Q1 The Big Picture: Does Quality Investing Work?
July 11, 2018
Q1 CLIENT CORNER AND NORTHSTAR NEWS OUR OFFICE MOVE AND STRATEGY AROUND CLIENT CONTACT
July 11, 2018
AECI is South Africa’s largest explosives manufacturer and a dominant player in the specialty chemical industry. The group has a long history in the South African mining landscape having been formed in 1924 with its main purpose to provide explosives and detonators to the gold and diamond industries. highly cyclical South African mining industry to gain exposure to new growth areas.

While explosives and mining chemical solutions remain the largest contributor to operating profit (69% in 2017), the group has been diversifying its revenue stream after the financial crisis (2009) through a series of acquisitions both locally and internationally. The introduction of several new strategic pillars was aimed at reducing exposure to the
Figure 3. AECI Operating margins.Source: Company financial reports, Northstar Asset Management.
New strategy enhancing the group’s moat

AECI has seen a strong improvement of its mining solutions business over the past year driven by a recovery in commodity prices and increased output from miners. Operating margins have improved in 2017 as operations in South Africa, Asia Pacific and the Rest of Africa recorded robust volume growth.

Notwithstanding improved trading conditions, the South African mining explosives industry, while fairly consolidated, is highly commoditised despite efforts from players to improve customisation and service offerings. Customer concentration and intense competition, in our opinion, have made it difficult for explosive companies to maintain a consistent competitive advantage in the industry. Operating margins, (Figure 3) have tended to be volatile through the cycle and not shown structural improvements despite efforts from AECI and other players to automate production and increase capacity utilisation of their facilities.

AECI’s diversification drive, although in its infancy stage, is compelling considering the lower returns on capital and margins of the SA explosives business compared to its chemical business cluster (Figure 4). The revised strategy has resulted in the formation of five operating segments which offer in our opinion exposure to industries with better growth opportunities and competitive dynamics, namely: mining solutions, water and process, plant and animal health, food and beverage, chemicals (Figure 5).

The improved moat stems primarily from two dynamics, exposure to a larger and more diverse customer base and participation in industries with higher levels of specialisation which lend to better pricing power.

In line with its strategic framework, AECI in 2017 concluded two acquisitions which will significantly impact the group’s results going forward. The first is Schirm, a German agrichemical manufacturer with a footprint in both Germany and the US. It was acquired for a consideration of ZAR1.9bn on an EV/EBITDA of 8x which compares favourably to other European chemical companies that trade on 8-10x multiples. Management sees several synergistic opportunities, including the replacement of some raw materials currently imported into SA from third party suppliers as well as the substitution of SA exports to European clients.

The second transaction relates to the acquisition of Much Asphalt (still awaiting competition approval), which according to AECI is South Africa’s largest supplier of hot and cold asphalt to the road construction industry. The transaction consideration of R2.2bn implies an EV/EBITDA of 7x (compared to AECI’s trailing multiple of 6.6x). The business will be integrated into the chemical cluster and management is confident of synergies in SA as well as being able to take advantage of opportunities in Africa.
Figure 4. AECI Operating profit to assets. Source: Company Financial Reports, Northstar Asset Management.
Management team

AECI’s management team is well established with Mark Dytor having assumed the role of CEO in 2013 and Mark Kathan occupying the role of CFO since 2008. The executive has been, in our opinion, effective in managing costs and working capital over the past five years which has translated into strong free cash flow growth and improved returns on assets, while maintaining an ungeared balance sheet.
Figure 5. Segmental Revenues. Source: Company Financial Reports, Northstar Asset Management.
While we are supportive of management’s acquisitive strategy, we are cautious of its execution as it introduces two new risks to our investment case. The first is the potential to overpay for acquisitions which may adversely impact returns on capital. The second is increased gearing (debt) in an inherently cyclical business. While we acknowledge these risks and are monitoring this very closely, we believe that the management team has so far, maintained financial discipline, set realistic targets and communicated transparently with investors. A final consideration to note with respect to corporate steering, is how the AECI management team’s incentive structure works, it is largely driven by HEPS (Headline Earnings per Share) growth. We believe this is an incorrect incentive approach as it encourages the pursuit of value destructive acquisitions. At the heart of any successful management incentive structure in our opinion, should be growth in shareholder returns on capital as well as growth in free cash flow.

Valuation

The group is highly cash flow generative, it trades on a free cash flow yield of approximately 5%. With respect to other valuation metrics, on an EV/EBITDA basis, AECI is rated at 6.1 times against its long-term average of 6.5x, the P/E is currently 12.6x – we consider this fair.

