Introduction

Agroton is a vertically integrated agricultural producer in Ukraine.[1]It is a regional leader in crop and livestock production. Based in Cyprus and operating from Kyiv, the company went public on the Warsaw Stock Exchange (WSE) under the ticker AGT in November 2010, where it still trades.

Agroton is a diversified agricultural producer focused primarily on crop production and land cultivation. The company generates 13% of revenues from its large livestock holdings, including cattle facilities, chicken farms and dairy production facilities. Roughly 84% of revenues, however, are derived from its sunflower seed and sunflower oil production. Virtually all production is exported.[2]

Ben Graham once wrote that the market is a pendulum forever swinging between unsustainable optimism and unjustified pessimism. Agroton is experiencing a period of unjustified pessimism—the liquidation value is currently greater than the total market cap of the company—due to Ukraine’s murky political and economic outlook. However, it is also a value investment that carries a large margin of safety.

To gain consistent alpha, investors often need to be contrarian, investing in securities that have sound fundamentals but that may be unfashionable to the broader market. Investing in Ukrainian securities is far from fashionable right now, but that hardly means that doing so is wrong. As this report will demonstrate, Agroton presents an excellent opportunity that should yield above average returns in the medium to long term.

Industry

The agriculture sector is Ukraine’s largest industry and represents roughly 12% of the country’s GDP. With agricultural land covering over 70% of the country, Ukraine is the world’s largest exporter of sunflower oil and routinely ranks as a top exporter of wheat, barley, corn, and poultry.

Agroton Price & Historical P/E (Chart from Bloomberg)

Agroton Price & Historical P/E (Chart from Bloomberg)

Administration of farmland is anything but efficient; approximately 10.5M of the 40.9M hectares of Ukrainian farmland are owned by the state, which has stifled industry growth. Furthermore, a moratorium instituted in 1995 prohibits farmers from selling farmland to corporate producers, which has constrained both investment in and development of the domestic agribusiness. Instead, individual plots of farmland are leased to corporate producers. In 2017, Agroton reported 110,000 hectares of plough land leased for an average of under five years. The moratorium should be viewed as an economic moat for Agroton. The highly complex nexus of relationships between farmers and Agroton will prove difficult to commandeer for challengers. The highly fragmented nature of the business will continue to shelter Agroton from new players.

Poor weather has marked an irregular 2018 for Ukrainian agriculture. On the one hand, the wheat harvest dropped ~14% due to the drought in the spring and torrential rains in the summer. On the other hand, late crops such as maize and sunflowers have recorded record harvests. Ukraine is forecasted to harvest 13.3m tons of sunseed this year, the second largest since 1991. Both sunflower seeds and sunflower oil exports have increased steadily since 2016; in 2017, seed exports grew 13.2% while oil grew by 29%. Ukrainian agriculture minister Maksym Martyniuk expects record-level sunflower exports to continue as the US/China trade war will provide a “boost in exports to new markets.” In fact, Ukrainian sunflower-based products have already experienced a strong uptick in demand in the third quarter from central and eastern Asia.

Macro

Economic

Ukraine’s GDP fell extraordinarily from $180B in 2013 to under $90B in 2015, the year of Ukraine’s banking sector’s collapse. The economy is slowly recovering to pre-crisis levels, registering a $117B GDP in 2017.  According to Moody’s, Ukrainian GDP growth is projected to slow to 3.2% in 2019 from 3.5% in 2018, bringing Ukraine’s GDP to $120.7B by the end of the decade. Sluggish reforms, political and geopolitical risks hampering investment, a weak banking system, and negative demographic trends have caused the pessimistic GDP projections. Furthermore, Ukraine has a 9.5% unemployment rate, a 14.5% inflation rate, and runs a -$9.4B trade balance. Overall, Ukraine’s economy is not yet strong, but is improving from its low point in 2015.

On 23 November, the Rada (Ukraine’s legislative body) approved the government’s streamlined budget for 2019. This is a key development that may finally give the IMF enough confidence in Kyiv’s fiscally-responsible intentions to unlock $3.9B in assistance, which will help to stabilize Ukraine’s economy in the first quarter of next year.

Geopolitical and political considerations

Ukraine’s economic prospects are constrained by its turbulent relationship with Russia and its pervasive internal corruption. Ukraine’s President, Petro Poroshenko, has been unable to end his country’s war with Russia or root out domestic corruption. The military conflict in eastern Ukraine has few immediate prospects for conflict resolution, and may even be heating up.

