A big risk when buying a company that is cheaper than its peers, is how expensive are those peers? If your company is trading at 20x earnings and your competitors are at 25x, both may be expensive. That is why value investors look for companies that are cheap on a absolute basis.
The financial crisis created a great opportunity for those who were patient and willing to do some work. What no one talks about is how much excess growth there was in the highly leveraged economy. How many more millionaires were created in the last 10 years that may not have been created by just flipping houses? I often wonder how strong earnings and revenue growth would be if the western consumer wasn’t encouraged to lever up so dramatically. How strong would the trends have been without the use of leverage? What would the growth rate have been? I’m not saying that we aren’t running out of oil, or that corporate earnings shouldn’t have grown over the last 10 years, I’m contemplating what the growth rate should have been. With the focus on the aftermath of the crisis, I find it easier to buy companies who have certain trends that are in their favor, even if the trend isn’t as strong as it was before.
I know what you are thinking, get on with it. My point is that I think I can spot a couple of trends to help my portfolio. I think the rising middle class in the emerging markets, China more specifically, will continue to drive the agriculture sector into higher revenues and profits, even if it doesn’t happen right away. I am not really a macro guy, but I have trouble investing in a sector that seems likely to be dramatically different by the end of my timeframe, the process of renting movies will probably be quite different in 3-5 years from now. The tailwinds for the entire sector may be the catalyst I am looking for.
Enter Migao. Migao came onto a screen I ran about two months ago. I had been doing some light research on the fertilizer industry for a while, but decided that now was the time to try to understand what are the key drivers going forward.
Migao operates fertilizer production plants (4 currently) in the PRC (People’s Republic of China) for the sale of specialty potash fertilizer, consisting of potassium nitrate and potassium sulphate. Here are some important points to consider…
- Current production (combined) is 320,000 tonnes annually
- Construction has been restarted to expand capacity by end of 2010, and continue to expand to total of 500,000 annual capacity.
- Also have a joint venture with SQM,
- Biggest input cost is potassium chloride
- Prices have started to firm in q4 09
- Inventory is high from management “purchasing at a oppourtune time”
- Looking to expand outside of China, though have nothing really concrete, to avoid the 105% export tax. Have an office set up in Singapore for the expansion.
- Seem to have ability to pass on costs, gross margin target is 22-24% and has been met
- Some of their plants are going to have to pay higher taxes in the coming years (from 12% to 25%) as they are going to be more than 5 years old
- top 5 customers are around 50% of revenue
- 54 million in debt (short-term) and 73 million in cash, before recent financing
- The customer mix has changed from 70% tobacco, 30% fruit and vegetables, to 50/50. The fruit and vegetables market look like it will be the growth engine for the company.
- CEO (Liu Guocai, don’t ask me to pronounce it) owns 33% of the company, and he went without his $100,000/year salary to help finance the company’s growth
- High teens pretax ROIC even in the event of capacity expansion, and a recession. This number could higher as the company has always been debt averse
- CCC has been trending higher at a very quick rate. Most of this is due to inventory increases. This is a pretty important fact, it this company can’t move inventory, then it is in trouble. According to the latest annual report the majority of inventory is “goods in transport”. This makes it a little easier to live with such a high CCC, which should moderate as the economy recovers and the market absorbs the new capacity.
- EBITDA margins in the high teens
- These margins should be able to be maintained or even improved as the company scales in higher production.
The only company that you can really compare MGO to in Canada is Hanfeng Evergreen (HF). HF has different fertilizers, including slow and controlled release, and a broader revenue stream. The same tailwinds that drive MGO should drive HF. HF also has aggressive expansion plans and usually carries no debt, unless needed for working capital. As with MGO, the CCC of HF has been rising, but instead of just DIO rising, it has been DIO and DSO, (days inventory and days sales). The numbers are somewhat tough to use because MGO recently changed its fiscal year-end.
As you can see MGO is the more profitable company. But it trades at a discount on net cash P/E (7.64 vs. 13.00) and on TBV (1.28 vs. 1.58). Maybe it should trade at a discount due to better prospects for HF that I am missing. But MGO also trades at a discount to other “fertilizer” and “ag trade” stocks, like Potash corp, Mosiac, Monsanto, Agrium. I know, I know, you can’t just compare any ag company to another. My thinking is, if (or when) the money pours back into this sector, “A rising tide lifts all ships.”, I want to own the cheapest ship.
- This is very tough for a fast growing company, but I will take a stab at it …
- EV/EBITDA trigger is $5.95
- EPV is $5.75
- DCF trigger is $6.65
- Discount to immediate peer (HF) is around 25%, and to entire “ag trade” is 50% or so
- Fair value is at least 14-15, but may reach high teens if I am right about agriculture
Summary and Risks
- Share dilution will probably happen if management wants to pursue the rapid expansion plans.
- The demand for all fertilizer or just MGO’s fertilizer falls
- MGO enters into the lower end of the fertilizer market, all that expansion has to go somewhere, and is faced with heavier competition
- MGO can’t pass on higher potassium chloride costs, gross margins fall
- Oh yeah, this company does business in China, anything can happen.
You are buying a company with a single digit multiple that is looking to expand capacity dramatically. This company has high ROIC and management is on your side. Oh yeah, you are entering a secular growth story.
All information was obtained through Sedar, Sedi and various company reports. If there is anyone who wants to share some more detailed knowledge on the sector or company, feel free to comment.
The author owns shares of MGO at time of writing.