Wednesday, June 16, 2010

Viterra: Case Study for Safe and Cheap Investing

Recently, Morningstar interviewed Amit Wadhwaney at Third Avenue Management (TAM) and Wadhwaney discussed one of his Canadian holding - Viterra. This interview piqued my interest in Viterra, and I spent some time digging through the annual reports of Viterra and Wadhwaney’s letters to shareholders to understand his investment thesis. Upon investigation, I found that Viterra fits TAM’s “safe and cheap” investing framework perfectly. In this case study (it is much longer than most articles on this website, but it is a case-study), I want to use TAM’s investment in Viterra to show how safe and cheap investing works and highlight how it differs from other value investing methodologies.

Let’s begin with understanding the elements of a "safe and cheap" investment:
• High quality balance sheet.
• Competent and shareholder-oriented management.
• Understandable and honest disclosure documents.
• Priced at a significant discount from realizable net asset value.

We will come back to these elements of safe and cheap investing as applicable to Viterra, but first let’s understand some key events that took place before TAM invested in Viterra.

1990-2000: The Pool goes Public
Viterra is an agribusiness based in Regina, Saskatchewan. It was formed from the take-over of Agricore United by Saskatchewan Wheat Pool (“Pool”). The Pool had been in operation since the 1920s as a farmer’s co-op, but it decided to go public in the 1990s. The company was undergoing the largest and the most expensive capital expansion in its history at that time and needed the access to capital markets. It got listed on the Toronto stock exchange, but it had a corporate governance structure that was inequitable for the public shareholders since they had no voting rights. The Pool’s board was made up of 16 farmer directors who were elected by the co-operative members, who represented both the 70,000 farm customers as well as the non-voting shareholders. With this dual-class governance structure, raising capital in the equity markets was difficult, and the Pool met its capital needs through the debt markets. But, many of its investments did not succeed and the company was burdened with $550 million of debt.

2000-2005: Financial Troubles and Restructuring
The Board replaced the senior management team and brought in a new CEO Mayo Schmidt. Schmidt had spent 15 years with General Mills’ agriculture business followed by a few years leading the Nebraska-based ConAgra Food’s expansion in Canada. All along, he had been observing Pool’s doomed attempts to grow its business. But, he saw an opportunity in this mess. “It was my view that the Saskatchewan Wheat Pool could be a catalyst for the changes that were necessary to make Canadian agriculture a major player in global food markets”, he said. Also, the Pool’s Board recognized the need for professional expertise, and brought two external Board advisors from the business community to actively participate at the board table. While the Board members did not have the authority to vote on Board matters, they challenged the Board to take the difficult and necessary steps. This led to Schmidt divesting the Pool’s non-core businesses, many close to the board member’s hearts, and reduced the work force by 60%.

Unfortunately, after the initial efforts, the company got hit with two years of draught which eliminated all its earnings so far. Now, its debt reduction strategies came to a halt. With the Pool facing significant debt obligations, Schmidt hit the road to negotiate with the banks and the bondholders. Thankfully, he could convince the lenders to allow Pool to enter a restructuring period to come up with a plan. He nearly saved the Pool from a bankruptcy, but at this point the lenders made one point very clear – they will no longer finance the company without having board representation. Thus, the Board was restructured significantly to match the regulatory governance standards – four members were replaced with outside directors and new positions were created for many of the required functions. Also, Schmidt put forward a restructuring plan to make the company financially viable. To eliminate more than $170 million in future obligations and to once again access the capital markets, Schmidt’s plan was a debt to equity swap. But, this transaction required common shares to have voting rights and the co-operative structure restricted ownership of voting shares to farmers only. Schmidt convinced the farmers, just barely, to relinquish their voting control, turning the Pool into just another corporation. This was followed by a $150 million rights offering whose proceeds were used to retire debt and to support its working capital requirements. Its debt to equity ratio improved from 61:39 a year earlier to 33:67 and total debt declined by 38%.

