Dongfang Modern Agriculture
I started looking at Australian-listed Chinese company Dongfang Modern Agriculture (ASX: DFM) more closely after I stumbled across its loan announcement yesterday. Agriculture is well outside my area of expertise, but if I understand the business model correctly, there are a few potential warning signs I’ve spotted (all figures are in AUD unless specified otherwise):
- Margins are astonishingly high (42% NPAT margin) especially given that its largest fruit orchards, tangerines (mandarins), are around half as productive (in terms of kg per hectare) as similar orchards in Australia. If you apply a 25% tax rate (Dongfang doesn’t pay tax) margins are still a remarkable 31%
- Margins are astonishingly high given that the company’s operations seem low tech and labour intensive. Dongfang only owns A$400,000 or so worth of property, plant, and equipment, with which it harvested and distributed 249,000 tonnes of fruit last year. One look at Costa Group Holdings Ltd (ASX: CGC)’s balance sheet (Costa’s the closest ASX listed comparison I could think of) suggests Dongfang’s efficiency is either very remarkable, or ludicrous. Where’s the irrigation system or transport trucks? Or is it labourers with watering cans? (The land is owned by China and Dongfang leases it, so it’s possible for example that irrigation systems etc are part of the property and not on Dongfang’s balance sheet.)
- Margins are strangely very consistent at around 40%-43% NPAT going as far back as 2012, except for a spike to 50% in 2014 due to upward revaluation of biological assets. Not being an expert on citrus fruit, I would have expected margins to vary widely year to year based on capex requirements, weather, and the maturity of orchards.
- Dongfang is extremely profitable, has A$30 million cash in the bank, no debt, and generated A$15 million in cash flow from operations last year. It has close to nil lease expense (~$70k) which might otherwise have explained the lack of property, plant, and equipment. Cash flow falls well short of reported profit, however.
- Despite all this, and despite the statement “As such, we are well positioned to fund further expansion and growth initiatives over the course of the next few years” Dongfang announced yesterday it had borrowed HK$300m (A$50m) at 10% per annum from a state-owned non-bank lender. This loan is secured against the CEO’s shareholdings in Dongfang.
- The company touts its large dividends, but actual dividend cash payments were just A$90k in 2016. 98.8% of shareholders opted for the DRP. Majority insider ownership hugely reduces the visibility of the cash flows that underpin the dividend.
- If you can read Chinese, please get in touch as I am interested in searching the Chinese AIC databases for the filings of the Chinese operating company ‘Ganzhou Chinese Modern Agriculture Co’ (Dongfang Modern is a holding company). I spent a few excruciatingly painful hours grappling with the Chinese corporate database and the Jianxi province AIC database using Google Translate but made zero progress.
Dongfang is on paper a cashed up, highly profitable grower of citrus fruits and camellias based in a number of provinces in China, according to its annual report. It earned around $140,000 on its $30m cash balance last year, implying an interest rate of 0.47%, which seems too low for Chinese deposit rates, and too high for Hong Kong deposit rates (based on HSBC’s China and HK websites).
Why does Dongfang need to borrow HK$300 million (A$50m) from a non-bank lender at an interest rate of around 10% per annum? The rate is much higher than I would have expected, and HSBC Hong Kong’s best commercial lending rate is 5% (may be outdated info).
The loan is also secured against the CEO’s shareholding among other things, an unusual arrangement I have not seen before. While I understand that the corporate and the personal are not always as separate in China as they are here, I still found it strange that the CEO would have to pledge his shares to back the loan, given his company’s seemingly obvious credit-worthiness.
This makes Dongfang a) look extremely un-creditworthy, contrary to what might be expected given its financial performance and b) makes me wonder about the existence of the reported cash on the balance sheet. Also c) I wonder why it’s better to borrow at 10% and risk the CEO’s holdings (he owns a majority of the company) rather than deploy some of that $30m in cash sitting in the bank earning nothing?
