Brasil Agro AGRO3 BZ
December 31, 2007 - 7:47pm EST by
xanadu972
2007 2008
Price: 10.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 584 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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  • Agriculture
  • Brazil
  • Latin America

Description

Introduction:

We are recommending going long Brasil Agro (AGRO3), which we believe to be one of the cheapest and most unique investment opportunities in the agriculture space providing between ~35% upside (project NPV of fully deployed IPO cash proceeds) and ~70% (30% premium for less conservative project assumptions and Brasil Agro’s ability to deploy additional capital). The company’s core business is the acquisition, development and resale of agriculture land in Brazil. Currently investors are able to buy Brasil Agro at a mere R0.60 premium to its’ IPO cash proceeds assuming full warrant dilution. We believe over the next year Brasil Agro will appreciate as the dramatic re-valuation of its’ land banks becomes apparent. Our upside target becomes more likely as Brasil Agro sells off mature sugarcane assets, deploying capital more efficiently than our conservative base case assumptions. While not directly incorporated into our valuation, we believe investors could receive a multiple of their original investment if Brasil Agro becomes a platform off of which additional capital may be deployed above management’s 25% IRR hurdle rate. Cresud’s (Argentine analog and 10% owner of Brasil Agro) tremendous shareholder returns demonstrate the multiyear return potential if the company is able to build a business platform to source and develop future land projects.

Valuation:

We believe that shares of Brasil Agro are worth between 35% (~13.50 reais) and 70% (~17 reais) more than its current share price of 10 reais. On the low side, we arrive at a valuation of ~13.50 reais based on the following sum of the parts:

1.      Cash balance: R552mln

2.      NPV of committed land projects: R170mln [Project details below]

3.      NPV of future land projects from IPO capital: R125mln

4.      NPV of cash received from warrants: R101mln

Total EV: R948mln

Post-exercise shares outstanding: 70.1mln

Value per share: ~R13.50


Business:
Brasil Agro will develop its ~120,000 hectares of land holdings (purchased or agreed purchases) into ~110,000 hectares of soy farmland and ~10,000 hectares of sugar cane farmland. Of Brasil Agro’s announced projects, we assume that only ~4500hectares (Sao Pedro Farm, Engenho Farm) of its ~120,000 hectares of farmland holdings will be sold before full maturity in FY2012. This conservative cash flow assumption (some might say poor capital allocation) lowers project IRR’s to 39% and raises maximum capital deployed to ~R260mln. Our forecasting assumptions are as follows: 5% per annum appreciation in sugar farmland (~R10900/hectare ending value), 10% per annum appreciation in soy farmland (~R5850/ hectare ending value), 12.5% cost of equity capital, 7% tax rate and R39 per bag of soy.

For the remaining excess capital, we assume that the remaining ~R290mln in cash will yield an NPV of ~R125mln when deployed in one year’s time with a project IRR of ~30% with otherwise similar assumptions to the firm’s existing projects.

Our upside target is an approximation to account for more efficient capital deployment, especially the utilization of 6-7% economic development bond borrowings. Additionally, it allows for value creation through the deployment of cash received from warrants being exercised. To understand the return potential on future capital deployment, we encourage investors to acquaint themselves with Cresud’s history.

 Management:

Perhaps one of Brasil Agro’s greatest assets is it management team and investor base.

  1. Cresud, which owns approximately 9% of Brasil Agro, is one of the largest landowners in Argentina. Cresud has used this business model successfully for years in Argentina and is closely involved in the day-to-day operations of Brasil Agro with numerous appointments to the board of directors. Conversations with Cresud management made it readily apparent that Brasil Agro is viewed as an important growth outlet for the firm.
  2. Elie Horn is one of Brasil Agro’s largest individual shareholders. Elie Horn is Chairman of the Board and controlling shareholder of Cryela development (the largest player in Brazil’s commercial and residential development market).
  3. The Elzstain family holds various personal stakes in Brasil agro. The family through it association with Cresud and Irsa in Argentina have more than 20 years experience in the development in real estate and agriculture projects.

 
Cresud, senior management and larger shareholders have commented both privately and publicly that they are interested in increasing their stakes in Brasil Agro through open market transactions. They will also increase or maintain their relative position size if the company raises further equity once capital is fully deployed

 Business Description:

Brasil Agro’s business economics are primarily driven by two factors:

  1. Expertise and relationships allowing the development of raw land into more valuable farmland.
  2. Unsustainably attractive differentials between global and Brazilian farmland.


Detailed Business Description:
  1. Brasil Agro has a unique management team, set of financial backers and business partners that allow it to generate excess returns by developing land, either raw or other use, into much more highly valued farm land. The following table illustrates the valuation differentials between different types of land:

Example of land valuations in Brazil (USD per ha)

Unproductive Land- less than $400 per hectare

Cattle Land ~ $800 to $1000 per hectare

Soy Land ~$2000-$2500 per hectare ( R3500-4400 per ha)

Sugarcane Land ~ $5000 per hectare (R8900 per ha)

We discuss the management team and financial backers within the management section. Brasil Agro has an exclusive relationship with Brenco, a Brazilian ethanol producer, which allows Brasil Agro to purchase and develop land in advance of Brenco’s future sugar cane mill announcements. We discuss an example project in “Other topics to discuss.”

