Description
If there was ever an idea that likely deserved a 1 rating based on “rules of thumb”, this would be one of them. Hell, the following four words – Canadian, small-cap, farm equipment – are probably sufficient to drive the majority of VIC readers to hit the back button on their browser faster than you can say “John Deere”. It is likely for that very reason that I believe Ag Growth Income Fund (AFN.UN – Toronto Stock Exchange listed) is a painfully dull common stock that offers uncommon profits.
Quite simply, an investment in Ag Growth is appealing because it actually has virtually all of the characteristics the average VIC reader is looking for. In no particular order the attractive qualities are as follows: cheap (double digit FCF yield off of depressed results), 11.5% cash distributions (that’s right, monthly cash distributions you can use to keep the lights on, buy baby a new pair of shoes, etc.), high and stable margins (30%+ EBITDA margins for each of the past three years), EBITDA not an EBIT business (EBITDA-Capex margins have been at least 29% for each of the past three years), meaningful ownership by management (CEO has 90% of net worth invested in the company), market leader with high relative market share (35% market share in North America, 3x that of next largest competitor), unusually stable revenue stream (less than 10% variability during past three years), element of recurring revenue (average item lasts about five years), pricing power (three price increases within the last 12 months) intelligent management (take my word for now, but I elaborate in the write-up), and lastly it is actually liquid enough to buy a position without driving up the price.
Ag Growth offers several different lines of farm implement equipment, and is the North American market leader in the grain auger market. Grain augers account for roughly two/thirds of Ag Growth’s sales, so you should probably stop reading if you are already thinking “This is just another one of those grain auger stories”.
A grain auger is a portable piece of farm equipment, usually 50 to 60 feet long, and weighing several hundred pounds. It is used to move grain from one location to another (e.g., unloading grain from a truck or trailer and loading it into a dryer or storage bin). Once moved to a desirable location on inflatable-type car tires and then raised into position, the discharge end is elevated to the top of a dryer or bin, and the opposite end is lowered in order to pick up the grain to be moved. The auger is usually powered by connecting a universal joint to the power takeoff on a tractor or other piece of farm equipment. Please visit one of Ag Growth’s websites at www.grainaugers.com for pictures.
The history of Ag Growth starts with Batco, currently the smallest of the three Ag Growth operating divisions ($6.2m sales, $1.0m EBITDA). Rob Stenson (Current CEO of Ag Growth) and his brother Art (Current GM of the Batco division) started Batco back in 1992, building and marketing an innovative line of belt conveyors targeted at handling specialty grains. By 1998 Batco had about $3.5m in annual sales and went public via a reverse takeover of Ultra Life Co., an Alberta Stock Exchange listed shell (the company subsequently changed its name to Ag Growth Industries).
Shortly after the RTO, the company acquired Wheatheart, what is now Ag Growth’s second largest division ($10.1m sales, $2.1m EBITDA). The Wheatheart acquisition took place at roughly 6.5x EBITDA and provided Ag Growth with a mature company with diverse product offerings and above average profit margins By combining Wheatheart with Batco, the Stenson boys were taking advantage of the company’s existing distribution network and laying the groundwork to reach critical mass in the small-line farm equipment industry.
By 2000, Ag Growth had continued to make progress, improving revenue and profitability, but was largely operating in obscurity on the illiquid Alberta Stock Exchange. With the backing of Tricor, a private equity sponsor, Ag Growth was taken private by management. While operating out of public eye (and with the ability to use greater leverage than is commonly accepted by public markets), a privatized Ag Growth completed its coup de grace, the purchase of the company’s third division, Westfield.
Westfield, the company’s largest division ($40.7m sales, $14.1m EBITDA), was a Western Canadian grain auger manufacturer that had consistently been run by the Plett family since the early 1950’s. Westfield offered Ag Growth critical mass, a leading brand, and further strengthened the company’s distribution channel. At the time of the acquisition Rob Stenson was quoted as saying "The marriage of portable grain augers, belt conveyors and grain-handling accessories opens a whole new area of development with worldwide potential. The new energy and synergism of our companies will bring some exciting results very quickly, moving us from a world leader in grain augers to a world leader in grain handling.”
The Westfield acquisition was successfully integrated and by 2003, Tricor, Ag Growth’s private equity sponsor, was itching for a realization event. After planning for an IPO in 2003 but retreating due to a soft market, AFN just barely managed to go public in June of this year. The recent IPO coincided with a general downturn in the income trust market that saw many deals get shelved, and those that proceeded were forced by underwriters to accept very poor pricing. As such, even an attractively priced AFN garnered minimal attention at the time of its launch, and has continued to operate in relative obscurity for its four month public existence.
