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Tongaat Hulett Ltd Recommendation: BUY

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Tongaat Hulett Ltd Recommendation: BUY Cavalry holdings This report is published for educational purposes only by students competing in the CFA South Africa Investment Research Challenge. Ticker: TON Tongaat Hulett Ltd Recommendation: BUY Target Share Price: R113.26 Food Processing Sector Current Share Price: R91.00 25 September 2009 Upside Potential: 24.46% Highlights over the past six months Company Data Significant expected expansion in sugar Price R 91.00 production: Management intends to increase sugar Date of Price 25-Sep-09 production by 77.22% by the end of the 2009/2010 Price Target R 113.26 season. Price Target End Date 25-Sep-10 52-week range R 102.55 - R 55.00 Consolidation of Zimbabwean operations: Market Cap R 9.56bn Following a shift to a Dollar and Rand based economy, # Shares in issue 103,247,000 Zimbabwean operations have been reinstated in the interim results through a large take-on gain. Beta 0.63 Source: Cavalry Holdings research, company data World sugar price at an all-time high: Supply shocks and increased demand have pushed sugar prices to unsustainable levels. Biofuel production offers the potential opportunity to move into energy industry: Ethanol production from sugar is a growing industry, yet true profitability lies beyond the analysts’ investment horizon. Anglo American Ltd offloads their 49.5% holding in Tongaat Hulett Ltd: Shock caused an instantaneous drop of 15% in market price, yet the entire bookbuild was quickly sold out. Shareholding Top 5 Holdings 10.87% Metlife 3.19% Source: McGregor BFA Liberty Life 2.38% PIC 1.85% GEPF Equity 1.77% Old Mutual Life 1.68% Director Holdings 0.31% Source: McGregor BFA EPS P/E P/BV ROA ROE Div Yield 2006A R 6.66 16.38 2.08 11.34% 15.92% 5.03% 2007A R 0.58 157.23 2.95 8.88% 9.19% 3.40% 2008A R 5.66 9.07 1.57 7.91% 9.72% 6.04% 2009E R 8.52 10.81 1.74 7.32% 17.91% 2.71% Source: Cavalry Holdings research, company data Important disclosures appear at the back of this report 1 CFA South Africa Investment Research 9/25/2009 Challenge Student Research Investment Summary The 2009 year has been very eventful for Tongaat Hulett Ltd. Tongaat has begun to reap the rewards of long-term investments in SADC countries. Furthermore, shifts in economic policy in Zimbabwe have resulted in the consolidation of Zimbabwean operations, which were previously excluded from the balance sheet. Zimbabwean consolidation In recent months, certain economic reforms were instituted in the Zimbabwean economy, which included a shift to a Rand and U.S. Dollar based monetary system. This has resulted in Tongaat being able to consolidate significant Zimbabwean assets in its financial statements. Anglo American Ltd offload On 12 August 2009, Anglo American Ltd announced the sale of its entire 49.5% stake in Tongaat Hulett Ltd. This immediately caused the market price of the Tongaat Hulett’s shares to drop by 15%. The analysts however conclude that the sale is related to Anglo American’s own liquidity and debt situation, and is not due to perceived overvaluation by Anglo American. The bookbuild was completed on 13 August 2009. Industry Analysis The global sugar industry is rife with distortion caused by protectionist measures, which can make global trade fairly challenging. In South Africa, the industry is dominated by a few large firms and will remain so due to insuperable barriers to entry. Global demand appears to be exhibiting an upwards trend, whilst global supply is being stunted by numerous external factors, such as weather. Another salient feature of the South African sugar industry is its low production costs, which bolster global competitiveness. Financial Analysis Analysis of the Tongaat’s financial statements indicates growing revenues, operating margins and cash flows, associated with expanded production. Leverage is being utilised in line with decreased costs of debt and the capital structure is well-managed. The company’s financial positioning appears fundamentally sound and conducive to growth. Investment Risks Political risk within Zimbabwe which could affect Tongaat Hulett’s Triangle Sugar subsidiary is considered a major concern associated with the company. The relevant risks associated with this operation include: exchange rate fluctuations, abnormal weather conditions, the volatile world sugar price and protectionism both within and beyond the South African context. Further causes for concern include property value, hedging risk and restructuring of the company Valuation A free cash flow to the firm model was utilised to calculate an intrinsic value of R 113.26. This was based on the planned 77.22% expansion in sugar production over the next two years, whilst accounting