Sino Agro Foods (OTC BB:SIAF)

GeoInvesting Interview Summary with Solomon Lee, CEO of Sino Agro Foods, on January 11, 2010

Let 's start with your cattle operation. How do you currently derive revenues from this segment?

Our subsidiary ZhungXing currently manages a herd of over 3,500 dairy cows and produces over 20,000 tons of organic liquid milk annually. We obtain the majority of our current revenue from this operation through wholesale contracts we have to supply some of the larger value added dairies operating in China. Two of our customers are among the largest dairy companies in china. (Mengniu Dairy Group and Yili Dairy Group)

Now your cattle operation is really the engine that kick starts the supply chain model. Please explain.

Yes, our model allows us to control the entire cycle to insure quality and maintain an organic product. We make use of farmer cooperatives to keep our costs low. The farmers provide us with the raw materials to manufacture our patented feed stock. We then provide the farmers with feed stock they use to raise their cattle. We then purchase the cattle from them. The entire cycle ensures quality, provides farmers with sustainable income and allows us to keep costs low.

Do you receive subsidies?

In this instance not directly, the farmers receive assistance to purchase our feed stock products which kick starts the cycle. So we indirectly benefit from subsidies provided to farmers who participate in our cooperatives.

Does the local government support your business model?

Of course, our model not only provides economic sustainability to the local farmers but we also provide educational and veterinary services. We are helping to modernize the cattle industry in China. We have recently formed a joint venture with the government of HaungYuan using this model and expect this to be a continuing trend across the country.

So what you essentially have is a supply network that your customers and the government, through indirect subsidies, are partially financing?

YES, it is a win/win for everyone.

What is it about your tech process that makes you different? I mean there are many organic firms out there that have there different extraction processes?

We use an exclusive patented enzyme that is mixed with our feed stock. This enzyme, combined with our sealed packaging, allows for our feed to be stored outdoors during the winter months. Our feed retains its maximum nutrients allowing cattle to have nutritional feed year round. We have already shown that our feed can almost cut in half the time required to bring cattle to full weight. This gives us an advantage over most our competition as our products have superior quality and shelf life.

Let 's chat a little about your customers who include of some of the leaders in the dairy industry.

Yes, we have contracts with some of the largest dairy companies in China such as Mengniun Dairy Group and Yili Dairy Group.

How long have they comprised your customer portfolio? Has the revenue mix changed much between them?

For the Dairy, they have been our customers from day 1, however after the Milk scandal of 2008, YiLi being the more aggressive wholesaler is currently our top revenue generator.

I would like to sneak in a capacity question since it will lead to some further questions. On the whole sale side, where are you at in capacity? I mean are you milking all the cows you can or holding back some?

Currently we have a milking herd of about 3,500 dairy cows with 1,400 on standby. We recently placed orders to import 1,800 head of cattle from Uruguay to help improve our breed. The introduction of the imported cattle should increase production from 6.9 tons per cow to 7.5 tons per cow each year by 2012. We are also expecting to increase the total dairy herd to over 15,000 cows which will allow us to produce over 120,000 tons annually.

Will there be demand from your customers as you increase production? Have they indicated that they will purchase more products from you or will you have to locate additional customers?

Certainly, right now in China there is not enough raw milk to meet demand. This is why there have been so many problems in China with dairy. The dairy companies dilute the milk and add additives in order to meet demand. The problem isn't a lack of demand, but a lack of quality supply. With the China government becoming more involved, demand for quality raw milk will continue to be high.

On the wholesale side; Do opportunities to supply smaller inefficient dairy companies, who would see the benefits of your organic product offering, exist? If so, is this a 2010 goal?

Yes, there is certainly opportunity to supply smaller players in the market. Our larger customers however would welcome additional supply so we will continue to enjoy a market for our wholesale milk as we expand regardless of whether we added new customers. Our major selling point is our quality; we are one of the few certified organic dairies in China.

I guess SINO 's dairy capacity also depends on the available land to raise cattle. I see by your chart on page 12 of your presentation that you have aggressive goals to expand your milking cow head count. I'm curious what type of head count your land can support?

We are currently only using a fraction of our available land bank. We planned for our expansion efforts when obtaining our current land bank which stands at a little over $6M worth in U.S dollars. We also have the ability to enter into joint ventures to gain additional land bank if needed.

