An overlooked Agri microcap?

A cotton gin separates cotton fibres from seeds and converts harvested cotton into a finished format. In addition to its ginning business, NAM owns a 51% stake in a joint venture marketing business which purchases and distributes ginned cotton into Asia all the while hedging price risk by way of cotton futures in the US.

Several years ago this marketing business nearly bankrupted the co-operative as the difference between the price of cotton in Asia and the US (the basis) ballooned. The firm was effectively unhedged and booked significant cash losses. NAM subsequently sold a 49% interest in the marketing business to global trading house Louis Dreyfus. By doing so, NAM mitigated the risk of future collapses as the new partner has an ability if need be to deliver physical cotton to the US exchange. 

The majority of EBITDA is generated from the ginning business. NAM owns 13 gins and is the biggest player in Australia with an estimated 30% market share. Cotton ginning requires significant fixed assets and has equally significant operating leverage. Although NAM’s co-operative roots might suggest the pricing structure is generous towards the grower ‘owners’, in reality the industry is competitive and NAM is forced to meet the market price. 

Ginning EBITDA is largely a function of throughput. Given NAM’s competitive position, throughput is driven by the size of the cotton crop which is in turn reactive to the availability of irrigated water in the Northern NSW and Southern QLD farming regions[1]. Accordingly, NAM’s EBITDA can be volatile - although the firm has made a profit from ginning in each of the last 10 years.

The near collapse of the marketing business and a series of poor cotton crops has starved the business of cash. The gins need capital investment in the order of $15- $20m to improve efficiencies, capacity utilisation and return earnings margins to historical averages. In the present form we estimate the co-operative would generate a return on tangible equity[2] of only 5% in an average cotton year. The current market valuation of ~$40m or 35% of the net tangible asset value suggests this cannot be improved. We have inspected the sites and believe modest capital works could more than double sustainable earnings and increase average utilisation to 70%.

The capital units do not presently carry sufficient voting entitlement. In order to source new funds, the inefficient co-operative needs to be converted to a modern company. To this end, the Board has appointed a corporate advisor and is in the process of negotiating with both stakeholders. We believe it is in all parties’ interest to follow through with the proposal. We don’t believe the co-operative model is appropriate for the 21^st century and expect the grower members would benefit from a faster service without a corresponding increase in price. The capital holders will benefit from increased voting power and earnings from operational efficiencies expected from new investment. We also think a modern company structure could facilitate a reduction in corporate overheads, which look high from the outside.

Our conservative estimate implies the current market price represents a 50% discount to the post conversion net tangible assets per share, or a normalised P/E ratio of 6-8x in an average cotton crop. We like the business’ high barriers to entry, significant tangible asset backing and industry exposure.