Agro-Investor magazine analyses Russian agricultural companies as investment objects based on the criteria of US investment guru Warren Buffett. Is it worth buying? In the spotlight was Cherkizovo Group. It was established in 2005 as an association of AIC Cherkizovsky and AIC Mikhailovsky. A year later, the company held an IPO on the Moscow and London stock exchanges. The holding sold 27.8 % of its shares for 251.3 million dollars. At the roadshow, management announced to investors that the money would be spent on M&A transactions.

However, in the end, they invested most of it in developing NAPKO (National Agroindustrial Company) – the company consolidated non-public agricultural assets of the Babaevs (the majority shareholders of Cherkizovo) not included in restructuring of the Group before the IPO. The founder of the holding, Igor Babaev, told Agro-Investor about this. Part of the money went toward refinancing debts.

In an interview with Agro-Investor in May, CFO and co-owner of Cherkizovo Ludmila Mikhailova said that the company went public mainly in order to be able to use shares to acquire other players. However, the holding concluded the first such transaction only in 2011, when the former owners of Mosselprom received about 2 % of the Group shares for their business.

Cherkizovo operates in four divisions: Poultry and pork production, meat processing, and grain farming. The company’s main shareholders are the family of Igor Babaev (63 %), Prosperity Capital Management, J. P. Morgan, and Norges. The holding’s free-float is 37 %. The Group’s capitalization after the IPO was 904 million dollars, and 470.4 million pounds as of August 8 (about 792 million dollars).

According to a survey of analysts, Cherkizovo’s business is quite well known. The company provides full information about its operations, publishes quarterly operating and financial results and makes informative presentations, says Elizaveta Lebedeva, a junior analyst with Aton Investment Company. “The holding also regularly reports its new projects and covers market highlights on its website,” she adds.

However, it is still hard to call the Group transparent. “There is less information about the business than we would like,” says Ivan Kushch, an analyst with VTB Capital, referring to the relationship with the NAPKO, which belongs to Cherkizovo’s shareholders. Mr. Kushch adds that the lack of information on agricultural holdings is quite typical of the agricultural industry.

However, the managers are quite open. They hold annual meetings with analysts and attend events for investors organized by investment banks. Ms. Lebedeva also noted that they regularly comment on the company’s operations in the professional media. “We always have an opportunity to speak to the management of Cherkizovo to get comments or clarifications,” Mr. Kushch adds.

There is no doubt in the effectiveness of management’s actions: The holding has done quite well in recent years. It has acquired assets to increase its share in core sectors, and its growing market presence not only improves performance, but also consolidates the Group’s positions. It is also developing promising new businesses, including a project for a turkey meat production and processing complex in a joint venture with the Spanish company Grupo Fuertes, Ms. Lebedeva says.

Maxim Kondratiev, a senior analyst and portfolio manager with Sberbank Asset Management, agrees that Cherkizovo is successfully implementing a strategy for growing its main business divisions. According to him, subsidized investment loans to agroindustrial companies and the preferential tax treatment system have significantly increased the production of poultry meat and pork, among other things.

“The Group’s pork division has not only increased commercial output, but has also invested in genetics which has reduced operating costs and increased control and management of the production of pigs for slaughter,” he says.

In its poultry division, the holding has made several M&A transactions at attractive prices in the last few years. The company bought the assets of Mosselprom and Lisko Broiler in Voronezh for 5 billion roubles in March of this year which, according to Mr. Kondratiev, has enabled Cherkizovo to strengthen its positions on the relatively mature poultry meat market.

Mr. Kondratiev goes on to say that the company has made a number of changes to improve business performance in its meat processing division. In particular, the meat processing plant in Labinsk (Krasnodar Region) was closed but at the same time the value of the sausage factory in Kaliningrad rose. Cherkizovo increased the share of high-margin products as part of its production optimization process.

According to the analyst, these solutions have improved the performance of the business line. “It's worth noting that meat processing has an important role in hedging risks,” he says. “Prices of consumer goods are less elastic and volatile than those for raw meat, and drop much less. So when meat is noticeably cheaper, processing revenue will increase.”

