I’ve decided to start a new series every Friday, entitled Weekend stock pick. The idea is that I will post an analysis of a stock that I think will be of interest to readers, and one that I haven’t covered before. Whilst I will most certainly aim to find great value investments every week, I can’t say that finding one so often will be possible. However even if I can’t find a stock of great value, I will at least try to highlight strong companies to add to the watch list.
The rationale for posting it late on a Friday is to give readers time to research the stock themselves and stop them being tempted to jump straight in. You may think my disclaimer blurb at the bottom is for show, but I firmly believe everyone should do their own research before investing, even if they read a very convincing argument. So as the markets are closed at the weekend, you may as well do some reading into the company yourself.
Without further ado, this is the first stock I’ll be looking at in this series. Not long ago I wrote a post on an ethical dilemma relating to the company Avangardco (LSE:AVGR). Today I am going to look at the same company from a purely investment viewpoint. I will warn you now, this is a long post but I like to be thorough. If you want to test the waters first you could start by reading the Valuation and Conclusion section at the end.
Avangardco is one of the largest agro-industrial companies in Ukraine, specializing in the production of eggs and egg products. Based on figures for the year 2012, the Company holds a 33% share of the Ukrainian egg market (52% of the industrial egg market) and an 88% share of the Ukrainian egg products market. As of 31 December 2012, the total poultry stock of the Company was 27.5 million heads. The Company’s plants are located in 14 regions of Ukraine and the Autonomous Republic of Crimea. In 2012 the Company exported its products to 32 countries, generally to the Middle East, Asia and CIS. As of 31 December 2012, revenues amounted to US$629.3 mln (2011: US$553.3 mln) and EBITDA was US$ 279.8 mln (2011: US$245.8 mln).
One of the most important things about this company is that it has a majority owner, Oleg Bakhmatyuk, who owns 77.5% of the company. I don’t see this automatically as a problem but it is worth doing some research on him. Here is a quote from an article in the Kyiv Post.
“Back in 2005, Bakhmatyuk was hired as an adviser at Ukraine’s state oil and gas company Naftogaz Ukraine – long known as a feeding trough for bureaucrats. In 2006, he was promoted by then Naftogaz chief Oleksiy Ivchenko, who also hails from western Ukraine, to deputy CEO of the strategically important company. It was around this time, in 2006, that Bakhmatyuk even made an unsuccessful bid for parliament on the losing ticket of current parliamentary speaker Volodymyr Lytvyn.
Bakhmatyuk finally left Naftogaz in 2007, selling off his assets in a string of lucrative regional gas distribution companies, a sector of Ukraine’s economy where the line between profit and politics is often blurred.”
There is little other information about him, which could be seen as good, or bad. However what is clear that in the Ukraine, it’s all about who you know, not your ability. He has appointed his sister as chairman, who has in turn hired a couple of young women as CEO and CFO. It’s hard to say whether they will be up for the job or not. One good thing about a majority owner however is that if they damage profits, you’d expect something will be done.
Despite some corporate governance issues, we can have some faith in their financial statements; they are audited by KPMG and investor relations seems to be quite thorough.
The table below shows a summary of their historical financial information.
I will point out a few things of interest. First are the government grants and income from special VAT treatment. Revenue is quoted net of VAT, but they can reclaim VAT for exports.
“There are two rates of value added taxes: 20% – on import and sales of goods and services in the territory of Ukraine and 0% – on export of goods and rendering of services and works outside Ukraine.
The VAT liability is equal to the total amount of VAT accrued during the reporting period and arises at the earlier of goods shipment to the customer or at the date of receipt of payment from the client.
VAT credit is the amount by which a taxpayer is entitled to reduce his/her VAT liabilities in the reporting period. The right to VAT credit arises on the earlier of the date of payment to supplier or the date of receipt of goods by the company.
The Group’s entities apply the special VAT taxation treatment prescribed by the Tax Code of Ukraine, which entered into force on 1 January 2011, regarding the agricultural activities, which provides preferential VAT treatment to support agricultural producers.”
The Ukrainian government plans to abandon these VAT rebates from 2018 onwards. The company’s report warns of frequent changes to the Ukranian tax system so this could come in sooner. That would reduce profits by 18% and can be seen in the highlighted profit row. I have also excluded profits from revaluation of biological assets. I don’t believe this is a true profit, merely a paper profit, and while I don’t have a problem with how they have revalued their assets, as an investor it doesn’t benefit me in cash terms.
Avangardco’s operating margins are still high even accounting for this (24% pre-tax). That makes me nervous. To understand why, lets take a look at another big egg producer, in the US, Cal-Maine (NASDAQ:CALM). It has seen its gross margins deteriorate from 2008 onwards as the financial crisis takes its toll. They have only half Avangardcos margins, 12.4% pre tax and have significantly less leverage. Even though they operate in a different market, could the same thing happen to Avangardco? Absolutely, there are few barriers to entry in this market and their huge gross margin makes it vulnerable, competitors will be eyeing up these large margins and good returns on investment. The only thing standing in the way of a competitor entering the market and driving down margins appears to be the difficulty of doing business in the Ukraine. Can that last forever?
Cal-Maine, even with lower margins, is still a strong business. It has a return on assets of around 10% and sells for 2x book value. This suggests that even if competition increases for Avangardco it will still remain a strong business.
