Monday, March 17, 2014

Calling all risk takers, a Ukrainian investment at 2x earnings and 45% of book value

"The time to buy is when there's blood in the streets." - Baron Rothschild

Investors who venture into risky markets can realize either fantastic returns, or encounter losses to be written off at tax time.  Right now feels like one of those times where a fortune could be made or lost by investing in the Ukraine or Russia.

I haven't spent any time looking at Russian companies, but I have seen a Ukrainian company written up on a number of blogs that I felt merited a further look.  The company is Avangardco (AVGR.London), an egg producer.  They are the number one egg producer in the Ukraine and in Eurasia.  If you're reading this and live in Europe you've probably consumed Avangardco eggs.

The company is compelling due to their extremely low valuation.  They trade for slightly over 2x earnings, and about 45% of book value.  This is a really low valuation for a company with a considerable market position.  Usually a valuation this low can be attributed to one time earnings, or another non-repeatable event.  That's not the case for Avangardco, the company's earnings appear relatively stable.  The company's book value is well supported by earning power.  Book value is close to five times net income.  This is clearly a two pillar stock.

When a stock is trading for such a low multiple an investor doesn't need to spent a lot of time considering whether it's good business, or if they have a moat, or if can earn acceptable returns on equity.  If you are interested in exploring those issues I'd recommend you read Dave Waters' writeup of the company from January.

In my view there are only two questions that need to be answered about the company, and if both can be answered conclusively then this is an incredible investment.  The first is will the company's business going forward resemble business the past, secondly is there a risk of permanent capital loss from some event or incident?

Back before Putin began to reassemble the Soviet Union the biggest risks outlined for an Avangardco investment were related to its billionaire majority owner.  A noted but not emphasized risk was that the company operates out of a politically unstable country.  That previously minor risk has come to the forefront lately.

To consider Avangardco as an investment we need to rule out two potential outcomes: that the company will disappear, and that their business is permanently impaired.  If both of these risks can be eliminated buying a company at 2x earnings and 45% of book value has a great chance of generating a return.

Let's tackle the first issue, that they will completely disappear.  I can see this happening under two or three circumstances.  The first is that Russia launches an all out war against the Ukraine and either destroys all of Avangardco's facilities, or re-collectivizes them.  I think this is the most remote possibility, I'd assign a very small probability of this happening.  There's a chance Russia might invade the Ukraine, but given how Ukraine resisted in Crimea I'm not sure there would be much fighting.

Hens are going to continue to lay eggs regardless of whoever is in control of the country.  As long as the eggs can get to a customer, and the customer as the ability to pay the company should continue to make money.

The second potential risk is that even if the company can conduct operations going forward it will be at a reduced level.  I'd consider this the best argument for the low valuation.  Some of Avangardco's facilities are in Crimea, maybe those will have to be abandoned.  If Russia invades Eastern Ukraine then maybe the company will lose half of their facilities or critical infrastructure.

If the company were to lose half of their earning power they would still be trading at a very low valuation of 4x earnings.

I think there's another alternative that investors should consider as well.  Prior to Ukraine's recent unrest they weren't known for having the most transparent or honest government.  Even in those conditions Avangardco was able to flourish under the control of their billionaire owner.  My thought is that the owner knows how to grease the political wheels to get favorable treatment.  Considering that the Russian economic system seems to be run by in a similar manner it's likely that Avangardco's owner will find a way to work in whatever new political system emerges.

The question to ask regarding Avangardco is if the worst case doesn't happen then what does the future look like?  If their facilities aren't destroyed in a war or collectivized in a communist revival, and the hens continue to lay eggs is it worth more than the current valuation?

If you think the worst case is a likely outcome then this is an investment to avoid at all costs.  If you don't think the worst case is likely then the company could return multiples once the political environment begins to settle.

I think Avangardco illustrates a few things about buying cheap companies and margin of safety concept.  If an investor is buying companies without much room for error their assumptions and estimations need to be very accurate to realize a return.  The cheaper a company gets the less accurate assumptions or estimations need to be.  At a certain point, as in Avangardco's case, as long as the company survives and is able to find a way to make money investors will most likely realize a return.

