Sturm Ruger (NYSE:RGR): Is there Value in Guns?

Sturm Ruger is an American manufacturers of firearms namely pistols, shotguns and rifles. The company was founded in 1949 and is one of the largest producers of firearms in the states alongside their main listed competitor AOBC formerly Smith & Wesson.

Background Check

I have been having a look at RGR due to the apparent defensive nature of their business. Gun sales tend to rise due to economic fears, terrorist incidents, civil unrest, legislative threats of further gun control and the election of Democrats. 

97% of sales are domestic US so this means the stock is a pure play on American fear;

Gun Sales Rise after Shootings

Gun sales also rise ahead of restrictions - and peak before Christmas

This may also explain why the present moment does not offer the best entry point into RGR. The Republicans are in, there is little talk of new gun control measures and for now the economy is lumbering along. Both RGR and AOBC shares fell significantly on  June 30th after AOBC announced a weak outlook for the rest of the year. 

So I tactically I feel I need a better valuation point or catalyst to really want to own RGR now.

What I like about RGR

It has no debt. RGR runs net cash on the balance sheet meaning it is extremely under leveraged compared to most US corporates. This kind of balance sheet is highly unusual in this day and age and makes RGR significantly more robust than AOBC which is a rather more volatile share. 

Therefore somewhat unusually RGR finance their buybacks from cash:

RGR Annual Report

ROIC is extremely high. The company averages a 10 year median net rate of return of 19.7%. Similarly the 10 year average ROA is over 20%! This company has excellent returns and capital allocation and throws off a lot of cash.

The FCF yield is around 6-7% with no debt and the company pays out a dividend of around 40% of earnings yielding 3%. That dividend has been in place and growing since 2009. In terms of Earnings the PE is 14x last years earnings - which is a good discount to the wider market. 

There is also no ongoing pension liability as the company settled the scheme in 2014;

RGR Annual Report

So this is definitely the kind of stable business that I would consider highly investable for the long term. However the wider sell off in the sector and weak immediate term outlook means the stock may do nothing or trend down for some time.

Valuation

A quick valuation in my model with conservative growth assumptions (3% revenue growth, stable margins) gives a DCF value around $90 a share which is a good premium to the current value of $60. However it only scores a $45 price target on the DDM model due to the low dividend payout because of buybacks as an alternative capital distribution. 

I think with a turn up in underlying sales this stock could head up towards my $90 estimate but currently there seems little in the way of an immediate catalyst to turn the sales momentum back towards stronger growth. Certainly one to keep on eye on going foward.

Disclaimer: I have no investment in NYSE:RGR at present but may do in future. These are opinions only, not investment advice. If in doubt read my disclaimer.

Portfolio Strategy: July update

So a quick portfolio update as I have made a few changes in the past month increasing some positions.

Amiable Minotaur Portfolio

Performance

I will call this my First Quarter review as the portfolio began on the 19th of April so just less than one quarter of performance. How has performance been? Including all fees and costs I have returned -4.01% in GBP since inception and relative to FTSE AW which gained 2.82% in GBP I have under performed by 6.83% in the period! The big drag has been my Energy and Retail stocks under performing.

Not a great start - but in my experience a well chosen portfolio with fundamental characteristics can under perform for significant periods of time. One swallow does not make a spring.

I would also mention that I face various up front fees including an exorbitant 1.5% spread on FX transactions which has cost around 50bps of performance as I have bought dollars for various investments. Fortunately I can hold and settle in USD once I have some so going forward FX moves should be less of a drag at least until I buy things in Euros.

Cash drag is another issue as being under invested hurts relative performance in an upward market but it is hard to invest a portfolio all at once. I am at the end of the quarter holding 24% in cash and 19.3% in gold with only a 56.7% investment level in equities.

I expect to continue to under perform for as long as the wider market and especially the S&P grinds higher. The stronger GBP also has a negative impact on performance in absolute but not relative terms due to around 40% of the portfolio being in FX (mostly USD) and another 19.3% in Gold which acts as a proxy currency.

Stocks: The Worst and Best

My worst positions have been in US Energy and  Retail. 

These sectors have been laggards due to poor oil prices and weakening consumer spending. Value investing means looking for value often ahead of market turning points - immediate pain for long term gain.

I continue to think both Diamond Offshore and Bed, Bath and Beyond are undervalued fundamentally and the sectors as a whole are in a depression. This will likely continue for the medium term so I do not plan to add to these positions - but when energy demand increases and consumer spending rises I expect very strong performance from these bombed out sectors. 