Another thing to note is that Avangardco pay no tax. Profits from agricultural business are taxed by Fixed Agricultural Tax, rather than income tax. I’m no expert on Ukrainian tax laws but I would want a margin of safety to protect me from possible income taxes being introduced.
One important thing about this company is they bank in Cyprus. A few months ago, we probably would have said ‘who cares!?’ but obviously now we have to look at how the deposit ‘tax’ could affect them. Most of their cash is held in the bank, but the annual report doesn’t disclose where. It does however say in their latest financial statements:
TD Investments Limited
2-4 Arch.Makarios III Avenue
I think it’s better safe than sorry, best to write off 60% of those bank deposits, or $122m (that’s the highest estimate of the tax I’ve seen). Besides affecting value this also hurts their liquidity, their short term borrowings are no longer adequately covered by cash. Moreover, if their cash is in Cyprus they can’t get to it. I don’t foresee a bankruptcy as it’s a temporary annoyance and they will surely be able to find financing to cover the short term.
- Their liquidity is at risk if their cash is frozen in Cyprus. They already have large outstanding borrowings from banks. Loans due within one year stand at $151m. Including lease payments, they also need to pay $45m in interest. They would need to find new financing or put all capital expenditure on hold.
- I will be performing some checks of financials such as those detailed in my article on manipulating financials. These are too lengthy to include here but if I find anything suspicious I’ll post a new article about it.
- Fitch has given Avanagardco a stable B rating, which is non-investment grade and means ‘financial situation varies noticeably’. The interest rate on their US$ bank loans is 11%, their 5 year bonds yield 10%. This gives us an idea of how the banks view the risk of this company, i.e. high. It’s also worth noting these are secured loans against assets and most of the debt is at a fixed interest rate which is good.
- Their loans are also mainly denominated in foreign currencies, US$ and Euro. This exposes them to risk if their operating currency (UAH) depreciates against them. A 15% adverse movement in currency rate reduces shareholders equity by $36m.
- The company operates in the Cypriot tax jurisdiction, and it’s very possible that tax laws could change unfavourably in the near future given Cyprus’ financial problems. It is also subject to Ukraine tax laws, which can change frequently and suddenly.
- One important note I came across in the financial statements relates to poultry purchase prices. They have been receiving them at fixed prices since 2009 but this contract has now expired. It is possible there will be a large increase in Cost of Sales if the new prices are above the fixed prices they were previously paying. However, could this be what the ‘revaluation of biological assets’ refers to? A bargain purchase of chickens? In which case I’ve already adjusted for it.
“On 28 November 2009 the Group signed new exclusive distribution agreement according to which the Group has an exclusive rights to purchase Hy-Line W-36 and Hy-Line Brown Parent Stock at a fixed price. The minimum quantity of purchases is not stated in the agreement. The term is three years to November 2012.
The financial effect of changes in contingent and contractual liabilities is not possible to be calculated as at the reporting period.”
- The companies management seem to be fairly relaxed about debt and are expanding rapidly. This isn’t automatically a bad thing as we have seen that investments have been wise, but it is unclear in the future whether they will continue to invest money in the name of expansion or return money to shareholders when it becomes advantageous to do so. I don’t foresee any dividends or share buybacks on the horizon given their increasing debt levels and continued capital investment.
Adjusting profits for VAT relief and biological asset revaluation, returns on investment and equity are high. Book value grew at 24% last year and I think even under a worst vase scenario e.g. government assistance removed and margins pressured by competition, this business is worth book value. In the interim, we can rely on them earning similar returns to 2012 for the next year or two, perhaps slightly lower if the price they pay for chickens increases. That would see book value increase by over 20% a year. That seems a reasonable return considering the risk in this investment. The business doesn’t currently produce any free cash so book value growth is all we really have to go by for valuation.
I would normally re-value book firstly to write down the cash due to Cyprus, and then remove recoverable taxes as it’s just an accounting adjustment. However I’m going to be generous and only write off the cash as I think that gives a reasonable proxy for the value of this company given its growth potential. Hence I would value Avangardco at $1bn. It’s interesting to note that’s similar to Cal-Maine’s current valuation and it earns roughly the same pre tax as Avangardco (adjusted). Of course Avangardco doesn’t pay income tax and currently has the VAT refunds, arguably offsetting risks over its base of operations.
I would value Avangardco conservatively at $1bn, slightly under book value. I would expect book value to grow at circa 20% over the next couple of years and hence the intrinsic value to grow also. As such I don’t necessarily believe a catalyst is essential for this to be a good investment. The current market cap is $505m, around a 50% margin of safety.
There are clear risks to this investment both in the short and long term (increased competition and majority shareholder). Their bonds are yielding 10% which means equity investors should be seeking in excess of this if valuing by discounted cash flows.
At this point it’s worth noting that I have focused on conservative estimates, there is also significant upside to this investment which would see its intrinsic value exceed book value. Wexboy gave a good explanation of the potential growth from exports to the EU which the current welfare laws have enabled. But given it is already at a 50% discount today I’ll leave that analysis until the price advances (its got to surely..?)
I’ve not put my buy order in yet, I’ll first read the financial notes thoroughly and search around for any news I haven’t yet come across. If I don’t find anything to put me off, I’ll be a buyer.