Post by
mountainpose on Jul 26, 2018 11:07am
Don't need to read it all. But DO READ FIRST paragraph.
This is a reprint of my prior post. It's much worse now. Company is not sustainable in current form. None of it made any sense. That said I believe Fairfax may keep them afloat for awhile and/or they get bought out by one of the hungry new players. Scary company! Summary Net debt stands at an astonishing 11.5x LTM Adj EBITDA and net debt excluding preferred shares at still stretched 8.3x LTM Adj EBITDA; interest coverage on verge of tripping covenant. Adjusted EBITDA is not an accurate representation of AGT's cash flow; the company has generated positive cash flow from operations in just 2 out of the last 10 years. Management has been increasing "non-recurring" add-backs and also recently reclassified interest expense on the cash flow statement from cash flow operations to cash flow from financing seemingly obfuscating cash burn. The current pulse "cycle" is now below prior troughs in terms of both volumes and margins, and largest international importer of pulses, India, is making structural changes to their industry to establish self-sufficiency, effectively cutting AGT off as a customer. Management sounds alarmed heading into the weak Q2-18 period. End-market collapse may lead to a potential bankruptcy scenario - TARGET: $4.15/share or 75% downside. AGT Food and Ingredients (OTCPK:AGXXF) is one of the largest value-added pulse processors in the world. Pulse processing includes peeling, splitting, colour sorting, calibrating, cleaning, de-stoning, polishing, and packaging. AGT purchases pulse crops (e.g., lentils, peas, chickpeas, and beans) from local producers; performs value-added processing such as cleaning, colour sorting, peeling, and splitting; and ships the finished products to customers in more than 85 countries. AGT reports in 3 segments, but the business can more easily be divided between their core Legacy business, described above, and their Packaged Food and Ingredients business which sells pasta, canned foods and processed pulse fractions intended as inputs into other packaged goods (pet food, cereals, snacks, etc). In 2017, AGT generated roughly 50% of Adjusted EBITDA from each business unit. AGT is a capital-heavy, cyclical commodity business with slim margins and perpetually low returns on capital. Despite this, the business has strapped on a shockingly large and increasingly burdensome debt-load. A financial overview is below: Source: Author, financial statements. AGT adds back to Adjusted EBITDA certain "non-recurring expenses" that have consistently ranged from 6-8% of total Adjusted EBITDA. Despite already adding back these expense items that appear to occur regularly, starting Q3-17 (two quarters ago), management began to add back duties and taxes incurred related to policy changes in India. In reality, these types of expenses are very common for export businesses who deal with ever-changing international trade structures. Moreover, these add-backs now total over 30% of total adjusted EBITDA. Source: Author, financial statements. You might ask, why would they decide to change that now? Well, Adjusted EBITDA is now the numerator in AGT's newly amended debt covenant. From the Q1-18 MD&A: Covenants which measured the fixed charge coverage ratios were removed and replaced with a minimum Adjusted EBITDA to Interest Expense ratio, for both AGT, on a consolidated basis, and for APP. At the APP level, as at each quarter end, the Borrower shall not permit the Adjusted EBITDA to Interest Expense Ratio to be less than 2.50:1.00. At the AGT consolidated level, as at each quarter end, the Borrower shall not, and shall not permit the Minimum Adjusted EBITDA to Interest ratio of AGT to be less than 1.75:1.00, provided that the ratio shall increase to 2.00:1.00 as at the quarter end September 30, 2018 and increase to 2.50:1.00 March 31, 2019 and each quarter end thereafter. (p.29, Q1-18 MD&A) Management does not provide sufficient disclosure to calculate the aforementioned leverage covenants at either the APP level (the OpCo level) or the AGT consolidated level, making it difficult for investors to accurately track leverage levels. However, with the financial figures that are available and taken directly from the income statements one can calculate an Interest Coverage ratio that should at least be illustrative of the trend. This calculation (in the table above) suggests that AGT must be extremely close to breaching their Interest Coverage covenant given the 1.72x calculated is below the required 1.75x covenant in the most recent Q1-18 period. If AGT had reported a "normal" level of non-recurring add-backs without those new costs related