China New Borun Corporation(NYSE: “BORN”) priced its IPO on June 11, 2010 at $7 per share. The stock subsequently fell as low as $4.93 and then more than quadrupled in price to as high as $20.50 last week, making it arguably the top performing IPO of 2010 so far, outperforming JinkoSolar (NYSE: JKS), SouFun Holdings (NASDAQ:SFUN), Hisoft Technology (NASDAQ: HSFT), Charm Communications (NASDAQ: CHRM), and China Lodging Group (NASDAQ: HTHT) among others.
BORN’s Chairman and CEO Mr. Jinmiao Wang first got into the edible alcohol business in 2004. BORN’s first production line was completed in 2006 and its Daqing newest production line was completed in 2009. Both new production lines were designed by Guangdong Zhongke New Energy Science and Technology Co., Ltd. (广东中科天元新能源科技有限公司). In fact, BORN CEO Wang does not have very strong knowledge or experience in the edible alcohol industry. Wang’s previous business experience was in the sea salt mining industry. So despite its fabulous debut, as I will show below, there are serious problems with BORN.
Industry experts I consulted in China believe BORN’s historical and current gross profit margins are exaggerated by more than 3X. Earnings per share are exaggerated by 4-5X. Three key facts support this view:
1. Outdated Technology – Contrary to BORN’s claims in its SEC filings, its wet process production technology is outdated, inefficient and environmentally unfriendly due to its over-reliance on toxic chemical solutions and resulting large volumes of waste water production. Today all efficient plants use an industry standard semi-dry technology that is much more energy efficient, requires lower capital investment and dramatically reduces pollution. I could find no major producers, other than BORN, using wet process production technology. To resolve its inefficiency, BORN’s CEO and CTO Mr. Wei Qi (who used to work for Shandong Jiujiu edible alcohol, a company that went bankrupt a couple of years ago due to poor performance) decided to upgrade the technology in both plants to the semi-dry method. BORN’s Daqing plant began being upgraded in July, 2010. BORN’s Shandong plant is just starting upgrades. According to industry sources, BORN contracted all the upgrades to Henan Sheng Wantongtong Machine Manufacture Corp., Ltd. ( 河南省万通通机械制造有限公司)
2. Understated Raw Material Pricing – In its F1 registration filing BORN stated its cost of corn in the Q1 2010 represented 83.5% of the COGS, which equals RMB 4,150 per ton of alcohol produced. BORN stated it produced 1 ton of edible alcohol from 2.98 tons of corn, a ratio in line with the industry norm. Dividing 4,150 by 2.98 shows BORN paid RMB 1,393 per ton of corn purchased in Q1. Using the same calculation BORN’s average corn cost for the second quarter was RMB 1,406. BORN stated it bought all its corn for both plants in Heilongjiang province. Table 1 (below) shows the historical market price of corn in Heilongjiang in Q1 was RMB 1,398. This is consistent with the average price BORN reported paying. Table 2 (below) shows the historical market price of corn for reference in Shandong, which is substantially higher, and explains BORN’s decision to purchase corn in Heilongjiang and ship it to Shandong.
However, BORN incurs substantial cost packaging and shipping corn from Heilongjiang to its plant in Shandong. Based on price quotes I obtained from three railway shipping companies, the average price from Daqing to Shouguang, including packaging, loading, unloading and rail transport charge is RMB 200-240 per ton. BORN’s Shandong plant’s capacity of 160,000 is approximately 61% of BORN 260,000 total capacity and therefore consumes approximately 61% of BORN’s total corn supply. Taking 61% of the conservative estimate of RMB 200 per ton shipping cost results in an additional RMB 122 per ton to BORN’s reported Q1 and Q2 corn cost. Therefore I estimate BORN’s true per ton cost of corn was at least RMB 1,515 in Q1 and RMB 1,528 in Q2, resulting in an increase of cost of goods of RMB 122 X 2.98 X 60,700 tons of alcohol sold = RMB 22,068,092 for Q1 and RMB 122 X 2.98 X 65,410 tons of alcohol sold = RMB 23,780,460 for Q2.
3. Overstated Corn Germ by-product sales – Neither of BORN’s plants are extracting and selling significant quantities of corn germ by-product according to the expert consultant I hired from a competitor in Jilin who visited both plants. The expert found that the corn germ extraction facilities were not operational nor had they been used in quite some time due to high energy costs and pollution problems. Additionally, analysis of the fat content of the DDGS by-product BORN sells shows it contains 8-10% fat indicating the high fat corn germ was not extracted, whereas DDGS after corn germ is extracted contains only 3-4% fat. Accordingly, BORN’s 8-10% fat DDGS selling prices in Q1 of RMB 1,789 and Q2 of RMB 1,767 disclosed in its SEC filings are consistent with local published selling prices in its primary markets (see Table 3).