The value of my holding Diamond Offshore is down around 16% over the period. The value of my holdings in Bed, Bath and Beyond is down 23%. 

Similarly my UK investments in these sectors; Next Plc and Tullow Oil have also been struggling but I have recently added to these on weakness.

The best positions have been in Gold Miners and IG Group. 

The Gold Miners have started to pick up a bit with Kirkland Lake having very strong performance up 19% due to exploration and insider buying alongside the removal of the GDXJ hangover. Acacia Mining has been up and down but is flat at 30 June awaiting news. Klondex has been outperforming too with only Goldcorp lagging a bit.

IG Group has been grinding higher since the big sell off on regulatory fears in December 2016. The stock is up 8% in the period in part due to benign regulatory actions in Europe. However a new Eurozone wide probe is delaying the UK regulatory enquiry until next year! This means the stock is 'dead money' for now to my mind but with a healthy dividend  I am happy to hold for now awaiting regulatory settlements.

Unfortunately these outperforming positions are some of my smaller ones. 

Developments

TLT

I sold my TLT bond ETF on the 14th of June following the Fed speech from Yellen. I made 3.5% overall. It seems to me that despite falling inflation the Fed seem intent on raising interest rates. The US credit growth is slowing and looks recessionary so if they were managing the economy this would be a bad idea. I believe this is because they in fact are trying to manage the level of the stock market - which has gotten rather too high. Rising rates and falling inflation is a bad environment for owning long duration bonds as the real interest rate picture will improve. 

Short term TIPS yields have all risen this month indicating rising expectations of higher real interest rates. Whilst I think the long term outlook for TLT is strong we need to see dovish moves from the Fed amidst the next recession before this really comes to the fore. So this is a tactical sale.

I bought SQQQ.

SQQQ is a 3x levered ETF which synthetically replicates the returns of the NASDAQ 100. As you will know I consider US stocks to be overvalued principally driven by overvaluation in the NASDAQ tech stocks. This is obviously a risky investment as if the index rises 30% I lose 90% of my position. However given that the Fed seems intent on attempting to 'manage down' the stock market a bit these stocks are highly vulnerable to a significant correction. 

Stocks like Apple, Amazon, Google and Facebook are all great businesses but the price of these companies is frankly outrageous. Similarly Netflix or Tesla are not even good businesses and their prices are even more outrageous. I am looking for a correction of at least 10% in the underlying index and probably more like 30% due to the fact that these stocks are likely being driven higher by passive ETF flows and algos which only know how to buy a bull market...what happens when that goes into reverse?

So this position (I wont call it an investment - it is tactical) - is a 3% of the portfolio. Now it is 3x levered so the real exposure is 9% of the portfolio and it is short so I now have the following levels invested:

Long Equity - 53.7%
Short Equity - 9.1%
Net Exposure - 44.6%

I consider SQQQ downside insurance against a broader drop in the stock market as this seems one of the most vulnerable areas.

Amiable Minotaur Portfolio

Gold Stocks

I continue to like Gold Mining stocks and have added to my position in Klondex Mines which has started to move upward as we move away from the GDXJ rebalancing debacle. 

I also continue to hold Acacia Mining as we await developments in Tanzania - now the big guns at Barrick Gold have weighed in I foresee some kind of revised royalty terms and a resumption of exports hopefully within the next month.

Kirkland Lake announced new exploration results which were very positive and the stock also has been gaining some momentum. If the gold prices moves up I expect these stocks to do very well.

I continue to hold some Goldcorp to give big-cap diversified exposure to gold.

Weights are:
ACA        2.7%
KLDX    4.7%
KL          1.8%
GG          2.4%

On the topic of Gold

I have been selectively adding to my Gold ETF position in GBSS and this now sits at 19.3% of the portfolio. I am reluctant to take any holding over 20% of the portfolio but have been keen to move cash away from GBP with recent strength in GBP and weakness in the Gold price. GBP cash stands at 22.8% with 1.2% of the portfolio cash in USD (most USD exposure is invested.)

Aside from ones view on Gold overall the negative real interest rates in the UK make holdings some Gold over GBP cash a 'no brainer' as far as I can see. Gold also acts as a cash proxy and with only brokerage to pay on ETF transactions it works out a lot cheaper to buy than FX. The only reason to own GBP over gold would be a significant change in the rate picture for the BOE - but with UK inflation running at around 3% and rates on the floor the BOE have a long way to go to create positive real interest rates. Recent hawkish comments have had some impact on GBP and I have taken this as an opportunity to add to gold. 

