China Green's Second Quarter Not So Green
j.a. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
China Green Agriculture (NYSE: CGA) is a small-cap Chinese fertilizer manufacturer. CGA came to the U.S. as one of a number of infamous Chinese reverse takeovers that as a group have been a massive disappointment to investors. CGA is no exception having dropped to just under $5 today from around $17 per share three years ago.
Unlike some of its fellow RTOs, CGA has not been under investigation for fraud. The decline is a long slow downward trajectory since 2010 with no steep sell-off.
Part of the decline is no doubt from the pervasive disenchantment with RTOs. The other factor keeping investors at bay is likely the radically altered margins and growth since the September 2010 acquisition of Gufeng--a conventional granular fertilizer manufacturer. Gufeng became more the 50% of revenue and lowered CGA margins and moderated growth.
In the first quarter ended September 2011, results were okay with inline receivables and more than 30% growth across the two major operating segments—Gufeng and Jinong. Cash flow from operations (CFFO) was negative, but that often happens in these small-cap Chinese fertilizer companies as they continue to push production for the growing season and receivables are paid following harvest. It was the first quarter that could be compared year-over-year as the Gufeng acquisition anniversaried. Results were credible.
Yongye (NASDAQ: YONG) is the other closely followed Chinese reverse merger fertilizer company. It has had significant difficulty with receivables and cash flow in the last two quarters with out of control accounts receivable and ever-lengthening days sales outstanding. Yongye’s fiscal year ends in December and its much anticipated annual and quarterly results will be highly interesting. They have not yet reported. Yongye is sticking with fulvic acid based products (similar to humic acid) while CGA has diversified into conventional fertilizer.
In Q2, CGA ran into cash flow problems with ongoing and unexpected negative CFFO as receivables rocketed upwards.
Q2 2012 results
Combined revenue was $47.1 million for an increase of 33.4% year-over-year. Both Jinong and Gufeng had more than 30% revenue growth.
Jinong’s (humic acid) net sales were up 33% as more distributors took on more inventory. The company is expanding its distributor network and total distributors went from 850 in Q1 to 876 in Q2.
Gufeng’s net sales increased 37.5% due to the increasing demand for granular fertilizer and an expansion of the distributor network.
Jintai is their segment that grows and sells produce. It's small and at only 4% of revenue does not merit much consideration. Sales declined last quarter. According to the company the poor results were due to:
“ the decreased production of agricultural products due to the change of surrounding environment.”
---whatever that is; it is appropriately vague.
Gufeng had 177 distributors compared to 699 for Jinong and is now dependent on one distributor, Sinoagri Group for 40.4% of Gufeng’s revenue and 22.8% of total revenues. This is a dangerous concentration and if the relationship terminates, will hurt profits. No other distributor wields that much power. It may be part of the problem with receivables;the company does not comment on individual distributor numbers beyond percentage of revenue.
Gross margins were flat yoy. Both operating and net margins were down around 1% as shipping costs and amortization were higher.
In other words, there was no significant degradation of margins in Q2 and sales were growing. Sounds good so far -- until we get to the balance sheet and cash flow.
Results Q2 2011-Q4 2011 are not normalized for the acquisition of Gufeng. Revenue increases are outsized.
Prior to the September 2010 acquisition of Gufeng, CGA margins were measurably higher across gross, operating and net than they are currently. The operating margins compared with other fertilizer manufacturers were puzzlingly higher than the norm-- anywhere from 25% to 100%. That did raise some questions among analysts who follow these companies -- how was CGA able to create such high margins and were they sustainable? It’s not clear why CGA sacrificed these industry-leading results to acquire a lower margin granular fertilizer manufacturer. Some speculated CGA's operating margins were both unlikely and unsustainable and the acquisition was a manuever to bring them growth and a more accurate profit and loss statement. The company has not specifically commented on the strategy other than to say it was necessary for continued growth.
Margins before Gufeng
The past two quarters growth including Gufeng can be compared year-over-year. Combined revenue is increasing 33%-34% for six months. However, before the acquisition, revenue growth had been running quite a bit higher--at times almost double current growth.
Combined growth in 2012 is far lower than the 50%-60% pre-acquisition results and margins are contracting. The company has exchanged high growth and high margins for much lower increases in revenue and margins that are in line with ttheir peers. It is possible that the humic acid business was undergoing changes and slowing with margins cramped by competitors and the diversification was an attractive alternative.
Since sales of humic acid were beginning to decelerate, CGA may have decided it was time to grow through acquisition in spite of the hit to margins.
The following table is the growth of the two segments year-over-year. Jinong sales pre-acquisition can be taken as a proxy for growth of the entire company.
Segment growth yoy
While Jinong revenue increases in June 2011 at 22% look high, it was almost 2/3 lower than the previous growing season March through September 2010. In the meantime, competitor Yongye had been turning in unbelievable revenue growth in excess of 100% for several quarters.
In spite of incredible growth in revenue for both of these companies that any USian fertilizer company would be happy to report, the price per share and PE ratios remain low, as the US market does not appear to believe the filings.
Yongye is at $4.00 with a PE of 2.3 and CGA goes for $4.75 and a PE of 3.5.
Stress fractures on the balance sheet
Since the Gufeng acquisition, days sales outstanding (DSO) has improved. The collections for humic acid based products appear to have been less disciplined and more generous credit terms were used. This applies to Yongye as well. Days in inventory (DIO) also tended to be lower post-acquisition.
The September quarter (Q1) saw an expected rise in DSO, but instead of a drawdown of inventory, DIO rose. Cash flow was negative. We expect that as a function of receivables, but the inventory levels were troubling. By the second quarter, receivables should be paid and put the company in a cash flow positive frame of mind. That did not happen in Q2. Receivables were running away and China Green remains in the red with CFFO negative for the year. This is a troubling trend.
With a much longer DSO, revenue has been recognized that has not been paid and that requires closer scrutiny of the reported revenue and growth. The company is in essence bank-rolling distributors and recognizing sales that have not been paid for and may represent product that will be a long time in selling (if ever). Yongye does the same thing to a much greater extent.
- AR is accounts receivable
- INV is inventory
- yoy is year-over-year
Two notable trends:
1) AR/revenue is a metric I use to help smooth the cyclical results. They should move in tandem. Outsized increases in the ratio are a red flag. Customers are slow paying bills or there is too much product in the supply chain. The revenue has been recognized but the product may not be selling through and receivables are piling up.AR/revenue is at an all time high and much higher than last year’s figure.
2) Inventory over revenue is also at historic highs and 12% greater than last year same quarter. Even worse is the 133 DIO number that had moderated to 2-3 months after the integration of Gufeng.
Combine the two -- inventory and receivables-- and at present, it paints a picture of slow-moving product and sluggish payment. This is sometimes a sign of channel stuffing as more inventory is put in the market than the market will buy. Because revenue is recognized upon shipment, revenue and earnings may look strong but the foundation is shaky. We can’t say this with certainty regarding CGA. It may be just poor inventory control, but these trends are something to watch next quarter.
The balance sheet rocks the cash flow statement
By the second quarter, cash flow should be positive as receivables are collected. That was not the case this year and for the first 6 months 2012, CFFO was ($2.7) million compared to a $1.2 million in 2011.
The $28.9 million increase in accounts receivable compared to a decrease of $1.7 million in 2011.
A $20.4 million increase in inventory; only $85 thousand last year.
We should expect to see a much better CFFO in the March quarter if there are no decelerating product demand issues and uncollectible receivables. It’s going to be critical to their credibility. We will be watching.
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