Last month, fellow Fool Rich Smith penned a column in which he advised readers to stay away from Chinese fertilizer upstart Yongye International
Chinese agriculture: the opportunities
From a top-down perspective, there are immense opportunities in the Chinese agriculture sector. Only 11%-15% of Chinese land is arable, yet the country must feed almost over 1.3 billion mouths, which is nearly 20% of the world's total population. Put in a comparable light, the US has 80% more farmland than China. Thanks to China's huge population, that amounts to 10 times more farmland per capita.
Because of this constrained space, China must continually find better ways of increasing farming productivity if it wants to prevent any food shortages and continue increasing quality of life for its growing middle class. A great way to do this is to utilize products like Yongye's shengmingsu that increases the productivity of small farms. Throw in government support for the sector -- in both 2008 and 2009, the country's No. 1 central document focused on agricultural issues -- and you have an area ripe for investment.
Within the space, Yongye's not alone. There's also China Green Agriculture
However, I think Yongye is the best of the bunch. Here are a few reasons to like Yongye:
- Innovative business model: Yongye has an innovative model where it rapidly expands its distribution by offering rural shop owners signs promoting its product (along with the prominent placement of its product that follows), in exchange for Yongye helping to promote the store. The arrangement has been tremendously successful and fueled the company's eyeball-popping growth. Also, keep in mind that Yongye's products are additives to other fertilizer options. So the company doesn't necessarily have to compete with companies like China Green Agriculture.
- Strong geographic footprint: Yongye has extensive networks in some of the strongest agricultural areas of the country but is still concentrated in Northern China. For example, Yongye derives 30% of its revenue from the Hebei province in north China alone. With the company expanding south and west, there are ample growth opportunities from new markets.
- Corporate governance: Yongye's the best you'll find in small Chinese companies. There's more on this below.
Spooky small caps
Investors might be gun-shy about investing in Chinese small caps. Frothy demand for Chinese equities in the middle of the past decade led to a rush of small companies exploiting the situation to get capital, and then following through with poor corporate governance.
However, in Yongye's case, there are reasons to believe the company is better managed than its peers. Our Global Gains team met with management on their recent China trip and walked away believing Yongye to be one of the better-run Chinese companies they encountered. Not only that, but Yongye uses Big 4 auditor KPMG. I don't believe its use of KPMG to be a trivial fact either; it recently affected the terms of how Yongye purchased a local distributor. The presence of the Big 4 accounting firm forces Yongye to act above board.
How well do you use cash, Yongye?
At this point, I want to address Rich's main complaint with the company: cash flow. While investors should closely watch Yongye's working capital flows, the situation is better than a glance at the company's trailing 12 months of cash flow would indicate.
Yongye is in an industry that's highly seasonal. After all, crops don't follow the whims of the farmer when sprouting out of the ground. So with revenue shooting all the way up to $89.4 million last quarter versus $24.9 million during the first quarter of the year, of course accounts receivable took a massive surge upward and took operating cash flow into the red.
Dealing with a rural set of customers, Yongye's accounts receivable collection time is admittedly slow, but if you break out last year's cash flow statement by quarters, you'll see that Yongye had a large decline in accounts receivable in the last quarter of the year. Expect the same overall trend this year.
Nota bene, there's no way to hedge all the risks from Yongye, and investors should be aware of the possible problems. Even with a Big 4 auditing team, investors are still entering a country that's traditionally had lousy corporate governance. Also, Yongye could always come up short on accounts receivable this year, or working capital and expansion needs could cause further dilution.
However, keeping these risks in mind, you're getting a company that grew 93.5% year-over-year last quarter and is a leader in an industry with tremendous growth potential. Also, its distinct business model and established distribution network give the company an advantage over rival agricultural products that could try entering the market.
Using growth estimate figures that appear conservative after Yongye's stellar second quarter and a 16% discount rate, Global Gains advisor Tim Hanson approximates the company to be worth north of $10 per share. With Yongye fetching about $7.60 per share right now, that leaves plenty of upside for investors looking to get in to the company.
Investors looking for exposure to the Chinese agricultural sector without the risk of picking from a handful of small caps could also look to more diversified plays. Caterpillar
However, on a pure risk-reward level, I think Yongye's a solid buy. Count me in on the "rocket stock" side of the fence.
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Eric Bleeker owns shares of Yongye. China Green Agriculture, Syngenta, and Yongye International are Motley Fool Global Gains selections. The Fool has established a bear put spread position on Caterpillar. The Fool owns shares of China Green Agriculture and Yongye International. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.