Legacy moat

British American Tobacco (BAT) has produced double-digit returns on capital for the last decade. We ascribe this to four factors. Firstly, being the third largest tobacco producer globally in a highly consolidated market; secondly, it’s significant cost advantage generated through economies of scale throughout its supply chain; thirdly, industry regulation limiting new competition and finally, the company’s Global Drive Brands fostering brand loyalty which propels pricing power of its products.

The abovementioned factors all relate to BAT’s legacy portfolio of combustible cigarettes. With regulatory bodies clamping down on tobacco usage across the globe, tobacco companies are selling fewer cigarettes – these businesses are experiencing retreating volumes of approximately 2% to 3% per annum. Whilst fewer sticks are being sold each year since 2010, British American Tobacco and the other dominant players in the industry have almost on an annual basis increased the prices of cigarettes – a sign of their significant pricing power.

New generation products

Due to the inevitable decline in industry volumes, big tobacco has been investing actively in New Generation Products (NGP’s) – these are ‘lower risk’ alternative products to traditional cigarettes. The hope is that NGP’s garner less negative interest from regulators and over time, broad us age will increase industry volumes once more.

Industry headwinds

A number of events relating to BAT’s legacy portfolio and sustainability of the new generation franchise over the past year, have led to the underperformance of the BAT share price (Figure 6). We will endeavour to cover these all briefly and summarise why we believe that the investment case remains sound.
Figure 6. Year 1 Share Price performance. Source: Bloomberg, Northstar Asset Management.
Reynolds American acquisition – value-adding or bad timing and wrong geography?

BAT announced the acquisition of the remaining 58% (it previously owned 42%) stake in Reynolds American (RAI) in 2016, at a 26% premium to the ruling price per share at the time. The initial 42% was acquired in 2004 when the US arm of BAT merged with RJR Tobacco forming the country’s second largest tobacco manufacturer.

The United States has historically been and remains so, a very lucrative market for cigarette companies (Figure 7), due to limited increases and stability of excise taxes, coupled with a large middle class, which is able to absorb aboveinflation price increases in igarettes.

In addition, the market is highly consolidated with Altria (51.4%) and RAI (34.5%) having 85.9% market share. Reynolds also owns three of the top four brands and the number one brand in the premium menthol category.

These above-mentioned factors were credible reasons for British American Tobacco acquiring the balance of Reynolds it didn’t already own. However, the market initially responded negatively to the deal based on the hefty price BAT paid to acquire RAI’s assets. The $59.64 per share offer implied a P/E multiple of 22.4x or an EV/EBITDA multiple of 16.3x – a significant premium to peers at the time of the offer. In addition, a mere month after the deal closed, the US Food and Drug Administration (FDA) announced it was exploring measures to limit nicotine levels in cigarettes as well as banning the use of flavours (including menthol) in combustibles (more detail below). The latter cast doubts on the timing of management’s decision to increase its exposure to North America, at the expense of its faster growing emerging market portfolio.

We believe that the acquisition has the potential to be profit and cash-enhancing due to improved scale efficiencies (Management guided for $400 million of cumulative cost savings per annum). RAI’s superior cash generation also increases the amount available for reinvestment in new technologies, without the need to rely on increased debt funding. In addition, it increases BAT’s potential to compete globally in new generation products as RAI’s NGP vapour product, VUSE, already has a 40% market share in the US – a technology that can be rolled-out to other geographies.
Figure 7. Reynolds Cumulative Pricing and volume growth. Source: Company Financials, Northstar Asset Management.
Regulatory and legal – the FDA steps in and possible spill-over from a class action suit
The FDA clamp-down

The FDA was granted the explicit authority to regulate tobacco in 2010 in the United States. A new ruling (as of 2016) extended the FDA’s regulatory authority to all tobacco products, including e-cigarettes. In July 2017, the FDA released a comprehensive plan for tobacco and nicotine regulation, with a focus on lowering nicotine levels in reduce nicotine levels to zero. Nevertheless, to fully appreciate the risk, we have revalued the business for a worst case scenario and believe that the current share price implies little value for the US business. Given the industry dynamics and historical performance, we believe this presents a favourable risk versus reward profile.

Canadian class action law suit

BAT’s Canadian business has been one of the defendant’s in a Canadian class action lawsuit related to two groups of plaintiffs: those that have become seriously ill from smoking and those that are addicted to smoking. In 2015, the Quebec Court ordered the three largest companies in Canada to pay CAD15.6 billion in damages to the plaintiffs.

BAT Canada’s share of the damages was CAD10.4 billion. An appeal was heard in November 2016 and the decision is still pending. Even though the assets of the Canadian subsidiary are ring-fenced from claims against the parent company, there is a nervousness that if the judgement is upheld, it will set a precedent for other countries (and larger profit pools) to follow suit.