The BOE are behind the curve on rate rises vis-a-vis the Fed in my opinion as they have nowhere to go as the next recession hits except more negative. 

This is one reason I stay bullish on Gold - it is not really wealth creation only the protection of purchasing power.

Total Gold exposure is 31% of the portfolio (Miners + Physical ETF).

Position Sizes

My biggest positions in terms of sectors are Gold Miners, Retail and Energy. 

Amiable Minotaur Portfolio

My biggest single stock position is Next plc at 7% which I added to on recent weakness. I continue to love this depressed stock - it has brilliant capital management, a flexible business model, excellent high street and internet presence and a strong mid market proposition. I think it is seriously undervalued. The market disagrees.

I also have upped my Tullow Oil exposure  to 5.5% as a trade on higher oil prices. The recent sell off to new lows in oil last week lead to excessive bearishness on the oil price. I expect some OPEC 'news' imminently to prop up prices - they may have low well head prices but they have big social budget constraints and the Saudis in particular have a major cash flow problem for their handout based social model.

Remember I sold down TLW from an older portfolio around the rights period after it ralled ex rights to £2.40 a share! I have been buying again under £1.60 as TLW has improving cash flow generation and low cost offshore oil production.

Interestingly my smallest stock exposure is Guaranty Trust Bank at 1.4% which has proved a great performer up 15% since April 24th. This is highly illiquid though so big trades can move the price significantly.

An Observation

I tend to prefer Mid cap stocks and small caps to large caps at this point. This is really a bottom up observation as I haven't been looking for any particular cap size. My only large cap holdings are Goldcorp and then SQQQ and IBZL ETFs which are principally large cap.

Amiable Minotaur Portfolio

Conclusion

I remain bearish overall as regards the wider market. Volatility is very low, equity prices are very high, central bank liquidity is very high, interest rates are very low. Not exactly fertile conditions for findings assets at attractive prices. I remain long term bullish commodities and associated stocks and gold due to under valuation vs financial assets. 

Clearly my investments in Energy and Retail have been a touch too early but I still believe both sectors are signalling recession and will be the first places to pick up on the other side of a downturn.


Disclaimer: I have an interest in all the securities mentioned in this article at present but i may change these in the future. These are opinions only, not investment advice. Construct your own portfolios with due care and attention.  If in doubt read my disclaimer.

Tesla (NASDAQ:TSLA) - Read Between The Lines

Tesla has become every short sellers nightmare. Mine included. It is the stock that just won't die despite its hideous 'cash burn rate' evocative of the Dot Com bubble. Much has been written by minds much smarter than mine (See Mark Spiegel's analysis) on the subject of Tesla's financials, the upcoming competition in the market, the build quality issues and the dangers of the autopilot.

I wanted to look at something a little different and that is the motivations and truth revealed by actions as opposed to words. As investors we always look for insider buying and selling as a yardstick for what management do with their own cash - this tells us much more than words. 

A guy like Elon Musk of course knows this - so he borrows some more against his stock to buy into his equity raises - giving the idea of firm commitment. Insider buying is a great yardstick unless the business in question is a 'confidence' business which means either a bank or another business that requires constant funding....like Tesla.

But I digress....

"As I grow older, I pay less attention to what men say. I just watch what they do."

           -Andrew Carnegie 

"And so when Cora Tull would tell me I was not a true mother, I would think how words go straight up in a thin, line, quick and harmless, and how terribly doing goes along the earth, clinging to it, so that after a while the two lines are too far apart for the same person to straddle from one to the other and that sin and love and fear are-just sounds that people who never sinned nor loved nor feared have for what they never had and cannot have until they forget the words. Like Cora, who could never even cook."

          -William Faulkner As I Lay Dying

So in that spirit let us make a few simple observations in relation to Elon Musk and Tesla. I have my own theory that 'everyobody tells you everything you need to know' if you read between the lines - it is like a form of dupers delight. Here is an example:

I read these Tweets as admissions of failure. He is saying that starting Tesla has nothing to do with making money. Think about this for a minute. The guy has a company with a $60bn market cap with which he never intended to make money.

Now the second tweet. I think he knows Tesla is failing - why would you be mulling over the origins of your business on Twitter, the great gamble of it all...if it weren't for the fact that you think it is failing? Maybe he is preparing the runway...

Or just chilling to get away from the stress....

