Fufeng Group: A Leader In An Oligopolistic Market

By Marc Melendez:

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Investment Thesis

Fufeng (FFNGY) is a leading producer of monosodium glutamate ("MSG"), other amino acids, and xanthan gum. Its largest market (MSG, 48% of 2018 sales) is an oligopoly. MSG prices went through a boom period from 2008 to 2012 before overcapacity and weak demand led to weakness in the industry from 2013 to 2018. MSG prices troughed in 2017 and are now starting to normalize after the market has digested capacity increases by the largest players. To counter weak prices, the company chose to decrease production rather than continuing to produce and build inventory pointing to potential rationality in the market. Fufeng continues to grow by adding capacity to higher value added products with higher gross margins.

Given its competitive position, profitability, and financial health, Fufeng is cheap trading on an EV/trailing twelve-month EBITDA of 5.4 times with a cyclically depressed EBITDA. It also trades on an EV/IC of 0.78 times and offers a 7.0% dividend yield.

The bear case assumes the company’s end markets remain weak with no growth into perpetuity and cyclical trough margins. Despite the poor outlook assumed by the bear case, there is still 28% upside to the bear case’s 2023 fair value per share of HKD5.03. The base case sees 4% growth per year over the next five years before fading to a terminal growth rate of 0% in the tenth year. Operating margins equals the average over the past few years when the market was adjusting to overcapacity. The base case’s 2023 fair value per share is HKD6.67 per share 78% above the current share price of HKD3.92.

An investment in Fufeng brings 28% upside over the next five years if the market remains depressed and 70% upside if the company’s end markets normalize.

Key Stats

Company Description

Fufeng Group (Fufeng, 546:HK) is the largest producer of monosodium glutamate ("MSG") and xanthan gum producer in the world. The company produces many other amino acids.

The company started in January 1999. On January 18, 1999, the Junan County government approved the sale of certain Five Factories (a government-owned business) assets to the management of the Shandong Furui Brewery Group, which then transferred the assets to Shandong Fufeng on June 9, 1999. From the outset, Mr. Li Xuechun was the controlling shareholder owning 48.72% of the company. In 2002, Mr. Li’s ownership increased to 50.94%. At the end of 2018, Mr. Li still owned 38.94% of the company. Shandong Fufeng manufactured and sold MSG, cornstarch, animal feed, seasoning products, animal farming, and power generation. In 1999, Shandong Fufeng produced 19,800 metric tonnes of cornstarch, 5,800 metric tonnes of glutamic acid, and 8,000 metric tonnes of MSG.

Fufeng’s revenue evolution by-product is illustrated in the chart above. In 2003, the company generated RMB449 million in sales and was a two-product company. Its largest product, glutamic acid, accounted for 46% of sales. MSG was the next largest product contributing 30% of sales.

In 2008, Fufeng’s sales equaled RMB3.6 billion. Glutamic acid and MSG were still the primary products contributing 57% of sales, down from 76% in 2003, but corn refined products, fertilizers, and xanthan gum all increased in importance with each accounting for more than 10% of sales.

In 2013, the company continued to diversify its product portfolio with sales reaching RMB11.4 billion. MSG took the glutamic acid’s share of revenue as Fufeng focused on selling MSG with its glutamic acid rather than selling it externally. From 2008 to 2013, the contribution of corn refined products, fertilizers, and xanthan gum did not drastically change, but the company introduced threonine and high-end amino acids.

In 2018, Fufeng’s revenue was RMB13.8 billion. MSG was 48% of Fufeng’s sales, corn refined products were 13% of revenue, threonine was 11%, starch sweeteners were 8%, high-end amino acids were 7% of sales, and xanthan gum was 6% of sales. Other products were 2% of sales or lower. The company continues to evolve to provide more value-added, higher gross margin products. From 2018, MSG declined from 56% to 48% of revenue with threonine and high-end amino acids contribution increasing from 5% to 15% of sales in 2018. The decline in contribution of MSG came despite little change in MSG revenue.

The product process map below illustrates the production process for each of Fufeng’s products.

The company has two segments, Amino Acids and Xanthan Gum. All products except xanthan gum are within the Amino Acid segment. 75% of Amino Acid sales are in China, while 78% of xanthan gum sales are exports.

MSG

MSG is the sodium salt of glutamic acid. Glutamic acid is naturally found in a number of foods, including tomatoes, grapes, cheese, and mushrooms. Like most MSG in the world, Fufeng’s MSG is created using a biofermentation process similar to processed used in making vinegar or yogurt.

