December 24, 2012

Recommendation

Kernel Holding S.A. (Kernel)

Price: 66.0 PLN

Price target: 69.5 PLN

This report is published for educational purposes only by students competing in the CFA Institute Research Challenge.

Whether the market’s optimism is reasonable

No rush is necessary. We initiate coverage on Kernel with a rating HOLD and a 12 month price target of 69.5 PLN, calculated using combination of DCF approach and peers valuations with weights of 70% and 30% respectively. Target price suggests 5.3 % upside, which perfectly reflects the fulfillment of gap from the current overvalued market price by the bright growth opportunities.

Russia: gaining the foothold. We expect the newly discovered Russian resource market to be the most crucial driver to ensure the availability of space for future company’s growth. Although we do believe that Kernel’s actions will succeed, we have to outline the challenging character of the expansion and possible drawbacks for investors. The main uncertainty which arises is whether Kernel will be able to complete the goals set by management to the full extent.

A charge for optimism. Currently Kernel appears to be significantly overvalued 15.3% over its peers. In our opinion, it’s a denotation of investors’ positive response to the company’s dash on Russia. However, Q1 2013 performance displays quite mediocre results. Therefore open question remains, whether the market expectations are grounded.

Successful implementation of synergy effect. One of the key Kernel’s competitive advantages is optimally structured vertical business integration that allows capturing the margin through the whole value chain. Although, this business model puts additional pressure on company’s logistics to be fully implemented. Some Kernel’s entities have already been experiencing provisioning disruption that caused additional losses due to bottleneck in the logistics chain.

Growing demand projected all over the Kernel markets. Two key trends are boosting the demand: population growth and household income increase. Latter also causes the change in diet habits. All the aforementioned results in augmentation of per capita consumption of main agricultural products and ensures stable demand for Kernel’s commodities.

Resilience. Kernel is perceived by the market as a company which can successfully evade or mitigate the risks, typical for the whole Ukrainian agricultural sector. Our analysis has shown that two main groups of Ukrainian agro-risks: weather and regulatory, historically had no substantial effect on the company’s operations.

Figure 1. Market Profile

Source: Bloomberg

Figure 2. Price performance chart

Source: Bloomberg

Figure 3. Key Financial Data

Source: Company data, Bloomberg, KNU estimates

Figure 4. Public offerings

Kernel`s IPO and SPOs on the WSE

Source: Company data

Figure 5. Shareholding Structure

Kernel`s shareholders, 2012

Source: Company data

Figure 6. Revenue Breakdown

Structure by segments, 2012

Source: Company data

Figure 7. Geography of Kernel

USD thousands, 2012

Source: Company data, KNU estimates

Figure 8. Kernel in Ukraine

Ranking in agriculture, 2012

Kernel Holding S.A. is one of the leading agricultural companies in the Black Sea region. Kernel Holding S.A. is a public limited company incorporated under the laws of Luxembourg. Production assets, infrastructure and logistics of the holding are located on the territory of Ukraine. Furthermore, there are plants and terminals in Russia. Several controlling enterprises and traders that are holding’s members, are registered in Netherlands, Switzerland, British Virgin Islands and Cyprus. In November 2007 Kernel was listed on the Warsaw Stock Exchange which resulted in offering 16 671 000 new shares and attracting USD 160 M. During 2008-2011 the company placed SPO worth USD 304 M. (see Figure 4). Andrii Verevskiy, owner of Namsen Ltd., is a founder of the company. The structure of shareholders is represented in Figure 5.

From a private company to a vertically-integrated holding. Kernel started its activity in 1995 as an exporter of Ukrainian agricultural products. In the early stages the company provided transport services of delivering goods to seaports and sold agricultural products to the world traders. Kernel eventually began to purchase grain elevators. Thus, in 2002 the first oil extraction plant was bought in Poltava (Ukraine). Afterward expansion of activities was carried out by acquiring production assets in the oil industry, elevators and seaport terminals, and by simultaneous constant increase in the land bank. In 2011 the company obtained sugar business and entered the Russian market by acquiring Russian Oil Group and the Taman terminal through a 50%-50% joint venture with Glencore International PLC. Therefore, expansion performed by acquisitions of manufacturing companies provided Kernel with an opportunity to complete creation of a large-scale production and logistics chain in the Ukrainian agricultural market and to become one of the largest holdings in the Black Sea region (see Appendix 2, 9 and 10).

Main activities of Kernel Holding S.A. are represented by 3 aggregated business segments that generated USD 2 157.4 M revenue in 2012 (see Figures 6-8). The holding formed a complete production chain for its key industry – bulk oil. Kernel’s essential business segments are as follows:

1. Farming and purchase of raw materials. According to the data of 2012 Kernel is an owner of large-scale sown land bank that totals 248 562 hectares. This land bank is used by the company for growing crops, namely wheat, soybeans, sunflower, maize, sugar beets, barley, rapeseed, and is used for further processing of raw materials and trading. The holding’s crop yield exceeds the country’s average figures not taking into account crop yield of sugar beets. Manufacturing crops with different sowing and harvest seasons bring the company an opportunity to spread its income and outgoings throughout the whole year to avoid their significant concentration. Moreover, Kernel buys 78% of the total amount of grains from more than 2000 farmers across the country.