to duties (equal to 8% of total Adjusted EBITDA), you can see they would have already violated their Interest Covenant by a meaningful margin. With the covenant tightening to 2.00x coverage by the end of Q3-18, AGT needs earnings to inflect upwards in a hurry. We also find it odd that starting in Q4-17, management decided to reclassify "Interest paid" on the Cash Flow Statement from the Operating activities section to the Financing activities section after a decade of consistent reporting. From Q3-17 Cash Flow Statement: Click to enlarge From Q1-18 Cash Flow Statement: Click to enlarge What would prompt that? When asked a question about leverage levels and covenant tightness on the recent Q1/18 call, management exuded more comfort than their actions related to disclosure would suggest: Listen, we've got a very positive working relationship with our bank syndicate. Where we always end up a little bit more tight is at the consolidated parent level because we have the bond interest and the other things there. So we'll continue to monitor it. We don't have any - I can tell you I'm not losing sleep over anything. I have strong relationships with our banks... The one thing that always helps in all those discussions is a strong equity that we have in this company. And the equity treatment of the Fairfax Financial injection of $190 million gave a very strong asset and very strong securitization of our debt. (Q1-18 transcript) We remain unconvinced that management is comfortable with interest coverage levels. Should the "cycle" continue to deteriorate, we believe the company would be forced to either seek relief from the recently amended debt covenants in the form of waivers or be forced to accept further dilutive capital from Fairfax Financial (likely at a higher rate than the current 5.375%) further impairing the common equity value of the business. The "strong equity in the company" AGT mentions in the quote above relates to the protection the debt holders have by having a $190MM tranche of preferred capital behind them in a wind-up scenario. That should be little comfort to an equity holder who would be last in line. For those analysts ignoring the $190MM in preferred shares when calculating the "Book Value" of AGT's common shares, do you really think Prem Watsa is going to walk away with nothing if this business goes belly up? The Tangible Book Value of AGT is currently $291MM or $12.00 per share. But subtracting the $190MM in preferred equity leaves $101MM in Tangible Book Value for common equity holders or just $4.15 per share. If the business bottoms at 1.0x Book, that is ~75% downside. Importantly, management's recent commentary would have investors believe that the cycle has "bottomed" and that they are hopeful for a recovery in the back half of 2018 and beginning of 2019 (from Q1-18 call): We see conditions as gradually improving, which are demonstrated in part by the trends on the results we're reporting, but also when considering a number of the market conditions and factors that we believe may lead to that normalization and improvementThe fact that we've kind of shown a trough and we've shown a recovery... We believe that earnings constraints we have seen in the recent periods are largely temporary. However, market data from reputable sources would suggest conditions are getting worse. Some recent publications include: India to be self-sufficient in pulses in 2 years - NEW DELHI - Oct. 21/17 - India will not need to import pulses in the next two years and the country will be self-sufficient to meet domestic demand, Agriculture Minister Radha Mohan Singh today said. The production of pulses stood at record 22.95 million tonnes in the 2016-17 crop year (July-June) as against 16.35 million tonnes in the previous year. India to be self-sufficient in pulses in 2 years: Radha Mohan Singh Low pulse prices lead to marketing change - April 19/18 - "The pulse market has slowed and prices have dropped following a North American winter in which India increased import tariffs on numerous pulse crops (lentils, peas, chickpeas). Traders haven't sold as many or as big of pulse shipments, and it doesn't look like things are going to change heading into spring planting." Low pulse prices lead to marketing change | The Western Producer Lentil Intentions Dismay Markets - April 28/18 - Lentil markets were dismayed by Statistics Canada seedings intentions report. Having expected farmers to say they would reduce area by around one million acres, the reported 355,000 acre reduction to 4.05 million was a surprise. STAT Communications Regular Edition Lentils Ignore Stocks Report - May 11/18 - Lentil markets finished the week unaffected by Statistics Canada's March 