China New Borun Corporation
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 (
), SouFun Holdings (
), Hisoft Technology (
), Charm Communications (
), and China Lodging Group (
) 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 d espite 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:
- 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production technology is outdated, inefficient and environmentally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
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. (
Understated Raw Material Pricing
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 1 - Heilongjiang corn price trend
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
Table 2 - Shandong corn price trend
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.
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 below).
Table 3 - DDGS price trend
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
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,
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
Going forward, BORN faces two additional
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 utilize 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
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.
Obviously I have serious concerns about BORN's past and present
financials. In the best case scenario, o nce 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.
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