Asian Citrus is a Chinese company that trades in London and Hong Kong. The code in Hong Kong is 73 and the ticker in London is ACHL. Their accounting year ends on June 30. Both the London and Hong Kong shares have the same rights.

The company has 1,249,637,884 shares outstanding. The price on the London exchange is 12.625 Pence at this time. In Hong Kong the price at this time is 1.680 HKD.

The company reports in RMB, but trades both in HKD and GBP.

Asian Citrus has 3 assets. A. Net Cash in excess of its market cap. B. Tree plantations in China where they grow mostly winter and summer oranges, but also grapefruit and bananas. C. Beihai Perfuming Garden (BPG), a producer of fruit concentrates and purees.

The company trades at about a 20% discount to its net cash on the books while it own a number of different assets, namely three fruit plantations and three juice and puree concentrate factories. The company had pretty much everything go wrong for it in the last year from excessive rain that negatively impact yields and cost to a decrease in price for the products it sells. In addition one of its orange tree plantations was hit with a disease. Still if the economics normalize to the performance of the last few years the company would trade at less than 3 times earnings not including its net cash balance. And this 3 times earnings number does not include the upside potential from better operations because of new management, the increased earnings from bringing its new concentrate plant up to normalized operating capacity and the increased quantity of fruit that will be generated when its immature trees mature and start producing fruit.

I believe the shares are worth between 4.54 HKD and 7.41 HKD (or 0.366 GBP and 0.572 GBP). The current share price in HKD is 1.68 and in GBP it is 0.12625.

Net Cash

Let us start with the net cash of 2,108,021,000 RMB. (Dec 31, 2013 cash) All this while the market cap in RMB is 1,679,513,316. So Asian Citrus trades at 80% of its net cash.

Tree Plantations

The tree plantations are Hepu, Xinfeng and Hunan.

On those plantations they grow winter oranges, summer oranges, grapefruit and bananas. (Actually Asian Citrus also sells tree saplings, but since that represents only 0.1% of revenue I am ignoring this business.)

The difference between winter and summer oranges is the time of harvest. Winter oranges are harvested from October through November, while summer oranges are harvested March through June. The growing cycle for oranges and grapefruit is that they do not yield any fruit in the first 3. In year 4 the average orange tree yields about 8 Kg. Growth is slow to about 50 Kg in year 7 after which it tends to make big nominal jumps to an expected quantity of 140 Kg by year 10. It is then expected that the tree will continue to produce at this level for 13 to 15 years after which production starts falling until year 35. This growth profile makes that the upfront cash expenses are high as true positive cash flow generation only starts about after year 8 or 9. And it isn’t just that one can plant those trees and go away for 8 years. No, the trees still needs fertilizer, pesticides and other maintenance work from the time of planting. Over the last 4 years fertilizer has represented between 50.7% and 52.2% of cost of sales for Asian Citrus’ plantation business. Pesticides represent between 8.4% and 13.1%. This is a sizeable expense that make that a new plantation will run cash flow negative for a long time after startup.

Here is a layout of COGS over the last few years:

Pricing for winter oranges is lower than that of summer oranges and that of grapefruit. Grapefruit sells for about double the price of winter oranges and summer oranges also sell for a significant premium versus winter oranges. Here is the price evolution for oranges sold by Asian Citrus over the years.

* NA as summer orange harvest was not yet final.

Grapefruit has a similar growth profile as oranges do. FYI. The reason I have no pricing data for grapefruit and bananas for Asian Citrus is that both crops were recently planted and there has not yet been a harvesting cycle for either fruit.

Bananas have a different growing profile as they need significantly less space and start producing after year 1. Bananas represent only a small part of Asian Citrus’ yield. They planted their first batch of banana trees recently and are expecting the first production in 2014/2015. This is a test to see if it makes sense revenue wise and as a way to diversify.

Oranges is the largest part of Asian Citrus’ agricultural business. Neither grapefruit nor bananas have had a harvesting cycle up to now.

Below is a layout of the number of trees by kind at each of the plantations by age:

Important is to look at the tree age profile of the plantations. As you can see, Xinfeng’s age profile is 7, 8, 9, 11 years. Meaning the plantation crop tonnage should continue to grow for the next 4 years at Xinfeng until the whole plantation reaches the age of 10. The Hunan plantation’s age is even younger with its eldest trees at this time being 4 years old. (FYI. In the following calculations you will see that I treat grapefruit equal to that of oranges. Why? Well it makes the picture easier to understand and since grapefruit trees are expected to have a superior revenue profile this is a conservative choice anyway.) Basically this means that we are destined to see a material increase in volume of product even in case we have no expansion in the total acreage. This way normalized tonnage should increase by 67% in 5 years from today and increase by 104% in 10 years time. (This assumes that trees get cut down at the age of 25 which is conservative.) No new capex is going to be required to achieve this increase in producing trees.