Staying on this chart, with your current acreage when are you maxing out on land capacity?

Really this will never be posed as a problem in Fengling District, as Fengling has over 300,000 square kilometers of agriculture land with a small population of just over 450,000 people, and the local Government is very corporative and willing to provide whatever land banks that the company may require in the future. Having said that, it is important to note that the way we house our cows do not need a lot of land (i.e. 10 m2 / head) which is different to the understanding of the westerners free ranch farming, as such most of our land will be used for cropping to produce sufficient feed for our cows that have an average consumption rate of 6 Tons of Livestock feed per year per cow whereby currently our yield of livestock feed per acre is working out at around 27 Tons per acre per year. In simple terms, the Company has sufficient land banks to carter for its expansion program up to 2015.

Great, that about sums up your wholesale business. Now regarding your retail branded products; can you provide some more color on what this is and why you are optimistic about this move?

In term of economics, it will mean that, instead of getting net earning of just over US$243 / Tons for selling to the wholesalers, the retailed line of dairy products will enhance over US$1,013 / Tons in net earning representing a rise of 4.17 times.

In terms of providing long term security for the Company 's business, it must be understood in manners as follows:

* Fundamentally, and in current situation, the big wholesalers are not doing enough to secure the supply of quality raw milk such that the Milk Scandal of ("Melamine and additives") will happen repeatedly from time to time which will affect the Company 's bottom line indirectly if the Company will supply only to the wholesalers. Well established brands and labels and independent marketing of the Company 's dairy products will eventually help the Company to avoid down-side events whenever the said scandal will happen and provide the Company with better and more consistent profit in the longer term.

Do you already have firms order commitments?

No we don't intend to commit the dairy products to any long term contracts, but to establish a direct distribution net-work to sell our dairy products from farm directly to the end consumers, because we only need to secure just over 25,000, 55,000 and 150,000 families within the Beijing City to sell all of dairy products for year 2010, 2011 and 2012 respectively. This is not difficult to achieve among a population base of over 60 million people live in the Beijing City and has the advantage of avoiding long term credit line (of anywhere up to 180 days) being given if we are to supply to the Retailed food chains alone such that the Company will have better cash-flow.

Are you concerned about stepping on the toes of those customers you supply to now? Will you be competing in similar markets at different price and quality points or just different markets?

Of course, we do not expect to directly compete with our wholesale customers. Our products will be targeted towards the more affluent middle class and will be marketed as "green and natural" products. For this reason our products will not directly compete with our customers.

Do you envision a scenario where these customers eventually desire to create higher quality products, especially in light of the recent tainted milk event? I see this risk to your branded line?

In fact it is essential for the big wholesalers to work toward the creation of higher quality products by firstly to improve the overall quality of raw liquid milk which will mean they must follow our model to do so, and if so, it will take more than 10 years and a solid revolution of the industry 's mentality to be successful. Yet presently they are not doing enough to change the situation genuinely.

What are the margins on your retail side vs wholesale?

It is difficult to answer this question directly because of accounting treatments, however the most simplified understanding is to quote what I said earlier that

• Right now we are earning just above US$243 / tons of milk wholesaling.
• By selling in Dairy Product we can earn more than US$1013 / Ton of milk.
• An increase of more than 4.17 times in earnings.

Being that the retail line is more profitable, do you see SINO capable of building a distribution network so that retail will become the majority of business?

This is the intension of the Company to establish a direct distribution net work to sell our own Dairy Products from farm directly to the end consumers starting from 2010.

Maybe there is an opportunity to create lines of high quality private label products for smaller inefficient firms as well as for your current wholesale customer?

Yes, in fact we can foresee this to happen within the 2012 (earliest) or 2013 (latest).

To be clear when you say retail you are not referring to actually setting your own retail stores?

No, we will rely mainly on franchising and selling through established super market chains.

Now, I would like to gain some insight into your stock feed and fertilizer lines. Currently, these stay within your supply chain framework, serving your farmers and SINO internally. At this time do you have the capability to produce more than current internal needs so you can supply customers outside this framework, possibly giving you another venue for growth? If so, is it something to get excited about?

