Gamble of the week: undervalued food group

By Paul Hill Jul 24, 2009

Paul Hill

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One bright spot of late has been the resilience of the Chinese economy, even after suffering a 20% fall in exports. The country clocked up an impressive 7.9% jump in GDP in the second quarter of this year, up from 6.1% in the first quarter, due largely to the £350bn stimulus package.

For me, the key difference between these measures and those being adopted by its profligate cousins in the West is that China can afford them. Over the past two decades, it has become Earth's manufacturing heartland, in turn building up over $2trn in foreign currency reserves.

One beneficiary of this improving outlook should be China Food, a domestic supplier of branded consumer condiments, such as soy sauce, vinegar and bean paste, and animal feeds. In 2008 the latter division generated 54% of sales, but the condiments unit stole the show by contributing over two-thirds of group profits in line with its superior margins.

China Food (Aim:CFC)

The company's strategy is to focus on these niche value-added products, as well as expanding capacity to cope with rising demand – driven by the continued urbanisation of China and the growing affluence of the local population. With this in mind the company is presently building a new factory (about 90% complete) in Shandong province. This should come on stream towards the end of 2009 and greatly enhance long-term returns.

So why have the shares slumped to near all-time lows?

Well, over the past nine months the board has issued two profit warnings because of the weaker economy, which has hit both consumption and profitability.

Next, one of the company's largest shareholders (Albany, with 20%), has recently delisted its shares on Aim, increasing the chance of a hefty stock overhang in the event that Albany decides to sell off its stake.

On top of this, there is a danger that China Food will have to raise more capital to complete its new site if bank finance cannot be secured, possibly leading to an equity placing.

Finally, being Chinese means that the organisation is also exposed to the usual risks (such as geopolitical issues, currency-exchange fluctuations and tax rates) of an emerging nation.

All the same, I'm not put off. China Food is an old economy stock operating in a growth market, whose shares trade at an attractive level for the adventurous investor – particularly as the recent falls have been exacerbated by the small 14% free float.

Assuming sustainable earnings before interest (Ebita) margins of 15% (compared to 20% in 2008), I would value the stock on a through cycle Ebita multiple of eight. After adjusting for net debt of around £5m this delivers an intrinsic worth of around 60p a share. The directors seem to agree – the chief executive and chief financial officer bought 150,000 shares at 33.5p on 30 June.

Recommendation: speculative BUY at 31p (market cap £21m)

• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

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