Description

I am recommending Tongaat (TGH JSE) as a buy. It is a simple reversion to the mean trade. The worst drought in 100 years has cut Tongaat’s sugar production to 1mil tons and profits from the sugar are down 80%.

The sugar business generated an operating profit of R1 400mil in 2013. In 2016, the profit was only R124mil. This is a bet that the rains will return and that sugar production will recover to 1.6mil tons per annum. There are signs that El Nino is lifting and hopefully the next set of results will begin to reflect a recovery.

Tongaat is currently trading at R107. My target price is R151. The high before the drought hit was R180.

DESCRIPTION

Tongaat consists of 3 operations

• Sugar production (growing + milling) in South Africa, Zimbabwe, Mozambique and Swaziland.
• Starch operation, operates the only wet mill in Africa
• Land development, Tongaat have a land bank of 8 026 hectares earmarked for development. They plan to sell from 3 736 hectares over the next 5 years, 683hecates are currently under negotiation.

In the remainder of the report I describe and value these operations and derive the following SOTP value.

The SOTP price is R151 representing a 41% upside on the current share price.

SOTP VALUATION

The operating profits generated by the three operations are shown below.

Land Development

(Note: 1hectare=10 000m2=107 600ft2)

Tongaat’s land streches to the north and west of Durban, South Africa's busiest port. As Durban expands, agricultural land needs to be converted for urban use. Tongaat has earmarked 8 026 developable hectares for sale. The initial plan is to have 3 736 hectares ready for sale over the next 5 years.

The profit form land sold since 2007 is shown in the following table.

Valuation

·         The average profit/ha from sales is R4.7mil. This implies a total profit of R37bil for the 8 026 developable hectares compared to the R19bil EV. Even with severe haircuts it is not difficult to understand why many analysts conclude that investors get the sugar and starch operations for free.

·         Tongaat provide regular reports on their land bank. [http://www.tongaat.co.za/downloads/Land_Portfolio_Nov_2015.pdf] I have spent hours on these reports and feel comfortable that R5mil/ha profit is a fairly safe bet.  Assuming the historic margin of 79% holds, this implies a selling price of R6.3mil for a hectare of land.

·         How much is R6.3mil ($400k) per hectare? This is what a developer of a mall is prepared to pay for land to ensure the economic viability of the mall. Residential land goes for a lot more. In fact, over 35% of Tongaat’s land by value is located in the wealthiest part of Durban (Umhlanga) were land is sold for R30mil per hectare. (See appendix for a current list of land for sale in the Umhlanga area.)

·         Management are currently in negotiations to sell 658ha over the next two years. The estimated profit on these deals is R3.35bil, or just over R5mil per hectare.

·         For my SOTP valuation I value the land at R12 000mil using the following assumptions: sell 200ha per annum, selling price = R6.3mil/ha and a discount rate of 10%.

Starch

Tongaat operates the only maize wet mill operation in sub-Saharan Africa. The four wet-mills use 630 000 tons of maize per annum producing a wide range of products for the food and beverage industry as well as some industrial users (eg paper).

The starch business locks in long term cost-plus supply agreements with their clients. Profits have grown steadily as the operation benefitted from

• Focus on higher margin products
• Increasing utilization
• Volume growth which has exceeding GDP growth.

I think the starch business deserves a premium ratings as

• the operation has long term cost plus contracts
• with defensive food and beverage customers
• limited competition (only from imports if SA maize prices exceed world prices by a significant margin.)
• Benefiting from economies of scale as utilization increases

Given the above,  I think an EV/EBIT multiple of 10 (equivalent to PE=14) is fair. This implies a value of R6 580mil for the starch operation.

Sugar Operations

Tongaat operate sugar operations in South Africa, Zimbabwe, Mozambique and Swaziland. The cane for the mills comes from a mix of their own farms and from external growers. Tongaat’s mill capacity is 2.1mil tons. (South Africa 1.2mil, Zimbbwe 0.6mil, Mozambique 0.3mil)

The sugar is typically sold in the local market and the balance is exported. The local market is protected by tariffs so the local prices are normally more attractive compared to the world price. The world price is regarded as a dumping price.

Until recently the EU paid a premium to the world price for sugar from Least Developed Countries (LDC’s) which included Mozambique, Zimbabwe and Swaziland. This premium has been falling putting pressure on export realisations for these countries.

The results of from the sugar operations are shown below.

Observations

·         El Nino has hurt the last two South African crops and production has fallen from 634 000 tons to 323 000 tons. This has depressed profits as very little sugar is left for exports after supplying the local market.

·         Mozambique and Zimbabwe sugar is irrigated and are only vulnerable to a drought if dam levels fall to dangerous levels.

·         Zimbabwe production is recovering from a drought and low dam levels in 2013. The operations are also adapting to the loss of the EU premium. Zimbabwean import tariffs are high and the operations benefited from a high local prices and limits on imports.

·         Mozambique operations have been hurt by the loss of the EU premium. In addition, import tariffs were not high enough to protect the local market from imports and Tongaat was forced to sell sugar at the low world price. Import tariffs have been raised to protect the local market which should benefit future profitability.

·         It is worth noting that Tongaat is the largest private company employer in Mozambique and Zimbabwe. Tariffs are important and are needed to protect these jobs.

Sugar Price

The sugar price reached a low of 10c/lb in Aug2015 and has recovered to a current 15c/lb. This should benefit both local and export prices of sugar in the various operations mitigating some of the losses from the drought.

Valuation

Illovo Sugar (ILV SJ), Tongaat’s main competitor, recently agreed to a take-over offer from British Foods. The offer valued ILV at 9 times it’s average 2015 to 2012 EBIT.

Using the same metric Tongaat’s sugar operations are valued at R10 000mil. (9*R 1 143mil). The minorities own 20% of the production and I estimate a R2 000mil value for the minorities.

The book value of the sugar assets is R20 000mil. The book value of the sugar crop alone is worth R5bil, so, the R10bil value is very conservative and is probably a fraction of the replacement cost of the mills.

Central Costs

I estimate central costs of R85mil per annum and knock R850mil off the valuation for head office costs.

CONCLUSION

 This a reversion to the mean trade and as experienced investors know timing is everything when making these bets. While it does appear that El Nino is lifting I do not recommend a full position until adequate rains have fallen as I believe there is lots of time to play the normalization of the weather. Tongaat report results on May30,2016. The news will not be good. I hope to build an initial position on weakness.

APPENDIX: LAND FOR SALE IN UMHLANGA

Below is a list of land currently for sale in Umhlanga. The list is drawn from the main on-line realtor site in South Africa.

http://www.property24.com/?gclid=Cj0KEQjwmpW6BRCf5sXp59_U_ssBEiQAGCV9GiIkDmi3F7LTUJ_dgcBljPPLHRiqG3uV44RJuKqkg_4aAvlf8P8HAQ

Catalyst

Drought ends and rain returns

Continued recovery in the world sugar price