For now, we mainly use the supply internally, but certainly we do expect to have excess that can be sold outside our current framework. There is also a strong market for these types of products. Our main focus is cattle however, so selling these products outside our cooperatives would have minimal impact on our overall revenues. This is mainly due to the logistics involved in selling these products to outside sources.

Anything else you care to share regarding your current cattle business before we move on?

I think and feel happy that our model of organic cycle is finally showing commercial viability and sustainability and confident that it will move forward at better pace here onward.

Let 's talk about your horticulture line which grows Dragon Fruit flowers. I must admit when I first read this I did not see the connection. I even chuckled a bit. Please tell us a little about the dragon fruit?

Dragon fruit is very popular in Asian culture. However it is not the fruit that we cultivate, but the flowers, or Hylocereus Undatus. A good comparison for the HU flowers would be Asparagus for Westerners. It is used as a vegetable in soups, salads and other dishes. It also has perceived medicinal and health benefits.

Do you have any stats on dragon flower demand, past and future?

Previously there were over 50,000 acres being harvested in the Guangdong province, but due to industrialization there are now less than 5,000 acres total being harvested. Demand for the flower has not subsided, but supply certainly has. Some of the demand is currently being fulfilled by imports from Vietnam. We can certainly continue to add more production, the demand is there and by providing domestic products we can compete well against the imported products.

Are you making an edible product?

We sell both fresh and dried HU flowers, just like Asparagus though it is normally prepared through various methods of cooking.

After researching this segment a little further it seems that you see some significant opportunities. Please elaborate.

Yes, as I mentioned before, there has been a major reduction in the amount of land being used to grow HU flowers. HU flowers can only be grown in certain climates and these areas have seen massive industrialization. We have acquired sufficient land bank in these areas to produce HU flowers. The margins are very attractive, the plants themselves have a life span of over 20 years. It takes approximately 2 years for a plant to mature to peak production. This said, we expect to double revenue from this operation in 2010.

Given the high margins of this business are there ways you can drive further revenue from this line? Do you see yourself getting involved in developing additional product lines in this segment?

Yes, the Company is doing various research and development of additional product lines having mapped already a few what we think are commercially marketable lines that we aim to start to process during later part of 2010 with the aim to fill the retailed sector with sufficient varieties to be able to market HU flowers line of products as a whole.

I assume Dragon flower have a short shelf life and thus is a seasonal business?

Yes, the harvest period is from July through October. During the winter months and spring there are no fresh flowers being produced.

What are you doing to address this situation?

We have invested in a number of new drying units that allows us to dry the flowers and package them for consumption during the off seasons. This process gives the flowers a long shelf life. There are excellent demands for these products during the off season so by drying the flowers we can fetch a premium for them during the off season.

Is this the main reason you are forecasting an acceleration in the growth in this segment?

Yes, the addition of dryer units, plus our cultivation of additional acreage is allowing us to double our production.

Are their other factors that will contribute to this acceleration?

Yes, the local government is encouraging us to increase production by offering to us more land and rapid recovery of grants for our expansion both on cultivation as well as processing, at the same time; there are now more investors willing to fund our expansion programs to satisfy the ever increasing demands.

Now I gather your cost advantage is that you can take the fertilizer you have produced in your cattle operations utilize it the harvesting of your dragon flowers? Or do you need to access fertilizer externally?

Right now no, we are not utilizing the fertilizer from our cattle operations in regards to the HU plantations. Logistically it is better for us to purchase fertilizer separately. However, we do employ special growing technologies which utilize spacing, concrete support systems and irrigation to grow the flowers efficiently.

Give me an idea of the cost/benefit situation here?

Each acre can produce about $25,000 in net profit each year when the plants reach three years old. We still have an additional 400 acres of land bank available for cultivation with rights for the next 30 years. As an average our development cost on one acre of plantation is about US$25,500 which will give good returns and yield for the next 20 and more years with return of investment within 3 years counting from planting.

Interesting. Do you have any data on past and future price trends of dragon flowers?

Yes, 5 years or more ago when there were over 50,000 acres of HU Plantation in Guangdong Province, their average yearly price was around RMB28 / Kg of dried flowers, and in recent years its price has been steadily increased per year to last year 's average of RMB42 / Kg and we are expecting this to increase to RMB 48 / Kg during 2010, having November 2009 price already at RMB 42 / Kg.