By buying large underdeveloped tracks of land and investing capital for soil correction, irrigation and new seed selection the company should be able to realize significant returns on invested capital. For example, they currently are transforming unproductive cerrado into cleared cattle farmland, cattle farmland into soy crop and soy crop into sugarcane plantations. Each step of this process creates significant price appreciation as the crops move up the value chain. Brasil Agro is currently involved in each step of this process and is able to enter at various points of the value curve

  1. Brasil Agro is able to take advantage of “relatively cheap” agriculture land in Brazil. Regarding soy farmland, a hectare of soy land in Brazil sells between 1500 to 2500 USD while a similar hectare in the US would be 7000 to 10,000 USD.  With similar crop yields and our assumed R4000 per Ha soy land price, we calculate the minimum incremental pre-tax return to the Brazilian soy farmer at ~16% [Assumptions: $10 per bushel, $7 per bushel cash costs, 40 bags per hectare yielded, R1.776 per USD, 60lb per bushel, 60kg per bag]. Within our model, we forecast soy farmland prices will appreciate 10% per annum for the next five years. We feel comfortable with this forecast given: 1. Argentina’s farmland sells for a much smaller gap to US farmland, providing comfort that the US tariff regime does not justify such a large gap; 2. Brazilian farmland has appreciated at 10-20% rates over the last four years; 3. We believe that yields will improve to 50 bags per hectare, keeping returns above 15% [11% without improved yields]; 4. Our model does not account for improvements which will lower Brazilian soy farming costs, especially related to infrastructure.  Regarding sugar cane farmland, we calculate the minimum incremental pre-tax return at ~18%, but do have the same data granularity as our estimates in soy production. However, we are comfortable with this given the low sensitivity to sugar farmland prices and continued soy to sugar farmland conversion which attests to the relative economics.

 Other topics to discuss:

  1. The company has placed all newly acquired assets in individual subsidiaries. Under a REIT like structure these subsidiaries are able to sell assets below R50 million at a 7% gross tax rate. The subsidiary is allowed one asset sale larger than R50 million at 7% gross tax rate but then must begin paying normal tax rates. However, limited costs and no legal barriers make it easy to simply create new subsidiaries (they mirror tax strategies used at Cryela).
  2. Speaking with management the company is putting Engenho and Sao Pedro assets up for sale. These assets were originally acquired in late 2006 for R9.9 and R10.1 million respectively. The company intends to sell each asset for as much as R20 million. Representing a doubling in value in a little less than a year
  3. Brasil Agro currently has an agreement with Brenco to develop 10,000 ha sugarcane crops at each of its future projects. These contracts should prove to be extremely valuable to Brasil Agro as Brenco is building its future mills on marginal land within Brazil. This allows the company to purchase soy land in advance of the mills production (2000-2500 USD per ha) and turn the land into sugarcane crop (5000 USD per ha) within a three-year time frame. Currently the company is pursuing this strategy at Alto Taquari and Araucaria farms.
  4. Brasil Agro in many cases has worked out extended payment agreements to farmers or co-ops in order to extend cash outflow over a two to three year period when acquiring assets.
  5. Brasil Agro is able to take advantage of economic development bonds when improving assets. These essentially allow the company to borrow at 6-7% rate while holding short term investment paying 10-11% (cost of debt to cash arb)
  6. Warrant structure: The company has a 2 series warrant structures. The first series allows founding shareholders to increase the total capital by 20% of shares outstanding over a three-year period (vesting 1/3 per year). The strike on these warrants is at IPO price (R10) indexed to IPCA inflation (NPV of the strike at ~R8.6). The second series is enacted in the case of a take-over. Foundering shareholders are able to buy 20% of fully diluted shares outstanding at the same offer price as the bidding acquirer. Our calculations presume full exercise as this is in the owner’s best interest and results in the lowest valuation.  

Operations:

While the primary focus of the company is to acquire and redevelop assets the business will involve a significant amount of farming operation. By the beginning of 2009 the company intends to run ~18,000 acres of soy, growing to over 30,000 hectares prior to sales on existing projects. While it is hard to forecast operating earnings for this business due mainly to fluctuating crop prices we feel a 35% EBITDA margin to be appropriate (normally range between 25 and 45%). While we believe there is value created in day-to-day operations we view this business as an ancillary means to an end. The company will not be spending capex on farm equipment, as it wants to minimize operational capex. Instead it will lease the machinery and in many cases outsource labor.

 

Risks:

·        Soft commodity prices collapse

·        Land prices increase slower than expected or decline

·        The company is unable to find viable acquisition to meet investment targets

·        Competition intensifies and returns on future projects fall


Catalyst

· Company is able to sell Engenho and Sao Pedro farm in 2008 for double acquisition cost

· Cresud/Management/Larger shareholders continue to acquire more shares

· Company fully deploys capital

· Further coverage from larger sell side banks
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