MSG is primarily used in the food industry as a flavor enhancer with an umami taste that intensifies meaty, savory flavor of foods. The main fields are food processing and condiment industry, catering industry and household consumption, accounting for 50%, 30%, and 20% of consumption, respectively. The structure of Chinese demand is similar to demand outside of China.

MSG is currently Fufeng’s largest product, generating 48% of total sales and 51% of the Amino Acid Segment’s revenue in 2018. MSG revenue was 30% of total sales in 2003. It reached a peak of 63% of total sales in 2010 before declining to 48% of sales in 2018.

China is the largest producer and consumer of MSG. In 2014, global MSG consumption was 3.2 million metric tons, China accounted for 55% of consumption and 65% of production. Other Asian countries account for an additional 33% of consumption and 30% of production. In 2018, China supplied more than 60% of the world’s MSG and accounted for 75% of the world's total MSG capacity.

Since 2003, the domestic MSG industry has consolidated from roughly 200 domestic companies to 3 major companies and a small number of smaller producers. The elimination of smaller inefficient companies levels the playing field within the industry decreasing the variability of cost structures among competitors, which should also decrease the amount of excess returns within the industry.

The largest producers in China are Fufeng, Meihua Group, and EPPEN. Fufeng is the largest MSG producer in the world with an estimated 31% global volume share and 57% volume share in China. According to OKChem, Meihua has 700,000 tonnes of capacity, and EPPEN has 420,000 tonnes of capacity. The top three producers account for 90% of the domestic market’s capacity and output. The next largest Chinese MSG producers are Lotus Health Group with 160,000 tonnes of capacity, Linghua Group with 100,000 tonnes of capacity, and Shandong Shenghua Group 80,000 tonnes.

On top of a culture of constant improvement and operational efficiencies, Fufeng enjoys economies of scale (R&D, purchasing investments in operational improvements) and an integrated supply chain that will be very difficult for any competitor to replicate. Despite its cost advantages, the company has no pricing power, so its profitability will see ups and downs associated with supply and demand in the MSG market.

In 2018, Fufeng’s effective capacity was 1.33 million tonnes up from 25,000 tonnes in 2013. The company has been able to sell all new capacity with sale volume matching capacity increases until 2017 and 2018. Fufeng's ability to sell additional capacity relates to the continued consolidation the market. The global MSG market is expected to grow at roughly 5% per year over the next five years.

Fufeng’s average selling price of MSG ranged between a low of RMB5,522 per tonne in 2017 and a high of RMB7,984 in 2011. The period of 2009 to 2011 saw the company’s ASP remain above RB7,500 per tonne. Fufeng’s MSG ASP was close to its trough in 2003 when it reached RMB5,556 per tonne. 2018 saw a bit of mean reversion in ASP to RMB6,085 per tonne from its low of RMB5,522 in 2017. MSG’s average ASP over the 16-year period was RMB6,613 per tonne.

2017’s ASP was low due to weak demand conditions and low raw material prices. In 2003, oversupply was the primary driver of the low ASP. 2007 saw consolidation in the MSG industry that accelerated into the first quarter or 2008. The industry consolidation leads to a more balanced supply and demand position causing the ASP of MSG to surge in 2009. 2010 ASP increase was related to an increase in raw material prices, while 2011 saw continued industry consolidation and increases in raw material prices. 2012 saw a downward reversion in prices towards the mean due to weak demand and more competitive pricing by Fufeng. The company’s capacity grew the fastest during the period of elevated prices from 2009 to 2012. In 2008, its effective capacity was 171,667 tonnes. In 2012, effective capacity increased to 1,008,333 tonnes.

In the first half of 2018, the MSG price continued to decline before government policy eliminated uncompetitive production capacity from the market. After consolidation, Fufeng started destocking to create a healthier operating environment causing the average price to increase by 10.2% in 2018. From 2003 to 2017, Fufeng’s average capacity utilization was 98.4% with a low of 87.6% in 2008. In 2018, the company’s capacity utilization was 71.0%, illustrating the previously mentioned destocking. The industry consolidation in mid-2018 may have eliminated a sufficient number of competitors to create a more rational operating environment.

MSG revenue was RMB134 million in 2003. It reached a peak of RMB6,738 million in 2012. In 2018, Fufeng generated RMB6,555 million in MSG revenue.

Corn Refined Products

Corn refined products, including corn germ, corn bran, and corn protein, are by-products of the process of turning corn kernels into cornstarch. Corn germ is used to produce corn oil. Corn bran and protein are used in animal feeds products. Given it is a byproduct of the production process, the company does not provide much information on corn refined products. Despite being a byproduct, from 2003 to 2018, corn refined products, on average, generated 13.3% of the company’s total revenue. Corn refined products reached its high of 15.6% of sales in 2007 and a low of 11.7% of revenue in 2015.