Disclosure: No position

26 comments:

  1. Wexboy was sniffing at this a couple of years ago. Donno how it played out for him: http://wexboy.wordpress.com/2012/11/06/a-letter-to-avangardco-avgrln/

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    1. Yes, I remember he engaged management as well. I'm not sure what ever happened with that.

      Delete
  2. The company may survive but not send any of the profits back to (former) minority shareholders. It can be confiscated by the controlling shareholder, the state, or a more cunning competing oligarch. "Ownership" in these jurisdictions is a very fluid concept. What remedy does a minority (foreign) shareholder have if, say, the listed holding vehicle sells all its assets to a related party for $1? I believe this explains the bulk of the discount on Russian (and satellites) companies.

    Many oligarchs have ended up in prison, exile, or with a lot of metal in their body, so not sure I would see much predictive value in the past successes of any given one (survivorship bias?).

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    1. Cig,

      You clearly articulated the bear thesis on this stock. For all the reasons you mention this is why it's cheap, no argument there.

      I would offer that Ukraine wasn't a shining beacon of transparent non-corrupt politics prior to the current events, and the company was able to operate without screwing minority shareholders. It's like the Who said: "Meet the new boss. Same as the old boss."

      The company IPO'ed, they were private prior. It seems strange that they'd want to IPO to raise money then take it and run five years later. This seems to be the strategy of the reverse China mergers. At least with them they acted quickly trying to steal the money as fast as possible.

      Given your thoughts are you short them and other Russian companies? If they're worth nothing then even at 2x earnings they're expensive right? Maybe that will turn out to be a good trade.

      Thanks for the comment, you were much more to the point than I was on this.

      Nate

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    2. Doing actual runners seems indeed less frequent than with Chinese overseas listings, I expect them more to steadily underperform through dilutions, delistings or buyback/mergers at bad prices. As an issuer, there are benefits in keeping a listing going if you think they'll be further opportunities to part "investors" from their money with secondary issues, especially as the trust and emerging market discounts are strongly cyclical. Chess players are long term thinkers :-).

      This makes it difficult to structure a short around this: short term you're exposed to a lot of unpredictable randomness, long term, not sure you can find the right instrument without too much exposure to the short term randomness. So indeed, I'm not short anything.

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    3. Interestingly though individual Chinese reverse mergers were sometimes frauds, the Chinese reverse mergers as a whole did not perform systematically poorly
      http://www.gsb.stanford.edu/news/headlines/charles-lee-chinese-reverse-mergers-performed-better-than-their-reputation-suggested

      Delete
  3. Hi Nate,

    I have recently also been looking at this company and cannot get comfortable with the risk of permanent loss of capital. It almost becomes a case of 'there is no cheap enough price' because the value could be $0.

    One other thing that does diminish the margin of safety in my eyes is the tax rate. If I am not mistaken they pay almost no taxes. Now, whether they operate under Ukrainian or Russian Laws, I cannot imagine that this will not change at some point. Given 30-40% tax rate, then you do trade at 4x earnings. Still not expensive, but does diminish the margin of safety of something that does seem quite likely...

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  4. Hi Nate,

    Avangardco is a favourite with many European Value investors because it looks so cheap. For me, the following 3 questions are important when investing in such companies:

    1. Is the company real and the numbers ?
    2. Are the managers/owners Thieves ?
    3. Can someone else take assets etc. away ?

    Re 1: In my opnion, the numbers do simply not add up. They produce 6bn eggs which translates into ~550 mn USD sales or roughly 10 cents per egg. This seems however to be the retail price in Ukraine (http://www.numbeo.com/cost-of-living/country_result.jsp?country=Ukraine&displayCurrency=USD). Unless Ukrainian retail outlets are charities, they would charge normal gross margins of 20-30%. and sales would need to be significantly lower.

    Re 2: Both, the "Chairwoman" and the Ceo seem to be recruited via a fashion model agency and have limited work experience (http://avangard.co.ua/eng/about/board/e/director_id/34/ and http://avangard.co.ua/eng/about/address-director-general/ ). Good looks, but suspicious. they are definitely not the ones running the company.