By this time readers (particularly those that visited www.grainaugers.com or are familiar with the products) are asking “What’s the secret sauce to having such high margins and are they sustainable?”. To use the Discipline of Market Leaders framework, this is one of those incredibly rare companies that lead the market in operational excellence, customer intimacy, and product innovation. By being a market leader in all three elements, Ag Growth has a very sustainable competitive advantage and margins are unlikely to see any significant erosion.
Operational Excellence – Best total cost
With market share of 35% (3x that of the next largest competitor) and growing, AFN benefits from tremendous economies of scale. As an example, AFN produces about 8,000 augers per year compared to roughly 1,500 for the typical regional competitor. Despite the fact that ASP’s are similar to competitors, AFN is earning EBITDA margins of ~30% when competitors are earning low single digits. Whether it be larger line runs, bulk buying of components, or a larger sales base over which to amortize distribution costs, AFN has clear size advantages over its competitors.
Even with these natural advantages of size, as a one-time LBO, AFN has already mastered the art of minimizing costs. Using Westfield as an example, despite its large number of product offerings, production of the Westfield products essentially involves component manufacturing, leaving product assembly to be completed off-site by distributors and dealers. Westfield’s product components are complementary and interchangeable, allowing the plant to complete very large process runs of basic components thereby increasing labor efficiency.
Customer Intimacy - Introducing solutions to your customer’s problems.
Ag Growth has a demonstrated ability to conceive, design and introduce commercially attractive new products and enhancements to existing products with relatively short lead times. Ag Growth’s commitment to after-sales service and support has entrenched it as a preferred supplier with its dealers and distributors, and has garnered strong brand loyalty among farmers.
Each of Ag Growth’s three operating divisions has its own strong, identifiable brand. Westfield, in particular, enjoys over 50 years of name recognition in the North American grain handling equipment market, with a reputation for providing top quality products at competitive prices. Ag Growth’s brand recognition and reputation translate into strong customer loyalty,
To put it in perspective, the types of products that Ag Growth makes cost and average of $5,000 and are equivalent to about 1% of annual farm costs. However, reliability is of the utmost importance, as a broken auger can cost you at least a day’s work (maybe even more if there are no replacements available). Successful Farming magazine estimated that for 800-acre corn-soybean farm, a single day of downtime knocks up to $325 off the bottom line, and that figure can climb to $900 during a poor harvest. As such, while there are cheaper augers out there, channel checks have lead me to believe that farmers have made Ag Growth products the “Augers of choice” due to their strong reputation, excellent reliability, high level of service, and overall value offering.
Product Innovation – Success through breakthroughs.
While the farming equipment sector evolves at a relatively mundane pace, there is room for companies such as Ag Growth to introduce innovative products.
A September 1997 article from the magazine Profit tells the following story:
“Swift Current, Sask. is not normally considered a hub of entrepreneurship. But Batco Manufacturing Ltd. is hoping to change that. Founded in 1992 by President Art Stenson, Batco first took a shot at manufacturing industrial-strength hand trucks and four- wheeled push carts. But after a year of slow sales, it was clear the company needed a new direction.
Finally, a local agricultural-equipment producer passed Stenson a tip: Farmers were crying for a product that would gently handle high-protein but fragile crops such as peas and beans. Traditional screw augers geared for grain were butchering these legumes, which were enjoying a renaissance as prairie farmers began rotating crops more often. Farmers complained that handling was damaging as much as 5% of their harvests. Batco designed a belt-driven conveyor that reduced the stress of loading and unloading as crops moved from field to storage bin to market. To make sure it was on the right track, Batco took a prototype to trade shows. "Not being actual farmers, we wanted to get public opinion and develop something that would generate high interest," says vice-president Rob Stenson, Art's MBA-trained brother.”
The article above went on to state that the Batco product, which sells for $5,000-$20,000, reduces damage in crop transfer situations to just 0.2%, which translates to annual savings of $5,000-6,000.
Given its size, Ag Growth can spend about $700-800k annually on R&D. While this does not sound like a particularly impressive figure, it is likely dramatically more than that of the company’s smaller competitors. As such, the company can continue to offer new products at a faster pace than the competition.
To give readers a better understanding of the financials, I will now discuss the income statement through an itemized discussion.
Revenue
2001 2002 2003
$60.4m $55.2m $57.0m
Given AFN makes short-life equipment (3-7 year life on average), AFN’s products are viewed by farmers as a consumable item. On average customers will fix an AFN product once before replacing it (maintenance parts account for roughly 9% of sales). While customers are price sensitive, they accepted a 3% price increases, followed by two 8% price increases all in the last year. From what we have been told by dealers “There are cheaper augers out there, but people still buy Westfield. It is the best value”.
