February 27, 2012

China Agri earnings looking anemic

by Sridharan Raman

Feeding more than a billion people is no easy task, and to do it, China’s agriculture industry has emerged as the country’s largest, employing more than 300 million people. With such a strong demand for food, one might expect the companies in the agriculture related industries to perform well, but China Agri Industries Holding Ltd (0606.HK) doesn’t seem to be conforming to those expectations. Falling soybean prices (dramatically illustrated in the chart below) due to a global oversupply, and the low-margin rice business is another challenge. As a result, China Agri has a poor StarMine Earnings Quality (EQ) score of 2, placing it among the lowest tier of those companies ranked in the region. That indicates that the company may have trouble sustaining its earnings level in the future. In this article, we delve into the reasons for its poor earnings quality and low EQ score.

StarMine has used computer-driven models to analyze the financial statements of China Agri and more than 33,000 other companies, and to calculate a proprietary StarMine Earnings Quality (EQ) score for each. These scores have proven to be reliable predictors of the extent to which a company generates earnings that are sustainable over the forthcoming 12 months. Expressed on a scale of 1 to 100, with a higher score indicating higher-quality earnings, the StarMine EQ score enables investors to compare a company’s earnings quality against the scores of its peers, other companies in the same region or across the entire universe of stocks. Companies with low StarMine EQ scores are likely to have difficulty in sustaining past earnings, while stocks with high StarMine EQ scores have a higher probability of building those earnings are solid. With this look at China Agri, we continue our series of in-depth looks at a handful of Asian companies that have an EQ rank that is either particularly high or very low compared to others in the region.

The chart below bleeds red. The red bars indicate semi-annual periods when the company reports free cash flow (FCF) that is less than net income. In spite of that, in fact the company has reported positive net income for in each period in the last five years. The free cash flow tells a different story, however. The FCF for China Agri has been negative for the last two years, and last year saw the company’s FCF fall lower still. Nor is that decline in free cash flow simply a consequence of higher capital spending. In 2009, the company allocated HK$1.6 billion to capital spending, and boosted that further to HK$3.6 billion in 2010. This took place against a backdrop of falling cash flow from operations, which turned negative to the tune of HK$8 billion last year.

One reason for the negative FCF is the company’s decision to ramp up capital spending (CapEx) in order to construct a soy processing facility. In its 2010 fiscal year, the company spent 3.6 billion Hong Kong dollars on capital projects, despite the large cash outflow, and since then (as noted in the chart above) soy prices have fallen amidst a global oversupply of the agricultural commodity. Such heavy spending levels should be met with skepticism on the part of investors, and followed by an attempt to understand what is going on behind the scenes. High levels of capital spending that aren’t supported by cash flows are usually not sustainable in the long run.

Source: Thomson ONE / StarMine

Investors might also worry about the increasing CapEx in a business environment characterized by falling margins. As can be seen in the chart below, the operating profit margins for China Agri have been sliding for the last three years, from a healthy 9.4% in December 2008 (when the margin topped the industry median) to a very anemic 1.6% in the most recent reported period, nearly 7 percentage points below the industry median. This doesn’t seem to be an industry wide problem, as the company’s peers continue to report healthy margins. Another cause for concern is the fact that China Agri’s return on net operating has seen a similar decline. These two measures can be regarded as a proxy for operating efficiency; a decline in these measures may signal unstable earnings ahead.

Source: Thomson ONE / StarMine

Certainly, the appetite for food on the part of China’s billion-plus citizens isn’t going to vanish, or even diminish. But this analysis tells us that solid demographics aren’t enough for food company products to do well. Indeed, it seems as if some analysts agree with the EQ model view of earnings for China Agri; the company has a large negative Predicted Surprise of -6.7% for the FY 2011 period. (In other words, the StarMine SmartEstimate is more bearish than the I/B/E/S consensus estimate.) That indicates that the estimates may yet be brought lower, or that the company may disappoint investors when it announces its earnings on March 29, 2012.

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