Investment Summary

Figure 18. Management guidance

M USD

Source: KNU estimates

Figure 19. Share of Russian project in price

P

Ukraine

Source: KNU estimates

After having performed the valuation of the company, we initiate coverage of Kernel with a HOLD rating and target price of 69.5 PLN. Three tools were used to assess current company’s performance and evaluate future potential: DCF model, peers comparison method and technical analysis. Moreover, the rating is defined not only by the valuation done, but also by mixed industry development results and unequivocal effect of expansion to Russia.

Thoroughly examined the results, we came to conclusion that the Kernel’s stock price is highly dependent on future performance of Russian expansion project. Therefore, it makes sense to separate future outcomes into three buckets:

• 100% fulfillment of managerial ambitious targets.

• Russian expansion is fairly successful but below initial mgmt expectations.

• Russian market is unsuccessful

We strongly believe in the first option because of the almost flawless management guidance history (Figure 18) and successful history of acquisitions. Therefore, DCF model was based on assumption of 100% fulfillment of Kernel’s goals. Peers analysis cannot fully capture the unique Kernel situation of entering Russian market, although we see it as a perfect proxy for the second bucket, given the underlying assumption of equal investment opportunities for all the peers. Third bucket is highly improbable due to high potential of Russian markets as well as good operational performance.

Considered described issues and benefits of each approach, we have implied the weights of 70% DCF to 30% peers comparison, which have given us the aforementioned price.

The results of technical analysis are also dubious. It suggests that the borders of the price tunnels are almost equal to the values obtained using DCF model and peers comparison (appendix 15). That is additional argument in favor of our rating.

However, if the 2013 years result is weaker than the management guidance, we will be less inclined to stick to the latter and will confer additional weight in our decision to peers comparison method, downgrading our rating to SELL.

Hereinafter we are to disclose our additional reasons for the HOLD rating more precisely.

Upside

• Resilient home market. Stable markets growth in key Kernel’s sectors (explained by grain prices increase and growing sunflower oil demand) will allow the company to keep its pace and ensure stable EBITDA margin of at around 15% during 2012/17. Optimized company structure will provide additional revenue growth at 30-35 USD per ton due to positive synergy. In additional minimum tax burden and high crop yields create strong competitive advantages.

• Low cost of capital. Additional financial resources received both by accretion of retained earnings and access to external borrowing (in the form of the shares, bonds, and loans on international markets) provide the foundations of realizing investment plans. It also will ensure the maintenance of existing optimal capital structure (30/70 - Debt/Equity).

• Good relationship history with government. The serious concerns of the players on Ukrainian agrarian market – the export quotes and government interference seems to have little or even no impact on Kernel’s activity. The company constantly gets enough export quotes for sufficient realization of its production abroad.

• Dividends. The announced decision to pay dividends in 2013 makes Kernel’s share more appealing. This factor will ampli the already high liquidity of company’s shares.

Downside

• New market entry is always a game. Search for new raw production suppliers, hustling the competitors and strengthening position are the fundamental challenges Kernel should be successful at in order to conquer Russian market and ensure that investments plans are worthwhile. Although our analysis advocates Kernel success, the risk remains.

• The other angle of synergy effect. Extreme vertical integration may be a veiled threat because of the accumulation of supply chain disruption risk that could destabilize the whole company and cause the loss of the synergy effect. The existing problems with railroad cars are a perfect example of this problem already being experienced.

• Limited choice of further growth options. Ukraine has exhausted its opportunities for Kernel for sustainable growth. Home market development cannot act as a groundbreaking driver in the future, as our analysis doesn’t give any reasons to believe in long-term impetuous market boost. Therefore our expectations about company’s growth rely almost solely on the Russian expansion.

• Optimistic investors’ expectations. Considering rather high market share price, we conclude that the great portion of it is contributed by investors’ expectations of company’s growth. Kernel is currently on the rise and thus, is more expensive than other companies available for investing due to exceed excitement.

Figure 20. Kernel’s goals in Russia

Figure 21. Kernel’s share price and goals complition

PLN

Share price without Russia projects

52,25 PLN

Payback limit

76.1% of goals

Capex does not pay off

Source: KNU estimates

In 2011, after it has depleted all the worthwhile opportunities for development in the Ukrainian market, Kernel has entered the neighboring country of Russia by acquisition of Russkie Masla Group. In the September of 2012 the company has strengthen its position by acquiring Taman Transbulk terminal and announced its strategic goals in Russia.

However, the results of their implementation is still involves a considerable deal of uncertainty. The situation is deteriorated by the results of 2012 which wasn’t as successful as anticipated and missed the management guidance by 6% in sales and 13% in net income.

There are several points of concern in the company’s entrance to the new market of Russia, that is, although quite familiar to Ukrainian one, is still new for the company. Yet, management is rather optimistic about the growth perspective, expecting to double grain sales and significantly increase oil output by creating new crushing capacities.

However, our analyze suppose that the company may face several significant obstacles, such as:

• Lack of seed supply. As the company expands to the Russian market the primary objective is to find the suppliers of the raw material needed for production. Considering the fact that seed is usually sold by small farming households, ensuring their willingness to work with the company becomes the issue of major importance. The worst case scenario may lead to smaller than expected sales of grain and insufficient oilseed supply which results in waste of crushing capacities

• The high pressure of the competitors who have already been established on the market. The previous item may be worsened by the fact that there are several companies which will protect their share in the resource market. These competitors in the Black Sea region, such as RosAgro, Black Earth Farming and Pava will not easily give their business ties which provide them an access to grain and oilseed.

• Reduce in EBITDA margin is expected. The growing capacities require additional costs to maintain them. Given the aggressive plan of their acquisition and creating, we expect the EBITDA margin to fall in the subsequent years. This fact increases the requirements to the company’s sales performance and decreases cash flow available for future investments.

• The demand may be weaker than anticipated. The fall in EBITDA margin may be successfully be compensated with the increase in revenues. However, if the sales won’t grow with the faster rate than capacities, the result may be quite deplorable Even if we assume the full utilization of new capacities, the menace may be located on the consumer side: Kernel may not be provided with enough demand to realize its production.

According to our estimations, the future Russian projects accounts for approximately 31% of the target price obtained using DCF method. The evaluated price is situated near the one we’ve got using peers comparison. We also made a sensitivity analysis of the target price with respect to the percent of completion of Kernel’s goals in Russia (Figure 21).