    Th "oligarch" behind all this, Oleg Bakhmatyuk is only 38 years old. He seems to have quite a lot of interests besides the egg producer http://www.counterpunch.org/2014/02/06/solidarity-ukraine-style/

    He also seems to have some angry creditors in the US as well: http://www.corpwatch.org/article.php?id=15838


    3. Yes, Thats clearly a risk. For instance those assets in Crimea....

    Overall I have my doubts if the profits of company are real.

    mmi

    P.S. The don't export to the EU, so I am pretty sure that I never had an Ukrainian egg....

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    1. "Th "oligarch" behind all this, Oleg Bakhmatyuk is only 38 years old. He seems to have quite a lot of interests besides the egg producer http://www.counterpunch.org/2014/02/06/solidarity-ukraine-style/"

      Given his success he probably isn't stupid. Self-serving certainly but not stupid. The creditors are due to a bankruptcy of a failing US venture. Its definitely self-serving to end the venture and leave creditors in the lurch but their is no fraud, nothing illegal and its appears that the business venture genuinely failed.

      Second it appears odd to me that he would attempt to screw over equity investors if indeed his ambition is build a huge international agricultural company. If you screw over investors you basically usually just take your money and run. You don't try to build anything. According to the article:

      "Bakhmatyuk foresees “billion dollar” equity deals with West and East Asian powers"

      He won't get new equity investors if he screws over existing ones. Its not a smart move if he wants to grow his company.

      There also appear to be quite a few non-models on his management team but I do agree that the CEO appears quite inexperienced.

      As for your egg calculation (which I love!!):

      2013 Exchange Rate = 8.5 (Note UAH has depreciated significantly during crisis)
      Numbeo Price of 12 eggs in UAH (based on past 18 months) = 13.07 UAH
      Price per egg in USD = 13.07 / (12*8.5) = 0.1281 USD per egg
      This provides room for your 20-30 % markup. Although I admit this still seems low to me give the transportation costs and other middle men. I will have to look into this further. But I like your calculation.

      NUMBEO prices will be obtained during the year in the local currency. However when you convert to USD you are always converting using current exchange rates as can be shown by dividing the US numbeo prices by the UAH numbeo prices. Thus your exchange rate is wrong.

      As stated on the numbeo blog:

      "Currency exchange changes during the year so comparing values is even more difficult if only in certain months data are gathered for statistical purposes.:"

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  5. A critical risk: do we know the legal framework over there protects shareholders enough?

    This is a talk by hedge fundie Bill Browder. It contains a story how Russian criminals, involving the government at various levels, robbed his company.

    https://www.youtube.com/watch?v=84MsRuC-1l8

    I remember Liu Lu said he invested in Russia (and made a lot of money) when stuff was 20c on the dollar. He said that discount was enough to overcome the uncertainty.

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  6. Gazprom stock was Bernstein's #1 pick for Russia 2014 w $13 p/t or ~100% upside: http://www.bloomberg.com/news/2014-01-02/gazprom-top-pick-to-bernstein-for-2014-russia-overnight.html

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  7. A couple of comments:

    Paying cash to security holders is one of the best forms of proving a company is 'real'
    i) AVGR has paid US$60m of cash interest in the form of semi-annual interest payments on its Eurobonds since they were issued in October 2010
    ii) The company recently instituted a new dividend policy of paying out 15-40% of the prior years net income in dividends. For 2014 the board has set the dividend at 25% of 2013 net income which should equate to about US$60m or US$1 per GDR or a yield of about 11% on today's price. No doubt investors will take some comfort when that cash arrives in their accounts later this year.

    Given the US$10m semi-annual interest payments on the Eurobonds and the current dividend policy the company will be paying out roughly US$80m cash to security holders per year or 14% of the current market cap.

    There has been no instance of minority shareholders being treated poorly since AVGR listed in 2010 and the level of financial and operational disclosure at AVGR is much greater than the vast majority of businesses anywhere in the world.