Threonine

Fufeng’s threonine is part of the animal nutrition business. Threonine is widely used in the food industry, breeding industry, and pharmaceutical industry. It is often added to feed for juvenile piglets and poultry. Adding L-threonine to the compound feed adjusts the amino acid balance of the feed and promotes the growth of livestock. It also improves the meat quality and the nutritional value of the feed with low amino acid digestibility, while reducing the cost of feed ingredients. Threonine is one of the fastest growing amino acid varieties.

The company started selling threonine in 2010. Threonine products contributed RMB1,449 million in sales equal to 11% of sales in 2018. At the end of 2018, its threonine manufacturing capacity reached 240,000 tonnes. In January 2018, Fufeng entered into a cooperation agreement with Evonik to ensure Evonik had a reliable supply of L-Threonine for its ThreAMINO product. Fufeng sees threonine as a growth opportunity.

2018 sales volume reached 200,312 tonnes up from 161,384 tonnes in 2017. Threonine’s ASP in 2018 was RMB7,713 per tonne down from RMB8,629 in 2017, and RMB11,097 in 2015. In the second half of 2018, China had a swine flu outbreak decreasing demand as the husbandry industry dealt with the swine flu by killing and quarantining a number of pigs. The demand decrease caused threonine’s ASP to decline. The increase in capacity has more than offset threonine’s ASP decline leading to a 4% increase in revenue in 2018.

A recent study expects the threonine market to grow at an approximate CAGR of 5.6% over the next five years from its current estimated size of USD1.1 billion or (RMB7.9 billion). Another study put the annual growth rate at 8.0%. There are a number of large and small global manufacturers but the large global manufacturers are similar to MSG competitors, including Meihua and Ajinomoto. Fufeng’s RMB1,449 million in MSG revenue places its market share around 18%, making it one of the largest suppliers in the world.

According to Meihua Group 2018 Annual Report, global threonine production was 838,000 tonnes an 22% increase from the 685,000 tonnes produced in 2017. China produced 718,000 tonnes of threonine. 446,000 of which were exported. Based on Meihua’s estimates of global threonine production, Fufeng’s production share is 24%.

Starch Sweeteners

Starch sweeteners are primarily used as a food additive. Fufeng first started selling starch sweeteners in 2006. In 2018, it contributed RMB1 billion in revenue equal to 8% of all revenue. The company’s starch sweeteners production capacity reached 420,000 tonnes at the end of 2018 up from 260,000 tonnes at the beginning of the year. Phase I of the new Longjiang Plant located in Qiqihar, Heilongjiang Province started production in the first half of 2018. Phase II of the Longjiang Plant Project, located in Qiqihar, began production in January 2019. Phase II added 300,000 tonnes of starch sweeteners capacity and 200,000 tonnes of lysine capacity.

2018 sales volume reached 373,861 tonnes up from 67,819 tonnes in 2008. Starch sweeteners’ ASP troughed at RMB1,842 per tonne in 2008 and peaked RMB3,444 per tonne in 2011. Since 2007, the average starch sweetener ASP per tonne was RMB2,702 per tonne.

Transparency Market Research forecasts the global cornstarch market will grow at a CAGR of 4.8% between 2016 and 2024. Asia is expected to grow at 6.4% per year. Starch sweeteners account for over 50% of the global cornstarch market, which was estimated at USD22 billion at the end of 2016. Fufeng is one of the three largest exporters of starch sweeteners in China.

High-end Amino Acids

High-end amino acids are used for skin care and pharmaceutical products. High-end amino acids include valine, leucine, isoleucine, glutamine, and hyaluronic acid. In 2018, high-end amino acids generated RMB960 million in sales equal to 7% of sales. Fufeng did not start selling high-end amino acids until 2011. The company does not disclose the gross margin in the segment but state it is higher than the company average. It hopes to become one of the three largest high-end amino acid producers in the world. Due to a large number of products within the category and previous insignificance of the segment, the company does not disclose much about high-end amino acids. Fufeng see the high-end amino acid business as a growth opportunity.

Xanthan Gum

Xanthan gum has many industrial uses, including food additives, oil exploration, personal care products, and pharmaceuticals. It is an effective thickening agent and stabilizer. It is commonly used in salad dressing and sauces to prevent oil separation by stabilizing the emulsion. It is also used in the oil industry to thicken drilling mud, which carries solids back to the surface.