Having undergone major transformation in its governance structure and financial position, TAM entered the picture. TAM’s International Fund led by Amit Wadhwaney took a position (9,155,750 shares in Q1 2006) in the Pool. Here is Wadhwaney investment thesis: “Following the recent restructuring efforts, we believe Pool now has a sensible governance structure, as well as one of the strongest balance sheets and one of the better networks of operating assets among its peers. Should the industry continue to rationalize, as it has over the last five years, Pool is positioned to not only survive; but, potentially thrive as one of the more efficient operators. Our investment in Pool Common was made at a single digit multiple of operating earnings.”

Now, here is a business that you would have missed completely if you used any traditional measures of value investing in your search methodology. It probably would not have met any of the criteria set by value investors like Brucewald’s earnings power value, Graham’s ten years of earning history (normalized earnings) or the modern version of using ten years of free cash flow history (normalized free cash flow). The Pool had very few years of profitability in its 10 years of operations then and probably no free cash flow. Its debt reduction was mostly due to the asset conversion activities, not earnings capacity. But, TAM invested because it met all the criteria of being a “safe and cheap” investment.
• Clean balance sheet that would be of much higher value to a potential bidder in case the management was unsuccessful at implementing its future plans
• New governance structure and elimination of the dual-class structure as an indication that the management team was shareholder friendly
• Easy to understand business and transparent management that addressed troubling issues.
• Very cheap price relative to (its only two years of positive) operating earnings.

So, here is what happened post TAM’s investment.

2005-2007: The Pool buys Agricore
Only eighteen months after the historic transformation, Schmidt was ready to take the Pool to the next steps. He made a bid for the much bigger Agricore United. Agricore initially dismissed the unsolicited bid from the Pool, which had about half as much in annual sales, and a six-month battle ensued. Schmidt decided to pitch to his investors the potential cost savings of merging operations, raising $920 million that led him close to the cash plus stock deal. TAM participated in the private placement of the subscription. Here is an excerpt from Wadhwaney’s letter to shareholders (Q2 2007): “One of the Fund’s larger investments during this period was a subscription to a private placement of subscription receipts, potentially exchangeable into common shares of an existing Fund holding, Saskatchewan Wheat Pool, Inc. (“Pool”), at a valuation that we considered particularly attractive. These receipts were to be exchangeable into Pool Common in the event that the Pool was successful in its acquisition of one of its rival grain handlers, Agricore United (“Agricore”). The proposed combination of Pool and Agricore is expected to create, by far, the largest grain handling network in the Canadian Prairie Provinces, with the attendant economies of scale that would ensue. Estimates of the percent of the Prairie grain that would be handled by this entity range up to 40%, although this might well, in time, prove to be an underestimate considering that these two companies have between them the most efficient grain-handling equipment in the industry. In addition, the merger will result in the combination of the two largest distributors of agri-products (e.g., seed, fertilizers, herbicides, pesticides, etc.) in the Prairies, enabling the Company to realize further economies in the combined operation. Following the end of the fiscal quarter, the Pool announced that it had been successful in its efforts to acquire Agricore and the subscription receipts were exchanged for Pool Common.”

Further, in his letter, Wadhwaney describes how return to its holdings can be realized due to asset conversion activities. I emphasize this piece because the concept of asset conversion activities is central to “safe and cheap” investing. Martin Whitman, the father of safe and cheap investing, in his Aggressive Conservative Investor book says that analyzing most firms as going concerns using earnings related measures is not appropriate because most firms are involved in asset conversion activities.

In the case of the Pool, the asset conversion activity is that of structural change in the industry. Wadhwaney describes it as follows: “Witness, for example, the above-noted successful tender by the Pool for Agricore; both companies are experiencing the current buoyancy in the Canadian agricultural sector. The tender offer was motivated less by the desire to wring out redundant, unprofitable capacity, but more to realize economies of scale which would be enjoyed by the combined entity, and the complementary nature of the two companies’ asset bases. Further, this would be expected to change the profitability of the industry, both in aggregate and its distribution. Structural change in an industry is one of a number of possible outcomes of resource conversion activities of one or more companies in an industry, which has the potential for consequences which reach far beyond the company (or companies) that engages (engage) in these activities. Periodically, such activities, by one or more in the industry, have the potential to affect the profitability characteristics for the entire industry which, in turn, has an impact upon potential returns of an investment in a company operating in the affected industry. The investee company may, or may not, be a participant in the structural change directly; but, in either case, is likely to be affected by it. Although Fund management does not claim to be able to consistently predict such structural changes in industries, the fact that we seek to invest in well-capitalized companies with competent management teams, tends to result in the Fund periodically benefiting from such structural changes when they do arise.”