I am assuming that the shrinkage of HU usable land will offer some sort of price stability?

Yes, the way things are it will be extremely difficult for the HU plantation to get back to 50,000 acres as it was, however, there are more commercial operators are venturing into HU plantation during the past two years, such that eventually HU plantations will be increased to about 15,000 acres within this decade and as such we are expecting the price of dried flowers to come down to an average of about RMB36 / Kg by 2020. However, the Company 's plan of increasing product varieties and to develop export markets will help to off set such decrease of prices.

Anything else you care to share regarding your horticulture business before we move on?

Yes, basically HU Plantation is a very good and steady agricultural business having strong market demands, stable prices, low cost of production with high profit margin, high yield per acre, and easy to manage especially when the plants are very much resistant to many diseases that are affecting many other vegetable crops such that the need to apply chemical is limited.

At the same time, in between each roll of plants our planting technique allows up to 4.5 meters of walking spaces that will provide the plantation further opportunities to grow other off season crops to bring addition incomes for the Company. In this respect we are now doing R&D and trials to explore such opportunities and we believe by the end of 2010, we shall be able to commence commercial trials and to increase the Company 's bottom lines further starting from 2011.

So that about sums up your current operations. Have you reached an inflection point where your current cattle operations and horticulture can support healthy internal growth?

The HU plantation alone could support internal growth moving forward.

Good to know. Now I would like to move on and discuss some potential new growth drivers for SINO. Let 's circle back and talk about your SanJiang JV project that will be part of your cattle operating segment and initially produce beef products with the inclusion of lamb products down the line. From what I have read you are very excited about this project which has been funded by 40% by SIAF, 40% by Government owned SanJiang and 20% investors. No doubt that having the government and a major AG player on your side gives you some credibility.

Certainly, San Jing is one of the largest state owned agriculture companies in China. They have over 35,000 employees and manage the equivalent of $4.4B dollars in assets distribution net work

Staying within the theme of our discussion please talk about why you believe this Project is a Win Win for Sino, especially as it relates to cost. Also I am trying to understand what SINO 's role is in this venture? Please explain - is SINO selling cattle to JV or does the relationship call for SINO to simply provide the cattle and share in the ultimate profits?

Sino provides the technology and knowhow and SanJing and the HaungYaun government provide the infrastructure. Our technology is our feed stock and fertilizer manufacturing processes. Our know how is the ability to manage and utilize farmer cooperatives. We have proven to San Jing that our process can bring cattle to weight in half the time of traditional methods being used in China. Also, the quality of meat is far superior to what is currently available.
San Jing and the Government are providing the land as well as the infrastructure. Our job is to manage the project and utilize our sales networks. San Jing is the machine and we are the person operating the machine.

Elaborate on why you claim you will be providing a better quality beef product than what 's currently available?

With the right nutrient in our livestock feed that the cattle will prefer to consume. Naturally this will help to increase their appetite to enhance faster growing rate in shorter time, thus the meat will be much more tender and juicy. Furthermore uniform quality standard of our meat will definitely be attractive to the households.

So again SINO provides the stock feed to these "beef cattle farmers" and the supply chain circle is put in motion again.

Yes

And SINO again is in a low cost situation. This JV seems like a marriage where each party is benefitting from each others strengths. SINO has the tech and management. SangJiang has the money and distribution channel that I assume SINO can use for its other products down the line?

Actually SanJiang being a Government owned entity has the ability to obtain bigger and better grants and other incentives from the Government to help the MGT to expand and to do further developments and commercial activities of other down-stream products.

You also mention and have explained that the sale of stock feed and fertilizer will be generated from JV? Will these products stay with in SINO or will you sell externally?

Sure, eventually we shall sell our Livestock feed and fertilizer to other external parties within the locality, but for parties outside the locality, similar models will be applied to avoid extra logistic costs.

Is their any risk to this JV falling through; as it is in your forecast? Are you on schedule?

Yes, there are always risk factors associating with agriculture industry, however, we are doing the Right agriculture business at the Right time and in the Right place, which is the 3 Rs theory that will apply well in any industry.