Unfortunately, it is nearly impossible to assign a probability to the likely occurrence of this event, consequently our approach is one of being cognisant of the risk it presents to the business case.

New generation products – a true replacement for legacy portfolio?

New Generation Products, or NGP’s, primarily come in two forms: Vapour and Tobacco Heating Products (THP). The categories were built to address different needs across a multitude of geographies and cultures and have vastly different profit profiles and competitive landscapes.

The common thread among the two, is the claim from tobacco companies that there is reduced risk of use to the consumer. This is what big tobacco is lobbying to regulators with the hope that it will allow them to increase their addressable market and reduce taxes. Lower tobacco content in NGP’s attracts lower taxes.

BAT estimates that the NGP global market size in 2017 was £14 billion split roughly 60/40 between vapour and THP’s. It further expects the market to grow by 114% and in 2020 to be at £30 billion, split equally between the two categories. There is an upside risk to this estimate due to the fact that THP may not legally be sold in the United States currently. Multiple applications for eligibility are in progress and once clarification is received, the addressable market could increase substantially.

At the forefront of the NGP market share race is Phillip Morris International (PMI) and BAT. These two tobacco giants are following two vastly different strategies with PMI putting all its eggs into one basket with its THP, iQoS, and BAT approaching it with a diversified strategy, with both a THP offering (glo) and a portfolio of Vapour products.

There is a perception that over time THP will be the only substitute for combustibles as it provides a similar experience to traditional smoking. Given the differences in adoption rates in Asia (high) and Europe (more moderate), the advantages of a diversified portfolio is clear in terms of expanding the addressable market. See Figure 8 for BAT’s estimates.

THP will be the higher margin category, as it follows the razor blade model, where the manufacturer makes little profit on the device (glo or iQos), but the consumable (the “cigarette”) attached to the device provides a high margin, annuity-like revenue stream.

Vapour devices largely operate an open eco-system and customers can easily switch between the consumable manufacturers. The market is also highly fragmented with low barriers to entry. BAT has already started to acquire smaller vapour companies in an effort to consolidate the category. Over time BAT’s scale will allow cost economies and it is likely to take market share from smaller competitors in a growing market.

We believe that BAT’s diversified strategy will bear fruit over time as it increases the respective addressable markets across geographies. Given the limited regulation and taxes on the new products currently, we consider it inevitable that this will become more onerous over time, however, the market growth in NGP’s has been impressive and assuming regulators do not completely stifle this, NGP’s in our modelling, will become a significant contributor to volumes and profits of the BAT portfolio over the next decade.
Figure 8. Modelled NGP Preponderance by 2020. Source: BAT 2017 Investor presentation.
New strategy enhancing the group’s moat

AECI has seen a strong improvement of its mining solutions business over the past year driven by a recovery in commodity prices and increased output from miners. Operating margins have improved in 2017 as operations in South Africa, Asia Pacific and the Rest of Africa recorded robust volume growth.

Notwithstanding improved trading conditions, the South African mining explosives industry, while fairly consolidated, is highly commoditised despite efforts from players to improve customisation and service offerings. Customer concentration and intense competition, in our opinion, have made it difficult for explosive companies to maintain a consistent competitive advantage in the industry. Operating margins, (Figure 3) have tended to be volatile through the cycle and not shown structural improvements despite efforts from AECI and other players to automate production and increase capacity utilisation of their facilities.

AECI’s diversification drive, although in its infancy stage, is compelling considering the lower returns on capital and margins of the SA explosives business compared to its chemical business cluster (Figure 4). The revised strategy has resulted in the formation of five operating segments which offer in our opinion exposure to industries with better growth opportunities and competitive dynamics, namely: mining solutions, water and process, plant and animal health, food and beverage, chemicals (Figure 5).

The improved moat stems primarily from two dynamics, exposure to a larger and more diverse customer base and participation in industries with higher levels of specialisation which lend to better pricing power.

In line with its strategic framework, AECI in 2017 concluded two acquisitions which will significantly impact the group’s results going forward. The first is Schirm, a German agrichemical manufacturer with a footprint in both Germany and the US. It was acquired for a consideration of ZAR1.9bn on an EV/EBITDA of 8x which compares favourably to other European chemical companies that trade on 8-10x multiples. Management sees several synergistic opportunities, including the replacement of some raw materials currently imported into SA from third party suppliers as well as the substitution of SA exports to European clients.

The second transaction relates to the acquisition of Much Asphalt (still awaiting competition approval), which according to AECI is South Africa’s largest supplier of hot and cold asphalt to the road construction industry. The transaction consideration of R2.2bn implies an EV/EBITDA of 7x (compared to AECI’s trailing multiple of 6.6x). The business will be integrated into the chemical cluster and management is confident of synergies in SA as well as being able to take advantage of opportunities in Africa.
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