POWER PLAY
How finance is helping fuel China Agri’s shift to ethanol.
By Don Durfee

Andy Li, the 35-year-old head of finance for Hong Kong-based China Agri-Industries, is a perfect front man for renewable energy. Alert and positively spritely while recounting a routine of all-nighters, he runs on a tankful of the stuff himself. “I work weekends,” he says, “and last night went to bed at 4:30.”

If Li’s been busy lately, it’s because he’s taken a top job at one of the handful of state-owned companies selected to create a new industry for China. At the center of the country’s increasingly urgent push to develop sources of renewable fuel, China Agri was recently spun off from Cofco, China’s largest oils and food importer and exporter. China Agri is a food processor that has set its sights on the biofuels business, a change that involves a lot more than introducing new equipment to produce ethanol. Given a mandate to create a new industry for China, China Agri’s owners have opted for a new type of finance department, too, introducing systems and skills largely unknown at Cofco itself.

Since joining the company in October, Li has executed a previously developed plan to list China Agri in Hong Kong, a job he completed in March. Now he must knit together the disparate financial management and reporting systems of more than 30 subsidiaries, nurture what he calls a “capital-markets-driven” culture of transparency and corporate governance, and manage outsized investor expectations (at one point in April, China Agri’s stock price was worth 85% more than its listing price).

He is also installing a standardized ERP and database system, and is helping find a service provider to monitor and analyze the company’s operating risks. Above all, Li is a key player in China Agri’s grand plan to spearhead the mainland’s ethanol revolution, which requires financial savvy to fund refinery construction, mergers and acquisitions, research and development, and other costly initiatives.

It’s worlds away from Li’s previous jobs with Hong Kong blue chips Hutchison Whampoa and Esprit Holdings. But then that’s the point. A certified public accountant and chartered financial analyst from Hong Kong, Li is transferring skills learned at venerable, established Hong Kong-based Asian multinationals and importing them into a Chinese state-owned environment desperately in need of the know-how. “There is room to make a difference,” says the financial controller and head of investor relations, who has an MBA from Canada’s Schulich School of Business. “In an established company, it’s hard to find room to make improvements.”

In this, Li is part of a growing band of young, Western-educated Hong Kong professionals attracted by the possibilities of reinvigorating Chinese enterprises, an adventurous fraternity that currently includes Daniel Lai and Eric Leung, the CFOs respectively of Tianjin Port Development Holdings and China Gas.

Typically brought in to reassure foreign investors as the mainland company seeks a listing, professionals such as Li see their role stretching beyond reporting and control to include strategy and capital markets transactions. It remains to be seen whether their enthusiasm and expertise can win over old-line subordinates, transform sclerotic financial systems, and give them a say over strategic decisions.

Li says he is making progress. “I’m now comfortable in terms of the financial figures, although there is definitely so much room for improvement,” he says.
For all of its promise, China Agri confronts serious challenges, including an uncertain regulatory environment and an outdated infrastructure ill-suited to fast-paced business.

The ethanol revolution

China Agri presents Li a rare chance to participate in a revolution. China aims to make renewable energy account for 15% of total usage by 2020, and the use of fuel ethanol is a key plank of that plan. Because it is highly biodegradable and burns away completely, ethanol is a more environmentally friendly fuel than gasoline. Depending on the farming and production practices followed, it can reduce emissions of the greenhouse gas carbon dioxide by 70% to 90%, compared with the extraction, production, and use of gasoline. Usually blended with gasoline, ethanol can also fuel some cars by itself, although such vehicles are not yet widely available.

In 2004, China launched a pilot program in four provinces and towns that makes it illegal to sell or purchase gasoline that does not contain 10% ethanol. The National Development and Reform Commission took on the task of issuing licenses for the production and sale of ethanol within China. It has granted five permits so far, and China Agri has two of them. The company also owns 20% of the third license-holder, Jilin Fuel Ethanol, while its parent, Cofco, owns 20.7% of the fourth awardee, Anhui Fengyuan Biochemical. The fifth licensee is Henan Tianguan, which is controlled by the provincial government of Henan.