Overall AFN revenue is driven by crop volumes, not crop prices. Hence, demand for grain handling equipment is driven by total grain production volume. AFN’s products for the most part serve the cash crop industry, which include corn, soybeans, and cereal. Over the past 50 years the production of these cash crops has increased from about 6bn bushels to about 14bn bushels (albeit there have been some bumps along the way). As grain production volumes have grown, so too has the demand for grain handling equipment.
It is reasonable to expect production to continue to increase due to 1) further farming productivity gains (Eg. Seed technology, continuous cropping, crop diversification, 2) growth in the world’s population (OECD forecasts global pop to increase from 7.1bn in 2002 to 7.6bn in 2008, and 3) rising personal incomes and improved diets in lower and middle-income countries (Chinese consumption of the world’s soybeans has increased from 14.2% in 1998 to 19.6% in 2003 > pg. 153 of the October issue of Fortune).
With respect to 2001-2003, the revenue line actually is quite representative of the peak to trough of the business. 2001 was a better than average year, while 2002 was a particularly poor year due to extensive drought, which was almost unprecedented in terms of its breadth and scope (Western Canada had worst drought in 100 years, US also had poor growing conditions in virtually all regions). 2003 was about midway between 2001/02 and represented slightly depressed results. So while there is some volatility to the sales line, peak to trough is probably less than 10%.
Part of the reason AFN has such stable revenue, in addition to the consumable nature of the items, is the geographic diversification of sales. Midwest US is the largest market at 35%, followed by Western Canada at 25%, Great Plains (US) at 20%, Northeast (US) at 6%, and finally offshore at 5%. This geographic segmentation reduces the exposure to natural disasters (drought) or any single crop.
On a macro basis, in addition to the increase in annual harvests noted previously, there are several other factors working in the company’s favor. Firstly, a trend exists towards increased farm size and greater on-farm storage. Larger farms require larger, higher capacity augers and conveyors and often acquire multiple pieces of the same type of equipment to avoid the costly downtime associated with moving such equipment around the farm. Since grain handling equipment is required to move crops into and out of storage, increased on-farm storage leads to an increase in demand for grain handling equipment.
One of the other factors that should play in the company’s favor is the gradual decline in farm subsidies that currently dominate the Western European market. This topic is fairly well covered by mainstream media sources, but a 50,000 foot summary is that the EU is concertedly lowering subsidies, thereby forcing small farms to consolidate. This is important, as small farms (which basically only exist due to subsidies as opposed to economic profit) have little reason for farm equipment to move grain (since they immediately sell into market whatever they produce). As larger farms become the norm, demand for equipment such as grain augers will increase. At present this is a nascent opportunity for AFN, but European distributors are in place and the company is well positioned to capitalize on this trend.
The other international expansion opportunity involves Australia. Although sales to Australia are presently rather modest, the demand is increasing. Historically Australian farmers (who typically are located close to port) have immediately shipped whatever the produce. However, after witnessing the more sophisticated practices of their North American counterparts, they have begun to adopt more sophisticated farming methods. What this means is that instead of simply dumping product onto the market and accepting the going price, farmers are beginning to realize the value of storing product and managing the cycle. As such the demand for grain augers is growing, and AFN hopes to continue to sell into increased demand.
On a company specific basis, the company can probably eke out about 3% growth per year just from new product introductions. During 2003, new products (defined as products introduced over the past two years) contributed to about 6% of sales. As an added bonus, many new products are designed to serve larger farms, and these larger pieces of equipment tend to generate higher gross margins than the current company average.
As for the short-term (2004/05), and this is very important, results are basically guaranteed to be good. It usually takes about three months to see the impact of a price increase (due to a 3 mnth backlog on avg), which means that the price increases will not be seen in entirety until next year. The company has already released one interim financial statement for a 44 day stub period, in which management provided pro forma results for the three months ended June 30. During this period sales were up 36% over prior year. In addition, the opening letter stated that:
“Our business, like any other, is challenged by external factors that affect the performance of the sector. Fiscal years 2002 and 2003 were plagued with an unprecedented number of events including the dramatic appreciation of the Canadian dollar, widespread drought in most of our core markets, and the mad cow crisis. These challenges were an opportunity to test the resilience of our operations and we are pleased to have passed this test with flying colors, continuing to produce significant cash flow. We priced the Initial Public Offering with these variables factored in.
We are pleased that our expectations for a rebound in industry fundamentals are being realized as we enter our first quarter as a publicly traded trust. Shipments in the quarter were at a rate not experienced since before the devastating drought season of 2002-2003. Order backlogs and underlying demand remain strong as we enter the third quarter, traditionally our strongest quarter of the year. Without major deterioration in crop conditions over the coming months, we expect to have a solid second half of the year.”