However, as a result of BORN not extracting any significant amounts of corn germ from its DDGS, its claim of Q1 sales of RMB 42.78 million and Q2 RMB 51.38 million corn germ are impossible.
Based on 1-3 above, I will now calculate adjusted Gross Margin and Net Income for BORN:
For Q1 and Q2, I deducted RMB 42,783,160 and RMB 51,381,930, respectively, of fabricated corn germ sales from BORN’s reported total sales of RMB 388,768,417 and RMB 432,469,590 to get adjusted sales of RMB 345,985,257 and RMB 381,087,660.
For Q1 and Q2, I add RMB 22,068,092 and RMB 23,780,460, respectively, of omitted shipping costs to BORN’s reported total COGS of RMB 301,674,443 and RMB 330,324,880 to get adjusted COGS of RMB 323,742,535 and RMB 354,105,340.
Deducting adjusted COGS from adjusted sales results in adjusted Q1 and Q2 gross profits of RMB 22,242,722 and RMB 26,982,320, respectively. For Q1 and Q2 the adjusted gross profit margins are therefore 6.43% and 7.08% versus 22.4% and 23.6% BORN reported in its SEC filings.
Based on these adjustments, BORN’s pre-tax income for Q1 and Q2 should be RMB 13,939,058 and RMB 13,675,440, respectively. BORN is fully taxed at 25% resulting in adjusted Q1 and Q2 net income of RMB 10,454,294 and RMB 10,256,580. Setting aside the earnings distributed to preferred shareholders and dividing by the weighted average 14,847,811 and 17,238,402 ADS shares outstanding in Q1 and Q2, respectively, results in earnings per share of RMB 0.70 and RMB 0.60. Converting earnings per share from RMB to USD at the average exchange rate during each period results in $0.10 and $0.09 EPS in Q1 and Q2, respectively, compared to $0.43 and $0.46 BORN reported in its SEC filings.
Going forward, BORN faces two additional challenges:
1. Lack of high quality customer base – BORN is in a rapid expansion stage. Yet all of BORN’s current customers are small and medium sized “baijiu” producers in Heilongjiang and Shandong province. Surprisingly, even though BORN claimed to be the second largest edible alcohol producer in China it has yet to sell products to any top tier “baijiu” producers. BORN nevertheless claims it will utilise its added capacity to target major “baijiu” producers, but it is hard to imagine it can enter this market easily since it has not succeeded to date generating sales to large producers such as Moutai (SHE: 600519), Luzhou Laojiao (SHE: 000568) and Wuliangye (SHE: 000858). Future capacity utilization could therefore be constrained.
2. Questionable legal restructuring – BORN’s legal restructuring was very aggressive. The company took a series of complicated steps to complete its offshore reorganization. The “circular 10” or so called “M&A” rules issued by the Chinese government on September 8, 2006 require PRC citizens who intend to set up offshore entities and use them to acquire domestic entities to get approval from MOFCOM (Ministry of Commerce). If PRC citizens intend to apply for foreign listing of newly setup offshore entities they need to get CSRC (China Securities Regulatory Commission) approvals. BORN’s Chairman and CEO somehow obtained a foreign citizenship for his mother and used his mother’s identity to set up the offshore entity. BORN’s PRC counsel, B&D Law, claims “M&A” rules don’t apply to this type of arrangement. However, all reputable Chinese counsels I have consulted would never approve this type of legal restructuring. It is very risky since the CEO’s mother is his direct relative. CSRC and MOFCOM could someday deem this restructuring a brazen violation of “M&A” rules.
Conclusion: Obviously I have serious concerns about BORN’s past and present financials. In the best case scenario, once BORN completes costly upgrades of its production method its gross margins could rise up from today’s miserable 7% toward the 11%-16% industry average gross margin, but of course nowhere near the fanciful 22-23% gross margins they have reported to investors. I think BORN is yet another lesson to U.S. investors who rely solely upon a company’s SEC filings and press releases for making investment decisions. Investors need access to industry experts in China to properly evaluate a company like BORN.
Table 1 – Heilongjiang corn price trend
Table 2 – Shandong corn price trend
Table 3 – DDGS price trend
Data Source: Feed Online
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