S-Chips may yet rise from their slumber

Liquidity is a valued virtue for investors. In 2008, I was enamoured of a company that was liquid in every sense.

China Milk, a Singapore-listed Chinese company (known as an S-Chip), was the principal producer of pedigree bull semen and cow embryos.

China's appetite for protein meant that milk consumption was surging. The volume of milk consumed there was just one-20th that of the United States', but China's GDP per capita was a 10th that of the US'.

Based in the fertile north-western province of Heilongjiang, China Milk had a vice-like grip on the source of China's milk boom: It had the rare licence to sell pedigree bull semen.

The productivity of Canadian cows is four times that of Chinese cows. By importing pedigree bull semen from Canada's prized Holsteins, China Milk aimed to turbocharge the country's milk productivity.

With the company well-entrenched through a network of distributors, its sales tripled from FY15 to FY18.

China Milk was a cash cow. Its operating margins were 75 per cent, which was unique for a consumer stock (any stock, really). It had a free cash flow (FCF) yield of 37 per cent, which was almost unprecedented for a growth stock.

The management spoke with the swagger of Californian tech wizards. They said that the company, standing on the cusp of China's milk boom, would ignite China's protein bomb.

At just five times forward earnings, China Milk seemed to be exceptional value in the summer of 2008, when S-Chips had tripled in value in two years.

I initiated with a "buy" recommendation implying a 55 per cent upside. My views were feted by the media. CNBC featured my recommendation as one of Asia's hidden gems.

However, the story soured almost instantly. The company reneged on its interest payments in 2009. Bond holders panicked and called for an early redemption.

Despite a net cash balance that was three times the outstanding principal, China Milk failed to remit the US$171m that was due, citing foreign exchange restrictions in China.

In February 2010, China Milk stated that it had not "made any formal application to the SAFE (State Administration of Foreign Exchange) for the approval of remittance of funds". It promised to do so, but never did.

China Milk's owners vanished without a trace. Efforts by the bondholders to contact the CEO, Liu Hailong, proved fruitless; one creditor employed a private investigator to track down the executives in Heilongjiang.

China Milk's cash balance was depleted by 70 per cent in FY10. Eventually, trading on the company's stock was halted, and the company, delisted. Both bondholders and shareholders were wiped out.

China Milk's investors were in a black hole. The company's operations were in Daqing in Heilongjiang, but it was headquartered in the Cayman Islands. The China Securities Regulatory Commission claimed that they had no jurisdiction on the matter.

China Milk was among several S-Chips that failed to pay their debts. Six out of the 11 S-Chips that issued convertible bonds in 2009-2010 failed to repay; another five S-Chips reneged on their corporate loans. Other S-Chips reported missing cash, overdue receivables, massive over-payments to suppliers. Most of the companies that have been suspended from trading on the Singapore Exchange are S-Chips.

The reputation of S-Chips has been dire, and investors have turned their backs on them for almost a decade.

However, the pendulum may have begun to swing in the opposite direction. The market has punished S-Chips severely, but many of them are legitimate businesses that are trading at a vast discount to their net cash.

Of the over 700 companies on the SGX, about 50 are trading below their net cash; another 70 seem to be trading below their net working capital. Many companies in these categories are S-Chips. For instance, China Star Food Group, a producer of branded snack foods in China, is trading at half its net cash and 30 per cent below its net working capital.

The market is discounting these companies as there is a perception that the cash is fictitious or unclaimable, but these companies have been audited by prominent firms.

The SGX offers investors the option of privatisation in a relatively transparent manner. There have been at least 12 privatisations of undervalued stocks in the last year.

On average, the purchaser paid an average premium of 29 per cent.

China Milk and its fellow S-Chips may have been a disastrous investment in the last decade. But not all the milk is tainted.

    The writer is head of Consumer Sector Equity Research at Tellimer

Nirgunan Tiruchelvam

30 May 2019