The below graph shows us the aggregate percentage of citrus trees by year planted. As you can see 42% of all trees are 3 years old or less and never had a harvest. And 74% of all trees are 9 years old or less. All these trees will have higher volumes annually until they reach the age of 10.

Additionally as mentioned above, the immature trees still require a fair amount of expenses after planting. The immature trees require fertilizer, pesticides and other maintenance expenses. Fertilizer tends to represent about 50% of COGS and pesticides about 9% to 13%. So when the immature trees become mature and start producing there will be significant operating leverage.

This all does not include 221,769 banana trees which will start producing soon.

Asian Citrus orange business can also be split between graded and ungraded oranges. Graded oranges are selected based on quality, packaged and delivered to the customer. Ungraded oranges are not selected, but just packaged and the customer is required to pick up the oranges. The graded oranges are sold at a premium price to ungraded oranges through supermarkets under the brand name Royal Star which is owned by Asian Citrus. Royal Star can be compared to the Sunkist brand in quality, but sells for a significant discount to Sunkist. Graded was about 18% of volume sold in 2013. In the future there will be the ability to grow Royal Star as the PRC market matures and the middle class grows in size. There is also the ability to grow the brand across Asia.

The agricultural business has struggled over the last two year though. The problems were multiple going from Citrus Canker, excessive rainfall causing lower yields and higher expenses, and lower prices. This combination of lower prices and lower volume resulted in a hit to revenue and earnings over the last 12 months.

• Excessive rain: In both 2012 and 2013 Asian Citrus plantations had to deal with excessive rain fall. In 2012 there was 1,938 mm of rainfall and in 2013 they had 1,975 mm of rainfall. This compared to an average rainfall between 1981 and 2010 of 1,521 mm. Excessive rainfall results in leaching of nutrients which results in lower yields which requires use of fertilizer and pesticides. Excessive rainfall also damages the plantations requiring increased maintenance expenses.
• Citrus Canker: Hepu plantation had an issue with Citrus Canker. Citrus Canker results in leaves and fruit dropping prematurely. Also it makes the fruit unappetizing to eat. Citrus Canker is a disease that is pretty persistent and requires significant attention. Asian Citrus handled this issue in a cautious manner and hired a US based expert/agronomist to assist them. A friend investor was at the plantation when the agronomist was available and the agronomist confirmed the problem was handled correctly. It is important to find out about Citrus Canker as early as possible and therefore Asian Citrus has changed it routine of twice monthly inspections to weekly inspections.
• Pricing: Pricing suffered too, especially the last year. The price decline at Hepu was between 3% and 4%, but Xinfeng took a significant hit in pricing of about 17%. Two issues drove this. First there was a dyeing scandal, where unsavory operators from Gannan would inject oranges with red dye in order to make them look more appealing. This naturally dented the reputation of oranges coming from this region and made many consumers buy other oranges thus driving down pricing. Second we saw an increase in supply of oranges. Other areas like Sichuan, Guangxi and Chongqing had great harvests while the Jiangxi region had excess rainfall which brought down yields (and increased costs). This year the expectation is about a 10% industry wide increase in oranges due to improved yields and maturing of trees. There is no growth in acreage going on right now.

The company has had lower yields (rainfall and Citrus Canker), lower prices and higher costs. Basically on every metric things went against the company last year.

I do feel fairly confident that the amount of rainfall will revert to its mean over the next few years. A reversion to the mean is most important as the biggest impact on results was caused by the lower yields and higher expenses caused by the excess rain.

On the Citrus Canker issue, that is a low to moderate worry. From what I learned, a diligent monitoring program cannot prevent outbreaks, but it allows for the damage to be limited.

An additional worry is the pricing of oranges. In the same way that Asian Citrus has a lot of young trees it could be that many other plantations have done the same. Something I was not able to confirm. On the other hand while it is possible to develop new large plantations, it isn’t that easy either. A. Building a new plantation requires a large upfront investment that will not generate any meaningful revenue for the first 7 years. Actually because of the need for fertilizer, pesticides and other maintenance, the plantation will run cash flow negative until about year 8 to 10. And B. In addition it is hard to find new large pieces of land that provide for the necessary economies of scale.