Coming back to the Pool, the combined entity was renamed to Viterra. In 2008, thanks to rising commodity prices, record grain volumes and added cost savings from Agricore, Viterra reaped a bountiful harvest of $288.3 million in net income, up 147% from 2007.

2008-2010: Viterra buys ABB
While Viterra is going through its developments, TAM started to build a large position in a Australian grain handler called ABB that had operations very similar to Viterra in Australia. I will come to why this is relevant to the Viterra story at a further time below. TAM initiated its position in ABB in Q2 2006 and continued increasing its position in the remaining of 2006 and through 2007-2008. What follows is Wadhwaney’s detailed business analysis on ABB and Viterra from his Q2 2008 letter to shareholders (key points are highlighted in bold).

“The two investments which currently dominate the Fund’s agricultural holdings are ABB Grain Limited (“ABB”) and Viterra, Inc. (“Viterra”). Both of these companies are focused on agricultural infrastructure, the former in Australia and the latter in Canada. The companies’ operating results are influenced only indirectly, at best, by price movements in the commodities in which they traffic.

Both companies are agribusinesses with multi-faceted operations and an international focus. ABB accumulates grain mostly from South Australia, while Viterra’s source of grain is primarily the Western Canadian provinces. While each company’s history is steeped in grain accumulation, the present reflects much more diversified operations, stretching across the entire supply chain. In the case of ABB, this includes a significant network of silos and export shipping terminals in South Australia, Victoria and New South Wales, incorporating joint ownership of Australian Bulk Alliance with Japanese trading company Sumitomo. Similarly, Viterra has a network of modern, highly efficient grain elevators across the Canadian Prairies connected via railroad to its export shipping terminals in Vancouver and Prince Rupert on the Pacific and Thunder Bay on the Great Lakes. These grain elevator networks and port terminals are the capital intensive portion of a supply chain which comprises operations in storage, handling and logistics, as well as providing a number of value-adding services. Such hard to replicate assets are the key to providing these companies with defensible competitive positions in their respective markets, and represent a meaningful obstacle that a newcomer would have to surmount in establishing itself in the industry.

The other characteristic shared by these two businesses is the sensitivity of their operating earnings to the volumes of grain passing through the network of grain elevators. Accordingly, periods of drought in their respective regions corresponded to reduced grain throughput, poorer profitability and reduced equity market valuations, which provided the Fund opportunities to purchase these shares at attractive long-term valuations.

The above-noted similarities obscure many of the differences between the two companies, stemming from their respective histories, regulatory environments and industry structures. All of these factors are likely to play a significant role in determining the profitability of these companies going forward. What follows is a thumbnail sketch of each company, highlighting some of their respective attributes.

ABB was born as the Australian Barley Board, whose intended role was to coordinate the acquisition and marketing of barley sourced across Australia. In late 2004, ABB Grain was formed by the merger of three South Australia-based grain companies, ABB Grain, AusBulk and United Grower Holdings, expanding its activities to other grains beyond barley. In addition, AusBulk was the parent of JoeWhite Maltings, which is Australia’s largest malting company, with malting plants located in all six Australian states, positioned close to international ports and transport links or to Australia’s premium barley growing areas.

ABB’s range of rural services includes the supply of fertilizer and agricultural chemicals, financial services and insurance, and wool and livestock activities. ABB Grain also has significant operations in New Zealand focused on the trading and distribution of grains and proteins.

