'Loquat Fan' contributed this article to NextInsight

SINO GRANDNESS is holding an EGM on 23 Feb to secure shareholders' approval for the spin-off and primary listing of its wholly-owned beverage subsidiary, called Garden Fresh, on the Hong Kong Stock Exchange.

I have encountered some confusion among investors with regard to the 'correct' profit figure of Garden Fresh to use in the IPO valuation.
 

Background

loquat softpackFunds raised via convertible bonds have enabled Garden Fresh to increase sales of loquat drinks rapidly.In 2011 and 2012, Garden Fresh issued convertible bonds (CBs) to fund its business growth. As it was then just a small startup, bondholders imposed very stringent terms for converting the bonds into Garden Fresh shares.

The stringent terms included profit targets. If Garden Fresh's profits were to come in below RMB 70m in 2011 and RMB 140m in 2012, the bond holders would redeem their bonds for cash.

The profits (RMB 70m for 2011 and RMB 140m for 2012) are known as "performance requirements".

If the "performance requirements" were met, and if 2013 profit were not below RMB 250m, bondholders would be entitled to own 23.4% of Garden Fresh.

A 2013 profit lower than RMB 250 m would result in a higher ownership by bondholders: specifically, a profit of RMB 150m would result in bondholders having a collective claim of 46% of Garden Fresh, instead of 23.4%.


5 Feb circular

For the EGM, Sino Grandness has issued a circular dated 5 Feb, which discloses, among other things, the following financial data (in RMB m) for 2012, 2103 and 2014: 

Table A 
RMB m 2012 2013 2014
Revenue 865.3 1,382.3 1876.7
Gross profit 366.1 578.8 800.3
Profit before tax 203.2 299.1 391.8
Profit 103.4 153.5 117.3 


The low profit of RMB 117.3m for 2014 has caused some anxiety among investors, as it will translate into a valuation of RMB 1,760m only, on 15 times earnings for the IPO. This is way below Garden Fresh's brand value of RMB 3,500m as assessed by the Asia Brand Association Experts Committee and Asia Brand Research Centre in 2013.


From Table A, we see that the 2012 profit was RMB103.4 million. If this figure were taken at face value by the bondholders, they would have considered Garden Fresh a poor performer (as it is below the target of RMB 140m mentioned in the 'Background' section) and opted to redeem the bonds.

The IPO journey would have ended in 2013 when 2012 audited results became available.


Was RMB 153.5m the profit for 2013? Obviously not again, as bondholders would end up entitled to own 46% of Garden Fresh as explained in the 'Background' section above. If they were entitled to own 46% of Garden Fresh, would they have allowed Sino Grandness to make the following statement in the 5 Feb circular:

"Assuming full conversion prior to the Proposed Listing and on the basis of an agreed valuation of RMB1,500,000,000, the Company will hold 76.6% in the Listco and CB1 Holders and CB2 Holders will collectively hold approximately 23.4% in the Listco."

 
So what does one make of the profit figures in Table A? 

On page 6 of its 2014 annual report, Sino Grandness provided the following 'adjusted earnings' for the group:


Table B
  2013 2014
Adjusted earnings 418.2 467.1
Profit in P&L statement 287.8 249.5
Difference 130.4 217.6

 
A note on that page explains that the profit in the P&L statement was lowered by two items:

(1)  'non-cash interest expenses of CBs', and 

(2)  'changes in fair value of the option derivatives in relation to CBs'.

Adding the 'difference' (as it is due entirely to Garden Fresh which issued the convertible bonds) in Table B to the profit in Table A gives rise to the following adjusted profits of Garden Fresh:


RMB m 2013 2014
Profit as shown in 5 Feb circular 153.5 117.3
Difference due to CBs 130.4 217.6
Adjusted profit 283.9 334.9
 
In an IPO, investors ignore one-off items and focus on core earnings. As Garden Fresh's IPO will be preceded by bondholders extinguishing the debts, the two items related to CBs will disappear from the scene, and it stands to reason that adjusted profit is the profitability measure.

IPO valuation: Two factors

Top on investors' mind now is the valuation that Garden Fresh can fetch for its IPO. Two factors matter (market volatility notwithstanding):

(1) the actual profit in 2015 (that will be released soon) and the profit forecast for 2016, and

(2) the price-earnings ratio that Garden Fresh will fetch.

The 2015 profit is expected to be good as in the first nine months, sales were 12% higher than the corresponding period of the previous year. Loquat juice is a new beverage in its early stage of product life cycle, and sales growth should continue in 2016.  


Taking RMB335 m (2014 profit) and using a 12X PE ratio will give us a valuation of RMB4.0 billion for Garden Fresh. Assuming the convertible bonds are fully converted into Garden Fresh shares, Sino Grandness' remaining stake in Garden Fresh will be 76.6%, which will be worth RMB3.08 billion, or about S$0.97 per Sino Grandness share.

That China Minzhong has not been faring well in its loquat drink sales (and is reviewing its presence in the sector) may indicate the rising dominance of Garden Fresh.

Will the market accord a higher price-earnings ratio to a dominant market leader whose products have been fetching a gross profit margin consistently above 40%?

There is another factor to note. According to the terms of the CBs, if the IPO offer shares are priced at a price-earnings ratio below nine, bondholders can opt to be repaid in cash comprising the principal amounts plus 10% compound interest.

It's therefore unlikely that Garden Fresh will go to market at a price-earnings ratio below nine.

See also previous article by 'Loquat Fan': SINO GRANDNESS: Whatever happened to its share price?


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Comments  

+2 #1 axe 2016-02-12 22:54
As pointed out by a forumer on Valuebuddies, page 43 of the circular dated 4th July 2012 states that the "Net Profit" to be used for valuation should exclude "extraordinary items", which in this case refers to the "non-cash interest expense" and "change in fair value of option derivatives".

Adjusting for these extraordinary items, Net Profit used for valuation should be close to RMB 334.9m as pointed out by Loquat Fan

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