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

Thoroughly examined the results, we came to a conclusion that Kernel’s stock price is highly dependent on future performance of the 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 management expectations.

• Russian market is unsuccessful

We strongly believe in the first option due to the almost flawless management guidance history (Figure 18) and successful history of acquisitions. Therefore, the DCF model was based on an assumption of 100% fulfillment of Kernel’s goals. Peers analysis cannot fully capture Kernel’s unique situation of entering the 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. The third bucket is highly improbable due to high potential of Russian markets as well as good operational performance.

After considering described issues and benefits of each approach, we applied the weights of 70% and 30% to the DCF and peers comparison respectively, which provided us with the aforementioned price.

Results of technical analysis are also dubious. They suggest that borders of price tunnels are almost equal to the values obtained using the DCF model and peers comparison (Appendix 15). That is an additional argument in favor of our rating.

However, if a result of 2013 is weaker than the management guidance, we will be less inclined to stick to the last-mentioned and will apply an additional weight to peers comparison method in our decision, downgrading our rating to SELL.

Our additional reasons for the HOLD rating are as follows.

Upside

• Resilient home market. Stable market growth in Kernel’s key 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 about 15% during 2012/17. The optimized company structure will provide additional revenue growth at USD 30-35 per ton due to positive synergy. In addition, a 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 borrowings (in the form of shares, bonds, and loans on international markets), provide grounds for completing investment plans. It will also ensure maintenance of existing optimal capital structure (Debt/Equity - 30/70).

• History of good relations with the government. Serious concerns of the Ukrainian agrarian market players, namely export quotas and government interference, seem to have little or even no impact on Kernel’s activity. The company constantly gets enough export quotas for sufficient realization of its production abroad.

• Dividends. An announced decision to pay dividends in 2013 makes Kernel’s shares more attractive. This factor will amplify the already high liquidity of the company’s shares.

Downside

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

• The other part of synergy effect. Extreme vertical integration may be a veiled threat due to accumulation of a supply chain disruption risk that might destabilize the whole company and cause loss of the synergy effect. Existing problems with railroad cars are a perfect example of this problem that has already been experienced.

• Limited choice of further growth options. Ukraine has exhausted its opportunities for Kernel’s 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 a long-term impetuous market boost. Therefore, our expectations about the company’s growth practically rely on the Russian expansion.

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

Figure 20. Kernel’s goals in Russia

Figure 21. Kernel’s fair 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 depleting all worthwhile opportunities for development in the Ukrainian market, Kernel entered the neighboring country of Russia by acquiring Russkie Masla Group. In September 2012 the company strengthened its position by acquiring Taman Transbulk terminal and announced its strategic goals in Russia.

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

There are several concerns for the company’s entrance to the new market in Russia, that is, although rather familiar to Ukrainian one. Nevertheless, it is new for the company. The management is rather optimistic about growth perspective and expects to double grain sales and significantly increase oil output by creating new crushing capacities.

However, our analyze suggests that the company may face several significant obstacles, namely:

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

• High pressure of competitors who have already been established on the market. The previous impediment may be worsened by the fact that there are several companies that 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 up their business ties providing them an access to grains and oilseed.

• Expected reduce in an EBITDA margin. Growing capacities require additional costs to maintain them. Given the aggressive plan of their acquisition and creation, we expect the EBITDA margin to fall in the subsequent years. This fact increases requirements for the company’s sales performance and decreases available cash flow for future investments.

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

According to our estimations, future Russian projects approximately account for 31% of the target price obtained by using the DCF method. The evaluated price does not significantly differ from the one we got using the peers comparison. We also made a sensitivity analysis of the target price with respect to percentage completion of Kernel’s goals in Russia (Figure 21).