2A. Sunflower oil production. Own production and purchase of sunflower (6% and 94% correspondingly) form a raw material base for oil production (bulk oil and bottled oil) that is carried out by 7 plants in Ukraine and 3 plants in Russia with overall crushing capacities of 3.0 MMT per annum. The holding produces 7.2% of the world sunflower oil output. Furthermore, the company produces one third of Ukrainian consumption of bottled oil under the three brands (Chumak Zolota, Schedryi Dar, Stozhar) and private labels.

2B. Sugar production is accompanied by further domestic sales, and is provided by 4 plants that were acquired in 2011. Kernel’s market share in Ukraine equals to 7%. Nevertheless Kernel’s low crop yield of sugar beets (17.4% below the country’s average) and small profitability comparing to other business segments explain the company’s current attempts to sell sugar production.

3А. Silos and logistics. Kernel has the largest private elevator network with a total capacity of 2.5 MMT (7.1% of the country’s capacities). Elevators are located next to railroads and are used for own needs and for farmers (2/3 and 1/3 of the volume of services correspondingly). In addition, Kernel possesses 2 terminals in Ukraine and newly bought one in Russia in 2012. The terminals with annual capacities of 6.0 MMT are situated on the Black Sea and satis own export needs of grains and sunflower oil. 3В. Product sales. Kernel sells its production on the domestic (15%) and foreign (85%) markets. Indeed, the holding was the third largest exporter of grains in 2012 that provided 8% of exports, and the biggest bulk oil producers in the Black Sea region. Kernel exports grains and sunflower oil to Egypt, India, Turkey, EU etc. Regional distributors and national trade network provide 56% and 44% of bottled oil sales on the domestic market correspondingly. Sugar is sold in B2B segment.

The company’s strategy stipulates the following expansion of its activities, namely: extensive expansion – growth of the land bank up to 400-450 Ths ha accompanied by building and acquiring new plants, elevators and terminals (planned CapEx in Ukraine amounts to USD 300-350 M, in Russia – USD 350-400 M); intensive expansion – implementation of modern technologies and abidance by operational discipline to provide efficiency of each element of the production chain.

Kernel’s social responsibility is aimed at:

1. Environment protection as a result of using mini-till and no-till farming technology to reduce land erosion and to preserve land humidity; generating green energy from sunflower husks (83 M m3 of natural gas were saved in 2012); using present-day harvesters to save 7-10% of sunflower seed; waste water treatment during storage and transshipment.

2. Support to agricultural regions where Kernel operates by assisting schools and local communities, creating new workplaces (1050 units in 2012). Direct donations stood at USD 0.6 M in 2012.

3. Employer’s responsibility: Kernel employs about 17000 people and conduct different staff training programs. Thus, USD 173 M were invested in training in 2012.

Ukraine is one of the major exporters in the region. According to forecasts of the USDA Ukraine will provide more than 50% of the world’s sunflower oil exports, 14% of maize, 12% of barley and 5% of wheat in 2012/2013. Ukraine produces one third of the sunflower output in the region and above 25% of grains if combined with Russia. Nevertheless we assume that the Ukrainian agricultural market will only grow qualitatively in the midterm outlook due to limited arable land.

Figure 9. Ukraine and Russia are major players in the world’s exports

Companies with largest capacities and sales by segments

Figure 10. The main oil-processing companies, Ukraine

Companies with largest capacities and sales by segments

1Source: USDA, KNU estimates

Strengthening regional positioning. Favorable climate, access to the Black Sea, good transport infrastructure in the country, low prime cost and prices of agricultural products guarantee sales of excess output abroad. Sunflower oil and grains of the Ukrainian origin are exported to Egypt, Algeria, Turkey, Iran, EU, India and China. A geographic location of developing countries, expected growth of their population and diet changes will promote further geographic expansion of sales of Ukrainian products to the developing countries taking into account relatively higher prime cost of goods produces by powerful rivals in the region, namely Russia, France and Germany.

Figure 11. Sunflower oil market

Porter's Five Forces Model*

*5-Most favorable to Kernel

0 - Least favorable to Kernel

Source: KNU estimates

Figure 12. Grain market

Porter's Five Forces Model*

*5-Most favorable to Kernel

0 - Least favorable to Kernel

Source: KNU estimates

Figure 13. World oil consumption

Average shares by oils

Source: FAPRI, KNU estimates

Figure 14: Top 5 Grain Exporters, 2011/2012

Shares of Companies in Grain Export of Ukraine

Figure 15: Crop yield in the world, 2011/2012

Ukraine’s potential to increase its crop yield

Sunflower oil market

Bulk oil is stable business. In 2011/2012 Ukraine produced 4.0 MMT of sunflower oil. 80% of this amount was exported abroad. Ukrainian sunflower oil market is characterized by a high level of market saturation, a large number of producers and few leaders that possess crushing capacities. Existing competition on the market is strengthened by demand for substitute products (palm, soybean, rapeseed, olive oils, see Figure 13). Many agricultural manufacturers prefer to raise sunflower because of its profitability. Yet an agricultural producer does not work on equal footing with strong agriholdings due to his small production capacities. We believe in case of an unfavorable situation in the agricultural sector Kernel is able to protect its market share, thus it has its own production, long-term cooperation arrangements with farmers. Simultaneously Kernel owns 36% of the sunflower crushing capacities in Ukraine and private storage facilities.