This excellent article from the Buffalo News tells you a lot - they report that the $750m former Solarcity (now Tesla) factory still remains effectively mothballed with a skeleton staff. Here are the things they are saying in this article:

Tesla has promised to hire 500 people to work in the factory within two years of its completion and create a total of 1,460 jobs in Buffalo within five years. But the clock does not start ticking on those deadlines until all of the manufacturing equipment has been acquired and delivered to the factory – a condition that has not yet been met.

Action undertaken: Funnily enough they have not been racing to complete the factory. The state government still think its on:

"It has all of the ingredients for great success," Zemsky said. "When that cake comes out of the oven – whether it's in the second quarter or the fourth quarter or mid-2018, I don't know – all of the ingredients are there for tremendous success. That's what I believe."

Hope is not an investment strategy. And the State government is hardly going admit its financing a huge white elephant...a white elephant with very little realisable value:

"By shifting more of the state funding toward the building, the contract amendments have reduced the amount of state money being used to purchase equipment and increased Tesla's obligation to purchase machinery. Tesla – not the state – will own any of the equipment purchased with the electric vehicle maker's funds."

If you never plan to actually open the factory, and your having to ramp it up is conditional on having all the equipment delivered why not just deliver some equipment (that you retain the rights of ownership on) and then sit on it. Do not install it - do not given tours of the factory.... 

Think about what a bad deal the state is giving themselves. Tesla can sell the equipment and leave the state with a huge white elephant of a an empty factory. 

What is the realisable value of an empty purpose built factory in Buffalo? 

Oh and if I were Tesla I would probably look to find a buyer pretty sharpish for that equipment...

Tesla now says the panels produced at the Buffalo plant will be a hybrid product that combines elements of the high-efficiency technology from both Silevo and Panasonic. As part of that deal, Panasonic is investing $256 million in the Buffalo factory, further easing Tesla's financing demands as it gears up for production to begin.

Hybrid product means the Silevo technology is technically rubbish and Panasonic have a better one. The Panasonic deal means another sucker (following the state government) is invested in this project and getting it built. Panasonic has workable technology evidently. What Tesla is doing here is setting up a deal where Panasonic has to buy them out because they will waste enough of Panasonic's money that the sunk costs become unbearable.

Oh and then you can be super clever and paint the deal as a factor slowing the progress on the project.

Smith said he believes SolarCity’s purchase by Tesla and the Panasonic manufacturing arrangement has contributed to delays in opening the factory.

The bottom line is Tesla are not remotely rushing to finish the factory. Otherwise they would be finishing it! 

The reason is making solar panels and selling them is no longer profitable. Tesla know that opening the factory will increase their cash flow drain more than keeping it closed. In the meantime they are hoping to suck Panasonic in to take it off their hands....

You could say this is all conjecture. You would be right. But it is obvious.

Read between the lines. You cannot trust any investment with Tesla written on it. 

Disclaimer: I have a modest short position in(NASDAQ:TLSA) Tesla. These are opinions only, not investment advice. If in doubt read my disclaimer. 

Grains & Canes; Adecoagro (NYSE:AGRO): Investment Case: Part II

After my qualitative discussion in Part I it is time to explore some risks and the valuation of Adecoagro:

Risks

Currency 

Although the Brazilian Real and the Argentine peso have suffered huge devaluations in recent years the local inflation rates play a part. This means that in real terms with 40% inflation in Argentina for instance costs have been rising in USD as the currency depreciates below that rate.

Adecoagro earns most of its revenues in dollars through commodity exports or in items linked to commodities and dollar prices such as Ethanol. This means the company does better when local currencies depreciate against the USD as it reduces their local costs.

The worst case macro scenario for the company would be a strong dollar driving down commodity prices in combination with also stronger BRL and AR$ rates driving up costs. This is an unlikely scenario and would require particular macro conditions in Brazil or Argentina to prevail that made their currencies appreciate with the dollar.

The debt of the company is split around 3/4 USD and 1/4 BRL:

Company Presentation

Lending in AR$ is essentially only short term due to very negative real interest rates. The debt seems fairly well matched in terms of currency given the domestic exposure to Brazil and predominantly USD derived revenue. Note also Net debt has been declining as the company pay down debt following a major expansion in sugar capacity (some of which is still ongoing.) 