Xanthan gum is a separate business segment for the company. It started selling the product in 2003 but only had RMB1 million in sales that year. In 2018, xanthan gum generated RMB877 million in sales, equal to 6% of total sales.

In 2018, Fufeng had effective production capacity of 64,167 tonnes. Xanthan gum effective production capacity peaked in 2015 at 87,500 tonnes. Capex to depreciation has been on the decline since the peak in capacity in 2015. Capex to depreciation reached a low of 4% in 2017 before slightly increasing to 20% in 2018. In 2018, 78% of xanthan gum sales were export sales.

Xanthan gum sales volume grew rapidly from 2003 to 2014 increasing from 33 tonnes to 65,387 tonnes. Sales have slightly declined since. In 2018, Fufeng sold 56,409 tonnes. The market was growing at a fast pace until 2013 due to the growth in xanthan gum use in the oil industry. After 2014, the fortunes of the company’s xanthan gum sales followed the troubles within the oil industry as a falling oil price caused a decline in production and demand for xanthan gum.

In June 2013, the United States determined xanthan gum imports from Austria and China were being sold at less than fair value and put an antidumping duty order on imports of xanthan gum from China with the final weighted-average dumping margins ranging from 12.90% to 154.07%. Fufeng dumping margin was 12.9%. All other Chinese firms received dumping margins from 70.61% to 154.07%. The anti-dumping order was reviewed in 2018 and upheld.

Xanthan gum ASP declined from a high RMB27,533 per tonne in 2004 to trough of RMB10,738 per tonne in 2016. Xanthan gum prices continue to decline but may have found a trough. From 2003 to 2007, xanthan gum prices averaged RMB26,010 per tonne. From 2008 to 2014, xanthan gum prices averaged RMB20,949 per tonne. In 2013, prices briefly breached the levels previously seen in the 2004 to 2007 period by reaching RMB25,254 per tonne. Since 2015, prices averaged RMB13,645 per tonne.

In 2018, corn kernel accounted for 25% of xanthan gum production costs, while coal was another 23%. All other costs were less than 10% of production costs.

Since 2006, xanthan gum gross margin averaged 37% with a maximum of 58% in 2013 and a trough of 15.9% in 2016. The segment’s return on asset (ROA) averaged 17%. The downturn in the oil industry over the last four years caused gross margin to be below average. When combined with a significant decline in asset turnover, ROA over the last four years averaged 4.5%. It is good to see the company decreasing the capital expenditures in the segment, given the recent weak returns. Prior to 2015, the segment’s average ROA was 22.1%.

Amino Acid Production Costs

All products other than xanthan gum are classified in Fufeng’s Amino Acid segment. MSG is the largest product in the Amino Acid segment accounting for 51% of the segment’s sales.

According to OKChem, typically, 2.2-2.3 tonnes of corn are used in the production of a tonne of MSG that accounts for roughly 55% of total production costs depending on corn prices. Coal accounts for another 10% of the MSG’s production costs, while depreciation accounts for 7% of the total cost structure.

As illustrated above, Corn kernels are the largest production cost within the Amino Acid segment. In 2018, corn kernels were 47% of production costs down from 57% of total production costs in 2007. From 2007 to 2016, corn kernels averaged 56% of total production costs but declined in 2017 and 2018 due to lower corn price in 2017 and lower MSG production in 2018. The chart below shows the average corn kernel price per tonne.

After corn kernels, coal is the next largest production costs averaging 11% of total production costs from 2007 to 2015.

From 2007 to 2010, liquid ammonia averaged 11% of the Amino Acid segment’s production costs. From 2013 to 2018, liquid ammonia decreased to 2% of production costs when Fufeng created a method to manufacture composite ammonia, which was used in all production plants except its Baoji Plant. The use of internally produced composite ammonia is an example of the company’s focus on constantly improving its operational efficiency.

Since 2006, the gross margin of the amino acid segment averaged 17%. Unlike the continued decline in xanthan gum’s gross margin, the amino acid segment’s gross margin is more cyclical reaching a high of 30% in 2009 and a low of 9% in 2007. The amino acid segment’s average ROA was 11% with a high of 26% in 2009 and a low of 2% in 2007 and 2013.

Other Products

Fufeng adopted a diverse development strategy to structure its production facilities allowing it to take advantage of regional resources, government policies, and cost advantages. Phase II of the Longjiang Plant Project started producing 200,000 tonnes of lysine. Lysine production and sales strengthen the company’s animal nutrition products creating a more integrated product solution.