Moving on let 's discuss your fishery operations. (Capital Awards). Please explain what a fishery is and the state of this industry in China right now?

In China aquaculture is a huge business, it accounts for nearly two-thirds of worldwide production. The vast majority of this industry however still operates using outdated technology and methods. Many times this results in poor quality or chemically polluted products.

And you have a solution to this?

Yes, Sino has exclusive license in China to market its A Power RAS system which is a portable, modern recirculating aquaculture system. Our system uses a controlled environment that is both scalable and economically efficient that produces quality, pollution free fish products.

So since the process is chemical free we have the potential for another organic line of products?

Certainly, of course, it fits in with our Organic model.

Do you see your self operating your own fisheries or more in the management of fisheries?

Our business plan calls for the management and training of these systems. We provide the technology and knowhow and future partners provide the investment.

Basically you are approaching this in the same manner in which you have approached your JV venture- identifying partners to bear the cost and SINO provides the management and technology?

Exactly, yes.

As I understand, fishery operations are not yet in your forecast as you still require funding to launch this venture?

Yes, we are still vetting potential partners.

Any chance of your fishery business contributing to SINO 2010?

Yes, we are expecting to start the construction of a Demonstration Farm that will have a production capacity of 500 Tons of high quality fresh fish per year within 2010, in turn, SINO will have incomes generated from the development and construction contract of the D. Farm executed with the future Sino Joint Venture Company in China that SINO will have an equity interest in.

To sum up thus far, It seems that you are building a company that really focuses on technology/license advantages, enabling the production of high quality organic products during a time when this is of prime importance in China. Furthermore, your business model centers around gaining cost advantages through unique relationships with farmers or through JV type relationships.

That is correct, our aim is to leverage our technology and management experience while making use of partnerships and cooperatives.

That brings us to the most relevant part of our discussion. What does all this mean for EPS? Please go over your financial forecast for each division and your related assumptions.

For 2010, we are projecting the followings based on organic growth:

• SIAF Group 's consolidated Revenue to be over US$50 million with Net Earnings over US$16.69 Million (or equivalent to US$0.32 / share compares to 2009 of US$0.13 / share). Whereas proportional rate of Earnings for each individual business is as follows:
• Net Earning of over US$9.8 million (representing 58.86% of total group Earnings) from ZX
• Net Earnings of over US$4.25 Million from HU Plantation (HST) (representing 25.5% of the group 's total Earnings)
• Net Earnings of over US$2.15 Million from CA 's fishery (representing 12.87% of the group 's total Earnings) and
• Net earning of over US$0.46 Million from our newly joint venture of the HuangYuan project, (Representing 2.77% of the Group 's total Earnings)

Are you basing any of your forecast on customer interest? Has SanJiang provided input to your forecast assumptions?

No, the forecast is based on growth after equity funding arrangement up to US$20 million being sourced successfully before first half of 2010, otherwise, if the said equity funding arrangement will not be successful, such that, under organic growth situation the Group 's net earning will be reduced to US$0.29 /share which still represents a growth rate of more than 123% for the year against 2009.

Have you taken an aggressive or conservative approach with respect to SINO cattle operations?

We always approach our businesses conservatively for the first three years with the aim to achieve steady profitability and sustainability, such that the cattle operation is no exception.

I had assumed you would not provide a forecast for the fishery operations. But it seems I am wrong on this assumption.

Yes, we are very optimistic to start the construction of at least a Demonstration Farm that will have fish production capacity of 500 Tons per year, and if it would be realized, we expect to generate over US$7.5 Million in Revenue and net Earnings of US$2.15 Million for 2010 generated through a development and construction contract that will be executed with the newly formed Sino Joint Venture China Company that SINO is intending to have an equity interest in.

Putting it all together it seems that under organic growth situation you are forecasting $0.29, 0.51 and 0.80 EPS for 2010/2011/2012 which would represent 123%, 292% and 515% growth rate from your 2009 forecast of $0.13.

Yes this is correct

While this growth Is very impressive, I often like to investigate any upside scenarios to a forecast. Is there any upside to the 2010 forecast?

Yes, it is possible that CA 's demonstration farm will be built doubling the estimated capacity, the HST 's expansion both in cultivation and processing will be increased, ZX 's dairy and dairy products operation will be progressed more rapidly and our revised project plans on the Huangyuan project will be materialized that will improve the overall bottom lines of SINO drastically.