Generally the debt levels are unconcerning to my mind at sub 2x EBITDA. Given that the appraised market value of the companies land holdings alone is $870m and they carry net debt of $600m it is effectively collateralized (but note the debt is mostly for the Brazil plants rather than Argentina farmland). It would be imprudent for a commodity company to carry high financial leverage due to the existing operating leverage and instability of the business. Still they do pay interest in excess of 6% on these debts (in part due to high rates in BRL) although interest coverage was around 3.5x last year which is reasonable especially given that net debt has expanded recently in part to finance the expansion of capacity which is now coming on stream.

Foreign Ownership Rules

Country and ownership rules mean it can be difficult to acquire land or hold onto it. Both Brazil and Argentina have foreign ownership rules and restrictions on land. 

Argentina has foreign ownership rules which restricts individual foreign owners from owning more than 1,000 hectares of land in the core area of the country. These were implemented in 2011. Presently Adecoagro have more than 200,000 hectares of land in Argentina but the restrictions are not retroactive however they do limit the ability of the company to acquire additional land in Argentina. This is however also a significant barrier to entry for competitors (or at least foreign ones) to build scale in the country.

Brazil has similar restrictions for similar reasons although the operations of the company are different there as they lease most of the sugarcane land and are instead more focused on industrial production of sugar and ethanol than actual land acquisition.

Obviously environmental disasters/problems can cause significant problems for production. Floods, droughts etc can mean entire crops are lost. One advantage is the diversity of crops that Adecoagro produce but still their geographical concentration is high. Environmental problems elsewhere can however be a boost due to raised global price conditions for a given commodity.

Is it cheap? How can we value it?

This has been a major headache. The reason being the predictability of earnings is hard as the company is something of a black box - by which I mean beyond say 1 - 2 years who can say what they will be planting - Soy or Corn? and what they will be producing? Ethanol or Sugar? As these decisions are all market condition dependent. This makes it very difficult to make a relevant and accurate DCF model.

This is further complicated by the accounting. Farmland is recorded at book value, crops to be harvested are carried as biological assets and there is a complex cash flow hedge accounting arrangement between the debt and expected revenues. Therefore the earnings look awful at +200x trailing PE! But the best thing is to focus on cash flow in my opinion.

What I can say is I think the stock is cheap for the following reasons:

Free cash flow:

Company Presentation

The company made positive free cash flow last year of $133m ($85m inc expansion capex) following several years of heavy investment and this gives gross and net FCF yields of 10.6% and 6.8% respectively. Note also 6 years of continued strong growth in operating cash flow, with the heavy investment of 2011-2015 in sugar capacity growth which is now operating. 

Remember this positive cash flow growth is during a generally depressed period in agricultural commodity pricing.

Capacity:

As I mentioned in Part I production capacity has expanded greatly in the past 5 years even while commodity prices have tumbled and the stock price has been broadly flat that whole time. So cyclically there should be great latent earnings capacity during a cyclical upturn.

Book value adjustment:

The company has a lot of land recorded at book value especially in Argentina which was acquired cheaply following the 2001 crisis. The book value is $122m -If we take the company's independent land value appraisal of $870m this means the accounts understate the value of the business by ~$750m. Currently the stock has a market cap of $1.2bn and book value of $671m meaning Price/Book is 1.8x but adjusting for this market value would increase book value to $1.42bn making the Price/Book 0.85x. 

Cheap.

Now yes stocks can trade below book value and not be cheap - it depends on the return on assets and the value of the assets underlying the business. But most of the other assets other than the revalued farmland are also tangible ~$500m+ of plant, machinery and buildings (recently built) from the sugar operation and ~$600m current in cash, inventories, unharvested crops and receivables offset by debt and current liabilities. No significant intangibles ($17m), deferred tax balances ($38m assets and $15m liabilities) or other difficult to realise assets.

Now those sugar / ethanol assets are very productive. In the segmental analysis the company notes the following assets in that business; 

2016 Annual Financial Statements

The Sugar/Ethanol segment generated EBIT of $142m last year on assets of $831m ~ 17% EBIT / Asset return. Even subtracting a proportional $40m in interest and taxing that at 34% gives net $67m and would give an ROA of 8%. Now lever that with the $298m of equity in this segment and you get an ROE of 22.5%. 

Note also the ROA +20% in farming but this is really much lower if we adjust the farmland to market value - because farming has low productivity of assets. If we take the farming EBIT of $49m less $10m in interest and taxing at 34% this gives $25m. Divide this by the assets of $245m + $750m MV = $995m and we have an ROA of just 2.5%. Now lever that with the $893m of equity in this segment and you get an ROE of just 2.7%. 