China Agri’s perceived first-mover advantage in ethanol and aggressive expansion is driving its stock price. Initiating coverage of the company in April, Yifan Deng of Beijing Gao Hua Securities, which has links with Goldman Sachs, was positive on the company’s “solid position in China’s growing fuel ethanol market” and potential high earnings growth in 2008 and 2009 when four new ethanol plants start operations. Biofuels and biochemicals accounted for only 6% of China Agri’s revenues of HK$17.9 bn (US$2.3 bn) last year, but that proportion is forecast to jump to 23% in 2009. “Currently, the key profit contributor is the oilseeds business,” says Li. “In two to three years, more than half of our profit will come from biofuels and biochemicals.”

Squeezing that profit from the company’s crops won’t be easy, however. For one thing, there is the rising price of corn, the feedstock China Agri uses to produce ethanol. In a report, Deng estimates that 1% higher raw material costs would trim earnings before interest and taxes (EBIT) margin by 0.9 percentage point, assuming no change in product prices. China’s Ministry of Agriculture reports that corn prices have soared 15% since the second half of 2006, not only from demand by ethanol makers but also by growers of pigs, chicken, and cattle.

Li argues that China Agri has room to maneuver. The company’s ethanol plants are located in the country’s corn belt, allowing it to cut out middlemen and pay farm-gate prices, as well as avoid expensive transport costs. Still, the company is looking at ways to mitigate higher prices, including the use of futures contracts, bulk purchasing for all China Agri subsidiaries (and eventually other Cofco companies), and long-term contracts with state-owned grain depots and strategic relationships with overseas suppliers such as Archer Daniels Midland and Cargill.

China Agri is also diversifying its raw materials. The new ethanol plants will use less-expensive starchy food crops grown in the areas where they are located – tapioca (in Guangxi province), sweet sorghum (in Liaoning), and sweet potato (in Hebei and Hubei).

But these crops share a big drawback: all of the arable land, water, and fertilizers needed to grow them can negate ethanol’s pro-environment contributions. That is why China Agri is teaming up with Danish firm Novozymes to research cellulosic ethanol – that is, fuel ethanol from herbaceous and woody plants, and agricultural and forestry residues (see “Gas from Grass,” below). Construction has started on a 50m-renminbi pilot cellulosic ethanol plant.

Show me the money

This is another reason why Li puts in very long hours. The ethanol refineries under construction – facilities that will increase China Agri’s ethanol capacity five-fold to 1.1m tons – will likely cost HK$2.8 bn. The company will build three other factories to produce corn-based biochemical products, requiring another HK$2 bn.

In all, says Deng, China Agri will shell out HK$6.1 bn in 2007 and 2008 for capital expenditures. The Gao Hua Securities analyst estimates that China Agri’s gross interest-bearing debts will jump 26% to HK$6.8 bn by the end of 2008. The gearing ratio will be 40% to 54% in 2007 to 2009, “which leaves the company with a high exposure to interest rate risk,” says Deng. For example, a 100 basis point increase in the interest rate would cut 2007 earnings by 5%.

Li will also need money to fund M&A deals. A non-compete agreement with Cofco obligates the parent company to dispose of its assets in biofuels and biochemicals. This means that China Agri will have the right of first refusal over Cofco’s 20.7% stake in Anhui Fengyuan Biochemical, owner of the fourth ethanol license, and the assets of Jilin Bio-chemical, which Cofco has been negotiating to buy since 2005. Despite the prospect of higher interest rates in China, Li says he is focusing at this time on debt financing rather than equity.

Still, China Agri raised more than HK$2 bn in new capital from the March listing, which Li says has brought down the gearing ratio from 57% to less than 20%. Going forward, he says he is comfortable with a gearing ratio of 60% to 70%. Will China Agri consider a second listing in China, where local companies are valued much higher than in Hong Kong? The company’s shares currently trade at around 22 times 2006 earnings, but it could possibly price an offering substantially higher than that in the ultra hot Shanghai bourse. “We believe we can do that,” says Li. “But we do not plan to do so at this moment. We have to consider the dilutive effect on our existing shareholders.”