90% of lysine is used in animal feed, 5% is used as a food additive, and 5% is used in pharmaceuticals. Lysine in animal feed promotes animal growth, improves meat quality and lean meat rate. It is the mainstream additive for livestock and poultry feed in China. Internationally, lysine is mainly used in the pharmaceutical, food, and feed industries. China accounts for 70% of global lysine production. Global Bio-Chem (809:HK) estimated 2018 global lysine production capacity was 4.95 million tonnes.

In 2018, the swine flu broke out in China impacting the Chinese husbandry industry. A large number of pigs were killed and quarantined to control the spread of the swine flu decreasing the demand for animal feed. Additionally, Russia banned the import of lysine from China intensifying the domestic market.

In the second half of 2016, Fufeng invested RMB30 million for a 30% stake in Jilin COFCO Biomaterial Co Ltd. Jilin COFCO is a joint venture focusing on manufacturing polylactide acid ("PLA"), a biobased material. PLA is a new type of environmentally degradable material that can be converted into biological fertilizer. It does not cause harm to the environment and conforms to the concept of environmental protection. The PLA could be worth over RMB100 million. PLA is supported by relevant policies as the use of non-degradable materials are explicitly prohibited in such fields as packaging in many developed countries and regions. Some Chinese provinces have also adopted relevant policies and launched a ban on free plastic bags. PLA products have a strong market potential and a wide range of applications including biomedical and daily-use macromolecular material. It also leverages Fufeng’s expertise of producing corn-based products.

Consolidated Key Value Drivers

As illustrated by the chart below, the size of MSG and the Amino Acid segment means consolidated results mirror the performance of Amino Acid segment.

The company saw tremendous revenue growth as it built out glutamic acid and MSG capacity. Growth started to slow in 2013. The company continued to build capacity in many of its product but at a slower rate. As an example, MSG effective capacity grew from 25,000 tonnes in 2003 to just over 1 million tonnes in 2012 or a CAGR of 51%. During this period, the MSG market was growing, but more importantly, the company was taking share as the market consolidated. The MSG market saw a surge in pricing in 2009, 2010, 2011, and 2012, which brought in new capacity on the market from Fufeng and its rivals. In 2008, Fufeng had an effective capacity of 171,667 tonnes of MSG capacity. In 2012, the company’s effective MSG capacity ballooned to 1,008,333 tonnes.

After 2012, the MSG market had to digest the capacity increases. The oversupply in the market caused Fufeng’s ASP to decrease from a peak of RMB7,984 per tonne in 2012 to a trough of RMB5,522 per tonne in 2017. As prices declined, the company’s capacity growth slowed. From 2013 to 2018, capacity increased by 32% or 5% per year from an effective MSG capacity of 1,008,333 tonnes in 2012 to 1,330,000 tonnes in 2018. Fufeng’s MSG revenue declined by 0.5% per year from 2012 to 2018.

While the company’s largest product market was going through an adjustment, other products have tried to pick up the slack. Corn refined products were stable growing by 1.6% per year. Threonine grew by 41% per year from 2012 to 2018 with its effective capacity increasing from 40,000 tonnes in 2012 to 228,500 tonnes in 2018 equal to a 34% CAGR. Revenue from starch sweeteners grew by 22% per year and high-end amino acid revenue grew by 50% per year. Fufeng adjusted to downturn in the MSG market by selling more glutamic acid externally rather than using it internally in MSG production. From 2012 to 2018, glutamic acid revenue increased by 21% per year.

Since 2003, Fufeng’s consolidated gross margin averaged 19.1%. Over the past ten years, its average gross margin was 20.0%. In the past five years, gross margin averaged 19.4%. Despite industry cyclicality and short-term fluctuations, over the long run, the company’s gross margin remained stable.

The average operating margin has trended down. From 2003 to 2010, the Fufeng’s average operating margin was 12.6% with a high of 21.3% in 2009 and a low of 1.3% in 2017. From 2011 to 2018, the average operating margin was 7.8% with a high of 11.4% in 2017 and a low of 5.2% in 2015.

The chart above illustrates the reason for the divergence between gross margin and operating margin. Administrative expenses have remained stable but selling expenses ballooned over the past 16 years.

Selling expense as a percentage of sales have increased from 1.9% of sales in 2003 to 7.6% of sales in 2018. In 2003, the company essentially sold two products glutamic acid and MSG. As the company evolved, the number of products increased. Selling a number of products in different markets requires additional sales staff. Unfortunately, the newer products do not generate similar sales to the initial two products making it more difficult to be as efficient with sales and marketing expenses.