Opposite that increase in supply sits the demand equation for citrus products in the PRC. For example, in the US in 2011 total demand for citrus products was 76 lbs. Of that 23 lbs. was for direct consumption, the other 53 lbs. was for use in concentrate/juice. Of that 76 lbs., 53 lbs. was the consumption of oranges with 10 lbs. being personal consumption and the other 43 lbs. for the use in concentrate/juice. If I overlay that 53 lbs. (24kg) per person on China they would need to produce 32 million ton of oranges a year. Currently China produces around 7 million ton of oranges. The aggregate supply from the top 10 producers in the world is only 51.7 million ton of oranges.

If we take a look at orange juice consumption then the potential growth in China versus the rest of the world then we see a lot of potential.

Per capita juice consumption in

• USA – 100 Liters
• Japan – 98 Liters
• Germany – 90 Liters
• UK – 70 Liters
• France – 65 Liters
• Australia – 47 Liters
• China – 9.5 Liters

If one looks are orange juice, it seems that there is some correlation between wealth and per capita quantity consumed.

And there is a lot of potential when it comes to fresh orange consumption too. With its 10 lbs. of per capita fresh orange consumption the US is actually far down the ranking. In countries like Brazil, Mexico, even the European Union per capita orange production is more than 4 times that of the per capita consumption of the US. Chinese per capita consumption of fresh oranges is about 11 lbs. at this time. Important to know is that in China fresh oranges play an important part in its food culture. I assume most of us have been to a Chinese restaurant where it is the habit to finish the meal with a piece of fresh orange.

As one can see, we’d need a lot of oranges even if Chinese per capita consumption increases by just 50% from about 12 Lbs. per person to 18 Lbs. per person.

Here are some of the relevant numbers related to the agriculture business.

Here is the revenue for the plantation business:

* Biological assets are an IFRS invention. Annually the NAV of the Asian Citrus plantations is calculated using an NPV calculation with an 18% discount rate. From that number the tangible asset value related to these assets on the balance sheet is deducted. If there is a change in this year’s biological asset value versus last year’s then the delta is run through the income statement and the change is then reflected on the balance sheet. For Asian Citrus this creates sizeable volatility in the income statement. All this is non cash.

** FYI In the PRC certain agricultural activities have a tax rate of 0%. Asian Citrus falls under these regulations.

Beihai Perfuming Garden

Beihai Perfuming Garden (“BPG”) is the 3^rd asset owned by Asian Citrus. Asian Citrus owns 92.94% of BPG which it bought for 2.04 billion RMB in 2010. BPG currently owns tree concentrate plants. The Hepu, Beihai and Baise production plants.

Hepu has a capacity of 46,200 ton and Beihai has a capacity of 14,850 ton. The capacity utilization of these plants tends to be between 90% and 95%. At this capacity utilization the gross margin tends to be between 20% and 30%. It all depends on the spread between world prices and the cost to input.

Baise is a new plant that is just coming online. Its capacity is 40,000 ton. In case Baise gets up to 90% capacity in a few years it should contribute nicely to the bottom line rather than be a drain. The new Baise plant represents a 65% increase in capacity for BPG.

I have an investor friend that has visited all 3 plants and says they all look ultra modern, clean and well managed.

The story here is somewhat the same as with the plantations. We have this production capacity in Baise that was just built and already paid for. The plant was just started up and is running far below its planned capacity utilization. In general it is expected that it takes a few years for this kind of plant to be up and running at full capacity.

There should be enough demand for this new plant. Below is the growth profile of BPG’s juice market globally and in the PRC.

Beihai BPG processes over 22 different types of tropical fruits, including pineapples, passion fruit, lychees, mangoes and papayas into juices or purees. The main groups of products sold by BPG are Pineapple Juice Concentrate, Lychee Juice Concentrate, Other Fruit Concentrates, Mango Purees, Other Fruit Purees and Frozen and Dried Fruit and Vegetable.

BPG also has the necessary export licenses and represents about 60% of exports out of the PRC in its category.

BPG’s business has been under pressure too. Basically just as with the plantations it suffered from lower volumes at lower prices. The issue is that BPG sells its products on the world market, but sources locally. For example the excessive rains shrunk the capacity of pineapple available for BPG at the same time global market prices were declining. Especially pineapple juice concentrate pricing has been under pressure due to increased volumes coming out of the Philippines and Thailand.

New Management, Corporate Governance and Ownership

Tony Tong, the founder and patriarch, controls 19.2% owned by him and his family through an entity called Market Ahead Investments. Sunshine Hero, the original owner of BPG, owns 9.34% of Asian Citrus and Chaoda Modern Agriculture* owns 5.9%. Lastly the public owns 65.74% of the company.