The Group’s grain division is still relatively small, and, according to Mr. Kondratiev, it is still not clear how effective it will be in this line of business. “In general, management’s ambition to reduce operational risks and supply the livestock division with grain, which accounts for 60–70 % of production costs, is a promising direction,” he argues. “What’s important is how field work will be managed and what the cost balance and yields per hectare will be.”

In the last six years, Cherkizovo has spent nearly 15.7 billion roubles on M&A transactions in the poultry industry. Through these investments, the Company’s market share increased from 2.5 % in 2004 to 11 % in 2013. EBITDA of the division increased from 36.2 to 176.1 million dollars between 2007 and 2012. Sales of poultry meat in the last five years in terms of volume nearly doubled to 343 thousand tonnes.

The holding invested more than 500 million dollars in building its pork division from the ground up. Sales rose from 58 thousand tonnes in 2009 to 158 thousand tonnes in 2013. This increased the Group’s market share from 1.6 to 6 % making it Russia’s second largest industrial pork producer last year, according to the rating of the National Pig Farmers Union. However, the division’s EBITDA and profit have declined in recent years. As of year-end 2013, gross income decreased by 38 % to 57.2 million dollars; and EBITDA fell by 37 % to 59 million dollars.

“The company has been constantly increasing production levels since 2009, and by 2013 it was showing stable growth of revenues and EBITDA,” Ms. Lebedeva outlines. Last year, however, Cherkizovo’s net income dropped to 71.4 % due to adverse market conditions: Pork price were at record lows, while grain prices reached their highest levels. Last year was quite challenging for the entire pork industry, she concludes.

However, analysts say the outlook for the holding is quite good. Mr. Kondratiev says that current market trends in meat and grain prices in Russia favour livestock breeders.

Prices for live pigs rose by more than 50 % over last year, while grain prices fell by about 20 %. “High world pork prices and protection of the domestic market through quotas and import duties, together with devaluation of the rouble mean that we can expect high pork prices in the medium term," he explains.

Mr. Kondratiev adds that given the lack of export capacity and the high cost of transport logistics to ports, a good grain harvest puts downward pressure on grain prices in the country, especially in regions where the company is present. “These factors should have a positive impact on its medium-term earnings,” he concludes.

Ms. Lebedeva agrees that the Group’s performance is highly dependent on the pricing situation on commodity markets, but says that this is typical of all enterprises in the sector. Cherkizovo is one of the largest vertically integrated holdings, with a stable market position and access to cheap debt financing. The analyst believes that in future the Group will continue to consolidate the market by making more M&A transactions, but will also more actively expand processing.

Ms. Lebedeva continues by saying that the main stage of the investment program in pork and poultry production has been completed, but construction of infrastructure facilities is continuing, including the turkey meat production project.

She is aware that Cherkizovo’s goal is to expand its business to achieve economies of scale. “Import substitution policy, government subsidies for the agricultural industry, and fairly good meat prices are motivating the company to expand production capacity,” Ivan Kushch agrees.

However, we should not forget that Cherkizovo operates in high-risk sectors, Mr. Kondratiev says. The market faced with significant fluctuations in yields and grain prices in recent years.

WTO accession substantially reduced pork prices in Russia for a while. Outbreaks of ASF were discovered in many regions despite the high level of biosecurity. “All of these factors, together with the presence of common operational risks, can significantly affect the holding’s margin,” he concludes.

Ms. Lebedeva thinks that Cherkizovo’s main advantage is its diversified business. This allows it to offset the negative results of one division due to unfavourable market conditions with good performance of another.

Average EBITDA margin for Cherkizovo Group was 10 % last year, but it had already reached 15 % in Q1 2014, Ms. Lebedeva says. “Generally, the margin is slightly higher than that for Russian agricultural manufacturers and similar players on foreign markets,” she notes.

Ivan Kushch says that the margin of agricultural companies is very volatile, and Cherkizovo is not an exception: Depending on grain and meat prices, any quarter may be very profitable, while another may be in the red.

The holding’s free cash flow has been consistently positive in the last three years. “Completion of the main CAPEX program should reduce the pressure on free cash flow,” Ms. Lebedeva suggests.

