SkyPeople Fruit Juice Is Not A Fraud: The Juice Is Worth The Squeeze

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By Finance Is Fun :

(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)

SPU is not a fraud: the juice is worth the squeeze

Introduction:


  • The purpose of this first article is to explain my thesis that, if SkyPeople Fruit Juice ( SPU ) is not a fraud, it must be a buy. Because I see such a massive upside, I want to separate valuation potential from concerns about fraud. I would like investors to have a chance to digest the current situation before getting into SPU's potential.
  • In my next article, I will get into SPU's valuation, its growth prospects, and potential catalysts like buybacks (including levering-up) and M&A. I also believe that examination and debate of my conclusion about the absence of fraud is likely to improve understanding and appreciation by investors.

Summary:

  • A simple explanation seems to make sense: investors aren't paying any attention. SPU is a micro-cap stock (which are unusually inefficient and frequently mispriced) and SPU has no analyst coverage. SPU suffers from 'sketchy Chinese stock' syndrome, and is avoided without any analysis.
  • SPU's cash exceeds its market cap (it has a negative enterprise value, or 'EV') -but it's also profitable.
  • SPU's valuation is absurd (I estimate between 200-400% upside with conservative assumptions).
  • SPU has strong, transparent, open management and good corporate governance (just contact them).
  • SPU's management owns just-over half of outstanding shares (strong incentives, yet low exec comp).
  • SPU is NOT a fraud (this is the most important element of the investment thesis, in my view).

Overview:

  • Business overview: SPU is a micro-cap Chinese company listed in the US on the NASDAQ, and uses US GAAP accounting. SPU is a solidly-growing producer of fruit juice beverages and fruit concentrates (like apple juice and pear puree). Investors are rightly skeptical of Chinese stocks because of fraud concerns, but I conclude that SPU is not a fraud. As a result, I believe that SPU's valuation is entirely absurd, and the stock has extremely unusual upside potential (well above 100%). I own SPU shares, it's my largest position.
  • SPU's cash exceeds its market cap: SPU's market cap of ~$57Mn compares to ~$80Mn in net cash (effectively zero debt). On a per share basis, SPU trades at ~$2.15 and has ~$3.00 in net cash.
  • SPU's valuation is absurd: Using reported CY12 results, SPU currently trades at a mere 3x EPS and cash flow. Despite its ~$57Mn market cap and (~$22Mn) negative enterprise value, SPU has reported roughly $30Mn in EBITDA in each of the last 3 years. If you ignore the ~$80Mn in net cash, SPU would still be trading below 2x EBITDA. Further, SPU trades below both tangible book value as well as my estimate of liquidation value. From all angles, SPU has a very cheap valuation, and SPU generates consistent, significant cash flow.
  • SPU has strong management that owns a lot of stock: Based on my analysis, I have developed a very favorable opinion of SPU and its management. Not only do I consider the company well-run (good margins, smart decision making, appropriately aggressive), but I particularly like management's 'skin in the game.' SPU management owns just over 50% of SPU's stock and is strongly incentivized to grow their wealth by running the company well.
  • Shareholder friendly management and good disclosure: I have found management to be very accessible and open to investor communication. Based on my experience, I applaud SPU's level of disclosure, and find their SEC filings to be unusually detailed and forthright, providing specific details, metrics, risks, and expense details.
  • Strong corporate governance: I like SPU's strong, independent board. Somewhat unusual for a 'growth' company, two of SPU's independent board members are accountants, one in the US, and one in China. Further, two of the remaining independent board members are lawyers with litigation experience, which presumably implies that both are experienced with litigation risk assessment work. Overall, 5/7 board members are independent -this is impressively high on a percentage basis (analysis has uncovered very few Chinese frauds with a board that's 50-75% independent). Recently, SPU separated the roles of CEO and Chairman of the Board, which is universally considered a positive (except for JPMorgan, perhaps).
  • In this article I will ignore positives/potential upside: Examples include: multiple expansion as the mix shifts towards bottled beverages, declining seasonality associated with bottled beverages, growth potential from exports and rising per-capita domestic consumption, massive accretion potential from stock buybacks, M&A valuation implications, USD/RMB translation benefits, and new growth opportunities from PP&E used to expand into new fruit segments.