*Choada used to be a much larger shareholder of Asian Citrus, but Chaoda turned out to be a fraud. Asian Citrus used to buy organic fertilizer from Chaoda which combined with the large ownership naturally tainted Asian Citrus too. So in October 2011 Asian Citrus stopped buying organic fertilizer from Chaoda, its representatives left the board and its ownership stake was mostly sold. I feel confident that Asian Citrus was not involved in the fraud.

Options are about 3.8% of the current number of shares outstanding. Most of these options are far out of the money. New management has already made clear that they will propose new option grants fairly soon.

Now that we got ownership and options out of the way I’d like to address the old and new management.

Tony Tong and his son, “Tommy” Tong are the founders of Asian Citrus. They had a board that was not independent and somehow felt this was mostly their company rather than the shareholder’s. This made the overall corporate governance poor. That naturally all worked fine as long as the company was doing well. But when the business got hit with Citrus Canker and the trifecta of lower yields, lower prices and higher costs, things went wrong. It all came to a head during the last AGM. A number board proposals were voted down. Current shareholders also directed a lot of criticism towards Tony Tong, his son and the board. In short, shareholders made clear they were tired of the below average management of the company. It seemed that it was quite the shock to Tony Tong and his son. They did not expect this to happen ... and then they did the right thing. Tony Tong resigned as CEO and Chairman of the board. His son relinquished his executive role and maintained his role on the board as the representative of the family and then new independent board members were elected, making the majority of board members independent including the new Chairman.

The new non-executive Chairman is Mr. Ng Hoi Yue, the new CEO is Mr. Ng Ong Nee. There is also a new CFO, Mr. Ng Cheuk Lun. Both the Chairman and new CEO have extensive experience in developed countries and understand capital markets. The new CEO spent a lot of time in Australia as well as China, while the new Chairman spent time in the UK and has been a CPA for many years in Hong Kong. Both have been on the boards of many companies, not just in China.

Both have a good understanding of what needs to be done, being:

• Improve shareholder communication and reestablish the trust of shareholders.
• First focus on the current core business before expanding for more scale. More size means more economies of scale in production as well as distribution which is to happen in the future.
• Improve operational efficiencies. For example there seems to be dysfunctional communication between different plantations and concentrate plants within the company. The Hong Kong headquarters is often not in line with the plantations and BPG plants. Often it takes a long time to get approvals. There are also cost opportunities like applying fertilizer when there is a dry period predicted rather than just apply at regular intervals even when it is raining. One can also work on creating infrastructure that will prevent less damage being done to the plantations in case of adverse weather. Better monitoring for disease and its remediation will also be important.
• Improve revenue generation. For example there are many markets, like Indonesia, that have significantly higher prices for oranges. In addition there are lot of middle men involved in the export side of the business. The CEO believes that by investing in cold storage in different markets Asian Citrus will be able to cut out middlemen and sell directly. The CEO also believes there is an opportunity to enter different higher margin business for BPG, like sugar cane concentrate and red bean puree. He also believes he can work with his customers, being ingredient mixers, and provide more value added services like pre-mixing ingredients.

The CEO has stated that by August he will present his plan for the company which will include new incentives for employees as well as strategic initiatives.

Now let’s not get too exited either. The most important factors will still be disease management, yield recovery and price recovery. If those factors go our way earnings will balloon independent of all the efforts implemented by the new CEO.

Valuation.

Before I get going on my own valuation exercise, in 2013 there was a bid for the company at 4.4 HKD per share, which was rejected by the board as too low. The current price is 1.68 HKD.

When valuing the company I adjusted the income statement and balance sheet.

Here are the adjusted income statement numbers for the last few years

* Adjusted Net Profit = Net Profit Attributable To Shareholders – Net Gain Biological Assets – Interest Income. Why exclude Interest Income? Later I exclude cash from my calculation of Adjusted Equity. So … no cash, no interest income. I also exclude the impact of Biological Assets as it is purely a non cash item.

On the balance sheet I made the following adjustments in order to get to adjusted equity.

* Adjusted Equity = Equity Shareholders – Biological Assets – Intangible Assets – Goodwill – 80% times Cash and Cash Equivalents. Why deduct 80% of cash? I assumed that Asian Citrus would need about 20% of its cash balance to operate.

** Why exclude the Goodwill? After all didn’t the company invest the cash to acquire the asset that put the Goodwill on the balance sheet? Yes, agreed. But I just don’t like to count on Goodwill as an asset and put a multiple on that in this case.

