Sorting the wheat from the chaff

PORTFOLIO POINT: Seeding a share portfolio with Australian grain stocks is difficult, but one rural play that could germinate is Ruralco and Elders if a hybrids solution can be found.

High wheat prices caused by drought in the US are good news for Australian farmers, but for most stockmarket focussed investors rural entry points are scarce. That is, except for a handful of usual suspects, and an emerging high-risk deal involving a classic “zombie” stock, Elders.

Top of the obvious players in the local grain market, which has been severely depleted by takeovers over the past few years, is Sydney-based Graincorp (GNC) which has enjoyed a 40% share price uplift over the past 12-months from around $6.45 to recent trades at $9.02.

Originally an arm of the NSW Government, Graincorp is the last of the pure grain-exposed stocks on the ASX after the takeovers of AWB (formerly the Australian Wheat Board) by Agrium, and then on-sold to Cargill, followed by Viterra acquiring ABB (formerly the Australian Barley Board) – with Viterra itself then acquired by Glencore.

The fact that two of the world’s biggest commodity traders, Cargill and Glencore, have cemented their positions in the Australian grain sector is a pointer to growing international interest in the broader soft commodity sector, and ensured that Graincorp’s name appears on most lists of potential takeover targets.

While not directly exposed to the wheat price, Graincorp is enjoying strong demand for its grain handling services, lifting profit in the half-year to March 31 by 39% to $122 million, and revising upward its profit forecast for the full year (follow this link to the company’s latest presentation lodged at the ASX yesterday.

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Source: IRESS

Fertiliser maker Incitec Pivot (IPL) is a secondary beneficiary of the recent 35% rise in the Australian wheat price, thanks to the potential of higher sales. But its share price has fallen 30% over the past year, possibly because of concern over slowing demand from the mining industry for its range of explosive ingredients that have dominated recent investment decisions.

Of those two possible grain entry points Graincorp is the obvious winner, although brokers who follow the rural sector are split, with a handful tipping the stock as a buy and others believing Graincorp has done its best work, in the absence of a takeover.

Credit Suisse, Citi, and Bank of America Merrill Lynch have a neutral or underweight recommendation on Graincorp. JP Morgan and Goldman Sachs see it as still being worth buying, though the potential capital appreciation is marginal, with JP Morgan seeing $10.10 as the price target on a stock already over $9, and Goldman setting $10 as its target.

The same “done its best work” accusation cannot be made of Elders, a one-time favourite of rural investors until it became a plaything of entrepreneurs such as John Elliott and one-time Robert Holmes a Court lieutenant, Alan Newman.

Two decades of unfortunate investment decisions saw Elders drift away from its rural roots as a provider of farm and pastoral services, into ill-fated forestry management and, most curious of all, as a maker of vehicle air conditioners during its time as an arm of the failed Futuris Ltd.

It was while part of Futuris that Elders made its biggest corporate mistake, and the one which a number of investment banks are trying to unlock. It raised $150 million in 2006 through an issue of $100 denominated “perpetual, subordinated, convertible, unsecured, notes” – now referred to in most reports as hybrids.

A good idea at the time, or maybe not, the hybrids had first bite at any dividend distributions using a formula based on the three-month bank bill swap rate, plus a margin of 2.2%. Thirteen quarterly payments were made, ranging from $1.76 a unit to 93c in June, 2009, when what had been billed as a superior (and safer) form of investment stopped making distributions.

The problem for Elders (which had changed its name back from Futuris) is that ordinary dividends were also frozen and cannot re-start until the hybrids are serviced.

To most outside observers the hybrid overhang, plus the collapse of the tax-driven forestry investment business, plus the problem of a low-profit car parts division, means that Elders has become a no-go stock.

But not to everyone.

Earlier this year, a small Tasmanian-based farm service company, which looks awfully like Elders of 30 years ago, started buying Elders shares.

In May, Ruralco Holdings declared that it had acquired a 10.1% stake in Elders. At first glance, Ruralco appears big enough to launch a full takeover bid for Elders. It is valued on the market at $189 million versus the current value of Elders ordinary shares at $103 million.

But, lurking in the undergrowth are $150 million worth of hybrids that must be managed in some way, plus a $373 million mountain of net debt, plus assets that Ruralco would definitely not want, including forestry and car parts.

What Ruralco has done, however, is buy an early seat at the table for what some people see as the eventual resolution and break-up of Elders into its component (and saleable) parts, keeping the historic and far-reaching farm trading operations which were once based on the national wool clip, but which include generational links to many Australian wheat and sheep farms.

Hints that Elders might be coming good after its time in the wilderness were contained in the company’s first-half result for the six months to March 31 when it reported a profit of $40.5 million compared with a loss of $14.6 million in the previous corresponding period, from a 2% fall in sales revenue.

Positive as the latest result looks, it was mired by a long list of extraordinary items (such as big tax refund), and losses from discontinued operations (mainly forestry). The net result was a modest after-tax profit of $6.1 million compared with $7.5 million previously.

The latest result, like so much of Elders, reflects historic events. More interesting for today’s investors is speculation that a number of investment banks are working on ways to get rid of the hybrid shares, possibly by encouraging stale owners (an estimated 2,000 of them) to take a substantial “haircut” for cash in the hand versus a longer wait for a resumption of distributions.

One possibility floated is for Ruralco, now that it has its 10.1% blocking stake, to launch a bid using its own paper, which would see it emerge with about one-third of an enlarged rural services business, existing holders of Elders ordinary shares another third, and hybrid investors the remaining third.

If such a deal could be orchestrated, economies of scale would be enjoyed, plus the benefits of merging outlets where Elders and Ruralco compete.

For courageous investors, Elders could become a way into the shrivelled Australian rural services (and grain trading) sector, though a leap of faith is required, plus a lot of corporate manoeuvring.

Over the past 12-months (as Ruralco has risen from $2.67 to its current $3.44). Elders has risen from 18.5c to 23c, well short of last year’s high of 38c.