On November 25, the Russian coast guard seized three Ukrainian military vessels in the Kerch Strait—a waterway shared by Ukraine and Russia—marking the first time Russia has officially attacked Ukraine in the nearly five-year conflict (up to this point, Russia has officially denied being involved). The next day martial law was introduced in the country in the ten Ukrainian regions bordering Russia and Russian-backed Transnistria. Martial law will not have any direct impact on elections, and will happen, as planned, on March 31.  Former prime minister and economic populist Yuliya Tymoshenko is ahead in the polls. Poroshenko is the next most likely candidate.

Tymoshenko’s policy stances are difficult to gauge: she ebbs and flows with her audience, as many populists do. Despite her leadership role in Ukraine’s 2004 Orange Revolution, her relations with Russia remain suspicious. She positions herself as staunchly pro-Western, but has made several subtle deals with the Kremlin over the years. Nevertheless, she seems to have a few clear priorities, one of which directly affects the agricultural industry.

Tymoshenko is vehemently against any kind of land reform. The IMF and other western institutions, as well as pro-Western figures within Ukraine, have pushed for land reform in Ukraine for years. After the collapse of the Soviet Union, Ukrainian peasants were given small plots of land. Now, those peasants aren’t allowed to sell the land (and therefore no companies are allowed to buy). Without the ability to purchase land, agricultural companies have fewer incentives for investment. Under Poroshenko, given his history of cooperating with the IMF and his more market-centric approach to politics, the moratorium on land sales may come to an end or at least lighten.

Valuation

Valuing Agroton under traditional forward-looking analyses may prove difficult and speculative. The cyclicality of the Eastern European agribusiness paired with unpredictable domestic politics and tense foreign relations have driven irregular cash flows for the business over the past five years. As such, we do not intend to predict or forecast future revenues. However, we would like to emphasize that Agroton’s financial footing is sufficiently strong to not only survive but to expand in periods of economic turbulence. As such, we consider Agroton’s financial strength to be undervalued, and see an excellent opportunity as a value investment.

Warsaw Stock Exchange Historical P/E (Chart from Bloomberg)

Agroton has extremely low outstanding debt. Loans & borrowings (which constitute total long-term liabilities) were reported at $7.7M[3]on 6/31/2018. On the other hand, the company reported cash & cash equivalents of $17.8M—an amount that could pay down all debt more than twice. While calculating the Net Current Asset Value per Share, several conservative adjustments were made: in order to remain cautious with reported current asset values, we assumed 50% of the stated value of inventories, biological assets (unharvested agricultural crops), and loans receivable. The adjusted NCAV resulted in PLN 5.97 per share, close to 2X the current price of Agroton, PLN 3.29. In other words, the NCAV calculation tells us that the market valuation of the company is currently less than 50% of the value of its total assets. The P/E ratio also reflects this margin of safety, sitting slightly above historical averages, at 1.53. For context, the Warsaw stock exchange has a P/E of 12.7. The P/B ratio also points at the undervaluation of the company, sitting at 0.21.

AGT Valuation Ratios

Agroton has also been able to generate a fairly consistent stream of free cash flow, stemming from its high margin sunflower business. Sunflowers are traditionally the most profitable crop in plant cultivation, and the mean value of its profitability during the last ten years has been around 40%. The low cost of sunflower seed production will continue to drive Agroton’s low CAPEX levels, and we expect the company’s high CFO/CAPEX ratio to sustain itself in the upcoming years. Similarly, FCF yield is extremely high (26.18% using FCF/EV), buoyed by the low CAPEX requirements of the business.

AGT FCF Valuation

With low outstanding debt and low CAPEX requirements, Agroton’s high margin business has been relatively stable in an otherwise unstable environment. Furthermore, the company’s high cash and liquid asset levels are underappreciated by the market; the instability of the region has clouded investor appetite. The sunflower business will continue to remain profitable on the global scale, and Agroton’s balance sheet will allow the company to not only meet current demand but also potentially grow.

Catalysts

The macroeconomic picture looks increasingly favorable for emerging market equities.

  1. US GDP growth, consumer sentiment, and corporate earnings have been re-revised downwards. The growth differential between the US and the rest of the world will continue to decline in early 2019. Investors will turn to EM in search of greater growth and higher returns.
  2. The dollar will drop in response to the lower appetite for US securities, which in turn will strengthen commodities, and commodity-dependent EM countries.
  3. The Federal Reserve will respond to lower domestic growth by pausing interest rate hikes, which will further strengthen EM economies.

As the macro picture becomes cloudier for US equities, emerging markets will stand to benefit. On the one hand, a lower dollar will support greater exports, effectively increasing revenues for commodity-dependent Ukraine and heavy corporate exporters, such as Agroton. On the other hand, greater foreign investment into emerging markets will help re-rate the current low P/E levels: the P/E of the Warsaw Stock Exchange is currently hovering above 5 year lows, at 12.7. A high tide raises all boats, and Agroton will benefit from greater investment appetite into EM securities.