Li says he is aware of the need to manage shareholder expectations. Beijing Gao Hua Securities has a “sell” recommendation on the stock on valuation concerns – China Agri ended the trading day at HK$6.28 on May 18, up 69% from the listing price of HK$3.72. Li believes that the best antidote to irrational exuberance is transparency and disclosure. “My long-term objective is to publish operating data on our website so the general public, not just the investment community, will know how we are doing on a monthly basis,” he says.

Another long-term goal is to stabilize margins. Last year, overall EBIT margin was 5.3%, led by biofuels and biochemicals (17.5%), brewing materials (8.1%), rice processing and trading (6.2%), and oilseeds processing (3.4%). However, Gao Hua Securities expects EBIT margins to be volatile, falling to 4.5% this year on rising corn prices and capex spending, before recovering to 5.6% in 2008 and jumping to 7.1% in 2009 as the factories come on stream. Biofuels and biochemicals are projected to account for 60% of EBIT in 2009, compared with just 6% last year.

Counting on Beijing

Can Li keep margins at even keel? One key factor is beyond his control – government regulations, which determine ethanol subsidies and incentives, and whether new competitors can enter China’s ethanol market. For now, China Agri is on the right side of Chinese policy. As a licensed producer, it does not pay the 5% consumption tax, receives a refund of all value-added taxes, and enjoys a subsidy of 1,373 renminbi for every ton of ethanol produced.

If and when government policy shifts, investors will be watching China Agri’s response. Regulators have already adjusted the subsidy amount, which has been sliding downward since 2000, when the government paid fuel ethanol makers 6,300 renminbi for every ton of ethanol produced. China Agri sells its ethanol to PetroChina, Sinopec, and other oil companies at a price equal to 91.11% of the ex-factory price of number 90 gasoline, which is a blend of 90% petrol and 10% fuel ethanol. The ex-factory gasoline price (the value at which manufacturers sell to distributors) is set by the government based on a formula that takes international oil prices into account, among other factors.

The problem for China Agri is that the current formula doesn’t account for corn prices, so its margins are getting squeezed. Li says the company is negotiating with regulators to create “a more flexible mechanism to ensure corn price fluctuations are considered in a new formula.” The point person is China Agri’s head of biofuels and biochemicals, who is also a consultant on the Chinese government’s Alternative Energy Committee. Another source of uncertainty is whether the subsidy will be readjusted upward if gasoline prices fall. “This is exactly what we expect,” says Li.

China Agri is also bracing for new competition. “As demand becomes higher, licenses will be given to interested parties with deep pockets, including possibly joint ventures in order to spur technology transfer,” predicts Kumaruguru Veerasamy, director for chemicals, materials, and food at US research group Frost & Sullivan. Ethanol imports pose another long-term threat. Singapore-listed supply chain player Noble Group is a major producer of sugarcane-based fuel ethanol in South America. “I don’t see China dedicating acres of land to corn to produce ethanol in a scalable manner,” says Noble COO Ricardo Leiman. “It will probably import from Brazil, which is the world’s lowest-cost producer of ethanol.”

Li argues that China Agri is well-placed to take on all comers. “We have the track record, we have the experience, and we have the capital as well,” he says. “And don’t forget that our main shareholder is the Chinese government.” (The government, via Cofco, owns 57.6% of China Agri.) While Beijing may issue new licenses, Li does not expect a change in its approach of granting only one permit per province, so the assumption is that China Agri will at least retain the ethanol monopoly in its current fiefdoms.

Inside job

The regulatory and other uncertainties add urgency to the internal task of making financial management efficient, transparent, and responsive. That’s important not only to support decision-making and strategy-setting, but also to speedily communicate information to investors and the markets. An IT committee co-chaired by Li is looking into the best way to integrate the patchwork of sometimes rudimentary systems that span the firm’s subsidiaries.

He is also enhancing the level of financial skills, and surprisingly, Li says he finds his mainland Chinese subordinates “better than those in a Western company. In most cases, they adopt more easily to decisions by top management.” They are also eager to learn. Li has arranged training programs on International Accounting Standards, corporate governance, financial reporting, and other topics, sometimes with help from Ernst and Young, China Agri’s auditor. The staff support helps make Li’s job a bit easier. But it seems the occasional all-nighter will remain part of the job description in the next few years.