Although the scandals surrounding small Chinese stocks in 2010 and 2011 never crept as high as the huge companies like Petrochina (NYSE:PTR) or Lenovo (OTCBB:LNVGY), Zhongpin (Nasdaq:HOGS) did come in for closer scrutiny and doubt. Although history suggests investors can never completely trust any company, hog producer Zhongpin may yet be a sound strategy for benefiting from improving standards of living in the PRC.

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The Number Four Player in the Protein of Choice
Zhongpin is the fourth-largest pork processor/packer in China, but holds less than 1% share of the hog slaughter market and the larger players will scarcely familiar to most readers in North America (Shanghui, China Yurun, and People's Food). With the top five producers holding less than 10% share, the Chinese market is a far cry from the highly concentrated U.S. market that is largely dominated by companies like Tyson (NYSE:TSN), Smithfield (Nasdaq:SFD), Seaboard (AMEX:SEB), Swift (owned by Brazil's JBS) and Cargill, where the top four companies have over 60% of the market.

Pork is a huge potential market in China. Although tastes are getting a little more diverse and poultry and beef are growing their share at the table, the fact remains that two-thirds of the protein consumption in China is pork, and 50% of the pork consumed in the world is consumed in China. As people earn more, one of the first things they tend to do is shift their diet towards eating more protein and this is definitely happening in China. (For related reading, see 2011 Look Back At Agriculture.)

Spending Money to Make Money
Zhongpin is spending literally hundreds of millions of dollars in an effort to expand its production potential. From a production capacity of over 130,000 tons in 2005, Zhongpin now has over 700,000 tons of capacity in chilled/frozen pork and will likely go over 1 million in the not-so distant future.

It remains to be seen if this is the best path for growth. With such a fractured market, it would seem to make sense for Zhongpin to buy versus build, particularly as the Chinese government is supposedly keen to reduce the number of slaughterhouse operators in the country. Unfortunately, acquisitions like that can easily get tied up in local politics. Worse yet, the operators who would be more inclined to sell, run the sort of operations that legitimate operators wouldn't want to buy and fixing them up would cost almost as much as building new.

The Elephant in the Room
Various allegations have been made against Zhongpin regarding the accuracy of its reporting and whether it actually owns and operates the facilities it claims. Zhongpin has defended itself rather vigorously and I'm content with management's explanations. That said, short of flying to China and counting pigs, there's always room for doubt.

To whatever extent it helps, Zhongpin does business with companies like McDonalds (NYSE:MCD), Yum Brands (NYSE:YUM), and Wal-Mart (NYSE:WMT) and these companies have supplier quality control validation processes that give me a little extra comfort.

The Bottom Line
Valuing Zhongpin is tricky, because the company has such robust growth potential, but also such large cash needs. Profitability is good here when compared to American comparables like Tyson or Smithfield, as are the returns on assets and capital. That argues that Zhongpin stock can support a larger EV/EBTIDA multiple than might otherwise be appropriate.

When it comes to cash flow modeling, there's a larger amount of guess work here than normal. There is no free cash at all, but that won't likely be the case past 2015. If investors are willing to believe that Zhongpin can continue to grow at a strong rate (double-digit revenue growth easing down to high single digits) for the next 10 years, and produce a free cash flow margin around 4%, then these shares represent a pretty good bargain today. (For related reading, see Free Cash Flow: Free, But Not Always Easy.)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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