The increase in selling and marketing expenses also comes with increasing competition in the industry. It is easier to take share from smaller, inefficient players than larger, efficient players. Against smaller, inefficient players, larger players can decrease prices or offer a more comprehensive solution to take sales from smaller players. In an oligopolistic market where all players are relatively equal in operating efficiency and product solutions, selling products is much more difficult. You have to take additional measures in the form of higher selling and marketing expenses to sell available capacity. If the oligopoly was more rational by each seller focusing on a different niche or geography, pricing would be better and selling and marketing expenses would not be so high. The problem is there would need to be some sort of coordination by producers.

The weaker MSG operating environment since 2011 has also contributed to the higher selling and marketing expenses.

Administrative expenses as a percentage of sales were stable over the past ten years with an average of 4.3%, a high of 4.8% in 2013 and a low of 3.9% in 2017.

Since 2011, the company’s average tax rate is 17.6%. The corporate tax rate in China is 25%. Some of Fufeng’s subsidiaries in China are considered new and high technology enterprises leading to a preferential tax rate of 15%.

Working capital is not a significant investment. Working capital turnover was 7.6 times in 2018, but has been very volatile over the past 16 years. Fixed capital is the major investment for the company. Since 2006, fixed capital turnover averaged 1.4 times. Over the last five years, fixed capital turnover declined to 1.2 times, which is a function of a weaker operating environment and more intense competition.

Over the last ten years, the average return on invested capital ("ROIC") was 11.4%. Over the last five years, the average ROIC fell to 8.0%. A path to a higher ROIC is a tighter supply and demand balance in the company’s end product markets leading to higher ASP. The company’s main product MSG saw a depressed operating environment over the last six years with the average ASP of RMB6,173 per tonne below the longer-term average of RMB6,619 per tonne.

All Fufeng’s products are commodities. In commodity markets, the only way to achieve sustainable superior returns is through being a low-cost producer and/or demand continuously outpacing supply. Demand can only continuously outpace supply if producers are rational. Rationality is more probable in markets with an oligopolistic market structure as producers can coordinate easier. In fragmented markets, it is impossible to coordinate the actions of all producers, so each producer attempts to maximize their own profitability meaning when commodity prices increase due to supply-demand imbalance producers that are able to add capacity will do until that imbalance is eliminated.

MSG and threonine markets both have oligopolistic market structures. Unfortunately, there is little evidence of rationality. In 2018, Fufeng chose to destock and decrease capacity rather than continue with all-out production and inventory build, which is a good sign. Unfortunately, in all of the company’s markets, any increase in price leads to an increase in capacity. The increase in MSG prices from 2008 to 2012 saw Fufeng’s average capacity increase from 171,667 tonnes in 2008 to 1,008,333 tonnes in 2012. Despite continued weakness in the MSG market, since 2012, Fufeng added over 320,000 tonnes of capacity. A slight increase in the xanthan gum price in 2018, and Meihua is already building more capacity.

Shareholder Structure

The Founder and Chairman of Fufeng Li Xuechun owns 38.94% of the company shares outstanding. Mr. Li Deheng owns 1.31% of the shares outstanding. He is the brother in law of Li Xuechun, the deputy general manager of the company and has been with Fufeng since 2003. Zhao Qiang, the CEO of the company owns 0.20% of the company and Treetop Asset Management SA owns 19.08%. The remaining shares are free float.

Mr. Li Xuechun’s share ownership has not decreased over time, the number of shares outstanding increased. At the end of 2007, Mr. Li Xuechun owned 786 million shares. At the end of 2018, he owned 992 million shares.

Management

Operating Efficiency

Management’s operating efficiency is good. Despite ups and downs of the company’s product market when competitors are having difficulty generating profits, it remains profitable and generates a return on invested capital close to 10%.

From 2014 to 2018, sales growth was slightly below its most comparable peer Meihua, but above all other peers. Its average gross margin was 400 basis points below Meihua’s, which could be a result of product mix. Meihua has more higher-margin downstream capacity. Fufeng’s gross margin was well above the peer group average. The company is 180 basis points more efficient that Meihua on operating expenses and 360 basis point more efficient than the peer group average. Due to the differentials in gross margin, Fufeng’s operating margin is 210 basis points lower than Meihua, but well above the peer group average of 0.9%. Evonik, Ajinomoto, and Meihua are the only peers with high operating margins. Three Chinese peers have negative operating margins illustrating the operating efficiency of Fufeng and Meihua. Fufeng is much more capital efficient than Meihua with an invested capital turnover of 1.19 times compare to Meihua’s 0.89 times. Despite bettering Meihua, the company’s capital efficiency is still below the peer group average. Due to its capital efficiency, Fufeng’s ROIC is 70 basis points higher than Meihua. The company’s average ROIC of 9.7% is 460 basis points better than the peer group average.