Unless SPU is a fraud, I believe SPU is one of the most undervalued stocks I've ever seen.

  • Let's begin with the hypotheses that SPU's current valuation is accurate and logically justified.
    • The hypothesis is wrong if SPU is a fraud and goes to zero (making SPU overvalued right now)
      • As explained later in detail, I do NOT believe SPU is a fraud.
    • The hypothesis is correct if the current valuation accurately reflects the cash generation outlook.
      • This means investors in a micro-cap stock have perfectly predicted the future (unlikely).
      • This hypothesis (valuation accurately reflects SPU's outlook) is easily disproven by DCF.
  • I believe that both hypotheses are wrong, neither logically justifies the current valuation.
    • My analytical conclusion: SPU is NOT a fraud.
      • My efforts to 'uncover shenanigans' have made me bullish on SPU, not cautious!
    • The implication: If SPU is not a fraud, then it's very, very undervalued and a great investment.
      • A 'fair value' for SPU if it's not a fraud is MULTIPLES of its current valuation.
  • A simple explanation of SPU's silly valuation makes more sense: Investors aren't paying any attention.
    • SPU is a micro-cap stock: micro caps are unusually inefficient and are frequently mispriced.
    • SPU suffers from a lack of attention: it has no analyst coverage, few shareholders, and is tiny.
    • SPU suffers from 'sketchy Chinese stock' syndrome, and is avoided without any analysis.
      • There IS reason for skepticism, as Chinese stocks have a higher incidence of fraud.
    • Undervaluation persists because of a 'circular bias' against optimism.
      • Bias = 'too good to be true'
      • Bias means that, the better SPU looks, the more cynical/skeptical investors become.
    • Noteworthy factoid: short interest just hit a 52wk bottom, down ~55% y/y in the latest data.

Set aside the fraud factor for a moment - a simple DCF underscores valuation absurdity.

  • While I prefer multiple-based valuation, I appreciate the usefulness of DCF analysis in certain situations.
    • In the case of SPU, an extremely simple DCF analysis illustrate SPU's absurd current valuation.
  • Based on my experience, the greater the mismatch between market valuation and intrinsic value, the more helpful a simplistic DCF can be in illustrating undervaluation.
  • In the case of SPU, the run-rate of >$20Mn in CFO annually compares to a negative enterprise value (more cash than market cap) and a market cap of ~$55Mn (or roughly 2-3 years worth of cash flow)

A 'simple DCF' sanity check implies massive upside: let's make some extremely conservative assumptions.

  • First, assume SPU's cash flow never, ever grows (annual run-rate of ~$24Mn in CFO, ~$15Mn in FCF)
  • Second, let's pretend SPU's cash doesn't even exist - let's ignore the ~$80Mn in net cash as of 1Q13.
  • Price it like a preferred stock:
    • Assume no growth - so FCFE is $15Mn every year and never grows
    • Use a conservative discount rate - let's use 15% (more than treasuries, about 2x S&P avg return)
  • The result: about 100% upside (a double) using silly-conservative assumptions -and ignoring the cash
    • Present value of $15Mn annually at 15% is $100Mn (15/0.15=100)
    • Buffett's words of wisdom (paraphrased): "You don't need complex spreadsheets to find value"
  • This 'minimum upside' ignores any/all growth and ignores SPU's ~$80Mn in net-cash.