A change on the horizon in the Australian grain market, which should represent a significant potential opportunity, is the elimination of the Australian Wheat Board’s export monopoly on wheat later this calendar year. The elimination of the Australian Wheat Board, which is the sole exporter of feed grain wheat, will allow companies like ABB, which have the existing infrastructure, logistical and marketing expertise, to fulfill that role. A second, more conjectural, opportunity might be looming, namely that of consolidation among the various owners of agricultural infrastructure within Australia or even on a cross-border basis. The attractions of the former would include the ability to exploit economies of scale across the combined entity, enhancing the performance of ABB’s network of assets. Cross border transactions (such as a combination of companies operating in different geographies) might potentially provide weather diversification, and reduce the riskiness of the business in the aggregate.

Viterra, on the other hand, was … [history of Viterra]. Estimates of the Prairie grain Viterra currently handles are on the order of about 40% of the volume grown and transported. However, the allocation of railcars for feed grade wheat and barley is overseen by the Canadian Wheat Board (“CWB”) which, unlike its Australian counterpart, continues to regulate the transportation and marketing of these grains. Were CWB’s role in rail car allocation to be eliminated, the percentage of Prairie grain handled by Viterra would rise materially, given its disproportionate ownership of the industry’s most efficient grain elevators. Given the sensitivity of operating performance to grain throughput, were such deregulation to occur, it would have a meaningful, positive impact on the company.

Grain buyers have historically dealt with a highly fragmented grain supply industry. Recently, the industry has changed significantly in Canada; and similar changes appear to be starting to play out in Australia. These changes (consolidation) will likely bring a shift of power within the supply chain, with potential benefits to both ABB and Viterra. Both companies are an integral part of the agricultural infrastructure and play a crucial role in the numerous steps involved in getting grain from producer to consumer. Both companies are well positioned financially, and in their respective market positions. Moreover, both companies are likely to benefit from unusually attractive opportunities as structural changes take place, be it via deregulation, consolidation or resource conversion. As agricultural companies, they continue to be beholden to weather conditions in their respective growing regions. That said, the Fund’s ownership of companies in two geographies, distant from each other, serves to mitigate that risk, somewhat.”

At risk of being repetitive, I will draw your attention to the fact that almost all the key points highlighted above fall in the category of benefits the two companies can derive from resource conversion activities, a cornerstone of safe and cheap investing.

Further, notice the comment on how the Fund’s ownership in two geographies serves to mitigate weather risk. Lo and behold, in 2009, Schmidt made an offer to buy ABB for $1.2 billion and the offer was accepted by 84% of shareholders, with only 75% required to pass the resolution. TAM had been building its position in ABB since 2006, and I doubt (I may be wrong here) if Schmidt at that time had any plans to make the offer to ABB. So, we can only speculate the role that TAM, as one of Viterra’s and ABB larger shareholders, played in bringing this opportunity to Schmidt’s attention. However, if our speculation is indeed true, then this is a great example of how a “safe and cheap” investor can play an active role in helping a company realize its value further through asset conversion (in this case asset combination).

In conclusion, Viterra is a great example of how a CEO (Mayo Schmidt in this case) took a company in a mess ($100 million market cap) to a vibrant growing company ($2.8 billion market cap) through various asset conversions in a decade. Also, if it were not for “safe and cheap” investing framework, one would have easily missed out on this phenomenal opportunity.

• Third Avenue’s pick in Food Chain, Morningstar.
• Aggressive Conservative Investor, Martin Whitman
• Viterra, Wikipedia
• Saskatchewan Wheat Pool, Wikipedia,
• Agricore United, Wikipedia,
• ABB Group, Wikipedia,
• Andrew Wahl, CB Online. Mayo Schmidt, Viterra, Top CEO
• 2004-2009 Annual Reports, Viterra
• 2006-2010 Quarterly Shareholder Letters, Third Avenue Funds

Disclosure: I have a long position in Viterra (VT) and I have investments with Third Avenue Management. Also, this is not a recommendation to buy or sell any securities. Do your own research before investing in any security.

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