SINO GRANDNESS FOOD INDUSTRY GROUP LTD (SFGI:SP) Author: newman9 (Value Investors Club) Date: 9/4/2014 Recommendation: SHORT Price: S$0.685 (US$0.547) Price Target: S$0.00 Market Cap: S$402 mm (US$321 mm) Disclaimer: As of the publication date of this report, the authors of this report have short and other positions in Sino Grandness and stand to realize gains in the event that the price of the stock decreases. Following publication of the report, the authors may transact in the securities of the company covered herein. The authors have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this report. All content in this report represent the authors’ opinions. The authors have obtained all information herein from sources believed to be accurate and reliable. However, the authors make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained in this report. The authors expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained in this report. Discussions regarding potential future events and their impact on any issuer are based solely on historic information and estimates and/or opinions, are provided for illustrative purposes only, and are subject to further limitations as specified elsewhere in this report. No guarantee can be made of the occurrence of such events or the actual impact such events would have on any issuer's future performance. INTRODUCTION Sino Grandness is a Singapore listed food and beverage manufacturer with operations in China. The Company has two distinct business lines: a) canning of fruits and vegetables primarily for the export market and b) manufacturing and distribution of branded beverages for the Chinese domestic market. We believe that the shares of Sino Grandness present a compelling short opportunity with a return potential of nearly 100% as current reported earnings significantly overstate actual earnings. We have conducted months of due diligence and hired local researchers to aid in our investigative efforts. In addition to scouring filings and performing typical public records searches, we procured Euromonitor and Nielsen data, visited over 80 retail sites, had dozens of conversations with distributors, retailers, former employees, competitors, contract manufacturers, and other sources, and visited the Company’s three internal beverage production sites. Based on our extensive research, we have come to a view that published financials have been materially misrepresented. Importantly, as we lay out in detail below, we believe published financials and the true economics of the business will be scrutinized imminently and will likely lead to a substantial dilution and/or impairment of the Company's equity. Sino Grandness needs to IPO its beverage subsidiary, Garden Fresh (HK) Fruit & Vegetable Beverage Co., Limited (“Garden Fresh”), on an internationally recognized exchange by October 2014 in order to comply with the terms of its convertible bonds and avoid a large redemption payment.1 Given current 1 Please note that the 2011 convertible bonds mature on October 19, 2014 but bondholders have an option to extend the maturity to June 30, 2015. Throughout this report we will refer to the October 2014 maturity, but this could get pushed back to June 2015. 1 | P a g e cash on hand of RMB 60 million2 and a potential redemption payment of RMB 723 million3, failure to list Garden Fresh will likely lead to a massive dilution of the equity. The company has been clear in its preference for a Hong Kong listing. Tighter listing requirements and tepid investor demand are already causing Hong Kong listing plans to be abandoned at other companies. Notably, sponsors now face criminal liability if misstatements are found in the prospectus. It appears Sino Grandness is already behind schedule on its listing plans. As of our latest check, Sino Grandness had still not filed a Form A1 to list on the Hong Kong Exchange, which analysts had expected to happen already in order to list by October. In our opinion, research coverage has been very weak to date. Sino Grandness is covered by 5 analysts who are Singapore based and cover S-Chips, whereas Hong Kong listed China beverage companies are covered by Hong Kong based consumer analysts. Even modest improvements in coverage or basic IPO due diligence, such as obtaining Euromonitor or Nielsen data, should result in regulators, underwriters, and investors agreeing with our conclusion that earnings are massively overstated. We believe this will most likely lead to a failed IPO, ultimately rendering shares of Sino Grandness practically worthless. Summary: 1. Reputable third party data sources such as Euromonitor and Nielsen suggest reported Garden Fresh revenues are significantly overstated. Sino Grandness beverage segment (Garden Fresh) reported sales of RMB 1.382 billion in 2013, which we believe would imply at least RMB 2.0 billion in sales at retail value. Garden Fresh does not appear in the top 23 of Euromonitor data or the