31 stocks in all positions report. Inventories on farms and in commercial positions totaled 1.53 million metric tons (MT), the second highest level since 2014, when there was a record 1.55 million MT on hand. Total supplies are up 35% from last year, with farmers holding just over 1.36 million MT. STAT Communications Regular Edition Just days after the Q1-18 call, the Indian government actually raised its estimate for grain production and estimates that domestic pulse production will actual be up 6% this coming season: Government Raises Estimate on Foodgrain Production - NEW DELHI - May 16/18 - India raised its estimate on food-grain production for the ongoing crop year ending June, with normal rains last monsoon season boosting the output of wheat, rice, coarse cereals, and pulses. Output of pulses - largely gram, urad and tur - is projected at 24.51 million tonnes, an increase of 2.34% over the second advance estimate, as a result of significant increase in the area coverage and productivity of all major pulses. In 2016-2017, production was 23.13 million tonnes. Government raises estimate on foodgrain production The articles listed above are just the beginning - these effects are being seen in real time in the volumes of exports out of Canada and the prices being realized for Canadian pulses on the market today. This dynamic was summarized recently in a research report from AltaCorp Capital quoted directly below: Supporting our view of an oversupply condition in the market was this past week's StatCan data on lentil stocks, the first such data point for 2018 (last reported December 31, 2017) which were up 34.8% from the same time last year. The StatCan commentary noted that the continuing trend from 2017 of increased stocks in lentil and dried peas was likely attributable to the Indian tariffs, which had reduced exports to that market considerably the most recent data from StatCan estimated farmers would be reducing their lentil acreage only 8%, which is significantly less than that initially estimated by Agriculture Canada which was a decline of 27% YoY. The planted acreage survey by StatCan is deemed more reliable as they actually ask farmers what their intentions are. If farmers only decrease their planted lentil area by 8%, the math suggests that inventory levels next year will top those very high levels we already have today. If that's the case, the average lentil price should decline further through next year, with the read-through being a further narrowing of AGT's processing margins in 2019. Compounding the negative outlook for this growing year has been the cold spring throughout Canada and the Northern US which has delayed planting. The most recent StatPub data on seeding progress for the Saskatchewan lentil crop as of the week of May 7 highlighted that seeding was just 9% completed, far below the 5-year average of 35%, and 2017 and 2016 progress of 37% and 60% respectively, for the same week. A delayed planting raises the likelihood of a shorter growing season and a late harvest, which normally takes place under colder, wetter conditions. Both of these conditions increase the risks for a poorer quality crop, which is likely to have a negative impact on AGT margins in their pulse processing business. Although food ingredients margins improved quicker than we expected, our go forward estimates already assumed an improvement in that segment. The issue remains that processing volumes and margins remain very weak and the Company's debt level is very concerning. (May 13, 2018) We agree with this near-term sentiment but would take it one step further: if India does achieve its stated goal of self-sufficiency as the report from this week suggests they are on track to do, and if new competitors from Central Asia continue to flood the global pulse market as they have over the last year, then this is not just another "cycle bottom" but rather a new paradigm that has permanently and irreversibly damaged AGT's legacy business. For over 3 years management has identified "growing the scale of processing and improving margins" in the Packaged Foods and Ingredients segment as a key pillar of AGT's strategy (MD&A). We believe the investor community has been led to believe this is a high-growth business with defendable margins and should, therefore, command a premium valuation multiple. When you take a closer look at the segment's actual results you can see this has not been the case. Despite significant invested capital to increase capacity, segment EBITDA has increased at just a 3.3% CAGR since 2015. What investors may be missing is that within this segment, over 60% of the earnings from are from sales of canned goods and dried pasta - which are