Bottled oil market heads towards exhaustion. Bottled oil provides higher margins for Ukrainian producers than bulk oil that is less resource-demanding. Bulk oil still remains more attractive due to its sales volume. Domestic consumption stands at 420 million liters and is completely satisfied by Ukrainian manufacturers. Excess of their production is exported to the neighboring countries of the former Soviet Union where sunflower oil still prevails over other types of vegetable oil in the diet. Kernel satisfies one third of the domestic consumption of sunflower oil. Kernel also works in Russia and competes with local producers and Bunge which is at the same time its main rival in Ukraine. We suppose there are no grounds for rapid growth of sunflower oil demand in the nearest future.

Grain market

Ukraine highlights its significance as a grain exporter. As of 2011/2012 Ukrainian agricultural manufacturers harvested about 57 MMT of grains including 22 MMT of wheat, 23 MMT of corn and 9 MMT of barley. Ukrainian exports average one fourth of the total output of wheat and barley and more than 60% of corn. The market is relatively concentrated, thus TOP 5 grain exporters represent a half of the country’s export potential.

Diversification of crops brings profits. Increasing demand for Ukrainian crops in the world has been backed up with an advantageous geographic position, absence of available substitute products and a growing number of potential grain consumers. The grain market is characterized by strong rivalry which pushes big players to take necessary measures to defend their market share (see Figure 14). Kernel takes the third place among Ukrainian grain exporters (9% of the overall crop exports). The company prefers to produce wheat, corn and soybeans contributing 30.4%, 15.6% and 16.5% of its cultivated land bank correspondingly among the aforesaid crops. Ukrainian favorable weather conditions provide grounds for further expansion of arable land for soybeans that generate high profitability.

Figure 16. Yield vs. Fertilizers

Wheat, 2008-2012 Average

Source: FAPRI, KNU estimates

Main trends

Crop yield vs. fertilizer use. Average crop yield of sunflower seed in Ukraine is one of the highest in the world (see Figure 16). Given favorable climate sunflower oil of the Ukrainian origin remains competitive on the market despite low fertilizer use. Grain agricultural output of Ukraine is significantly less than in the EU and USA and is caused by poor agricultural machinery. Kernel’s crop yield surpasses average figures in Ukraine while its sunflower and maize agricultural output exceeds average crop yield figures of the strongest agricultural producers in the world. Moreover, it was achieved by relatively bigger fertilizer use. Hence we do not expect further improvement of Kernel’s crop yield taking into account average figures in the industry.

Neighboring opportunities for integration. Russian agricultural sector attracts Ukrainian producers with its 72% of non-cultivated farmland (Ukrainian figure stands at 33%). Big players often open an affiliate in Russia to get an opportunity to buy land and to prevent themselves from negative impacts of any possible trade wars in the future taking into account a recent precedent with dairy products.

Figure 17. Wheat Price Convergence

Wheat Price, USD

≈ -38% annually

Source: FAPRI, KNU estimates

Advantages of using competitive market positioning. We see Russian wheat and sugar beets more competitive comparing to products of the Ukrainian origin assuming that prime cost and export prices do not differ significantly. Thus, Ukrainian agricultural producers that integrated into the Russian market have an opportunity to use funds accumulated from production and sales of sunflower, corn, soybeans, barley and rapeseed in Ukraine to finance their activities connected with manufacture and sales of wheat and sugar beets in Russia.

Price boost. Decrease in a spread between world and export prices of Ukrainian agricultural products ascertains the fact that foreign consumers are willing to pay some extra margin to a Ukrainian manufacturer for available transport infrastructure connected with a favorable geographic position. World grain prices impacted an income margin of traders and demonstrated rather high volatility (see Figure 17). The spread between winter and fall prices reached up to 10% and the overall trend was directed upwards with an average annual growth of 20% over the last 3 years. Absence of destabilizing factors corroborates the aforesaid trend.

Searching for new trade areas. Continuing growth of Ukraine’s dependency on global processes and available arable land stimulates the government to search for new trade areas. In case of attracting foreign loans and investment from potential buyers of Ukrainian agricultural products it is planned to improve production technology, renew fixed assets of agricultural enterprises and to maintain further cooperation with China, Qatar and Bangladesh. Kernel attracted loans in USD with a low interest rate which it used to strengthen its position on the market.