Friday, March 30, 2012

Avangard: You Need Eggs to Make an Omelete

Avangard (AVGR:LI) is an Ukrainian agro-industrial holding company, specialized in the production and distribution of shell eggs and egg products. The company is vertically integrated and owns and operates each of the key stages of the production cycle.

This little known company is the second largest egg producer in the world, with its flock of 25 million birds having produced 6 billion eggs in 2011. The largest egg producer in the world is the US based Cal-Maine Foods, which has a flock of 33 million birds and an annual production of almost 10 billion eggs.

The company has a 51% share in the industrial production of shell eggs and an 87% share in the production of dry eggs in its home country. This is impressive, given that Avangard was established in 2003, and within 7 years became the market leader in Ukraine. In 2010 the company floated 22.5% of its equity, with the remaining being under the control of the Chairman, Mr. Oleg Bakhmatyuk. More on him later…

Over the last years the company experienced impressive growth, driven mainly by:

  • an increase in consumption of eggs in Ukraine (+90% over the last 10 yrs)
  • an increase in capacity (from 2.4bn eggs in 2008 to 6bn in 2011, and is expected to reach 7.6bn in 2012)
  • increased focus on increasing export capacity to MENA and Asia regions
  • customer base shifted from 88% wholesale / 9% export / 2% supermarket chains in 2009 to 35% wholesale / 30% export / 35% supermarket chains (supermarket chains generate substantially larger margins)
  • introduction of own brand (Kvochka), with Avangard targeting a packaged eggs market share of 50% by the end of the year

The Numbers

As I said before, the growth of Avangard has been nothing short of impressive but is still has plenty of room to grow:
- Produced 6 bn eggs in 2011 vs 2.4 bn in 2009 (7.6bn 2012E)
- Produced 1.1 bn pcs dry egg product 2011 vs 0.08 bn in 2009
- Total flock stands at 25mn vs 16.1mn in 2009

As a result of the increase in capacity earnings also increased::
- Revenue of 553mn in 2011 vs 320mn in 2009
- EBITDA of 246mn in 2011 (44% margin) vs 130mn in 2009 (41% margin)
- Net profit of 196mn in 2011 vs 134mn in 2009


One would expect that a company with these characteristics and in this business would have considerable debt but this isn't the case. Avangard has been reducing net debt, which now stands at 0.3 times 2011 EBITDA (80mn). This compares very favorably with similar companies in Ukraine.
The shares are currently trading with a PER of 3.9 (25.6% earnings yield), which compares with 14.5 for the Stoxx600 (couldn't get feasible numbers for Ukraine). Cal-Maine Foods trades at 16 times and an Ukrainian company, MHP, in a similar business (mostly poultry products) trades at 6 times earnings.

I would argue that (1) given the growth prospects, (2) recurring characteristic of the business, (3) the solid balance sheet, and (4) past execution quality, Avangard deserves a higher multiple. I would not go as far as assign it the 16x of Cal-Maine, but 7.5-8.5x is a conservative multiple range. This means an upside in the region of 96% to 122%.

Take into consideration that despite Cal-Maine being more productive / efficient than Avangard, is a mature company, with limited growth opportunities, and enjoys lower operating margins (about 9%). My view is that a 7.5 to 8.5 multiple is not demanding at all.

As the company is growing very fast it becomes hard to look at FCF, since Capex is very high, and you would expect it to be negative. Even though the company managed to generate positive FCF for the year.

Future Developments

Mr. Oleg Bakhmatyuk consolidated his 77.5% ownership of Avangardco into UkrLandFarming (ULF), which he owns 100%. ULF (private company) operates as an integrated agricultural producer engaging in grain growing and cattle breeding. The company also produces beef and Milk.