What does this tell us? Well farming has a poor ROE compared to the sugar and Ethanol business. But there are a few important reasons for this:

• The farming assets are owned outright with very low leverage (adj for market value) hence the low ROE. This is a good defensive strategy for selling commodities as your operating leverage is already high.
• The Brazilian lands for sugar cane are mostly leased so are off balance sheet driving up the ROA - also industrial assets should be inherently more productive due to greater capital efficiency
• The Brazilian assets have higher leverage and hence a better ROE (but they are now paying down debt)
• Remember the farming assets were acquired at very low prices meaning their ROA and ROE base level is extremely high. If we back out the market value adjustment ROA and ROE are 10.2% and 17.5%. This is an unrepeatable feat and is a 'mini moat' shall we say...

Now also remember that sugar pricing has been better in the past few years while grains have remained depressed - so there is cyclical upside in the farming business.

The Bottom Line:

So what is it worth? I will be conservative and say 1x adjusted book value or ~$12 a share (+20% from current levels). This is however not factoring in cyclical improvements in commodity prices and other improvements in efficiency and scale. 

Why 1x Book? Well that seems a fair and conservative price to put on the business assuming one wanted to start from scratch to make a similar business. Given the tangible nature of the assets a low multiple seems warranted but it does also provide some bearing on the realisable value of the assets of the company. 

As a quick excercise combining the two segments of the business we get our pro forma earnings post tax of $67m + $25m = $69m. Now subtract $20m in overhead at 34% tax means ~$56m in earnings. The equity value of the business is $440m + $750 MV adj =  $1.19bn which is a 4.7% ROE. 

I would not pay a lot more than 1x book for a business with a 4.7% ROE - but I feel this could be improved in future by better profitability from improved pricing. Also remember this is the adjusted ROE - if the business actually could revalue the land and release some of that adjusted equity the equity base would be lower meaning a more capitally efficient business.

I can't help but wonder how much the founders have made from this business before the IPO in 2011 - buying up farmland which with improvement is now worth 8x more! However I still see value here for a patient investor such as myself betting on a longer run improvement in commodity prices and happy to take a cash cow option on that for the future which trades below its book value.

Disclaimer: I am long NYSE:AGRO at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

Grains & Canes; Adecoagro (NYSE:AGRO): Investment Case: Part I

If you want to find an unloved sector look no further than soft commodities. Agricultural products in particular grains look cheap having been in a cyclical bear market for several years now. With most stocks and financial assets looking decidedly pricey I wanted to set out my investment case for my recent purchase of Adecoagro. 

Adecoagro is a Latin American agribusiness venture centred in Brazil and Argentina. The company is a scarce pure play on agricultural commodities as most stocks in this sector gain exposure through fertilizers, equipment or single commodity businesses like Indonesian Palm Oil stocks.

Adecoagro Presentation

Initially Adecoagro was focused in acquiring farmland in Argentina following the 2001 crisis and growing grains. In the past few years the company has expanded strongly into sugarcane and ethanol production in Brazil. 

Why Soft Commodities?

Well as I noted in my thesis on CMP they currently look cheap - soft commodities in particular are in a multi year bear market;

StockCharts.com: Bloomberg Grains Index

Somehow we need to feed the world with a growing population of people. Now obviously over the past century crop yields have achieved fantastic improvements - but structurally more farmland and higher outputs will be required to keep pace with the growth of mouths to feed. Only Africa and Latin America have substantial untapped and underdeveloped land.

Adecoagro has the scale, diversity and capital to be able to change crops to suit market conditions and also to grow the business in the direction of demand. At present they produce Rice, Soy, Wheat and Corn. Aside from grains they also produce dairy. 

However the main business is sugar. They have grown scale in sugar substantially in recent years and much of the cane is crushed by Adecoagro and used for producing ethanol. In Brazil ethanol is a common additive to fuels and is used extensively.

Company Presentation: Ethanol & Sugar production

Now sugar too has been in a cyclical bear market although prices rose substantially last year;

StockCharts.com: Bloomberg Sugar Index

So with generally depressed pricing for their major products how has the share price done?

Well it has been stable, rising about 6% over the past 5 years:

Google Finance

I think the reason for this is that underneath the lower prices for their products Adecoagro has expanded production massively. The underlying volumes and capacity of the company have increased greatly meaning a cyclical turn in pricing could lead to an explosive financial performance:

Company Presentation

Note how production has increased in the past 5 years. Farming area +15%, farming production +41%. Then see sugar planted +109% and sugar crushed up 165%. But sales in farming have been flat and sugar sales up only 58% due to weak pricing. Despite all this the company has improved the EBITDA margin by 710-bps in the meantime. Corporate expenses are down every year for the past  5 years. This to me has the hallmarks of a very good operation.

