The Long Shot: Sowing SEEDs of Success

Real Money's Long Shot column is dedicated to trading ideas that are highly risky, but which present an opportunity for significant payoff if they work. Such ideas are sometimes characterized as lottery tickets and are for only the most risk-tolerant investors, as the potential for 100% loss is high. Being a native Iowan, I carry a spot in my heart for the agriculture industry. I grew up in small-town Iowa and still spend my summers there at the fabulous Lake Okoboji, so although I did not grow up on a farm I understand the contribution made to our well-being by one of our most important, yet underappreciated industries. Silicon Valley makes amazing products, and I really do get pleasure from having 15 different apps for sharing photos, but when you are hungry you quickly realize that farmers and the food industry are what keep us alive, healthy and able to waste precious hours binge-watching serials on Netflix. Americans are well fed, to put it diplomatically, but there are still opportunities to get rich from agriculture in less well-fed developing countries. In particular, the agriculture industry in China is able to feed its billion people rice, but is quickly developing the sort of protein-rich, varied and delicious menu of foods that we take for granted. In that transition lies opportunity, which leads me to today's Long Shot Idea. Origin Agritech (SEED) is a Beijing-based seed company making the transition from basic, old-school simple crop seeds to genetically engineered, high-value seeds. The main products today include hybrid varieties of corn, rice and canola seeds, with hybrid corn seeds generating 86% of sales in 2014. SEED specializes in crop-seed breeding, genetic improvement, and the production, processing, distribution of seeds. The company has 474 employees, 10 breeding stations, five production and processing centers, and four marketing centers across China, with sales centers located in key crop-planting regions. The company built China's first in-house agricultural biotechnology research center in 2005, and in 2009 its phytase corn was the first transgenic corn to receive the Bio-Safety Certificate from China's Ministry of Agriculture. This was the world's first genetically modified (GM) phytase corn and also the first genetically modified corn seed product in China. SEED is also pursuing the approval of other GM seed products, including glyphosate resistant corn and bacillus thuringiensis, or BT, corn. The genetic engineering efforts focus on herbicide tolerance, insect resistance, nitrogen efficiency, and drought stress tolerance traits in corn. That may sound great, but the stock has struggled for several years, due to shrinking revenue as the company rationalizes its operations in the highly competitive commodity seed business, and plows its cash flow into R&D for the GM traits mentioned above. The 10-year chart tells the story, with the stock hovering between $1.00 and $1.50 for the past three years. This represents a market cap of $32 million. The poor stock performance has been justified if you look at the old business alone. Revenue has declined to $67 million in 2014 from $94 million in 2010. Sales are highly visible, because spring planting sales are recorded in deferred revenue until payment is collected at harvest, but the 2015 deferred revenue is in the mid-$50 millions, which leaves some work to avoid another down year. The company is able to maintain the 50% gross margin quite well, but loses money due to operating expenses. R&D is nearly 10% of revenue, a healthy amount that compares with industry leaders such as Syngenta (SYT), which spends 9% on R&D. SEED spends far higher than more similar comps, such as small-cap S&W Seed (SANW), which spends only 1.6% of sales on R&D! This investment by SEED is slowly building an impressive intellectual property (IP) estate, which includes trademarks and patents relating to its seed products. It currently has 13 Chinese patents registered with the State Intellectual Property Office (SIPO), and three more being evaluated. Six domestic patents and one PCT patent are related to biotechnology corn seed, as are the three most recent. In addition, the company has 31 Chinese trademarks registered with the Trademark Office. As of September 2014, SEED had 20 proprietary corn seed products, 15 proprietary rice seed products and one proprietary canola seed product in commercial production and distribution. The play here is a potential turn in the regulation of GM crops by Chinese regulatory authorities. As the company's 20-F describes it: GM products continue to be controversial in China, and, to date, very few GM products have been approved. There is public concern regarding the potential for adverse effects of GM products on human health. In May 2001, the State Council of China enacted the Agricultural Genetically Modified Organisms Safety Regulation... SEED is obviously building a formidable IP portfolio in the expectation that regulations will be loosened, enabling an explosion of growth. Indeed, early signals show a loosening of regulation. Chinese news agency Xinhua reported last week: China will step up reforms and innovation to speed up agricultural modernization in 2015, according to a key policy document released by the Party and government on Sunday. As the Chinese economy, under the new normal, shifts from high-speed to medium-to-high-speed growth, it has become a key issue to continue consolidating the position of agriculture as the foundation of the economy and to further increase farmers' income, said the document. The No. 1 Central Document refers to the first major policy document of each year released by the Central Committee of the Communist Party of China and the State Council. This the 12th consecutive year in which the document has focused on agriculture and rural issues. On a smaller, but not completely insignificant note, Reuters reported in December: A top Chinese government official said the country has approved imports of genetically modified Agrisure Viptera corn and two varieties of biotech soybeans after years of review, U.S. Agriculture Secretary Tom Vilsack said on Wednesday. Betting on a change in government regulation in any country is always risky, but in the case of Origin, I like the risk/reward. The stock has been sitting above $1 for three years, so your downside is most likely that nothing happens and you pay a high opportunity cost. If the GM regulations loosen, however, you could get a multi-bagger payday, even before the sales start ramping aggressively. To see the potential, look at a similar company in Israel: Evogene (EVGN). Evogene is a world leader in using databases and software tools to genetically modify seeds for specific productivity traits. Evogene is still a technology start up in the sense that they have built amazing tools, but the products are not yet on the market selling in volume. Evogene has a $228 million market cap on only $17 million in sales last year. SEED could be valued as some combination of its current base business -- probably worth near today's market cap, or higher with a return to profitability -- combined with some high fraction of an Evogene-type valuation. Should SEED receive even half the credit that the market gives EVGN, the market cap could move to $150 million, a return of over 4x. To me, potential upside of 4x against little/no downside is a risk/reward ratio worth considering.

The Long Shot: Sowing SEEDs of Success

Looser Chinese crop laws would give Origin Agritech the chance to blossom.

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