Dawes Point - Note from the Broker

Here is a note from Barry Dawes, industry stalwart, of Paradigm Securities (the broker).

"Listing of Dongfang Modern
11 am Monday 19 Oct 2015

Key Points

• A$39.2m raised in A$390m market cap IPO
• DFM.ASX is one of China’s largest growers/harvesters of citrus produce
• Produce sales expected to be 15% higher in 2015 at 230,000 tonnes
• Harvest season providing all DFM income now underway in Dec Qtr
• Prospectus forecast give A$75m earnings (EPS A$0.19) and PER <5.5x
• Cash balance of A$80m rising to A$150m (pre acquisitions) by end Dec 2015
• China consumer goods demand still growing strongly
• Excellent long term growth prospects

Dongfang Modern has successfully met its ASX listing conditions and should now provide an outstanding opportunity for Australia investors to participate in the rising affluence of China’s middle classes. Rising personal incomes and increasing health consciousness are driving the demand for nutritious, clean, safe and enjoyable foodstuffs like oranges, tangerines and lemons and these secular trends are likely to last for decades. DFM is very well positioned for this growth.
Recent data from China continues to show strong growth in demand for such produce and prices are still quite firm.
So much data from China continues to show a growing and resilient economy.
Imports of crude oil for China are up 8.6% year to date and iron ore imports rate in September was well over 1 billion tonnes (1047mtpa) after 932mt total imports in 2014.  Just to show you that the China collapse story doesn’t quite hold true.
This recent graphic from Goldman Sachs divides China consumption trends into Opex and Capex.  Not so much new construction capex (although infrastructure spending is still very robust).

You can draw some very interesting conclusions here about sector rotation.
So when looking at Dongfang Modern here is what you find.
First of all I hope you expect that the Due Diligence carried out on this company is of a high standard.   The Legals were overseen by Piper Alderman and the accounts were reviewed by PKF Lawyers.  The accounts have been audited since 2009 by PKF Hong Kong so the data is reliable. The cash on the balance sheet is actually there!
I have made mention previously that this has to be the most impressive set of accounts I have seen in my +30 years.
This company was set up in 2005 and in 2008 the current Chairman injected about US$6m to acquire an 89% holding.
This was the last capital injection to the company.  No more equity and no debt at all.
The plan was to acquire as many plantations as possible and by 2012 it was 9 plantations over 4500 hectares and by end 2015 it will be 19 plantations over 9,000 hectares.
That initial investment of US$6m in 2008 has probably provided the highest multiyear IRR ever recorded.  After A$57m (A$ equivalent) earnings in 2014 DFM’s June 2015 Interim showed Retained Earnings of A$216m.  All done without additional equity capital and without debt.
These numbers are attractive and make interesting reading.  2015 and pre 2015 are PKF numbers and the forecasts post 2015 are Dawes Points alone.

The company is now probably the largest citrus grower/harvester in China with about 1.3% market share by revenue in a very fragmented industry.  So many industries in China seem to be highly fragmented and the aggregation and consolidation process there has probably twenty years more to run.  These are important business drivers and help to show another side of China.
Paradigm carried out major financial due diligence and modelling and made a site visit to several of the plantations.
Detailed forecasts were made based on all available published information and then some conservative assumptions were made.
Growing and harvesting citrus produce isn’t all that far from something like coal mining.
You have a resource (trees) that should give a certain grade (harvest) with output of net fruit (grade) and at an expected recovery (yield).  The selling price is the market price so revenue is saleable output time’s price.  Costs are roughly fixed so improved yields and productivity improvements can increase volume without fixed costs rising.  Dongfang is hoping improve yields by about 4-5% pa for the next few years.  So output should rise and costs rise less so.
Output will also rise as additional plantations are acquired.
Prices have been rising over the past few years too because demand has been stronger than supply and supply growth.
Dongfang’s operating margin has been over 40% for the past few years and it expects to will stay high.
A study of future earnings for the next decade based on increasing tree volume through plantation acquisition, rising labour cost (which they are doing), modestly improving harvest yields and marginally higher product prices gave some quite astounding numbers.

Dongfang was #2 by sales revenue in 2014 with 1.2% market share after AIM listed Asiatic Citrus but the increased output to 230,000tpa in 2015 by Dongfang coupled with a couple of operational issues for Asiatic Citrus should now make DFM #1 with about 1.3% market share.
Market leader with 1.3% market share reinforces this fragmented industry concept.
Dongfang would like to go to 4-5% market share over the next several years so that implies organic and acquisitional growth
The numbers for Dongfang as assessed from public information by Dawes Points look like this with historic data in RMB and converted to A$ at historic rates or using the IPO Prospectus forecast of RMB 5:A$1.00.
This Valuation Matrix shows DFM’s P&L and Balance Sheet in one and also gives a valuation target for DFM.
Note three years earnings history, the current year estimate and three years forecast for EBITDA on a product basis (note the very low D&A levels) and no interest cost.
Forecasts are deliberately conservative on prices, output, acquisition growth and costs but still show earnings rising steadily rather than surging.
The staff levels are low (only about 100 people) so administration expense is low and all harvesting is by contractors so EBITDA for each product is net cash. Note no tax is payable on earnings from agricultural food production and that almost all earnings have been reinvested, with capex mostly into acquisition of additional plantations.  
The balance sheet is cash-rich without debt and EBITDA against estimates of sector assets gives a Return on Investment (on book value) of 30% overall and almost 100% for tangerines.
If we put each product division on 5x EBITDA, and add the cash, the appraised value for DFM is over A$500m and A$1.47/share compared to the IPO price of A$1.00.
Note that the forecasts have used 5:1 on the exchange rate, well above the current level, so A$ earnings would be higher with today’s 4.62:1.
I expect over time that the market will give a much higher rating after DFM delivers on its plans.
  
The Chinese Equity Market

The recent volatility in the Shanghai Index had many calling for the end of China.
The commentary had conveniently ignored that China’s equity markets had declined a total of 65% over 7 years whilst its economy more than doubled.  The 150% rise in less than a year seems quite modest compared to previous surges.

Dongfang Modern is one of the largest China operations listed on ASX and shouldn’t be the last.
If you came into the IPO, (and thanks for your help), you probably only came in in a modest contribution.
If you haven’t, the hard work has been done so you should now be able to come in at lower entry risk to share the gains.
Barry Dawes
19 October 2015
I own DFM and Paradigm was the lead manager of the DFM IPO."

Note I also helped distribute DFM