Does your forecast include subsidy income or taxes?

No, again we don't receive direct subsidies.

Ah yes...I apologize.

I believe its equally important to highlight factors that could give downside to your forecast. To that end I have compiled the following list:

Tainted milk scandals.

(In my answers earlier we already implementing plans to cover such a situation except in the instances that the impacts of repeated scandals happened in very near future that will collapse all of our efforts to carry out our protective plans.) The tainted milk scandals did have an impact on our bottom line in 2008, however compared to the rest of the industry we did fairly well. Our products are 100% organic so in some ways we offer an alternative for those people looking for a safer dairy product. This in some respects works to our advantage over the long term.

Changes in the pricing environments.

This situation will not happen for the next 5 years while growth of demands will still be exceeding supplies especially so in quality organic dairy products and raw milk. Pricing in the dairy industry is controlled by the Government, so there will also be some measure of price protection. The demand for raw milk will continue to remain high especially if the China government begins to tighten regulation due to so many scandals. It is important to remember these scandals stem from a lack of quality supply.

Your JV project is delayed.

Yes the CA 's demonstration could be delayed and under this situation, the overall group earnings will be reduced by US $0.04 / share. Many of our JV projects are backed by Government controlled business, so there is quite a bit of support behind them. Right now all our projects are actually moving ahead of schedule due to this support.

Wholesale Customers consider growing vertically.

The larger dairies are at least 20 years away from being able to no longer depend on wholesale milk producers. They are simply too large and the amount of capital required to vertically grow would be a liability if done to quickly. So we will continue to enjoy a market for quite some time.

Expiration of licenses

Not really since our technology licenses are for very long term i.e 55 years and above

Weather

OK, China has its worst winter in 60 years in 2008 yet that did not affect our overall operation too poorly, but it did killed more then 25 acres of our HU plants planted just before winter 2008, so from time to time this kind of scenarios will happen, but we are confident our operations are now prepared and consolidated to certain extends to minimize their impacts.

Any risks to add?

Yes if the big dairy milk wholesalers really want to kill us off before we can establish our planned direct marketing net work that will have an impact on ZX 's bottom line for 2011 and onward. However the way we planed to establish such a net work based on 10%, 15% and 25% of our total milk production for 2011, 2012 and 2013 respectively should not grant too much concerns to the said wholesalers to take drastic actions within the said periods since we shall increase our yearly supply of Raw Milk to them every year thereof.

The Appreciation of US$ rapidly will have an impact on the group 's overall earnings when translated from RMB to US$. Is there a circumstance where you could see yourself retiring some shares to help drive EPS growth?

Yes, we are currently working to retire about 700,000 shares. We also have the ability to retire up to 5M shares, however we have not made any decisions yet.

How about your financing needs? I am becoming somewhat concerned over the financing activities of many Chinese firms, at what I believe have occurred at fire sale prices. What are your financing needs? With debt on the books I see equity as the only option?

We have several options; however financing would only be needed to accelerate growth. We are capable of sustaining some level of organic growth moving forward without additional financing. We have approximately 5M shares already issued and outstanding that could be used for such future financing, or retired if not needed. We could also obtain longer term bank financing using our land bank as collateral.

My commitment to shareholders is that I do not wish to dilute the company. My investment as well as that of my partners are in the common stock of the company. So any dilution of common shareholders is dilution on us as well. We currently have no preferred shares or convertible debt and I am well aware of the impact it can have on the market for a company 's stock. In fact we recently adopted a dividend policy and hope to begin distributing a small portion of our retained earnings in 2010 to help facilitate a stronger perception of our Company and its stock.

Do you have plans to reduce debt? This could help with P/E expansion, down the road.

Yes, we will be looking at all options. However, I do not plan to do anything that is not accretive to shareholders.

Lastly Solomon, do you have an exit strategy?

Yes of course. We intend to spin off all of our subsidiaries once they have been properly nurtured. We are currently in the due diligence phase with an investment bank on conducting an IPO for our dairy business on the Bursa Malaysian Exchange. It is our intention to do something similar to both the HU plantation and the SangJing/HaungYaun joint venture.