One for the Watchlist - Elders Ltd.
For the past few months, I've been watching with interest as an attempted business turnaround takes place in Australia. The company in question is Elders Ltd., a venerated agrobusiness that has fallen on hard times. Elders provides a suite of services to Australia's rural wool and beef industries and farmers, including animal feed, wool trading, live export, and financial services. Elders' lengthy history began in 1839, when Alexander Lang Elder traveled from Scotland to the new colony of Australia to expand his family's merchant empire. The business took off, and over the next several decades Elders expanded into mining, wool trading, banking, brewing and other businesses. Elders underwent multiple restructurings, ownership changes and name changes, but finally returned to the public markets in 1993. Elders spent the 1990s and 2000s expanding some divisions and divesting others, but generally growing its balance sheet and taking on debt in the process.
The financial crisis hit Elders hard. Elders had invested heavily in its forestry operations for years, only to record hundreds of millions in writedowns. The company's automotive assets began to bleed red ink as global demand for autos crashed. The company's debt load threatened to drag it into bankruptcy, so in 2010 Elders proceeded to raise $500 million in equity, using the proceeds to pay down debt. Hopes that the restructuring would restore Elders to profitability were soon dashed. The years 2011 and 2012 saw the company report a further $456 million in losses. Elders' problems ran far beyond the balance sheet. The company had become a bloated, unwieldy conglomerate with entirely too many lines of business and too little accountability among them. In 2012, the company's marquee rural services unit earned an EBIT margin of only 1.6%. Forestry continued to produce losses and automotive limped along. The only bright spots were Elders' equity investments in various insurance and banking companies.
From June, 2007 to October, 2012, Elders stock plunged 99%. What was once a vibrant company with revenues in the billions was now struggling for life as losses continued and the debt load remained unsustainably high.
Elders began divesting its forestry operations in 2011, and announced it would also divest its automotive holdings. In October, 2012, the company announced it would begin preparations for the sale of its rural services unit. It looked as if a very old business, once an Australian institution, would see itself parceled off to other firms, a victim of over-leverage and poor management.
Ultimately, the sale of the rural services business was not to occur. Shareholder dissatisfaction reached a fever pitch, resulting in new management being installed in April, 2014. New CEO Mark Allison has extensive experience in agriculture, and revealed plans to return Elders to an agricultural pure play by selling off remaining non-core investments and focusing on increasing profitability in the rural services unit, with a focus on high-margin, asset-light businesses.
Elders has spent most of 2014 selling off remaining non-core assets (forestry, real estate, feedlots, and many other small operations) and applying the proceeds to reducing its term debt. Earlier this month, the company announced the final steps in this process: an equity raise via a share placement and rights issue, and a new debt package. As a result, Elders will have no term debt for the first time in decades, and will finally be able to focus on profitability and growth rather than survival.
Elders' new management team has released detailed plans to increase profitability, and hopes to nearly triple EBIT by 2017. Before looking at those plans, let's take a look at Elders' new capital structure. Following the share placement and rights issue, Elders has 837.2 million shares on issue. At todays' price of $0.175, that's a market capitalization of $146.5 million. Elders also has a class of "hybrid equity" outstanding. This is essentially floating-rate non-cumulative preferred stock. Dividends have been suspended since 2009, and Elders will have to pay 12 months of delinquent distributions before it can declare dividends on common shares. Elders has $150 million par value of hybrid equity shares outstanding, and they currently trade at 55% of par. Following the equity raise, Elders has $21 million in net term debt. However, the company just closed on the sale of its 50% interest in AWH Pty Ltd. for $32.4 million in cash. Finally, Elders' new banking facility provides up to $308 million in working capital financing, of which $145 million will be drawn.
Elders' new capital structure and enterprise value look like this:
In connection with its capital raising, Elders' new management team released a detailed presentation outlining they steps they will take to increase profits and reduce capital requirements. Elders new focus will be on its highest-margin, most profitable business lines. Below are a few selected slides from recent presentations. The first two contrast Elders' current lines of business with where the firm will now position itself.
