Time to Cotton off

This was like the gold digging days when it wasn't the miners getting rich but the owners of the businesses where the miners spent their money.

Unfortunately, the time has come to wave the white flag and surrender to what we had thought were sound reasons to accumulate the stock. Since issue 34 (Accumulate - $4.35) we'd been struck by how undervalued Queensland Cotton looked.

Depressed Mr Market

It's been priced at less than net tangible asset backing, yields have approached double digits (100% franked) and the PER has seen single figures. But, while important, these facts are not enough on their own.

In our recent feature and Investor's College articles we've considered the mood swings of 'Mr Market'. Queensland Cotton looks a good case for a depressed Mr Market. Therefore, isn't it time to buy?

No. While the share price may be down in the dumps, cotton remains a poor business with no sign of recovery.

In the past, cotton production boomed and acreage expanded. Queensland Cotton supplied the loans, seeds, property mapping and advice. Then, when the cotton was ready for picking, it would 'jump down, turnaround and gin (process) a bale of cotton' - and follow through with the marketing, brokering, selling and shipping. The share price boomed.

From 1994 the share price rose 170% to $6.20 in 1997 but it's been falling ever since. A push into the USA didn't run as smoothly as planned, drought and floods have wiped out crops, cotton prices are wallowing at 15-year lows and regulations and subsidies are muddying the waters.

Despite these pressures the company has continued to make profits and return on equity has been in the teens.

That's good but it's easy to make high returns on equity if you keep increasing debt. Debt-to-equity is now over 200%. Provided cashflows remain strong, this isn't a problem but the loans made to farmers could be.

Loan concerns

We attempted to clarify the issue of financing provided to farmers with the company but it wasn't too helpful. The loan books have grown and if farmers were to start defaulting, there could be difficulties for the company.

Also, where's the incentive for farmers to increase crop sizes (and more business for Queensland Cotton) when returns are poor and water scarce? There's no point turning to the government. Cotton farming is small beer and has never got any support.

The company may look undervalued but, given the broader industry risks, that's warranted . You may be tempted to hold for yield but we'd now SELL.