Teak Holz International AG - Vienna Exchange: TEAK

Now and then I run across a company with a truly unusual business model. So far as I know, Teak Holz International AG is the only pure-play publicly-traded producer of teak wood in the world. (If I'm mistaken, I welcome corrections.) Teak Holz is established in Austria and traded in Austria and Germany, but owns nearly 4,800 acres of teak producing land in Costa Rica. Teak is a tropical wood that has long been prized for use in furniture, boatbuilding and construction due to its excellent durability and water resistance. The tree is native to Asia, but is now cultivated in Central and South America as well. The teak industry increasingly uses sustainable forestry methods and complies with fair labor practices, and Teak Holz emphasizes its leadership in these areas. The company's teak plantings are not yet mature, and many years will pass before Teak Holz realizes meaningful cash flows from harvesting timber. Teak Holz's unusual cash flow profile complicates the valuation, which makes the company all the more interesting to me. Even more interesting is the company's 79% discount to tangible book value.

Most of the companies I evaluate and invest in are dependable cash generators. Valuing these companies is a process of normalizing this cash flow and applying the appropriate multiple based on industry prospects, capital structure and management quality, among other factors. Businesses like Teak Holz present a different challenge because their cash flows are far off and highly uncertain. The present value of the future cash flows generated by Teak Holz's timber harvest is highly sensitive to factors like discount rates, harvest timing and teak prices, all of which are impossible to predict with any degree of accuracy.

According to the company, the growth period for Central American teak crops is 15 to 20 years. The majority of Teak Holz's trees are 5 to 6 years old. Not saplings, but also not ready for harvest. Between now and then, these plantings will be thinned multiple times, allowing the remaining trees to increase in diameter and become much more valuable. These thinnings will generate a small amount of positive cash flow, but the big payday will not arrive for another 10 to 15 years. Teak Holz provides an estimate of the present value of its teak crop. Discounted at 12.75%, Teak Holz's own estimate of its cost of capital, the company values its teak assets at €97.65 million at the end of fiscal 2013. This figure is net of all costs to plant, manage and harvest the teak crop.

As of fiscal 2013, Teak Holz's balance sheet looked like this, in millions of Euros.

Teak Holz has EUR 77.24 million in balance sheet equity value, yet its market capitalization is only EUR 14.97 million. That's among the largest discount to book value I've seen, especially for a company not in dire financial straights. Teak's 79% discount to tangible value is just as stark.

That leaves us with a question: why? Why does the market assign such a massive discount to the stated value of Teak Holz's assets? Turns out, there may be some solid reasons.

Possibility #1 - Overstated Assets

Perhaps Teak Holz is simply wildly over-estimating the value of its teak plantations. It's a reasonable hypothesis because Teak Holz recently took a huge writedown, reducing the estimated value of its teak assets from over EUR 135 million to the current figure of nearly EUR 98 million, a reduction of 28%. Ouch. The writedown was done in response to a new valuation survey commissioned by the company after a significant leadership change. For the first time, the company contracted an outside expert, Legacy Appraisal Services of Gainesville, Florida, to provide a new estimate of the teak crop's value. Legacy Appraisal Services' valuation process incorporated much less optimistic inputs for teak prices and harvest yield than the company's own process, resulting in a substantially decreased balance sheet value. The new balance sheet value is likely closer to the actual present value of the company's teak harvest, but investors may remain suspicious of the company's published figures. Nobody wants to invest in Teak Holz, only to suffer through another 10% of 20% writedown.

Possibility #2 - Financing Issues and Dilution

While Teak Holz may ultimately realize a handsome profit on its teak harvest, the company will have to fund its ongoing corporate expenses in the interim. These expenses reduce the value that shareholders will ultimately realize from the teak crop, moreso because they are current expenses while the teak harvest cash flows will not be received for several years. In fiscal 2013, Teak Holz spent roughly EUR 3.2 million on operating expenses, compared to EUR 2.6 million in fiscal 2012. Because Teak Holz has minimal cash reserves and nearly no revenues, these operating expenses must be funded by raising capital or selling assets. This is where the company's depressed stock price becomes a serious issue for the company and for shareholders. Selling equity as a means of funding operations is extremely unattractive, because selling shares at 19% of book value is extraordinarily dilutive. Traditional debt financing is only marginally feasible because the company has little capacity to make periodic interest payments. Payment-in-kind debt would circumvent this issue, but such debt usually comes at a cost of high, high rates. In order to finance its ongoing operations, the company has settled on a mix of bank debt, loans from a related party and convertible debt. Teak Holz's bank debt of EUR 4.96 million is secured by a mortgage on the personal property of a company insider, who in turn holds a contingent mortgage claim on one of Teak Holz's plantations. The same insider has also provided Teak Holz with a EUR 3 million loan, again secured by one of the company's plantations. Finally, the company has EUR 11 million par convertible bonds outstanding, bearing interest at 5%. These bonds come due in 2015 and are convertible at a share price of EUR 5. Since the last annual report was filed, Teak Holz sold an additional EUR 2.35 million in convertible bonds with the same terms. Refinancing the convertible bonds is a looming issue for the company, one that sustains uncertainty and contributes to the depressed valuation.

Simply put, Teak Holz's small size, ongoing cash needs and depressed valuation leave the company with few good financing options. The market may rightly be pricing in the possibility of significant dilution between now and the eventual teak harvest, an outcome that would reduce investors' pro rata shares of the eventual harvest proceeds.

Possibility #3 - The Market is Wrong

Questions concerning asset value and financing risks notwithstanding, it's possible that the market simply has Teak Holz all wrong. Perhaps the teak assets are fairly valued or even under-valued, and perhaps the company manages to fund its operating expenses at a reasonable cost between now and the first big harvest in several years. In that case, investors buying at this price will likely do very well.

Unfortunately, I can't get comfortable enough with Teak Holz's financial position to even consider possibility #3. Rather than rely on expensive and short-term convertible debt financing, I'd rather see the company execute some long-term forward timber sales or selectively sell acreage/plantation ownership interests. (A little strategic self-liquidation doesn't hurt anyone. If Teak Holz's acreage is really worth what they say it is, they shouldn't have too much trouble liquidating a little each year at a price sufficient to fund operations.) The company has announced some medium-term forward timber sales, but I'd be happy to see them explore this financing method further. Another factor that gives me pause is Teak Holz's management team. The corporate officer and director ranks seem to be a revolving door of Austrian businessman who know each other through outside business dealings. I am not suggesting any nefarious activities are in progress, but I'd rather see some consistency in leadership and a few more experts in teak and Costa Rican forestry.

That said, Teak Holz is a fun one to watch and a nice change from the typical industrials, banks and telecoms that are my bread and butter. As a final note, Teak Holz's convertible bonds may make an interesting speculation. They trade on the Vienna Exchange with the ISIN AT0000A0K1F9. The last trade was at 76.101 for a yield to maturity of 29.1%. More importantly, they have plenty of asset coverage if Teak Holz's harvest valuation is even remotely realistic. Please note I am not any kind of authority on Austrian fixed income and bankruptcy law, so I have no idea what special risks these bonds would carry.

Alluvial Capital Managment, LLC does not hold shares of Teak Holz International AG for client accounts.

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