    AVGR does pay very little tax as they get favourable tax treatment by virtue of being an agricultural company. First, they get to keep the VAT proceeds they receive from the sale of its products rather than remitting them to the government. This special VAT treatment will be effective through to 1 January 2018. Second, AVGR can elect to pay a 'fixed agricultural tax' rather than normal corporate income tax, again by virtue of being an agricultural company. Even if these favourable tax treatments are stripped out, the company is still very cheap on usual valuation metrics.

    The Chairman is Oleg Bakhmatyuk's (the owner's) sister. Not ideal but fully disclosed and not the first case of nepotism to be seen in a company (including in the US/Europe etc).

    Interestingly, Cargill recently paid US$200m for a 5% stake in Bakhmatyuk's Ukrlandfarming which holds his vast agricultural holdings including his 77% ownership of AVGR. The price implies a US$4bn value for Ukrlandfarming. It is hard to know how valuable the non-AVGR part of Ukrlandfarming is (and, therefore, what the implied value of AVGR is in this transaction) but it is encouraging nonetheless.

    http://www.ft.com/intl/cms/s/0/8dde553c-7b92-11e3-84af-00144feabdc0.html#axzz2wGvRGF6U

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  8. They sold 6.3 b eggs for 565 m. Little under 9 cents/egg. They stated in the report that the shell egg price for 2012 was .7 uah, about 8.6 cents/egg using the exchange rate back then. I think these are real profits but I could be wrong. If they are real then this is a business that is earning good returns and is growing, and they are in a simple business that you know will be around in some form unless things get seriously chaotic over there.

    Looking at their map, it looks like one of only 3 breeding farms is in crimea. I wonder how this will shake out with the new government?

    The thing that makes me wary of these companies is, what happens to you if you do screw shareholders over in these countries? At least in the U.S. people are worried about being sued. I doubt Bakhmatyuk is too scared of that.

    Do you have any plans to buy Nate? Or have you written this off as too risky?

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    1. Matt,

      I was thinking of opening a speculative position with this one. The more I think about it I might create a small basket of Ukrainian and Russian stocks and toss this in there. They're all very cheap right now. I agree with many posters that there is extreme political risk with a trade like this, but these companies are also at historical lows. Many of these cheap companies are vital to the Russian and Ukrainian economies, I don't just see them shutting down.

      It also looks like the US sanctions aren't going to be an issue for their economy.

      Nate

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  9. Just one more comment: The listed company is actually registred in Cyprus......

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  10. Is there a search feature on the blog? I think you wrote up Mexican Restaurants (CASA) a few years ago. It's being bought out at $4.06. It's not liquid enough to do anything with, but yet another example of your information arbitrage. Around 10k shares traded today below $3.00. Only place I could find the news was the otc website.

    I owned 100 shares from back when you first wrote it up (all I could get after trying to buy for a couple of weeks). Guess I'll treat myself to a nice dinner.

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  11. Net profit margins of 35% for an egg business? I don't even know if there are other publicly traded egg businesses, but I'd be highly skeptical unless you find such margins are normal for this industry.

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    1. Joshua:

      There is at least ONE other publicly traded egg company. Cal-Maine (CALM) foods in the USA. They can have good margins at the top of the cycle, but no where near 35% net.

      Delete
  12. I agree net profit margins of 35% are high. But Avangardco's business differs significantly from standard egg businesses.

    Avangardco is vertically integrated. Which means that they produce the chicken & the eggs. This brings some significant benefits (I don't know how many % points though).

    Transport of chickens is very expensive. Chickens can't survive long periods of transportation and are therefore in most cases transported by air. Transportation by air is far more expensive than transportation by road or by water.

    So a normal egg business buys chickens from another company for which they pay the costs of that company plus a profit margin. Transportation is a significant portion of costs.

    Avangardco has about 0 transport costs and pays no profit margin to another company.

    This explains (at least a portion of) the difference in profit margins compared to other egg businesses.

    Just some thoughts.

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    1. Interesting points Maarten. But then why wouldn't non-vertically integrated producers have been crowded out by vertically-integrated producers by now, all around the world? If there's a massive cost advantage to being vertically integrated, then wouldn't the industry have completely shifted in that direction? Just playing devil's advocate.