Multiple-based valuation suggests upside of 200-400% -even ignoring ~$3.00 per share in net-cash

  • Even 'haircutting' comparable valuations, SPU is massively undervalued (using CY12 results)
    • P/E: SPU now: 3.1x, comps: 19x, target: 10x (CY12 EPS of $0.68)
      • Implied price target: ~$7.00/share (ignoring my estimate for CY13 EPS of ~$0.80)
    • EV/EBITDA: SPU now: N/A, comps: 13x, target: 6.0x (CY12 EBITDA of $29.8Mn)
      • Implied price target: ~$9.50/share
    • EV/Sales: SPU now: N/A, comps: 2.0x, target: 1.3x (CY12 sales of $102Mn)
      • Implied price target: ~$8.00/share
    • P/Sales: SPU now: 0.56x, comps: 2.2x, target: 1.6x (CY12 sales of $102Mn)
      • Implied price target: ~$6.00/share
    • P/Book: SPU now: 0.34x, comps: 2.3x, target: 1.3x (1Q13 book value of $168Mn)
      • Implied price target: ~$8.25/share
    • Liquidation value: I estimate $107Mn in liquidation (about 2/3 of current book value)
      • Implied price target: ~$4.00/share
  • I prefer EV/EBITDA - it's comparable across capital structures, tax rates, and is fairly specific
    • Closest comps are listed in Hong Kong -EPS isn't really comparable to a US GAAP company
    • Some comps have net debt, but some have net cash -EV/EBITDA is comparable for both

Bears wrong either way - contradictory short theses cannot both be true

  • Short thesis #1 - the cash isn't real (net cash of ~$3/share)
    • As I explain later, my analysis leads me to the conclusion that the cash is real.
    • Even ignoring the cash, 5x EBITDA of ~$30Mn in CY12 implies almost 200% upside.
  • Short thesis #2 - the cash is real, but SPU will spend it all on growing production facilities
    • As SPU progresses with its expansion plans, they will spend-down their cash (growing PP&E)
      • SPU plans to grow their supply/production by expanding into two new product lines
      • SPU management has stated that they will pay for the expansion over 2013 and 2014
    • The cost to build the two new lines totals ~$120Mn - the cash will become machines & buildings
      • SPU can afford it: ~$90Mn in gross cash as of 1Q13, plus ample cash flow generation
    • Based on my analysis, the capex investment has two key benefits:
      • Resolves uncertainty about 'real cash' -cash will decline, long term assets increase
        • Should remove the source of the 'fraud' overhang, boosting SPU's valuation
      • Enables substantial growth for SPU, with quick/attractive cash return on investment

Winning record with previous capex investments

  • Longer-term capex/PP&E trend reflects very well on management's operational execution
    • Let's compare CY12 with CY09 year-end results (pre-IPO, pre-boost in investment into PP&E)
      • PP&E grew by ~$28Mn to ~$52Mn at the end of CY12 vs. ~$24Mn at the end of CY09
      • EBITDA generated in the next 3 years (CY10-CY12) was ~$87Mn
      • CFO generated in the next 3 years (CY10-CY12) was ~$56Mn
    • In other words:
      • SPU generated almost 2x as much cash flow as they spent in PP&E
      • Exiting CY12, SPU generates ~$30Mn in annual EBITDA using ~$52Mn in PP&E
        • That's a massive return-profile from capital invested in PP&E
  • Specific example: In December of 2011, SPU added another pear juice production line costing ~$7.4Mn
    • For CY2011, SPU generated pear-related sales of $13.4Mn and gross profit of $3.2Mn.
    • For CY2012, SPU generated pear-related sales of $28.9Mn and gross profit of $8.5Mn.
      • In other words, SPU saw an incremental ~$15.5Mn in sales and $5.3Mn in gross profit the year after it completed the enabling capex of $7.4Mn.
      • If you can find other businesses with such rapid, impressive returns on their capex investments, please do me a favor and let me know so I can look into them.

SPU is not a fraud.