The Group’s capital investments for the last five years have exceeded 926 million dollars; last year they were 161.1 million dollars. All earnings go toward capital expenditures, and it is not easy to track their effectiveness, Mr. Kushch notes. “The company doesn’t pay dividends, so I don’t think the managers, who are the majority shareholders, put the interests of minority shareholders above their own,” he adds.

Ms. Lebedeva recalls recent statements about the possibility of paying dividends based on this year’s results. CEO of the holding Sergei Mikhailov said of this at the Agro-Investor conference “Agro-Holdings of Russia” at the end of May, emphasizing that there was a high probability of paying dividends based on the results of 2014. This message was reflected in the quotations of corporate securities on the LSE, where depositary receipts rose by 3.5 %. “We regularly return to the question of paying dividends. At an extraordinary meeting of shareholders in early October, the Board of Directors of Cherkizovo Group recommended payment of dividends worth more than 1.5 billion roubles, or 34.44 roubles per share.”

“It all depends on the aggressiveness of the capital investment program and the financial results,” Ludmila Mikhailova said earlier. According to her, the dividend policy is being discussed both to support shareholders and increase Cherkizovo’s investment attractiveness. Based on last year’s results, the Group spent its free cash flow mainly on buying Lisko Broiler. Ms. Lebedeva notes that the Group’s shares have been illiquid for a long time, which stops most investors from buying them, and there have been no visible efforts from management in this area.

Return on invested capital decreased significantly in 2013, dropping to 6.8 %, whereas previously the holding always had one of the industry’s highest values for this indicator (more than 20 %), she says by comparison. Nevertheless, it is a good indicator for agricultural companies, since they have high liquidity, Ivan Kushch adds.

However, he doesn’t think Cherkizovo has a strong or obvious competitive advantage. Meat prices have clearly reached a peak, but in the long term, they will likely drop due to increasing supply. Thus, analysts at VTB Capital see prospects for good performance this year and next, but the Group’s effectiveness will decrease in future.

The Group’s relatively high direct capital expenditures are also confusing. According to the analysts’ calculations as of August 8, the target price was $13.40/GDR. The shares of Russian food producers began to rise after restrictions were imposed on imports of agricultural products.

Trading in Cherkizovo securities closed at 680 roubles on the Moscow Stock Exchange, and gave $12.10/GDR in London. BCS Financial Group started analytical coverage of Cherkizovo Group in October, according to the holding’s press centre. Analysts had estimated the target price for securities at $18/GDR. Trading on the LSE closed at $12/GDR on October 13.

“Our recommendation is ‘hold’,” Mr. Kushch says. “In principle, the company is fairly good but something is missing. There are interesting stories, like Rusagro. BCS recommends ‘buy’.”

Mr. Kondratiev on the contrary considers Cherkizovo’s level of capital expenditures moderate and is confident that in the next few years the Group will have substantial free cash flow. “At the same time, it’s trading at low multiples (EV/EBITDA, PE),” he notes. “If there is a decision to distribute free cash flow to the shareholders, the issuer’s securities would provide a high level of dividend yield.”

“This would probably increase investors’ interest significantly,” Mr. Kondratiev says. Sberbank Asset Management has calculated a target price of 900 roubles or $17/GDR. Ms. Mikhailova confirmed in May that the company is significantly undervalued with respect to the main multiples. According to her, investors are buying stocks not only on spec, but also with the expectation that the Group will start paying dividends.

Ms. Lebedeva thinks the presidential decree banning food imports from the EU, United States, Canada, and Australia for a year will keep the holding’s meat divisions profitable.

She says that, on the one hand, this action by the government implies consistently high profitability of agricultural producers for the next year, which may be attractive for investors. On the other hand, this move once again confirms the unpredictable nature of developments in the sector, which has always been a deterrent to investment.

“We consider Cherkizovo to be one of the best public companies in the Russian agro industry,” Ms. Lebedeva says. “Its shares are a good investment for those who want to put money into the agribusiness.” However, she acknowledges that the Group’s low liquidity stops many investors, and under difficult market conditions this is a significant deterrent.

In addition, the dependence of business indicators on the volatility of commodity markets makes investing in the holding riskier compared to investments in the consumer sector as a whole, the analyst concludes.