SEED

Business Context and Reporting Period

Company: Origin Agritech Limited (BVI-incorporated, operations primarily in China via PRC Operating Companies).
Reporting Period: Fiscal year ended September 30, 2010.
Business Overview: Leading technology-focused crop seed company in China, specializing in corn, rice, cotton, and canola seeds. The company operates through a mix of proprietary and licensed hybrid seeds and recently expanded into agricultural chemicals via the acquisition of Shandong Kunfeng (80% interest) in June 2010. The company utilizes stock consignment agreements to control PRC subsidiaries due to foreign ownership restrictions in the seed industry.

Key Financial Metrics (Fiscal Year 2010)

Note: USD amounts are translated at the period-end rate of RMB 6.7011 to USD 1.00.

Material Changes vs. Prior Period (FY 2009)

• Revenue: Decreased slightly by 1.29% (RMB 592.49M to RMB 584.86M). This was driven by a 34.18% decline in rice seed revenue due to weather-related production issues, partially offset by a 2.44% increase in corn seed revenue and the introduction of pesticide sales (RMB 18.96M).
• Profitability: Significant turnaround from a net loss of RMB 40.82M in 2009 to a net profit of RMB 49.05M in 2010. Operating income improved from RMB 45.70M to RMB 61.98M.
• Gross Margin: Expanded from 33.7% in 2009 to 39.5% in 2010, primarily due to higher corn seed prices and improved product portfolio management.
• Operating Expenses: Increased by 9.96% to RMB 169.29M, driven largely by a 21.41% rise in General and Administrative expenses (salary increases and stock option grants) and a 14.61% increase in R&D expenses.
• Debt: Interest expense decreased by 49.11% following the full repayment of convertible notes in late 2009. Short-term borrowings increased slightly to RMB 85.9M to fund working capital.
• Investing Activities: Net cash provided by investing activities turned positive (RMB 15.1M) due to proceeds from the disposal of a 34% equity interest in Biocentury (RMB 60M), offset by the acquisition of Kunfeng.

Guidance, Outlook, Risks, and Unusual Items

• Outlook: Management expects continued growth driven by the consolidation of the Chinese seed industry and the increasing adoption of genetically modified (GM) seeds. The company received approval for the first GM phytase corn in China in 2009 and is pursuing approvals for glyphosate-tolerant and BT corn.
• Seasonality: The business is highly seasonal. Most revenue is recognized in the third fiscal quarter (October to June sales season). Cash flow is often negative in the third calendar quarter (July-September) due to advance payments to farmers, requiring short-term bridge loans.
• Key Risks:
  • Regulatory: Dependence on PRC government approvals for GM seeds and seed variety registration. Foreign ownership restrictions require the use of stock consignment agreements, which carry legal enforcement risks.
  • Operational: Reliance on a network of over 100,000 farmers for production; risks include weather events, natural disasters, and inventory aging (seeds sold as feed if not sold as crop).
  • Market: Competition from multinational corporations and local state-owned enterprises. Fluctuations in commodity prices affect both input costs and farmer purchasing power.
  • Tax: Contingent U.S. tax liabilities from a 2005 reverse merger transaction (estimated RMB 39M to RMB 64M) remain unresolved pending IRS review.
• Unusual Items:
  • Divestiture: Sold 34% stake in Biocentury for RMB 60M, recognizing a gain of RMB 8.88M.
  • Acquisition: Acquired 80% of Shandong Kunfeng (agricultural chemicals) for RMB 14.96M.
  • Convertible Notes: Fully repaid remaining convertible notes in December 2009, eliminating a significant non-recurring loss charge seen in 2009.

Investor Verification Checklist

• Revenue Recognition Policy: Verify the timing of revenue recognition, as the company defers revenue until final sales prices are fixed with customers (often after the selling season), leading to significant deferred revenue balances.
• Stock Consignment Agreements: Review the legal enforceability of the agreements used to control PRC subsidiaries, as direct foreign ownership is restricted.
• Inventory Valuation: Assess the risk of inventory write-downs, as seeds have a limited shelf life and may be sold as feed at reduced prices if not sold as crop.
• Contingent Tax Liability: Monitor the status of the U.S. tax liability related to the 2005 reverse merger and any potential IRS assessments.
• GM Seed Approvals: Track the regulatory progress of the company's GM corn pipeline, as future growth is heavily dependent on these approvals.
• Seasonal Liquidity: Confirm the company's access to short-term bridge loans to cover the cash flow gap between farmer payments and customer collections.