  • Verified cash balances: Conclusion of my analysis is that SPU's cash is real.
    • In 1H2012, Nasdaq (exercising impressive responsibility) requested 'cash verification' from a very large number of China-centric, US-listed companies, partially in response to several fraud incidents, particularly among the RTOs (reverse takeovers).
    • SPU slam-dunked the cash verification request: SPU put out a press release/8-K on 4/20/12 stating that SPU's independent auditor (quoting verbatim) "from January 5 to January 9, 2012, independently verified the Company's cash balances held in financial institutions in China in which the Company and its subsidiaries maintain bank accounts (the "Accounts"). "Independently verified" means that an audit firm visited in person each of the institutions and physically observed bank employees printing or otherwise preparing or completing documentation, which substantiated the cash balance for the Accounts. It does not mean that an audit firm relied solely on documentation completed and returned by bank personnel by mail or facsimile. Based on the Audit Firm's independent verification, the verified cash balances of the Accounts in aggregate represent substantially all of the cash, cash equivalents and restricted cash amounts as stated in the Company's 2011 financial statements as reported in the Company's recent 10-K filing."
      • SPU further noted in its press release that "Nasdaq has reviewed the cash balance submitted and has no further comments." This was not the case for other Chinese companies, some of which remained halted pending satisfactory response.
      • Of importance: SPU specifically references in-person visits to their banks, and they directly stated that their auditor did NOT simply collect faxed/mailed statements. Based on my analysis, of the few Chinese frauds that DID overstate their cash balances, NONE of those frauds -that I've uncovered in my research- were able to meet the same 'physical proof' standard that SPU did. Related examples include China MediaExpress (CCME), the massive Satyam blowup (India-based, but same issue), and ShengdaTech (SDTH). Does this mean that fraud can totally be ruled-out? No. However, unless about half a dozen banks all faked statements that actually added-up correctly, I believe that SPU's cash balances are accurately listed on their SEC filings.
    • SPU management GOT the message. The press release contained the following bold, direct quote: "At a time when there is speculation as to the credibility of certain Chinese companies, SkyPeople investors can be reassured that our cash balances have been independently verified and that we employ of a high degree of financial integrity in terms of our financial management systems," said Mr. Yongke Xue, SkyPeople's CEO. "Investors can have confidence in the strength of our balance sheet that enables us to take advantage of the growth opportunities available to us in our sector."
    • A copy of the press release is available from the 8-K filed with the SEC here
  • SPU has TWICE shot-down the 'cash is fake' claim
    • In early June of 2011, SPU was accused of being a fraud by a short seller that released a bearish report on SPU, after initiating a short position in SPU (seller referred to here as 'Absaroka'). Absaroka basically accused SPU of faking its cash balance and actual level of sales.
    • After SPU was accused of being a fraud in early June of 2011, the Company hit back hard.
      • First, SPU stated that it "believes that the article contains many materially false and inaccurate claims" and added that "it is important to alert the general public to such fake reports and the false information contained therein" (8-K filed with SEC June 3, 2011).
      • Second, SPU released another 8-K that listed its actual cash balances at each of almost a dozen banks. The filing provided information evidencing the accuracy of its SEC filings, and it also corrects/reconciles the mistaken calculations from the short report.
      • Third, SPU immediately sued the analyst/fund that put out the short report.
        • SPU hired 'heavy hitting' legal counsel and spent a LOT on clearing their name.
    • My view: SPU won its fight against the short report/seller -SPU was right, they were wrong.
      • Absaroka settled with SPU, and agreed to remove/retract their short report entirely.
      • Key conclusion: As a financial analyst, I deeply respect and admire the work Absaroka did trying to uncover numerous Chinese frauds, particularly RTOs. I acknowledge that they were RIGHT about several OTHER companies, but they were WRONG about SPU. I can understand how, given the multitude of 'guilty' companies, Absaroka would be inclined to believe fraud was occurring -they were correct about most of them.
    • SPU got some unexpected support: another analyst immediately said the short report was wrong.