in fact categories in structural decline. Adding to this, the pasta business may soon see a meaningful drop off in volumes as on April 12, 2018, the Canadian Border Services Agency implemented a 27.3% import tariff on all Turkish pasta in response to the dumping and subsidizing of these products on the Canadian market (a ruling directed squarely at AGT as the only large-scale importer of Turkish Pasta into Canada). Source. Finally, the Ingredients business that is less than 40% of the segments earnings, or less 20% of the overall businesses earnings, isn't really that fast-growing or unique at all. Between Verident Foods (160,000 tonnes), Roquette (250,000 tonnes), Canadian Protein Innovation (100,000 tonnes), W.A. Grain & Pulse Solutions (100,000 tonnes), and Prairie Green Renewable Energy (136,000 tonnes), the potential exists for new pea ingredients facilities to process up to an additional 750K tonnes of peas per year vs. AGT's current capacity of 140K tonnes per year. Those projects alone represent almost $900MM in invested capital in just the last few years, with many of those facilities still not expected to come online or ramp production until this year or later. This is a declining margin business seeing stiff competition from well-capitalized players and as such EBITDA has been essentially flat for over 3 years despite significant invested capital; investors should not be valuing this segment anywhere near 10x forward EBITDA. Despite the above, some sell-side analysts are remarkably unfazed. The Analyst at BMO had this to say in a report following Q1-18 earnings: [we have] greater conviction AGT has bottomed post Q1 beat. An AGT bear thesis is typically based on a tough pulse dynamic (persisting owing to Indian oversupply/restrictions) and a pulse-based food ingredients business that never delivers on promise. However, in Q1, Food beat with its best quarter ever (pulse processing beat too), so bears beware. Unfortunately, this analyst has missed a few pertinent facts: 1) the "Q1 beat" was only possible due to the fact that the seemingly recurring "non-recurring" items totaling $2.1MM pushed EBITDA to $16.1MM from the actual $14.0MM against the consensus estimate $14.7MM, 2) that the "bear thesis based on a tough pulse dynamic" has not only been true but worsened for AGT since the last report, and 3) there was no "Food beat" - the segment's growth of 22% y/y in the Q1-18 period is actually below the ~30% FY2018 growth rate implied by the consensus analyst full-year estimate. Despite this optimism from sell-side analysts, management felt the need to remind investors on the recent call that the outlook for volumes continues to be weak and that Q2-18 is their weakest seasonal period: The problem in our flow now is that there is product on farm, but we're into the Q2 period now, which, again, with the - even just an average harvest in India and an average harvest coming in Turkey at best, this is not a traditional export period. I mean, we had a relatively strong Q2 last year, I think, but the Q2 period has seasonally been our weakest quarter for the history of this business. And we expect that, that to be - in terms of volume - no, we think margins may be okay with the balance we have now, so no sounding off of a massive problem for Q2. But we don't see the volume recovery in the near term. Conclusion If the core Pulse Processing and Bulk Packaging legacy businesses do not experience a significant reversal of fortune (which is looking increasingly unlikely), the aggregate business will not be saved by the small and struggling Food Ingredients business, and AGT will face meaningful solvency risks. Our target of $4.15 per share represents more than 75% downside in the share price and is based on the Tangible Book Value of common equity per share. To be clear, to calculate the "Book Value" attributable to common shareholders and not account for the preferred shares would be assuming that Prem Watsa simply gifted $190MM to the public shareholders of AGT, something we do not think a sophisticated investor would ever contemplate. As such, we also believe that any future life-line investments in the form of more preferred shares would only serve to further damage the common equity value of the business as the significant cash outflows needed to service the dividend would further damage the financial health of the company. The company may pursue assets sales to lower debt, selling off any low utilization bulk processing or rail assets, but due to the currently weak market outlook for those businesses, we believe they would likely fetch distressed prices below tangible book value. I wrote this article myself, and it expresses my own opinions. GLTA