for the additional political risk associated with the Zimbabwean operations. Compared with the current market value of R 91.00, the derived intrinsic value indicates that the company is exceptionally undervalued. Conclusion Based on a complete fundamental value analysis, the analysts post a BUY recommendation with a 12-month target price of R 113.26. Source: McGregor BFA with additions by Cavalry Holdings 2 CFA South Africa Investment Research 9/25/2009 Challenge Student Research Valuation For the purposes of determining fair value, it was decided that a Free Cash Flow model would be most appropriate. The deciding factors included positive projected cash flows over the coming years, together with the expectation of revenue growth, due to the use of previously unutilised capacity. These factors could both be sufficiently incorporated into the FCF model. The reason for selecting Free Cash Flow to the Firm (FCFF) over Free Cash Flow to Equity (FCFE) was due to recent fluctuations in total leverage. Revenue Growth Over recent years the company has made significant investments in sugar cane and sugar production facilities in Southern Africa, primarily in its Zimbabwean and Mozambiquean operations. Management has repeatedly stated that it intends to increase production from 1,106,000 tons in 2008 to in excess of 1,960,000 tons by then end of the 2009/2010 season. This represents an increase in sugar production of 77.22%. However, the company has sufficient capacity to generate production in excess of these targets. Source: Cavalry Holdings research, company data The analysts prudently assumed that this capacity would only be achieved by the end of the 2010/2011 season – one year later than management’s expectations. Historically, 63% of Tongaat Hulett’s revenue stream is generated from sugar production. It was therefore decided to extrapolate a 77.22% increase in the 63% Recommendation: BUY portion of revenue generated by sugar production over 3 years. As it was Target Share Price: R113.26 estimated that approximately 17.63% of the 77.22% excess will be utilized by the end of 2009, the remaining portion of 50.97% of growth was allocated as 22.87% to 2010 and 2011 respectively. It is assumed that after this period of above average growth, the growth rate of revenue will revert to the long term sustainable growth rate of 7.53%. WACC 12.74% EBIT Margin Cost Of Debt (after tax) 9.70% The EBIT margin for 2009, from the period of January until June, amounts to Cost Of Equity 14.99% 22.06%, up from 17.15% in 2008. Both these margins are significantly above the historical average. This can be attributed to the relatively cheap sugar Beta 0.63 production within Zimbabwe and Mozambique. With the capacity expansion Market Risk Premium 12% within both these markets, the analysts believe this trend is expected to continue. Risk Free Rate(R153) 7.43% However, it is prudently assumed that this trend is ultimately unsustainable, and Interest Bearing Debt to Equity ratio 0.74 for the purposes of the model a constant average margin of 19% is used. Long Term Sustainable Growth Rate 7.53% Net Investment in Fixed Assets Source: Cavalry Holdings research, company data Following a period of large capital investment in Mozambique and Zimbabwe, net investment in fixed assets is expected to decline in the next three to five years. Free cash flow to the Firm Model Estimate Estimate Estimate Estimate 2008 2009 2010 2011 2012 Revenue 7106000 8358840 9573855 10965482 11791183 Revenue growth% 11.12% 17.63% 14.54% 14.54% 7.53% EBIT Margin 17.15% 22.00% 21.00% 21.00% 21.00% EBIT 1,219,000 1,838,945 2,010,510 2,302,751 2,476,148 EBIT growth% N/A 50.86% 9.33% 14.54% 7.53% Tax Rate 28% 28% 28% 28% 28% Tax Expenditure -341,320 -514,905 -562,943 -644,770 -693,322 Depreciation 262,000 470,000 343,000 355,914 368,828 Net Investment in Fixed Assets 1,704,000 1,380,000 1,214,400 1,260,122 1,305,844 Change in Working Capital -83,000 167,000 115,615 119,974 124,332 Free Cash Flow to the Firm (FCFF) -481,320 247,040 460,552 633,799 721,478 FCFF/share -4.6618 2.3927 4.4607 6.1387 6.9879 #shares 103,247 Weighted Average Cost of Capital (WACC) 12.74% Terminal Growth Rate (g) 7.53% Intrinsic Value R 113.26 Source: Cavalry Holdings research, company data 3 CFA South Africa Investment Research 9/25/2009 Challenge Student Research Weighted Average Cost of Capital (WACC) CAPM was used to derive a cost of equity of 14.99%, with a share premium above market consensus added to account for the additional political risk in the Zimbabwean operation. Cost of debt was calculated as 9.7%. The WACC amounts to 12.74%. Intrinsic Value Based on the FCFF model, which indicates that the share is highly undervalued, a BUY recommendation is issued with a twelve month exit price of R 113.26.
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