Capital Allocation

The capital structure of the company is one of the most important capital allocation decisions a company can make. If management decides to take on too much debt, a company could face an existential risk. Financial risk is even more of concern in commodity industries with perfect competition, which are subject to booms and busts cycles.

At the end of 2018, net debt to EBITDA stood at 0.71 times so the company is currently in a strong financial position. The current financial position is stronger than it appears as its key markets are cyclically depressed. Since 2013, net debt to EBITDA ranged between a high of 3.54 times in 2012 and a low of 0.22 times in 2009.

At the end of 2018, 62% of Fufeng’s RMB4 billion in debt was long term. On August 28, 2018, the company issued USD350 million (RMB2.4 billion) in three-year bonds with a fixed rate of 5.875%. The company repurchased USD32.62 million and at the end of 2018 USD317.4 million (RMB2.2 billion) of the bonds were outstanding. At the end of 2018, 63% of debt was in USD, 30% was in RMB, and the remainder was in HKD. The weighted average interest rate on debt was 4.86%.

The company first issued shares to the public in 2007, when it issued 460 million shares raising RMB955 million.

In May 2013, Fufeng completed a right issue resulting in the issuance of 348,209,600 new ordinary shares at HKD1.80 each on the basis of 1 share for every 5 shares held on April 10, 2013, the record date for the right issues. The rights issue was available to all existing shareholders. The share price on April 10, 2013 was HKD2.70. A study of 268 UK rights issues between 1994 to 2012 showed the average discount for a rights issue was 29% for non-financial firms. The 33% discount for Fufeng’s rights issue is similar to other rights issues. Using the share count immediately after the IPO, the 2013 rights issue increased the number of shares by 21.0%.

In April 2017, Fufeng placed 140 million shares to six independent investors at HKD5.55 receiving HKD777 million or RMB679 million. The issue price was a 7.5% discount to the closing price on April 20, 2017, the day of the transaction and a 9.1% discount to the average price over the previous five trading days. Using the share count immediately after the IPO, the 2017 share placement increased the number of shares by 6.3%.

The average annual increase in shares outstanding from the rights issue and share placement is 2.2%.

In 2010, 2012, 2014, and 2015, the number of shares outstanding increased by 58.686 million, 22.362 million, 18.48 million, and 5.117 million shares outstanding, respectively. Since its IPO in 2007, the company’s shares outstanding increased by 104.65 million shares or 9.51 million share per year due to employees exercising share options. The annual average share increase due to share options since its IPO is 0.57%. At the end of 2018, there were 21.2 million options outstanding with a weighted average exercise price of HKD4.22. The weighted average price at the date of grant of HKD4.05.

Fufeng has used convertible bonds to finance its operations. In April 2010, the company issued convertible bonds with a total par value of RMB1.025 billion in April 2010 at a fixed interest rate of 4.5%. The bonds matured in five years with a conversion price of HKD7.03 per share. The estimated equivalent interest rate for a non-convertible bond was 5.08%. None of the 2010 convertible bonds were converted to shares. The company redeemed all of the 2010 convertible bonds in April 2013.

In November 2013, the company issued RMB975 million in convertible bonds with an interest rate of 3.0% maturing in five years with a conversion price of HKD4.173. Assuming 100% conversion, the 2013 convertible bonds would convert into 297,114,448 shares. The average share price in November 2013 was HKD2.95 meaning the conversion price was a 41% premium to the average price, which is reasonable. The company estimated the equivalent interest rate for non-convertible bonds was 6.06%. In 2015, 5.7% of the 2013 convertible bonds were converted to shares. The remaining were converted in 2017.

Fufeng’s management has bought back a small number of shares. In 2013, the company repurchased 1.697 million shares at an average price of HKD2.29. In November 2014, the company repurchased 0.833 million shares at an average price of HKD3.33. In December 2014, the company repurchased 0.705 million shares at an average price of HKD3.33. The company restarted repurchasing shares in May 2019. In May 2019, Fufeng repurchased 3.4 million shares at an average price of HKD3.85.

Since 2006, Fufeng generated RMB14.7 billion in operating cash flow before working capital investments. It spent RMB2.7 billion on working capital, RMB17.9 billion on capital expenditures, RMB2.3 billion in dividends. The company has done a good job of allocating capital solely to its core business. The net internal cash flow amounted to negative RMB8.3 billion. The company financed working capital investments, Capex, and dividends by raising RMB4.6 billion in debt and RMB2.3 billion in equity. Despite the external financing, Fufeng spent RMB1.4 billion more on working capital, Capex, and dividends than it raised.

