROIC is 14%. It is down from 24% in 2009.
Sign off

CGA is not a buy for me. I don’t think they are a completely unreasonable investment, but there are related party transactions and some strange inconsistencies in management communications that make me wonder what is really going on. If I have to wonder about that, I don’t buy the stock

Why did they take an abrupt left turn into low margin conventional fertilizer?

Why does the CEO admit to inaccurate numbers in Chinese filings to keep the competition from gaining inside knowledge of the company’s business? If they file in the US and those are accurate, it is a simple matter for the competition to get the SEC documents just like I did. Or maybe the US filings are inaccurate too? That would be consistent with the CEO’s reasoning.

How do they keep operating costs low enough to create margins twice as high as the competition? And was Gufeng a way to legitimately ease into lower margins without having to do a lot of ‘splainin?

Both companies are not excessively shareholder friendly and appear to have been conceived and run for insiders. YONG has been slightly worse with share counts up 170% over 3 years and much of it went to the CEO for capacity they really did not need.

CGA is also enriching insiders. The share count has increased through calls and options, PIPEs and some issues to fund expansion. Share count is up by 64% since 2008.

There will be no dividends and with scant cash flow and too much growth, share repurchases look questionable.

If growth slows, momentum will not allow shareholders to gain through price appreciation and the outlook is opaque. Unless we have feet on the ground in China and can run our own investigation of sales, distribution, stores and competition, we have to rely on second hand news like J Capital and Roth who could have agendas far different than long investors.
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