CGA, CAGC: These fertilizer companies are not necessarily enriching

Wall Street may have it wrong about these Chinese fertilizer makers

Presently, the Chinese spend the bulk of discretionary income on food. With half of the arable land per capita of the US, it is logical to assume that Chinese fertilizer companies should benefit from a growing middle class in the PRC. Hence the investor interest in China Green Agritech (CGA:NASDAQ), and China Agritech (CAGC:NYSE). Watch out. These stocks are not the quality of Potash (POT), Agrium (AGU), or Mosaic (MOS). There are over 40 other companies in China that turn weathered coal, lignite, or peat into humic acid compound fertilizers like CGA and CAGC. 50 other companies produce potash products, while the numbers of urea fertilizer producers are even larger. Consequently CGA and CAGC represent only .1% and .4%, respectively, of the 46 million metric ton Chinese fertilizer market while SINOCHEM, a subsidiary of Chinese petroleum company, CNOOC, commands 21% of the fertilizer space. Its footprint is solidly established in 91% of arable real estate in 26 of China's 30 provinces. China Blue Chemical and China XLX are also much lager players than CGA and CAGC. Despite all of this domestic fertilizer production, China is still a net importer and multinational producers like POT, MOS, and AGU will increase competition for small caps like CGA (370 million) and CAGC (293 million). If you were prescient and purchased when these stocks were OTC and less than a $1/share, take your profits and run. If you still want to make money on these companies, try shorting them. Any serious read of the SEC filings of these companies would not warrant the present buying frenzy.

Readers who follow my analysis of Chinese equities know that I am bullish on small caps that target the demands of the growing Chinese middle class. Growing demand for food make products that increase food production an obvious play on China's economic prosperity. Fundamentally, both of these companies are sound. Both are cash rich, 35 million for CGA and 19 million for CAGC, with no debt for CGAC and only 3.2 million for CGA. Both companies have experienced greater than 50% revenue growth, yoy, with CGA leading in earnings growth at 47% versus -10% for CAGC for the same period. However, nine month earnigs for CAGC have been outstanding, while CGA has only reported one quarter of earnings for this fiscal year that began in July. Gross, operating, and net margins are close but CAG holds the edge with 58%, 49%, and 41% respectively. As momentum investors continue to drive up share price, valuation ratios are outpacing probable earnings. CAGC's P/E is a bit deciptive because they recently underwent a 1-for-4 reverse split leaving only 6.6 million diluted shares for earnings calculations. With a limited float of 4.5 million shares, CAGC's P/E will not be affected by meaningful dilution and seem attractive to retail investors and day traders. This provides limited catalyst for institutional demand to drive share prices going forward. CGA's ROE of 44% eclipses CAGC's 13%, but CGA's better cash ratio is weighted by $28 million raised from a recent public offering of common shares and dilutive for CGA's P/E.

Earlier this year, CAGC introduced granular formulations of its liquid products and met the incredible demand that is sparking present investor interest. CGA is due to release solid forms of their products this year and should be met with the same enthusiasm. Again don't be misled. Granular and powdered forms of humic acid fertilizers, although popular to farmers, are lower margin products. Lignite and peat are ubiquitous in China, so barriers to entry for local production of humic acid fertilizers are limited. CAGC has no proprietary patents and CGA has only 1 patent for its automated production process. Trademarks are limited to packaging, not content, for both companies. CAGC's combined 2007 & 2008 expenditures for R&D was a paultry $3,500. Interestingly, CGA makes revenue on R&D. To test fertilizer formulations, CGA has an intelligent greenhouse for fruits, vegetables, and flowers. These agricultural products are sold in local and regional markets, account for 18% of revenues, and offset the seasonal slowdown in fertilizer sales. Greenhouse testing allows for customized fertilizer development for regional or individual markets in just 3-9 months. CGA feels so strongly about R&D and its ability to profit from it, they plan to invest $36 million to construct 88 more intelligent greenhouses over the next 2 years. This production of "designer fertilizer" and agricultural product revenue may offer CGA a unique competitive advantage.

Both companies use limited numbers of suppliers for raw materials, with CGA purchasing all of its weathered coal from 1 local supplier. Without pricing pressure and abundant supply of raw materials, neither company sees supplier concentration as a risk. CAGC relies on 10 distributors for 25% of sales, while CGA's larger distribution network limits its top 10 distributors to 7% of sales with the top performer accounting for .8% of sales versus 8% for CAGC's top performer. CAGC's staffing is heavily weighted toward managemnet having more than twice the adminstrative staff and less than half the sales and marketing staff of CGA. In a highly competitive environment, this may tip the marketing advantage to CGA.

Unfortunately, the SEC filings do not indicate any significant growth strategy for either of these companies. CGA's expected 55,000 tons and CAGC's planned 200,000 tons of annual fertilizer production pale in comparison to the 10.6 million tons produced by SINOCHEM. Both lack product diversification and an aquisition strategy. Yes, both companies will continue to make money but it is difficult to see any significant growth that warrants the present P/E expansion. I think Wall Street has it wrong. Shorting these companies and/or purchasing SINOCHEM (600500.SS:Shanghai), China Blue Chemical (3983.HK:HKSE), POT, AGU, or MOS are better plays on the growing demand for food in China.