Chardan Capital Initiates with "Sell" and $16 price target
Volume Growth Coming At Expense Of Margin Erosion. During FY:09, China Agritech expanded its sales of humic acid fertilizers to over 80k metric tons, up from 13k tons in 2008. On the other hand, we suspect that China Agritech's gross margins declined to the mid-20s in Q4:09 from 35.5% in Q3 and 53.3% in Q3:FY07. Concurrently, the company has re-focused its humic-acid (HA) fertilizer business from the high-margin liquid segment to the low- margin granular segment. Granular product accounted for 44.3% of total revenues in Q3:09 vs. 25% in Q3:08.
HA Fertilizer Industry Growing, But Discipline Required. We believe the trend towards farmland consolidation coupled with growing adoption of advanced agricultural methods in China will result in growers increasingly utilizing liquid HA solutions, as part of their overall soil/plant nutrition regimen. However, with these trends still in the early stages, we believe companies that aspire to be volume leaders will increasingly be forced to direct production capacity to lower-end margin formats, such as granular solutions.
Elevated DSOs Limit Revenue Visibility. As of Q3:09, we estimate that China Agritech had an average daily sales outstanding (DSOs) of 157 days. However, we note that DSOs have exceeded 200 days in Q4 during prior years. While we see an opportunity for the company to improve its DSO performance, our sense is that cash flow improvements may be partially offset by supplier pressure on China Agritech to reduce its payment cycle. More importantly, we remain cautious on potential future receivable write-offs in light of China Agritech's current and past DSO levels.
See ~50% Downside Risk In Shares, Excl. Potential Dilution. With shares of China Agritech trading at 38.5x our FY:10 EPS estimate of $0.79, and a premium of 181% to its peer group, we see significant downside risk to shares during the next 12 months. We believe valuation now exceeds the company's current growth profile. In addition, we believe the company may raise additional cash for working capital/expansion purposes through a follow-on offering.
We are initiating on China Agritech with a Sell rating and a 12-month price target of $16/share.
