Stock Review

Moving towards the one-stop farm

15/07/2005

    Company Price at review Current price Fundamental risk Share risk Our view
    ABB Grain (ABB) $2.05 $9.35 2.5 3.5 Long Term Buy
    Elders (ELD) $2.05 $0.070 2.5 3.5 Long Term Buy

    ABB Grain and Futuris possess valuable assets in an industry hungry for consolidation

    ‘There are three easy ways of losing money—racing is the quickest, women the most pleasant, and farming the most certain’. So said Lord Amherst, an 18th century British military officer. And, according to the Australian Bureau of Agricultural and Resource Economics (ABARE), the government’s primary industries scorekeeper, it seems things haven’t changed a great deal over the past few hundred years.

    In the period 2002 to 2005, based on historical and forecast data, Australian broadacre farms will return just 0.73% pa on the capital they employ (the figure is higher if the price appreciation of farm land is taken into account, but most farmers wouldn’t consider such unrealised capital gains to be ‘real returns’). So if agriculture produces such poor investment returns, why do we bother researching agriculturally oriented stocks ABB Grain and Futuris? And, even more pertinently, why do we have a Long Term Buy on each?

    The answer to the first question is that the industries in which these groups operate fall into the ‘circle of competence’ of at least one of your analysts, and you never know where opportunities might lie. The answer to the second question, in a nutshell, is that they’re both asset plays. Before we get too far ahead of ourselves, though, let’s take a look at what each company does.

    ABB is a grain handling and marketing company. It operates South Australia’s single barley export ‘desk’, which means that it has a monopoly over the barley exported from South Australia. It also owns more than 100 grain silos, seven export shipping terminals and a 50% stake in the Port of Melbourne terminal. If that weren’t enough, it owns a grab bag of related businesses in malting, grain grower finance, stevedoring, containerisation, and fertiliser distribution. Its history goes back to the second world war and it’s now aiming to become a ‘one stop grain shop’.

    Industrial conglomerate?

    Futuris describes itself as an ‘industrial conglomerate’, but labels can be misleading. Around 70% of the group’s assets are in agriculture-related businesses. It owns the 166-year-old Elders pastoral house and a 50% stake in Elders Rural Bank, which specialises, curiously enough, in rural finance. Futuris’s other main agricultural assets are a plantation forestry business and a 45% shareholding in listed beef producer Australian Agricultural Company . Its non-rural businesses include the design and manufacture of car parts and a property development business.

    While at first glance it appears that ABB and Futuris have little in common, beyond both being involved in agriculture, they are currently pursuing similar strategies and we have a strong suspicion that their futures will have a lot more in common than their respective pasts. We’re also detecting a palpable feeling of tension between the two. Take, for instance, the following comments from Futuris chairman Stephen Gerlach at last year’s annual meeting:

    ‘It is also welcome that the Federal Treasurer is maintaining the Federal Government’s commitment to competition policy in respect of the deregulation of the single desk for barley in South Australia – albeit with resistance from both sides of parliament in South Australia and the local monopoly’.

    If that shot across ABB’s bow wasn’t enough, Gerlach went on to launch a broadside at AWB , operator of Australia’s single wheat desk, which he said ‘not only denies farmers the benefits of competition for their produce but also distorts other competitive markets the monopoly chooses to enter’. This seems to be a clear reference to Elders rival Landmark, which AWB acquired from Wesfarmers in August 2003.

    That’s Futuris’s side of the argument, and we’re sure the management teams at AWB and ABB would present strong cases for the maintenance of their monopolies. But whatever the merits of the various (and often emotional) arguments, the simple fact is that these companies really want to move into areas of each other’s businesses. And a changing regulatory environment, as alluded to by Stephen Gerlach, may speed up this process.

    The broad strategy is to build a one-stop shop, where multiple products and services can be delivered to the farmer from the one location. It’s basically a rural version of the kind of cross-selling that banks have successfully achieved over the past decade. If managed successfully, this could work like a dream. As a practical example, if a farmer already sells their sheep through a pastoral house, they’d more than likely be happy to sell their grain crop through the same place, assuming they could. And there’s quite a bit of historical evidence indicating that farmers are willing buyers of multiple products and services from the one agent.

    In his book The Rural Entrepreneurs: A History of the Stock and Station Agent Industry in Australasia, Professor Simon Ville discussed the historical move by the pastoral houses into the provision of farm-related finance. To paraphrase: the idea was that while the loan business in itself was not profitable, it brought other, more lucrative, business along with it. The icing on the cake is that farmers, generally, tend to be very loyal customers. As a case study, let’s take the current situation in Tasmania as a somewhat extreme microcosm of what may end up happening on the mainland.