top 13 of Nielsen data, which is as far as either company breaks out the data. The #23 on the Euromonitor list had retail sales of RMB 77 million and the #13 on the Nielsen list had retail sales of RMB 135 million, which we believe suggests reported sales overstate actual sales by at least 15-26x. Major investment banks with analysts covering China juices companies subscribe to Euromonitor. Furthermore, key beverage manufacturers listed on the HKEx, such as Tingyi, Uni-President, and China Huiyuan, reference Nielsen data in their filings. We believe that if and when regulators, underwriters, analysts and investors inevitably scrutinize this data, they will see a company materially overstating revenues which will most likely derail the IPO. 2. Our channel checks, which consisted of speaking with distributors, retailers, former employees, competitors, contract manufacturers, and other sources, uncovered overwhelmingly negative feedback regarding Garden Fresh trends and outlook and cast significant doubt on the reported size of the business. Sales of Garden Fresh products were 2 2Q14 financial statements 3 Maximum redemption payment based on Principal Amount multiplied by 1.25x for the 2011 Convertible Bond and Principal Amount multiplied by 1.20x for the 2012 Convertible Bond, where x = number of calendar days from and including issue date, but excluding Redemption Date, divided by 365. This has been described in various Company filings and also by various sell-side pieces. 2 | P a g e described as “disappointing,” “not selling well,” and even “shrinking.” Distributors have indicated an interest in terminating their distributorships. The Company is “not well known” and several industry participants we spoke with outright doubted the reported sales level. Our site visits found the Company’s beverage production facilities essentially idle. We believe the Company has overstated its external capacity, based on our research into and conversations with its contract manufacturers, which further casts doubts on reported sales levels. In our opinion, the feedback we gathered is wildly inconsistent with reported sales levels and growth. 3. Benchmarking key metrics to industry peers supports the idea that sales are overstated. Compared to industry peers, Garden Fresh sales personnel purportedly generate 3x the sales while costing 1/2 as much to employ, meaning “sales return on sales labor” is purportedly 6x peer levels. Furthermore, when measured as a percentage of sales, Garden Fresh spends 1/4 as much on advertising & promotion as industry peers despite being an unrecognized new entrant lacking scale in a competitive market. 4. Margins are unbelievably high. Garden Fresh reported EBIT margins of 25-30% are almost as high as the 30-35% gross margins of leading industry peers such as Tingyi, Uni-President, and China Huiyuan. Garden Fresh’s 2013 reported EBIT margin of 27.8% was 7.9x the median EBIT margin of peers. 5. While we believe the beverages business is the most significant driver of value at Sino Grandness, and thus the focus of our research efforts, we also see evidence to suggest the vegetable canning business has overstated earnings: a. We believe the Company overstated the market for canned asparagus in its IPO prospectus by a factor of 4x. b. Company reported sales have completely bucked market trends. Despite already purportedly being the largest company in the industry, Sino Grandness reported its asparagus sales increased by 127% from 2007 to 2013 while the overall market declined 40%. c. Specifically in 2008, we believe there is a large inconsistency with the Company reporting substantially increased sales volumes while the market, production volumes, and employees decreased substantially. Furthermore, a former employee recounted that sales volumes were down in 2008. Sino Grandness reported total sales volume increased 31% year-on-year, which we find highly inconsistent with China canned asparagus exports (down 22% year-over-year), internal production volumes (decreased 35% year-over-year), and full-time employees (decreased 40% year-over- year). d. Reported profitability is completely out of line relative to peers. Sino Grandness reports EBIT margins of over 20% for canning private label vegetables compared to the 5-6% reported by peers. Sino Grandness margins even exceed those of global branded food manufacturers. 3 | P a g e 6. The Company has never generated free cash flow as reported profits have been consumed by accounts receivable and capital expenditures. Despite reporting cumulative net profits of RMB 1.1 billion from 2006-2013, cumulative free cash flow has been negative RMB 463 million, leading to share or convertible bond issuances every year since going public in 2009. With the announcement of its massive Anhui facility and indications that the company is expanding upstream into farming, it looks like any prospect of free cash flow generation is in the distant future.