Presumably the cash is kept China, not Hong Kong, and presumably Dongfang’s operating subisidiary Ganzhou Chinese is required to file reports with the Chinese government. Given the HK-based lender is owned by the Chinese state, surely there would be no problem recognising Dongfang’s outstanding performance and financial position? I’m quite suspicious of this loan.
Do the numbers make sense?
I spent a few hours last night running through a few things to try and unpick the company’s implied numbers. I spent a lot of time seeing if the workforce productivity numbers worked, given the lack of equipment etc.
How many tangerines can a Chinese seasonal labourer pick in an hour?
How many hours does it take X people to fertilise a hectare with no machinery? Etc
Prima facie it all seems to work, although I am not experienced in this area. The costs of goods sold, seasonal workforce required to harvest the fruit, their wages, possible costs of trucking etc don’t stand out as deviant (although there’s not a lot of disclosure), even though Dongfang’s orchards aren’t that productive by Australian standards. I focused mostly on tangerines (59% of FY17 production), and did not spend much time on camellias or pomelos.
Taking a closer look however, some of the other figures don’t pass the smell test. Ganzhou Chinese had just 98 full time employees at the time the company listed, overseeing 201,000 tonnes of fruit produced, and 8000 hectares of land, in 2014. That sounds low for a $300m company. Costa Group has 6,000 employees in peak season for 3,500 hectares of farmland.
Despite the lack of regulation, low wages, minimal equipment, and so on, I also find it very difficult to believe that Dongfang’s lower production orchards could be so wildly profitable. I mean, a 42% NPAT margin (!) on orchards that are only ~60% as productive as western equivalents? Cmon. Either there’s something unusual here or I totally, totally misunderstand the business model and its economics (which is also a possibility).
Then there’s this chart from a broker report, which was an instant red flag in my opinion:
It’s a little hard to read, but if you look at Dongfang Modern’s EBITDA and NPAT as a % of its revenue, this company is over twice as profitable as its closest peers. Closest competitor Yuan Longping High-tech Agriculture has $89.8m profit from $427.1m revenue, giving it a NPAT margin of about 21%.
(At first glance I’d say Yuan Longping is also worth a closer look for uncommonly high profitability.)
By comparison with Yuan Longping, Dongfang has under half the revenue ($204.2m) and yet achieves nearly the same profit of $85.8m, giving it a NPAT margin of 42%. I just find it very unlikely that Dongfang, this small company, is somehow so many times more profitable than its much larger peers – especially so given its orchard productivity doesn’t look remarkable. Costa Group, a well-run Australian berry farmer, has just a 7% NPAT margin.
I may or may not look into Dongfang further, depending on if I can justify the brain damage and find someone who can read Chinese. The question for me is, out of all the companies on the planet, why should this particular company – led by a ~30 year old investment banker – be the cream of the crop with the most efficient business model? To my way of thinking, the chances of Dongfang Modern being the world’s greatest and most profitable agriculture company – despite having zero advanced machinery and an unremarkable level of productivity – is astonishingly small.
I am also sceptical of the idea that Dongfang borrowed HK$300m to “add shareholder value by broadening its revenue base outside China into high margin business markets in Australia that complement our agricultural business.” Is the Australian market so good that Dongfang thinks it can replicate its high margins here? I’m a bit sceptical as to whether there’ll be an actual expansion into Australia – that would be silly, given how profitable these Chinese orchards are and how rapidly Chinese citrus demand is reportedly growing.
Still, if they do actually try to expand into farming – or any business – in Australia, I guarantee you they’ll be getting margins much closer to 7% than to 42%.
In fact I’ll go you one better and do a John McAfee.
If they replicate their Chinese business here, I’ll eat my dick.
I have no financial interest in any company mentioned. This is a disclosure and not a recommendation. I also have no association or relationship with John McAfee, although I do enjoy his occasional Twitter insanity:
“That voodoo thing didn’t work. You promised that my ex wife – an average looking bitch – would turn into Quasimodo. She now looks like Beyonce.”