    In southern Tasmania, one rural agency reigns supreme: the Hobart-based Roberts . As you wheel your way around the south of Tasmania, you’ll struggle to spot a rival firm. But as you make your way north, the Webster–Elders joint venture is the clear overlord. This strong geographical dominance highlights the lack of competition due, we believe, to the remarkable level of customer loyalty. If, on the mainland, a group could bring together the powerful economics of successful cross-selling with strong customer loyalty, then the combination would most likely prove a huge money-spinner. And that’s exactly what each player is pushing towards.

    Valuable assets

    All of that said, our current recommendations actually have less to do with this broad strategic vision and competitive dynamic, and more to do with valuation. As mentioned previously, we view Futuris and ABB as asset plays, meaning that we believe the value of each company’s assets exceeds its market value.

    Seasonal variations, commodity price fluctuations and a volatile Australian dollar combine to make earnings a relatively poor yardstick for these businesses. In a boom year their PERs should look low and, in a tough year, comparatively high. So we look to the assets.

    The place to start in a situation like this is generally the company’s net tangible asset backing (NTA) per share. And note 6 to Futuris’s latest half-yearly accounts reveals NTA of $1 per share as at 31 December 2004, up from 86 cents a year earlier. So with the share price at $2.05, and our recommendation standing on the positive side of Hold, what gives?

    Basically, our research suggests that a number of the company’s assets are undervalued in its accounts. Let’s start with the easily demonstrable, though small, example of Futuris’s 50% stake in Elders Rural Bank. Note 34 to the 2004 accounts reveals that this asset has a book value of $83m. Considering this stake earned $10.9m in 2004, that looks pretty low. For example, Bendigo Bank , the other party in the venture, trades on around 15 times earnings. Applying that sort of multiple to Futuris’s stake implies that it’s worth more like $160m.

    And what about the intangible value of a brand name like Elders Pastoral? Well, AWB saw fit to part with more than $500m to buy the goodwill and brand names of Landmark when it bought that business from Wesfarmers. Futuris, on the other hand, has just $133m of intangibles (goodwill and brand names) on its balance sheet. While there’s a fair argument that Wesfarmers shareholders did a lot better from the Landmark deal than did AWB shareholders, that’s still a huge difference—especially given that, in our opinion, the Elders name is at the very least worth as much as the Landmark franchise. It’ll be interesting to watch the respective accounting policies on goodwill now that new international accounting standards are being implemented.

    While many ASX listed companies possess assets with values higher than their book value, Futuris is something of a special case. Its management team has an uncanny ability of turning understated assets into stated profits—a point we discussed in detail in issue 150/Apr 04 (Long Term Buy—$1.58). Over the past ten years this ability has generated an average of $16.8m per year, after tax, for shareholders.

    The task of pinpointing ABB’s value is somewhat trickier due to the three-way merger between ABB, AusBulk, and United Grower Holdings in September last year.The company’s most recently published NTA figure was $3.43 per share as at 31 March 2005. We presented the reasons why we think ABB’s assets are likely understated on its balance sheet in issue 169/Feb 05 (Long Term Buy—$7.00), when we also drew comfort from the fact that the shrewd team at Guinness Peat Group is one of the company’s largest shareholders. ABB’s assets would most likely be very desirable for Futuris or AWB, or both. Each group is somewhat larger than ABB, although it would still be a huge financial bite for either to take. That said, ABB’s assets are, to use the management lingo, ‘highly strategic’. And yes, we are conveniently ignoring that ABB currently has a shareholder structure that makes such corporate activity awkward. But as we’ve said, this industry is changing, and it’s changing rapidly.

    Given the rate of industry change, we wouldn’t be surprised to see ABB swallowed whole or broken into pieces and split up between various other players. It’s something that we’ve seen before. Those of you old enough to remember black and white television may also recall firms such as Goldsborough Mort and Denny Lascelles—and what happened to them. Certainly Guinness Peat has a track record of being involved, at least behind the scenes, in similar situations. So there would seem to be worse places to park your money than this reasonably priced package of ‘strategic’ assets in an industry hungry for further consolidation. The stock is up 16% since issue 175/May 05 (Long Term Buy—$5.45) and it remains a LONG TERM BUY for patient, conservative investors.

    As for Futuris, we aren’t betting on any changing circumstances. But unless things go horribly awry, the 4.5% dividend yield provides a reasonable base for acceptable future returns if management can position itself sensibly in any industry shakeout, or engineer another one of its irregular but highly profitable corporate deals. The stock price is up a touch since issue 175/May 05 (Long Term Buy—$1.81) and our view is unchanged. LONG TERM BUY.

    Disclosure: Interests associated with The Intelligent Investor own shares in Futuris.


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