What is Adecoagro's sustainable competitive advantage?

Agriculture does not lend itself to 'moats' generally due to commodity pricing and high competition. However the company does have a few good resources;

Land is scarce and irreplaceable. 

Good farmland more so. They acquired a lot of land in Argentina after the 2001 crisis when it was cheap. They own most of their farmland in Argentina. Today due to foreign ownership rules enacted in 2011 this would not be possible. 

More recently they have expanded into Brazil where they lease most of their land. The book value of land is presently $122m whilst an independent appraisal now values that at $871m. Adecoagro develop and enhance land that they acquire for agriculture. They tend to sell small portions of the developed land bank each year and acquire new areas.

Farmland in Brazil and Argentina is incredibly productive. For instance the humid pampas in Argentina allow farmers to plant two crops a year due to the excellent growing conditions. This means Adecoagro are a low cost producer - wages are low and productivity is high in these areas. Transport logistics are a headache but in Argentina at least access to the Rio de la plata mean shipping is relatively economical.

Note also that the company itself is a scarce asset. It is highly unusual to find a listed agricultural producer. Most methods to gain exposure to agriculture require investing in fertilizer companies (Potashcorp/Mosaic), seed/GMO stocks (Monsanto) or farming equipment stocks (John Deere.) Most farms are disparate and privately owned - therefore Adecoagro is somewhat unique and unusual as a pure play on Agricultural commodity prices.

Other things of note

Adecoagro also are building scale in sugar and a ready home market for bio ethanol in Brazil. Much of their sugar cane is crushed to produce bio ethanol fuel. Since 1976 the government has mandated that all vehicles must run on a minimum amount of ethanol. Between 20 and 25% of fuels are ethanol based. The ethanol in Brazil is grown from sugar rather than Corn which is used in the US. Sugar is a much more efficient crop for producing ethanol due to the extremely high photosynthetic energy efficiency of the crop.

This means the economics of bio ethanol production are good in Brazil - the ethanol is already in the country reducing transport costs and a ready and substantial home market exists. This is of course government policy and could change but it has been in place for over 40 years.

pri.org

Ethanol prices generally trade at a discount to gasoline due to the lower energetic content of the fuel - therefore with low oil prices we would expect weaker returns from Adecoagro's ethanol division. 

The company has an all star management team; The venture was originally driven by George Soros and the company was managed by Alan Boyce. Alan Boyce remains on the board today and is an amazing authority on all things agricultural despite having a background originally as a fixed income trader. You can watch his videos on Realvision if you are a subscriber. The company has extensive local directors and a good track record of managing crisis.

The Qualitatively important points

There is so much to say about this stock - the 20F filing alone is a nearly 200 page treasure trove of data. But to my mind the key drivers for the stock will be:

• Sugar prices
• Brazilian ethanol prices, demand and oil price
• Soft commodity prices/ USD strength
• Localised weather events and yields
• Argentine & Brazilian macro events

So having established this, is the stock cheap?

Valuation & Risks

Please see part II for my discussion on valuation and risks - coming shortly.

Disclaimer: I am long NYSE:AGRO at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

A quick note on Bed, Bath & Beyond (NYSE:BBBY): How Women Shop...

This weekend I was enjoying The Investors Podcast episode 143 which featured a round table discussion on four stock picks. One of these was a stock I own namely BBBY. As I noted before this is a very cheap retail stock and I like the valuation despite the rise of peak Amazon.

During the podcast it was interesting to hear their discussion on BBBY and the ways in which the margin had declined and whilst it was cheap it was potentially a value trap. Preston Pysh was saying how he would just buy all the things BBBY had on Amazon. At this point I paused the podcast and had a chat with my lady about this - and it is something i mentioned in my original note on BBBY:

 'I think retailers with things like clothes, home-wares, furniture etc have a greater chance of survival against total 'e-commercialization' due to the tactile nature of their products.'

The way women shop is different from men. These men think like me - I want a specific thing - I go on Amazon and order it - it saves hassle and is usually cheaper than driving to a store. This fails to capture how women shop. Women want to go and browse things, smell them, sense them etc - my partner declared she would never buy a towel or bath accouterments online as she wants to feel them first and check the colour in person.

Funnily enough on resuming the podcast it turns out that everyone's wives do shop there too! If you do not already follow this podcast I highly recommend it to any would-be value investor - it is a great moment in the this episode....