Achieving EBIT of $60 million and a return on capital of 20% by 2017 will require a mixture of improved sales margins and reduced corporate costs. Elders has set out its specific initiatives in all its business areas that it believes will help achieve these goals. The entire presentation is worth a read and can be found here.
In my view, Elders' decision to return to its strengths is a good one. Elders has been a constant presence in many of the rural communities that it serves for generations, and the brand recognition and relationships that come with that kind of longevity carry value. The company's long experiment in empire-building has rightly come to an end with the company barely surviving the venture. Rebuilding Elders' profitability requires a return to the company's roots in serving Australia's large agricultural sector in rural communities.
If Elders is successful in growing EBIT to the $60 million target, the returns to shareholders could be substantial. For 2014, the company has guided for pre-items EBIT of $23-28 million. At the mid-point, Elders trades at 14.2x 2014 adjusted EBIT. The company trades at only 6.0x its 2017 EBIT target.
Elders hasn't revealed the cost of its working capital financing (that I can find) so I'll use an estimate of the 1 year Australian government bond rate of 2.59% plus a 2% spread. I'll also assume that Elders increases the draw on its working capital facility 5% annually, as sales increase. For the hybrid capital securities with a rate of the ten year swap rate plus 4.7%, I'll use an estimate of 8.56%. Note that the hybrids cost is an after-tax expense, with Elders passing on franking credits to the holders. Assuming Elders can meet its 2017 EBIT goal in exactly three years, let's estimate profits at that point.
If Elders achieves its goals, it stands a chance of earning close to $24 million annually for shareholders. This is slightly misleading, however, as Elders will not likely be a taxpayer for quite some time. The company has accumulated deferred tax assets totaling $255.9 million. A simplistic way of valuing these assets is to assume they are used up linearly over 10 years, beginning in 2017. Even at a high discount rate of 11.56% (the hybrid capital cost +3%) this yields a present value of $44.2 million.
Elders' 2017 value under all these assumptions depends on the multiple assigned by the market to the company's pro forma earnings, but it's not hard to arrive at a value much higher than today's, even using modest multiples. The chart below shows Elders's prices per share and three year compounded returns at various pro forma earnings multiples, including the present value of the tax assets.
In reality all that matters is whether or not Elders can successfully achieve the goals it has laid out. If they do, the company will stop being valued as a distressed equity and will begin to be valued on an earnings/cash flow basis, and the share price will rapidly appreciate to some multiple of anticipated future profits. The chart above is mostly intended to illustrate what the magnitude of that appreciation could be based on various extremely uncertain scenarios that include a lot of my guesswork and crystal ball gazing.
On the other hand, if Elders' new management team fails to make progress and investors lose hope, Elders shares will be in trouble as investors begin to contemplate yet more restructurings, write-downs and management turnover. Given the company's troubled history, investors will understandably show little patience and won't hesitate to punish the stock price if management's confidence proves unwarranted.
For those inclined to take a flyer on a successful Elders turnaround, the hybrid capital securities are also an interesting bet. Management has guided for no distributions for at least a while as the company dedicates capital to rebuilding and re-positioning. However, at some point common shareholders will demand a dividend, and hybrid capital holdings will receive a year's worth of skipped distributions. If the arrears payments equal roughly 8.56% of par, distributions take three years to resume and the securities trade at par when they do, investors buying at today's 55% of par will earn a total return of 97.4% and a compounded return of 25.4%. That's competitive with the equity on a risk-adjusted basis. Given the uncertainly of Elders' ultimate turnaround, perhaps investing slightly senior to the common stock is wise.
Personally, I require more evidence of progress before giving Elders serious consideration as an investment. Though its short-term financial troubles have been assuaged by the capital raise, the company faces a difficult task in restoring its profitability and expanding its margins. Even if the next financial report's numbers look good and the stock pops, there will be plenty of time to buy in before the potential returns lose their attractiveness. At least for now, Elders remains one for the watchlist.
Alluvial Capital Management, LLC does not hold shares of Elders Ltd. for client accounts.
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