Australia is the third largest exporter of wheat in the world, controlling ~13% of the world wheat trade.  Historically, Australia has granted one company, the Australian Wheat Board (“AWB”), a legal monopoly to export wheat from the country (the so-called “Single Desk”).  In early December 2006, however, the Australian government stripped AWB of its monopoly for the 2006/07 crop year due to the discovery that AWB had paid A$224 million in bribes to Saddam Hussein’s regime to secure Iraqi purchases of Australian wheat.  Most industry observers, ourselves included, expect this to be the first step in the full deregulation of Australia’s wheat export market.

 

We believe that the biggest winner from the elimination of the Single Desk will be ABB Grain Limited (Australian Stock Exchange ticker: ABB AU).  ABB owns more than 90% of the grain handling assets that manage the storage and transport of wheat, barley and other grains from farms in South Australia to end use customers in Australia and abroad.  Its assets – which consist primarily of silos, warehouses and export terminals - are well located and low cost.  Given the scale, scope and replacement cost of ABB’s assets (which we estimate to be 3x the company’s current enterprise value), its asset position will likely never be replicated. 

 

Despite owning virtually all of the infrastructure assets central to the export of grain from South Australia, ABB has never earned an economic return on its assets (note: its ROE was 7.6% in f’06 and 2% in f’05).  This is partly due to the company’s origins as a co-operative (more on this later) and partly due to the fact that AWB’s export monopoly prevented ABB from pricing its services commensurate with commercial rates of return (ie, AWB was essentially ABB’s only customer for its export terminals). 

 

 

In our opinion, the elimination of the Single Desk will be the catalyst that permits ABB to earn an economic return on its assets.  This is because in a deregulated world, it is the owners of the physical assets who dominate grain trading.  Under deregulation, we expect ABB to replace AWB as the dominant exporter of wheat from South Australia.  Accordingly, ABB will be able to earn the profits from the marketing and trading of wheat on international markets that were previously earned by AWB.  This opportunity is significant relative to the size of the company.  Over the last three years, ABB has marketed an average of 6 million tonnes of grains per year (mostly barley and other grains).  Over this same period, South Australia has exported 2.6 million tonnes of wheat annually, none of which was marketed by ABB.  Going forward, we expect ABB to market most, if not all, of South Australia’s wheat exports, potentially increasing ABB’s marketing volumes by 40%. 

 

In addition to profit growth from marketing Aussie wheat in export markets, we believe there are substantial opportunities for ABB to extract more profit from its highly valuable asset base.  To understand why we think this is the case, it is important to understand ABB’s history.  Founded by the Australian government in 1939 as the Australian Barley Board, privatized in 1999 and IPO’d in 2002, ABB historically has been run for the benefit of its farmer-owners.  However, since its IPO in 2002, farmer ownership of ABB’s Class B shares has fallen from 95% to 75%.  Management believes that, within a few years, more than 50% of the Class B shares will be owned by non-farmers and that their role as managers is to run the business for the benefit of its Class B shareholders.  In our conversations with the company, management repeatedly emphasized the need to earn a commercial rate of return on its assets.  Moreover, it stressed that there is latent pricing power in its assets to do so.  As they put it, ABB has been “providing Rolls Royce service at Cadillac prices”.  While management recognizes that the transition to improved profitability needs to be a gradual one, as farmers still own 75% of the stock and control the board, management appreciates that “ultimately, farmers need to pay for this stuff” and the company needs to earn returns acceptable to non-farmer owners.  We expect that this transition will be done quietly and opportunistically, such as the company’s recent closure of 40 of its most expensive grain silos in response to Australia’s record drought this year.  We believe that there are many such opportunities across the asset base to improve profitability and that these will be slowly tackled by management in the coming years. 

 

While it is difficult to quantify these opportunities, a comparison of ABB’s returns with other grain traders, and our trust in economics, has given us confidence that the opportunity to improve profitability is significant.  For context, in f’05 and f’06, ABB earned ROE’s of 2% and 8%, respectively, on a book value that we think dramatically understates replacement cost.  In comparison, ADM and Bunge each earned 13-14% ROE’s over the same period.  Taking a longer term look at profitability, ADM’s has averaged a 10% ROE over the last 15 years and Bunge has averaged a 10% ROE since 1999.  Importantly, neither company has the dominant asset position that ABB has in South Australia.  

 

 

On the surface, the stock doesn’t look cheap.  With ~145 million Class B shares outstanding, trading at A$6.70/share, and approximately A$100 million of net debt[1], ABB has an enterprise value of ~A$1.1 billion.  In fiscal 2006 (ended September 2006), ABB generated A$107 million in EBIT and earned net income of A$0.47/share.  Thus, on trailing numbers, ABB trades at 10x ebit and 14x earnings, clearly not compelling for a low growth, low return, cyclical commodity business like grain handling and trading – particularly given the dual class structure.  On forward numbers, the story looks even less compelling, as the driest growing season in 100 years has decimated the Australian wheat and barley crops.  Based on f’2007 consensus EPS of A$0.25, ABB is trading at 27x forward earnings.  Again, not interesting.

 

Nevertheless, we believe that ABB is an attractive investment opportunity today because (a) we think its assets have significant scarcity value and are materially undervalued relative to replacement cost and their potential earnings power; (b) we expect the elimination of the Single Desk to drive a step-change in the company’s earnings power; and (c) because, beyond the opportunities created by the elimination of the Single Desk, we believe that management has the means and the desire to earn substantially higher rates of return from its assets.