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  13. Here are the red flags for a possible fraud that I see. I got caught in a Chinese Fraud - I think it opened my eyes to red flags.

    1. 42% EBIT margin in 2012. ROE 24% on beginning book. There is no competitive advantage in producing eggs.
    2. $102m of tax recoverable - what is that?
    3. Looks like they make about .04 an egg or almost .50 a dozen. Seems like too much.
    4. At end of 2011 there was $237m of cash and $288m of debt for a net 51m. Finance cost in 2012 was ~$36m. Would you hold $237m of cash and have that kind of negative carry?
    5. Look a the pics on page 48 of the 2012 annual. You can form your own conclusions.
    6. The numbers look very steady and smooth.

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    1. These are good points, here are some general thoughts.

      1. There is a competitive advantage if you can form a monopoly in a market through political power. There are a lot of companies like this, they would have no advantage if it weren't through an political monopoly in their home country. The company has struggled to operate outside of a few favorite markets where they presumably have some sort of advantage.

      2. This is the tax credit they receive from Ukraine for being an agricultural company. Commenters above hit on this, they don't have to pay a portion of VAT.

      3. Not sure about egg prices in Ukraine, are they higher than the US?

      4. Good point.

      5. The company's board is stacked with family and friends? Surprised?

      6. What I'd expect from a monopoly.

      I haven't purchased any of this, I went a different route and purchased a Russian small cap etf, I'd consider building a position, but the ETF gives a bit more protection.

      Delete
    2. Re: point 4. If I had planned CapEx in thee coming year of $300 million and I was based in a country like Ukraine, YES I would.

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    3. Are you long on this Tim? I have followed you on COB&F forum for a while and I'd be interested to hear your thoughts.

      Anonymous, I had the same thoughts you did when I first looked at Avangardco. One thing to note about Cal-Maine is that they do not produce all of the eggs they sell. For the eggs they raise they reported a 78 cent cost/dozen, and their selling cost/dozen is 1.30. If Cal maine raised all their eggs and made a 40% margin on all their 1.29 B sales that would be a 516 m GP. They had 127 m sg&a so that would make for about a 30% EBIT margin. I guess the sg&a would go up some in this scenario, but that is not too far off what Avangardco's margin would have been if they had not had the 46 m income from special VAT treatment.

      I am thinking this company really is making this money because of special tax rules and lack of competition. I think the controlling shareholder probably got his money through unscrupulous means and I am a little uncomfortable with it. The fact that I own it may say more about the lack of opportunities elsewhere than it does about the attractiveness of Avangardco. Maybe I'll get burned and learn the hard way why Buffett and Munger only partner with good people. Anyway, I'd like to hear more thoughts about it from anyone who has looked into it.

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  14. Nate since you had to bring politics into your post, I have to reply. America has been the primary aggressor in all of this. The Pentagon's budget last year was $700B (US spends a total of $1.7 trillion on military EVERY year). Russia, by comparison, spent $91B. Who's really the bully here? I hope Putin is not making the same mistake that America has been making since 9/11, i.e. the colonization of the world by an imperial power.

    As for this stock has it ever paid a dividend? Nuff said.

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  15. According to this Avangardco had 23% market share of egg production and 53% for egg products in 2010. If they had a monopoly and earned those margins and ROIC I think that would make sense but it looks like there is a lot of competition. So there competitors should be killing them.



    http://www.kyivpost.com/content/business/billionaire-bakhmatyuk-finds-eggs-are-golden-74985.html

    “We are the engine of the industry,” he said adding that Avangardco’s closest competitors lag far behind. According to Bakhmatyuk, Avangardco holds an impressive market share of 23 percent of overall Ukrainian egg production and 53 percent of egg products.

    The other red flag is the capex. I have heard of companies with big capex where it is really a scheme to extract money out of the company.

    In China they bribe people who work in banks to falsify they cash balances for the auditors. All the numbers look great, nice and smooth - big cash balance on the balance sheet. Then one day everyone is gone along with investor money.

    If I had a position I would hire a couple of people in the UKraine to go in the supermarket and get me the competitive situation with pricing, competition, etc.

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