So I retain the view that whilst BBBY is ultimately a 'no moat' business the fact that most of their customer base are women means it is more likely to survive in physical format than an electronics retailer. I still see this as a cyclical downturn in the US economy as much as it is a structural change in retailing.

Disclaimer: I am long NASDAQ:BBBY at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

Compass Minerals International (NYSE:CMP): An alternative play of Agriculture: Part II

So I have covered my qualitative thesis on CMP in Part I - now I want to talk a little about valuation.

Risks:

Debt.

Debt is high in CMP - it looks very high against current comps at 65% of capital and 4x EBITDA but this only captures one partial first year of Produquimica in the equation and the full balance sheet year end debt.

However debt levels are still high. CMP were downgraded one notch by Moodys to Ba2 following the acquisition due to the elevated debt levels of the company. They have bonds totalling $500m issued in the market but funded most of the acquisition by expanding their revolving credit facility. Some $130m is due for repayment/refinancing this year but most of the credit is not repayable before 2021 so there is decent headroom to pay down debt and drive up profitability in the meantime.

CMP Annual Report 2016

The total debt load means interest payments should be north of $50m this year alone. The company has a reasonable ability to generate free cash flow but a lot hinges on the success of Brazil and firmer salt prices. You can carry this kind of leverage in a utility (i.e a stable business like salt) but it is dangerous in a cyclical commodity stock which CMP is becoming.

Amiable Minotaur CMP Model - Net Debt & ROE projection

With reduced Capex expected in 2017 down 25% at ~$130m there should be decent free cash flow generation to pay down some debt whilst still maintaining the dividend.

Dividend.

The dividend from CMP is high for a US company. They do not buy back stock instead they pay a dividend which was $2.76 a share last year with a yield of 4.2% that is quite high. The total cash payout was $94m in 2016. The risk is FCF generation is too low this year and that dividend gets cut. It is generous anyway but a cut in the dividend could seriously harm sentiment toward the stock despite not changing its real intrinsic value. On the other hand should it be maintained the chance to own an option on higher fertilizer and salt prices from cyclical lows, that pays 4.2% a year, seems quite attractive.

Amiable Minotaur CMP Model - EPS/DPS history and estimates

Honestly I think they should halve the dividend and pay down some debt for three years even as an equity investor. I don't think they will though due to the signalling.

Pensions.

Not a big risk. They have a legacy defined benefit scheme in the UK but it is fully funded (albeit with a slightly high discount rate around ~3.8% - high for the UK anyway) -  the total liability is relatively small at $60m or so. Therefore pension blow up risk is muted.

Margins.

The current picture for margins is slightly problematic. The company discloses an EBITDA margin in Salt of  25% last year and it has been steadily improving despite cyclical weakness. In North American ferts the margins are disclosed as 28% for 2016. The South American margins are much lower at 18.8% last year diluting the combined ferts margin proforma to 22%. So from a margin perspective the Brazil acquisition is not immediately accretive. There may however be significant improvement in future from synergies and best practices. 

Generally I should note the history of CMP is one of excellent capital allocation with 10 year median ROIC at 13.9% so I feel they have a good track record of growing by acquisition and organically.

The Valuation:

I see a tough year in 2017 for CMP trading at around 21x PE due to weak salt pricing and low margins in Brazil following the acquisition. So near term it looks a little expensive but looking further out on my DCF and DDM models I see good upside with price targets of $114 and $75 respectively. Ultimately I think CMP is worth around $80 a share without cyclical improvements in fertilizer prices and with a slight recovery in the salt segment pricing in the high debt risk to that DCF valuation.

[My assumptions are a Ke of 6.7% (RF 2.5%, RP 6%, Beta 0.7) and a Kd of 5.5% pre tax giving a WACC of just 5.17% - which accounts for the lower target price on the DDM despite the relatively high payout ratio. DDM growth rate was 3%]

Portfolio:

Therefore I think CMP offers reasonable upside of 20% to fair value with a 4% yield and potential as a leveraged option to higher fertilizer prices and better than expected synergies with Brazil. I like the macro positioning, annual share price depreciation to date, decent moats in Salt and SOP and a stable dividend.

From a Porfolio perspective this adds exposure to a new sector; Basic Materials, it has diversified economic risk across North and South America and it has exposure to the agricultural cycle which none of my other investments presently do.

Disclaimer: I am long NYSE:CMP at present. These are opinions only, not investment advice. If in doubt read my disclaimer.