 

In terms of asset value, we gained significant confidence during the course of our due diligence that ABB’s physical assets provide a substantial margin of safety.  In our conversations with industry experts, we learned that strategic acquirers/builders of grain handling terminals and silos typically use replacement cost analysis as their primary valuation tool (ie, they’re constantly making “buy versus build” decisions).  In ABB’s case, we learned that it would cost ~A$3 billion – 3x ABB’s enterprise value – to rebuild its storage and handling assets.  Because of the quality of its assets and the significant cost to replicate them, they will never be rebuilt.

 

Also during our due diligence, several experts in the international grain trading business commented on the attractiveness of ABB’s assets.  On multiple occasions, we heard that if Australia were to eliminate the Single Desk, that major multinational grain traders such as Cargill, Louis Dreyfus, Bunge and ADM would be eager to get into the Australian wheat business.  Initially, we were told, they would seek to partner with ABB but that if that were not possible, that they may even try to buy ABB outright.  Given the opportunities that deregulation offers to ABB, we doubt that ABB would be keen to enter into such partnerships or be bought out, preferring to market the grain themselves wherever possible[2].  Still, we take comfort in knowing that control of 90% of South Australia’s grain infrastructure is a scarce resource with significant value – particularly when the assets are trading at such a large discount to replacement cost. 

 

So what’s ABB worth?  Given the nature of these physical assets and the cyclicality of the earnings stream, we believe that the value of the assets should be analyzed relative to replacement cost and versus book value.  In terms of replacement cost, certainly some discount to replacement cost is appropriate.  However, in our opinion, a 70% discount is too large a discount, particularly given the dominance of its asset position in South Australia, the importance of South Australia to the global wheat trade and the opportunities for the company to earn excellent profits from these assets subsequent to the elimination of the single desk. 

 

In terms of price to book, ABB trades at 1.1x book value today.  This compares to 2.2x book for ADM, 1.9x for Bunge (BG), 1.7x for the Saskatchewan Wheat Pool (SWP CN) and 1.0x for Agricore United (AU CN).  For more context, ADM has traded at an average of 1.6x book over the last 15 years and Bunge has traded at 1.5x book since going public in 2001.  In terms of these comparables, Sask Wheat Pool and Agricore initially appear to be the best comps, as these companies have co-operative origins similar to ABB’s and Canada has long had a single wheat desk (the Canadian Wheat Board) to manage its exports.  There is one major difference, however, that we think distinguishes ABB’s situation from the Canadians and that we think justifies a multiple that is above book value and, over time, one closer to that of ADM and Bunge: the Canadian wheat handling market is extremely competitive and massively oversupplied, with 30% excess capacity inland and increasing domestic consumption that soaks up grain internally, resulting in significantly underutilized, stranded port terminals.  Conversely, ABB dominates the grain handling business in South Australia, controlling over 90% of the assets.  Moreover, there is little population living in South Australia, so virtually all of South Australia’s grain is exported (ie, ABB doesn’t face competition from domestic consumption that the Canadians do).  And with the possible elimination of the Single Desk, ABB would be able to market wheat itself.  Thus, for the reasons described above, we think the deregulation of the Australian wheat export market and ABB’s strong competitive position will allow it to increase returns significantly over the next few years, driving earnings, book value and the stock price higher.

 

We think ABB will be worth A$9.75 in two years.  Our target price is based on our estimate that the company will earn $0.75/share in f’09 and will trade at 13x that number.  Our target price also equates to ~1.5x our projected book value.

 

Deregulation of Australian wheat export market beyond 2006/07 crop year (note, there is a major drought in Australia this year, so current year earnings will be depressed; it will take some time for more normalized or higher profits to emerge from these assets)

 

Major cost savings from the company’s recently announced restructuring program, pursuant to which it is closing 40 of 110 silos (the oldest, least efficient ones).  These cost savings will become evident in f’2008 fiscal year (ending September 2008).

 

 

One clear risk/negative for the stock is its lack of liquidity.  The stock barely trades.  However, over the course of just a few weeks, we were able to secure two substantial blocks.  So it is possible to accumulate a position, but you must be comfortable with the margin of safety here and willing to accept holding such an illiquid investment. 

 

One major fundamental risk is that Australia does not abolish the Single Desk.  Recall, so far, they simply have taken it away from AWB for the current crop year.  They haven’t yet said what they will do beyond 2006/07.  In our opinion, it is very likely that they will eliminate the Single Desk, but it is not a certainty and we do not know what a replacement system, if any, would look like.

 

Another negative is ABB’s dual class share structure.  The company has two classes of stock – A and B.  The A’s are owned by farmers and entitle them to elect a majority of the board.  The A shares do not have economic rights.  The B shares trade on the ASX, but 75% of these shares are still owned by farmers.  While these shares are coming out of farmer hands over time, there is no question that there are mixed agendas here and that management cannot act 100% in the best interest of financial shareholders.  Over time, we expect the business to be run more commercially – this is a big part of our thesis, and management has said as much -- but the transition will be a gradual one due to the politics involved here.

 

Lastly, you should be aware that the recently completed 2006/2007 crop was amongst the worst ever, due to a significant drought in Australia.  Accordingly, ABB’s earnings for f’06/f’07 will be down substantially from f’2006.  Thus, even if our thesis is correct that the company is poised to substantially increase its earnings power, it will take time for them to deliver high profits.

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