With the exception of 2012, Fufeng paid a dividend every year dating back to its IPO. From 2008 to 2018, the average dividend payout ratio was 28% with an average dividend per share of HKD0.13.

Corporate Governance

There are no material related party transactions, and management does not extract too much value. Remuneration to key management personnel in related parties was 3.5% of operating income in 2018 and averaged 2.8% of operating income over the past ten years.

Earnings quality is good. Beneish M score is consistently below the manipulator threshold meaning it is highly probable that Fufeng do not manipulate their earnings. Since 2006, operating cash flow averaged 107% of profit before tax.

The fraud rate among Chinese companies listed in Hong Kong is much higher than typical fraud rates in other markets. Frauds have a number of common characteristics. Fufeng does not exhibit any of those characteristics. The company’s net outflow was 9.8% of operating cash flow before working capital means the company has not raised excess capital. The company financial metrics are similar to its peers. It lacks a high cash balance. The company balance sheet is clean with no significant soft accounts (non-operating assets other than cash). From 2006 to 2017, non-operating assets only averaged 8% of total assets. Assuming cash is an operating asset, non-operating assets to total assets average 1.1% over the same period. Fufeng was able to finance itself in corporate bonds markets. It Beneish M score is consistently points to a high probability of the company is not manipulating its earnings. There are no major related party transactions. All indicators point to the company not being a fraud.

Management is not too aggressive with its accounting estimates. Their accounting policies are similar to its Chinese peers.

Valuation

Fufeng is valued using a blended average of a residual income model, and a discounted cash flow model ("DCF"). Both have a five-year forecast period before assumptions fade to the terminal value in year ten. The company is valued under three scenarios. The stable assumptions are the discount rate, the effective tax rates, and capital efficiency. The discount rate is stable at 10% throughout the forecast period. The effective tax rate is 16.5% as the company is able to extend its preferential tax rates. Capital efficiency is also stable throughout the forecast period at historical averages.

Sales growth and operating margin change depending on the scenario. Under the bear case, the company’s revenue does not grow into perpetuity, and the operating margin remains near cyclical lows at 6.0%. The bear case sees no ASP or capacity growth and an inability to offset selling and marketing expenses with high margin downstream products. The bear case’s 2019 fair value per share HKD4.07, 4% above the current share price of HKD3.92. Its 2023 fair value per share is HKD5.03, 28% above the current share price.

Under the base case, Fufeng’s revenue grows by 4.0% per year over the next five years before fading to a terminal growth rate of 0%. The base case’s sales growth is well below its historical revenue growth rate of 18.5%, but similar to the company’s revenue growth rate over the past six years, when the company’s main industry was reverting from a boom period towards a bust period and now is reverting towards historical means. The base case operating is 8.0% below the long-term average operating margin of 8.7%, but close to the 7.8% average over the past seven years. The base case assumes the company is marginally able to grow revenues, and offset margin pressures with higher margin products, but the lack of growth in end markets means the company’s operating margin is below historical averages. The base case’s 2019 fair value per share HKD5.14, 31% above the current share price. Its 2023 fair value per share is HKD6.67, 70% above the current share price.

Under the bull case, Fufeng sales grow at a 10.0% CAGR over the next five years before fading to a terminal growth rate of 0% in the tenth year. Sales growth in the bull case reverts towards historical averages but does not reach the company’s previous heights as its main market MSG is mature and expected growth will never return to previous levels. Consolidation in the market was previously a tailwind for revenue growth but given the oligopolistic nature of the MSG market, further consolidation is unlikely. Given the irrationality in the market, ASPs are unlikely to provide a growth. Any ASP increase will lead to capacity increase and a reversion to the mean in ASPs. The bull case operating margin is 10.0% above recent averages but equal to the average operating margin since 2003. The bull case operating margin assumes a reversion to more profitable times for the industry. The bull case’s 2019 fair value per share HKD6.71, 71% above the current share price. Its 2023 fair value per share is HKD9.34, 138% above the current share price.

Risks

The biggest risk to an investment in Fufeng is prolonged irrationality of players within the company’s product markets. Prolonged irrationality through capacity increases at any sign of an increase in ASP will lead to depressed ASPs and inability to fill capacity decreasing ROIC through lower utilization of fixed costs and lower capital efficiency.

Slow end market is another concern because it will also lead to weak ASPs, margins, capital efficiency, and ROIC.

Given the commodity nature of the Fufeng’s markets, trade wars and tariffs would either need to be absorbed by the company to maintain end demand or the product will be more expensive than competitors without tariffs hurting demand.

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