China Green Agriculture (OTCBB: CGAG)
6/6/2008
Xi’an, Shaanxi Province, China

China. Green. Agriculture. Are there 3 hotter investment words that we could string together? Perhaps Web 2.0 Water Solar. You get the point…

I originally found China Green at the Roth Capital conference last February. And when they invited us to come visit their facilities in Xi’an, I knew we just had to go. But before I get to all of the things I like about China Green, it’s worth noting some of the problems that prevent us from making this an official recommendation anytime soon.
First, the stock is EXTREMELY expensive. At $28 per share, the market cap is $512mm. Given the company’s TTM revenues of $19.6mm and TTM earnings of $9.6mm, that means we’re looking at a P/S of 26 and a P/E of 53. Yowsa.

Then there’s the problem of liquidity. The company told us it only has about 300,000 shares of float (or $8.4mm worth), and on any given day, it is likely that none of those will trade. Given that the stock trades OTC, in a service like ours, subscribers are staring down some significant trade execution risk. What’s more, without liquidity, the stock simply is not allowed to trade down to a level at which I would find the valuation attractive.

Now, the silver lining to the liquidity issue is that the stock is held mostly in the hands of insiders (and predominantly those of founder, chairman, CEO Tao Li) who don’t want to give up their ownership stakes. That’s because they are very optimistic about the business opportunity here…and for good reason.

About the business
If you don’t know China Green Agriculture (and why would you?), the company is a Xi’an-based manufacturer of organic fertilizers. The raw material for these fertilizer products is humic acid, which the company derives from cheap and plentiful weathered coal (a crappy version of coal that can’t be burned for energy).

Tao Li founded the company in 2000 following a career in academia. He seems to be well connected with the government, and is growing his company alongside the government push towards more sustainable growth (his organic fertilizer won’t taint groundwater) and healthier eating habits in China (people are now looking for organic foods more and more in cities where the middle class is emerging). Mr. Li is also vice chairman of the board of the China Green Food Association, the group that certifies the companies that want to use their organic label on their products. Currently, there are just 4 fertilizer companies (out of the 1,900 in the country) that have received this certification. And while they would not say this, it seems like Mr. Li could slow or keep competitors out of the market.

And while there are 4 fertilizer companies with organic certification, China Green is the only one with national distribution. It has distributors in 27 provinces, and its 111 different fertilizer products, through work in the company’s vast R&D facility (which we toured), are tailor-made for China’s different climactic zones and growing patterns.

These organic fertilizers tend to be priced more expensively than their chemical-based counterparts, but the company thinks the tailwinds of the fledgling organic movement in China and its brand-building efforts nationwide will help it continue to grow.

And grow it has…
The company’s top line has grown 71% yoy and its gross profits are up 59% (though some of this is due to conversions of RMB into the $US, and I haven’t had time to re-engineer it back to RMB). The company believes it could have grown faster this year, but it had capacity constraints. Those constraints will disappear very shortly since the company has begun construction on a new 50,000 metric ton manufacturing facility (it currently has just a 10,000 metric ton plant). Obtaining the capital to build that plant is the reason why the company tapped the capital markets, and they estimate that the plant will be operational by the beginning of 2009.

Perhaps even more impressive, though, is that the company told us that they anticipate having to build another enormous facility by 2011…because the new 50,000 ton facility will have reached capacity. (It’s worth noting here that China is the largest fertilizer market in the world, and it should get larger as food demand increases and the amount of arable land and people farming that land -- due to urbanization -- decreases.)

That’s enormous anticipated growth on their part, and if it happens as they say, it means they will be doing roughly $140mm in sales and (using current margins) and $56mm in earnings. But again, if you look at the current valuation, we’re looking at a P/S and P/E more than three years out of 3.7x and 9.1x. That’s more reasonable, yes, but again, we should be looking to get this stock at a better price.

But back to the company…
We got a tour of the company’s R&D facility, which were very neat. The company grows more than 5 million plants there, including orchids, cucumbers, eggplant, tomatoes, squash, and peppers. (I have pictures that I will try to post when I get back to the U.S…I stupidly have forgotten my USB cord.) It tests various concentrations and versions of its fertilizers to determine which work where and why (and then puts the directions on the bottles accordingly), and also tests its own concoctions against competitors products.

In a very neat little twist, the company sells the products of is R&D (flowers, vegetables, etc) to hotels and restaurants in China…a side business that generated more than $1mm in extra profit last year. (There are lots of companies that wish they could sell the byproducts of their R&D rather than pay to dispose of them.)

I asked the company if it would consider getting into the pesticide or seed businesses -- perhaps becoming the Monsanto of China or some such. For pesticide, they said not yet. They think the opportunity in fertilizer is big enough to occupy them for now. As for seed, it turns out that the government controls all seed allocations in China in order to ensure that farmers are growing the proper distribution of food (so as to avoid the corn economy that we have in America today). (CGAG sews their own seeds and cuttings from the plants they already have.)

In the end, this is a limitation for the company, but it may open up with time. In the meantime, it does help keep multinationals like Monsanto out of the market since so much of their strategy is based around selling seed to farmers that is engineered to interact best with its own fertilizer and pesticide products. Such a model would not work in China today. What’s more, CGAG says they know their farmers best and offer superior customer service.

Going forward
The company says a Nasdaq-listing is in the future. Hopefully, that will solve the liquidity problem and give the stock an opportunity to drop (remember that in broader contexts those bad market days like last Friday aren’t all that bad…provided you have an up-to-date watchlist).
We’ll be watching China Green Agriculture, and if the valuation comes down to earth, you may hear more about it in the future.

I’ll see if I can get the pictures public when we get back. I think (though I’m gardener, so I may be biased) that they’re fascinating. I’m also happy to answer any questions.

Tim