      • Rick Pearson, who speaks Mandarin and focuses on Chinese stocks, wrote an article about SPU as a contributor for thestreet.com, which was published one day after the short report. He noted that he had "visited the company, its distributors and retailers."
      • He stated that he was "puzzled why the firm would use arguments that are so easily refutable" and noted that he had "no position in SPU" when refuting the short report.
  • SPU's 'clean-slate' auditor is reassuring:
    • After SPU was accused of fraudulent actions in June of 2011, the company began a search for a new auditor to provide a totally fresh and clean assessment of the financials.
      • The dismissed former auditor (BDO) did NOT -importantly- note any concerns/issues. Put simply, BDO got 'dumped' -unlike most frauds where the auditor dumps the client.
      • SPU elaborated in an 8-K: "During the Company's two most recent fiscal years ended December 31, 2010 and 2009 and the subsequent periods through the effective date of the dismissal of BDO, there were no disagreements on any matter of accounting principles or practices, financial statement disclosure or auditing scope of procedure, which disagreement, if not resolved to the satisfaction of BDO, would have caused BDO to make reference thereto in its reports on the Company's consolidated financial statements for such periods." The filing included a letter from BDO agreeing about the financials.
    • SPU's auditor was specifically hired to verify and audit SPU's financials, and is the FOURTH auditor to determine that SPU's books were clean.
      • The current auditor does not have a local China affiliate that they use to 'farm out' audit work: they actually fly from the US to China to conduct their audit work. This is very notable, because numerous Chinese frauds have resulted from audit work being done by outside, local accounting firms that do not have to comply with US audit standards. This applies specifically to the 'big 4' accounting firms, and others. As a result, SPU is less-likely to have influenced/biased auditors, and their auditors adhere to higher standards.
  • Investor-friendly US GAAP accounting:
    • It's rare among its peers in that it reports in US GAAP, which should help SPU's relative valuation. Most of the Chinese juice/beverage companies are listed in Hong Kong, with less-frequent financial reporting and less-robust accounting standards and corporate governance.
    • GAAP is expensive to satisfy (eg, Sarb-Ox costs) and demonstrates a commitment to verifiable financial reporting and transparency. Public company costs are a common reason to go private.
    • GAAP requires quarterly filings (greater frequency & consistence), and avoids infrequent 'interim' filings.
    • Net result: Required GAAP disclosures and frequency make SPU easier to model and follow.
  • Cash flows support earnings : Fraudulent companies are often associated with 'fake' earnings with little to no cash flow to back it up, with sharp analysts focusing on the cash flow statement and balance sheet to detect evidence of 'fake' earnings that are either overly-inflated or overstated.
    • Good cash conversion: In the case of SPU, CFO exceeded net income over the last couple of years.
    • Matching growth in cash balance: Thus far, SPU's cash flow has been real -cash has steadily built since SPU's IPO back in 2010. As of 1Q13, SPU has grown its cash balance since IPO by about ~$42Mn, which is almost identical to the sum of CFO less capex over that period.
  • Management reassuringly owns ~50% of outstanding shares .
    • Just over 50% of SPU is owned by the Chairman of the Board and the CEO, creating a strong incentive to avoid 'fraud' and risk losing the substantial value of their investment.
    • Management has been putting money BACK INTO the company: In 1Q13, the Chairman lent SPU a small sum to SPU for short-term use (borrowed about $4Mn), and the interest rate he's charging the company is below-market (not a way to bilk interest payments from the company).
      • In my opinion, it is highly unlikely that an investor (the Chairman, a former banker) would invest additional capital into a known fraud (e.g., the Chairman knows that SPU is a fraud but risks more of his capital regardless of the risk).
      • Historically, management exploits frauds by EXTRACTING money from the company, which is not the case with SPU.
      • Historically, loans as a sign of fraud are more commonly associated with Ponzi schemes like Madoff's funds where frequent withdrawals require frequent additions.
      • In summary, SPU passes the sniff test: the Chairman lent money to SPU, and it's very unlikely he would have done so if SPU (which he owns about 50% of) was a fraud.

Disclosure: I am long [[SPU]]. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

See also Insiders Are Buying PulteGroup on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

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