Ann: Pause in Trading, page-25

@Darre11

It's a very good question. I've now updated my FRM spreadsheet with the latest accounts (previously I had only included data up to H1 FY17 and FY17).

I should start with the question of what sort of sustainable return on its capital I am willing to entertain for FRM. This is the key issue. My problem is that a cyclical industry of this sort, where the cycles are long enough to offer periods of hope, will for ever be going through periods of over-investment (in PPE), that will inevitably be followed by periods of belt tightening. The fact that the industry has some good tail winds (1) unfortunately, on my viewing, only adds to the allure of the carrot (and the over investment) in the good times. The supermarkets of course have a vested interest in cutting the suppliers enough slack that they can increase capacity, especially in "higher margin" segments like free-range, only to then again squeeze margins, so that the prospects of higher ROEs remain for ever an illusion.

In short, I have little faith that sustainable, through-the-cycle, after-tax returns on un-levered capital of greater than 5% will be achieved, going forward. Perhaps this is too harsh, and I welcome any contrary opinions.

I'm inclined to think in the following terms.

If FRM had minimal debt, and little surplus capital, then my guesstimated prospective returns on capital would imply an ROE of 5%. If I accept a 7% return as a fair return (2), and if FRM was to deliver it's earnings to shareholders in each of the years in which it earns them, then we could say that the business would be worth about 0.05 x B / 0.07 = 0.71 x B (where B = book 'value'). Further, if we assume that the earnings are fully franked, then we could increase the value of these earnings somewhat. I'd be inclined to increase the valuation by roughly 20% (3), which would then give us a value for the business of about 1.2 x 0.71 x B = 0.86 x B.

However, to assume that all earnings will be paid out here, is fanciful, I would suggest. The business can be expected to for ever be retaining a good proportion of its earnings (and if track record is anything to go by, even this would seem optimistic). There will always be a need to upgrade systems, or to reduce flock densities etc etc, as customers demand ever more humane approaches (quite rightly, in my opinion), or healthier feed options, or greater disease control etc etc etc etc etc etc.

So I would suggest that a 50% dividend payout is far from pessimistic, from a valuation perspective. The problem here is that, if my prognostications about prospective ROEs are correct, then each dollar retained by the business is being invested at 5% rates of return. Now as I desire a 7% return, then clearly it means that each dollar invested is generating < 1 dollar of value. If we do the math, here are the implications. The value of the business, ignoring the value of franking credits, becomes: p x 0.05 x B / (R - g) . Where p is the dividend payout (50%), R is my desired rate of return (7%) and g is the growth rate (2.5%) (4). This value works out to: 0.5 x 0.05 x B / ( 0.07-0.025) = 0.56 x B. As previously, we can beef this up by 20% to allow for the value of franking credits, to give us: 1.2 x 0.56 x B = 0.67 x B.

However, the notion that the business is going to be in a position to be returning capital (via a dividend or otherwise) directly to shareholders, any time soon, is also fanciful. Remember, the business is grappling with the balancing act of having to keep pumping out caged eggs, whilst shifting to cage-fee and free-range. If we assume that the business will not start paying a dividend until 5 years have elapsed, then we can say that it will keep retaining all its earnings until then, and so B will swell at 5% annual rates (the ROE). That means that by year 5, the B will be larger by a factor of 1.05⁵ = 1.28, and so the dividend will also be larger by this factor. However, the present value of the dividend will be reduced by a factor of 1.07⁵. As such, the value of the business will decline by a factor of (1.05 / 1.07 )⁵ = 0.91. As such, we have to shave a further 9% off the value of the business. If 10 years were to elapse before shareholders were to see a dividend, then the factor would be 0.83, and so we would have to shave a further 17% off our valuation.

If we settle for shaving off about 12% from our fair value, then we can settle for a fair value of about (1-12%) x 0.67 x B = 0.59 x B ~ 0.6 x B. However, why would anyone settle here for an expected 7% rate of return, when it comes with so much uncertainty, and the very real risk of a substantially lower return? I personally would not be tempted to begin nibbling at this, unless a price of half this valuation was on offer. That would of course imply a price of ~ 0.3 x B. The business currently has a book value of about 80c per share, and so this would imply a share price of about 27c.

However, the business has now taken on about 25c per share in debt, and finds itself in breach of its banking covenants. So as far as I'm concerned, all bets are off the table (5).





(1) The benefits of including, and even increasing, eggs in our diet, look to my like they gathering converts (as we dust off the remnants of the "high cholesterol diet = bad" dogma, and continue to move away from the "food pyramid" imbecility).
(2) 7% is about 300 bp's above current 10 year high grade corporate bond yields.
(3) If we assume we can claim the full value of imputation credits, going forward (ie, that the current system will be in place indefinitely) then the influence of franking is to boost the pre-tax value of the dividend by a little over 40% ( 0.3 / 0.7 ). Clearly this is a very risky assumption.
(4) A business that retains 50% of its earnings, and invests them at 5% rates, will theoretically grow at about 2.5% annual rates.
(5) It's remarkable to think that only as recently as in the FY17 report, management was saying "With the improved position of the company, directors have reviewed a number of options to utilise cashincluding the payment of dividends, share buybacks, investment into new facilities and growthopportunities.". Unfortunately they chose the latter options, just as the egg over supply intensified and the drought caused an increase in feed prices. Initially, it seems to me, management thought reducing gross-margins in H1 FY18 would recover, or stabilise, and so they borrowed in order to sustain the new capex plans. Unfortunately, both the over supply and the drought intensified.