“The EU’s biggest asset is Ukraine” – George Soros

In addition to international monetary developments, occurrences unique to Ukraine may also become a catalyst for Agroton. Since the collapse of the Soviet Union, Ukraine has had massive economic potential. But corruption, rocky relations with Russia, and poor fiscal policy have kept the country’s development in check. Recently, Ukraine’s situation has worsened: Russia annexed Crimea and invaded the Donbass in 2014 and the Ukrainian banking system collapsed in 2015-16. With assistance from the IMF and increased anti-Russia sentiments spreading around much of the West, the global community is keen to ensure that Ukraine does not sink any deeper. Prominent investor George Soros has gone so far as to say that “the EU’s biggest asset is Ukraine.” It therefore follows that for the European project to continue, Ukraine will have to be protected and cultivated. Frankly put, the situation in Ukraine cannot be much worse.

Risks

Structural Risks

The major risk inherent in investing in Ukrainian equities (which holds true for Agroton despite its being traded on the Warsaw Stock Exchange) is the possibility of a squeeze out, which is the compulsory sale of the shares by minority shareholders of the jsc in exchange for fair cash compensation. Yury Zhuravlov has steadily increased his stake, and currently holds just over 75% of the company. In order for him to enact a squeeze out he needs to achieve a 90% stake. In the case of a squeeze out, the price would be determined in one of two ways: either by the previous 6 month average traded price of the security or by an independent investment auditor. In either situation, this would be a major potential downside for any investment in Agroton, but there appears to be a degree of safety—both legally and in the fact that he would need to acquire another 14% of the company.

Yury Zhuravlov (Photograph by bizagro.com.ua)

Another major structural risk is related to climate. All of the land Agroton harvests is within Ukraine. Its output would be greatly harmed by poor climactic conditions, such as drought, heat waves, and crop freeze. Although unlikely to affect all of Ukraine—a country marginally smaller than Texas—severe weather could impact major parts of the country and choke production levels.

Political Risks

Any country that borders Russia, but especially Ukraine, has to be wary of the potential for a Russian invasion. The 2014 invasions of Ukraine were met with little resistance from the West. Although NATO and the EU appear to be divided right now, an act of further aggression by Russia will probably not be met with economic sanctions; militaries will likely be deployed. In the event of a ground-war, Ukrainian agriculture would be decimated along with Agroton.

There is also the unlikely chance that a pro-Russian politician wins the presidency in Ukraine. Access to financing will certainly be more difficult under a Moscow-centric leader. Past pro-Russian presidents, Leonid Kuchma and Viktor Yanukovych, did not exactly usher in times of economic openness and prosperity. That pattern will likely continue.

The final political risk we foresee is the potential for a permanent pro-Russian caucus in parliament if the Donbass conflict stalls or is resolved in a politically advantageous way for Moscow.  This could lead to a long-term stagnation of judicial and economic reform, two very important factors that will affect the long-term health of Ukraine’s economy. Any sort of flaccidity on the reform side will also hurt this company’s minority shareholder rights.

Conclusion

Agroton’s success lies in the strength of its financial footing. Negligible debt, steady cash flow, and a high cash balance will allow Agroton to navigate through uncertain times. Although Ukrainian companies are currently shunned by many Western investors, there is still alpha to be gained.

Ultimately, the future value of every investment is a function of its present price—the lower the price paid, the higher the potential return. Volatility in the market should not be a concern to investors willing to take a chance on Agroton: if bought at a solid discount, the short term price fluctuations should not matter—the odds are that the value will ultimately be reflected in the price of the security.

On the one hand, Ukraine appears to have bottomed out, and as it rises, well positioned companies operating in key sectors there are poised to benefit. On the other hand, even if Ukraine’s economy does not recover, Agroton is still well positioned financially, and will still be able to generate cash flow, as it has done in years past.

 

[1]Agroton is domiciled in Cyprus, operates in Ukraine, and trades on the Warsaw stock exchange. As annual reports are are reported in USD, we have assumed a PLN-USD exchange rate of 0.27 PLN/USD

[2]Agroton does not include customers or countries of exportation in its annual financial reporting. According to the USDA Foreign Agriculture Service, the largest importers of sunflower seeds and sunflower oil are the US (29.6%), the Eurozone (25.7%) and India (16.4%). Due to the company’s size and scope of business, one may assume these countries and bloc as the main destinations for Agroton product.

[3]Financial reports are released on a semi-annual basis. Both annual and interim reports are audited under Cyprian law, using KPMG as independent auditors.

Disclaimer: This article is not intended as investment advice and is intended for informational and entertainment purposes only.