Talks of a merger of Avangard into ULF have been going for a few months, but things got more interesting recently. On Avangard’s 2011 financial results there was a paragraph saying: "AVGR shareholders will be offered an opportunity to convert into shares of ULF at IPO of the latter. This is planned to be a voluntary offer that will allow existing shareholders to gain exposure to a larger and more diversified food commodity and food products play with greater liquidity at capital markets"
This is very important, as it will act as a catalyst to value realization in Avangard.

I would not mind taking a position in Avangard, doing some time arbitrage and waiting for value to be realized as the market would eventually realize that the company deserves a much higher multiple, but this catalyst will most likely speed up that process. The downside here is that one will most likely not realize "all the value" one would ideally realize.

The Cherry on Top of the Cake...

The company is vertically integrated, but it doesn't produce the fodder to feed its chickens. This is an important variable to take into consideration, as fodder accounts for 60% of COGS and influences margins.

Ukraine's corn price declined 35% in 2011 to $170/t in October-December 2011 thanks to a record harvest. Also sun seed and soybean meal prices (source of protein in fodder) also fell by 15-20%.
As prices were exceptionally low, the company took advantage and hedged this input for most of 2012. Of course in the following years the company will be subject to the market prices, but it is good to know that they're covered for most of 2012, and at low prices.

And a Free option

Avangard doesn't export to Russia or the EU (largest importer of eggs in the world, with 62% share). Recent EU regulation mandated that egg producers increase the size of hen's cages, which decreased production by 10-15% and sent egg prices in the soaring in the EU. Avangard claims it complies with the new regulation, but EU export permission still hasn't been granted. The company is also seeking permission to export to Russia.

I'm not factoring this in my analysis. I will leave it as a free option that would improve the upside. But opening the doors to the EU and/or Russia would most certainly create substantial value in Avangard.

The other side of the coin

  • Ukraine has its share of problems, borrowing money from the IMF several times in the last decade. The country was severely affected by the 2008 crisis (GDP dropped by 15% in the 2008-09 period). Despite all this Ukraine's relationship with the EU has been improving, and is moving to gradual economic integration and deepening of political cooperation.
  • Fx Risk: the Ukrainian currency, Hryvnia (UAH), is pegged to the USD with a ratio of 8:1. This brings some comfort, since the majority of Avangard's debt, cash and exports are denominated in USD. But despite this peg, Ukraine devalued its currency from 5:1 before the 2008 crisis to the current ratio. So the peg does not eliminate Fx risk.
  • There is a 77.5% controlling shareholder. The CEO, Nataliya Vasylyuk is Mr Oleg's sister. (The only positive point I see here is that both have an incentive for the company to succeed due to his substantial stake in the company). Also the company improved transparency, cleaning up related party deals and appointing KPMG to audit the accounts, which brings some comfort. Also it states that it is committed to international governance standards. Also, it has one of the most complete investor relations website I have seen so far, which is always a plus.
  • Risk of disease or even some sort of bird flu. The company has its production facilities spread out across Ukraine, which would reduce the contagion effect, but this is still a serious risk.
  • The company has government support. Despite this, the Company’s income from state subsidies has decreased significantly year-on-year to US$0.3 mln (2010: US$17.5 mln) due to the absence of loans in the Company’s portfolio.

Making the omelet

You have a little known company, growing fast, trading at very low multiples and with a healthy balance sheet. On top of this you have a short to medium term value-unlocking catalyst and a massive free option.

Could you ask for more? Well yes … the company is located in Ukraine, which I’m not 100% comfortable with, and despite the UAH/USD peg, I’m also not totally comfortable with taking this risk, which leads me to, at least for now, be conservative in my allocation to Avangard.

I started looking into Avangard a few weeks ago, but decided to wait for the 2011 results (released on March 21st) to confirm my thesis and only after make an investment in the company and post my analysis here. In the mean time the shares traded up significantly, but still present an excellent risk-reward opportunity. I stand by my decision, it is better to have the thesis confirmed, even if that meant not taking full advantage of the recent rally in Avangard.

Disclosure: Long Avangard and may increase position in the next weeks

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