To me it seems that this might be a better business than people think. We have had pretty much everything go wrong for Asian Citrus, starting with two years of horrible weather which drove down yields and forced up expenses, the red dye scandal in the Gannan region where Xinfeng is located, a super harvest in the other growing regions which drove down prices, Citrus Canker hitting Hepu, delays in opening the Baise plant, lower prices on the world market for concentrate and purees all the while the increased rain limited the availability of local fruit at attractive prices. As I said, a lot of stuff went wrong. What are the odds that that will continue? It seems to me that the more likely outcome is that we will see a reverse of fortunes and go back to how it was in years prior over the next few years.

So I decided to create a valuation matrix assuming that given the historical performance Asian Citrus was worth between 1 and 2 times the Adjusted Equity + the 80% of the Cash and Cash Equivalents we excluded earlier. With this return profile I believe that a 1 times multiple is conservative and, a 2 times multiple to be the upper limit. Although in case things turn around and go back to the economic returns from 2011 and 2012 the stock will likely trade at a 2 times multiple. After all, the adjusted net profit in 2011 and 2012 was already more than 500 million RMB and then there is still the added volume related to the Baise plant and the aging of mature trees which will increase volume of fruit every year for the next 10 years. In my mind there is little doubt that in case the economics return to what they used to be this is a multi bagger and if they don’t then, we still have a margin of safety due to the negative enterprise value.

FYI. One should expect that when June 2014 numbers come out that they will be bad. We had a bad year and it is likely that the new management might do a kitchen sink operation to get rid of legacy issues.

* 80% times cash December 31, 2013.

Dividend

New management states that it was a mistake to cancel the dividend, especially since the company has so much cash on hand. There is an issue though with paying out the cash. For the dividend to be paid, cash needs to be transferred from China to Hong Kong and there seem to be some issue related to that transfer. Personally I don’t care about the payout of a dividend. I’d much rather have a tender offer for a large chunk of the company and/or other forms of buybacks at this stock price. This is a unique time to retire a lot of stock. Still I believe that creates the same cash transfer problem from China to Hong Kong than the dividend payment does.

Risks

The impact of disease, not just Citrus Canker, but also Citrus Greening. Either disease can wreak a lot of havoc and it is pertinent that the plantations are closely monitored at all times. The sooner you catch it the less the damage.

A continuation of the abnormal weather patterns of the last 2 years. I am a firm believer in return to the mean, but it is not guaranteed that we will not have excessive rain next year too. I have a 3 year window for my investments to work out so I can wait it out if need be.

A continuation of low prices. The good news is that there does not seem to be an expansion of acreage in the PRC going on. On the other hand I have no idea how much of the planted acreage in the PRC is already mature (above 7 years) and how much is immature (below 7 years). And it will naturally also depend on the growth in demand and imports/exports. Demand for oranges and other fruits continues to increase every year in the PRC at a nice clip and it should be able to absorb the additional quantity but one never know what kind of event might impact demand.

More food scare scandals like the red dye scandal in Gannan.

Increasing costs. The biggest risk here is the cost of fertilizer at about 50% of COGS. An increase in that cost can have a big impact.

The Chinese economy crashing is a worry too. We all know about the debt, real estate bubble, infrastructure bubble, etc. I understand the risk and also realize that such an event will have a big impact on Asian Citrus. It is very reasonable to expect that pricing of its products would take a big hit for some time. On the other hand I know Asian Citrus has no debt and a lot of cash. Cash it can use to survive and even buy distressed assets. Basically I think the thesis that the Chinese economy needs to go through an adjustment at some time in the future is correct, but I do not believe it is possible to put a timeframe on it. After all I have been hearing for four years now that China is about to fall apart any day now. I guess I am making a bet on a company with a descent business trading at a large discount to IV in a risky macro environment. Also if China crashes in the way many of the pundits have been saying US based stocks won’t be safe either.

Fraud is always an issue, especially given the recent past with Chinese companies. There have been multiple efforts made to ensure investors, like having an outside company count all the trees. Also annually there is the calculation of the value of the biological assets. Asian Citrus’ auditor is Baker Tilly, ranked 8^th in the world. My main worry was the status of the cash and how was it invested. In note 22 of the Dec 31, 2013 interim report it states that most of the cash is in bank deposits and cash on hand. None of the cash is invested in time deposits longer than 3 months, nor have they played shadow bank with the cash. Given that information I feel comfortable that Baker Tilly can assess the right cash balances. Lastly my investor friend has visited each of the concentrate plants and a number of the plantations and his feedback is positive. He hasn’t noticed any discrepancies. I have know him for a while now and highly respect his opinion. If it was not for him having visited the company in China I would likely have passed.