Of the half dozen random dealers I polled, all are operating with minimal or zero inventories of grain augers (quote: “We wish we had more to sell”). This suggests that 2005 should at least be a respectable year as dealers restock depleted inventory levels.
What this all means is that the short-term looks good, and while AFN is not a long-term 20%/year grower, it is not a completely mature company either. Via continued market share gains, international expansion, new products, and GDP type growth of the existing market, the company should on average grow revenue in the mid single digits.
COGS
Gross margin has been relatively stable around 50% or so for the past three years. The cost structure is broken out as follows: major components 31%, labor 26%, steel 23%, and other stuff 20%.
I can already hear someone asking “How is the company impacted by higher steel prices”, so I will nip it in the bud right now. The company has hedged about 60% of its needs for this year and next. On the unhedged portion the company has seen prices increase about 60% when steel hit its most recent high (price has already receded from its 2004 high). Assuming that prices return to their highs, it would be an impact of 23% (steel as proportion of costs) X 60% (currently hedged needs) x 60% (increase in steel prices to high compared to 2003 levels). Overall that implies an 8% increase in annual costs, which not coincidentally is equivalent to the first 8% price hike the company introduced this year (although the full effect of the price hike will not show up until 2004).
Other
G&A and R&D are the other significant line items. G&A should be around $10.0M on average, while R&D is about $700k-800k. This is a relatively simple business, so there are not a lot of other items that merit discussion.
Management
We have had spoken with management on several occasions and are confident in their abilities. The CEO has grown the company from a standing start and “gets it”. He has an MBA from Western (Canada’s top MBA school) and told us outright that he cares about profits not sales. He owns a couple percent of the company, but actually has 90% of his net worth invested in the units.
With respect to acquisitions, he is keeping his eyes open. Ag Growth Industries (predecessor) had publicly outlined acquisition criteria as follows:
1. All acquisition targets should be short-line agricultural implement manufacturers, primarily in grain handling equipment, in order to capitalize on overlap in distribution networks and expand the geographical marketing scope of all products in a cost effective and timely manner.
2. Acquisition targets should have EBITDA of approximately 20% of gross revenue.
3. Acquisition targets should demonstrate sales growth potential in terms of market demand and marketing capability, to capitalize on the expanded marketing network.
4. Acquisition targets should be located in the three Prairie Provinces or the northern U.S. states of North Dakota, South Dakota, Minnesota or Montana, in order to facilitate centralized purchasing and shipping.
As for valuation, to quote the prospectus “Ag Growth will make acquisitions or investments only if it believes that the acquisition or investment will result in an increase in distributable cash per Trust Unit”. Management has indicated to us that they are looking for a low capex business similar to AFN that they can purchase for about 5x EBITDA. That being said, management currently believes the units are undervalued and the team is reluctant to issue equity at these prices to fund an acquisition.
Subordination
There is a nice subordination feature on management’s and Tricor’s remaining interest (4% and 19% of the units, respectively). This gives some distribution protection for 2004/05, but since these will likely be good years this probably does not matter. Readers can find the subordination agreement in the prospectus if they are interested in the details.
Competition
As previously noted AFN is the market leader and picking up a bit of share each year. This is a small fragmented market and we have not uncovered anything to suggest that the weak will not get weaker. As one dealer who switched from a competitor to Westfield stated “I figured it was time to switch because everywhere I drove, all I saw were Westfield augers sticking up in the air”.
The obvious question is “What if John Deere targets the market”. Well, Deere tried to break in 10 years ago and left quickly with their tail between their legs. To put it in perspective, AFN is the market leader and does CAD$55m in sales. The size of this niche market probably is not large enough to attract the big boys from coming in or increasing exposure. Other existing competitors include Feterl (private), Midwest (private), and FarmKing (a division of Buhler > also publicly listed on TSE). Moreover, our research indicates that while farmers are very loyal to their brands, that loyalty does not extend across non-complementary products, Eg. A farmer will be a Deere man for tractors, and a Westfield man for augers, but he will never move to a Westfield tractor or a Deere auger just because such a product was introduced.
THIS WRITEUP IS CONTINUED IN A SUBSEQUENT POSTING
Disclosure
We own shares in AFN.UN and may buy more, sell some, sell all at anytime. We have no intention of updating this website with our trading activities.
Catalyst
I think this is a fat pitch that few people know about
Release of strong results (in the bag)
Initiation of analyst coverage in the intermediate future
Double digit cash in your pocket distributions while you wait