Avarga Limited (Part I)

 

Investing amidst COVID-19

Avarga Limited (Avarga), formerly known as UPP Holdings Limited, is an investment holding company.

The investment holding company holds ownership in three core businesses, 1) paper manufacturing, 2) power generation and 3) building materials distribution. As at the market’s last close on 15 September 2020, this counter with a track record of racking up at least $1.4B revenue annually for the last three years, has a market capitalization of $217.8MM.

Avarga has been attracting a lot of attention from the investment community due to a positive surprise in its 2Q 2020 results. This set of results sparked bullish sentiments for stocks associated with the lumber industry but the lumber party was short-lived.

What are Avarga’s businesses? What do they do?

Below is a visual representation of Avarga’s various businesses and its effective stakes.

Source: Avarga, Golden Apple

Building materials distribution: This business is represented by Taiga Building Products Ltd (Taiga). Taiga is Canada’s largest wholesale distributor of building materials, such as lumber, panels, mouldings, sidings, etc.

Taiga is listed on the Toronto Stock Exchange. Taiga has 15 distribution centers across Canada and 2 in Northern California, USA as well as 6 reload stations in Pennsylvania, New York, Michigan, Vermont and Illinois.

Taiga’s customers include Home Depot, Lowe’s and Rona.

Paper manufacturing: UPP Pulp & Paper (M) Sdn Bhd (UPP Paper) represents Avarga’s interests in the paper manufacturing industry. UPP Paper is one of Malaysia’s top 5 paper mills and produces almost 10% of Malaysia’s domestic output of brown packaging paper.

The pulp and paper mill sits on a 32.5-acre land in Kuala Selangor, Malaysia (north-west from Kuala Lumpur).

Power generation: UPP Power (Myanmar) Ltd (UPP Power) accounts for ~2% of Myanmar’s total power generation. UPP Power is contracted to sell a minimum of 350MM KwH annually, for 30 years, to the Myanmar Government.

How is Avarga’s performance year-to-date?

Source: Avarga, Golden Apple

The impact of COVID showed up in Avarga’s performance through a battered paper manufacturing business, a resilient power plant business and an unexpected windfall for the building products business.

Taiga experienced higher selling prices for its commodity products during the 1H 2020. Despite the significant decline in revenue (sales decline of over 30%) during April, Taiga still brought in ~S$40MM of revenue and also enjoyed gross profit margin expansion!

Source: Avarga, Golden Apple

It appears the impact of COVID-19 was felt more keenly in the Canadian market which posted a ~C$10MM decline in revenue.

Diving deeper to uncover the actual revenue growth of Taiga in 2Q 2020. I assume revenue for Taiga in 2Q 2019 is evenly spread out and divided it by three to obtain sales on a typical April. Following which I applied a 30% discount to the April revenue and deduct it from 2Q 2020 revenue. This will be the implied revenue for May and June 2020.

Source: Avarga, Golden Apple

The implied yoy revenue growth is an astounding 16%!

A boom in home renovations amidst the pandemic had caused a jump in in-store and online spending for home improvement products. The spending boom had in part been driven by COVID-19, as people looked to improve their living spaces which they had to spend more time working or learning in. This had led an increase in revenue and gross profits.

Where is the meat?

The performance of Home Depot’s 2Q 2020 results are indicative of Taiga’s 3Q 2020 performance in North America.

Source: Home Depot 2Q2020 10-Q

Link:https://ir.homedepot.com/~/media/Files/H/HomeDepot-IR/reports-and-presentations/quarterly-earnings/2020/2Q/HD_10Q_vf.pdf

The robust demand in US is also evident in Canada. In Home Depot’s 2Q 2020 earnings call, Home Depot described a broad-based strong demand with a high degree of performance uniformity amongst their three US divisions and Canada. 

The market upswing for home building products in Canada is further corroborated with Lowe’s 2Q 2020 earnings call where Lowe’s shared that they posted positive comps that exceeded 20%, driven by similar consumer focus on the home.

Significantly, lumber prices experienced its own “Tesla” moment. The following charts are historical one-year and five-years lumber prices.

Source: https://tradingeconomics.com/commodity/lumber

Prices of building materials typically fluctuate in similar direction to lumber prices. But as Taiga accumulate inventory, it continues to roll in significant inventory gains. Between 1 July 2020 to 16 September 2020, lumber prices jumped a whooping 114%. This meant that Taiga is set to book significant inventory gains in the coming quarter.

However, building products is a seasonal business. As winter sets in, home improvement and home building activities tend to dial down. This will spell a decline in demand for building products and this decline will be reflected in lumber prices. Already, lumber futures expiring in November 2020 traded at $640 while those expiring in January 2021 traded at $590.

A breakdown of Taiga’s quarterly revenue shows a seasonal impact of its business during the winter months.

Source: Avarga, Golden Apple

In 4Q 2020, we should expect yoy increase in revenue albeit a lower one. Sales in value should come down along with sales in volume but we should bear in mind (if futures prices are a good proxy for spot prices) that the expected lumber prices in end-2020 is still higher than when 2020 started which can mean higher sale in value in end-2020 than in end-2019. However, management should exercise caution to prevent excessive inventory pile-up which can lead to significant inventory losses as lumber prices start to decline in the winter season.

Below is my back of envelope forecast for Taiga’s revenue and gross profit in FY2020.

Based on the above, Avarga is trading at an implied FY2020 PE of 4.1x.

Is Avarga undervalued? Typically, investors will value the individual businesses. From the summation of the value of the different businesses a holding discount will be applied.

Valuation for paper manufacturing is straightforward. Readers may refer to listed peers such as Nine Dragons Paper (Holdings) Limited (2689 HK) to obtain their PE ratio and apply towards the earnings of UPP (Paper).

As for valuation of UPP (Power), readers may wish to apply a discounted cash flow model based off the EBITDA of the business.

As for Taiga, we may simply use its listed share price on the Toronto Stock Exchange. However, if readers are only interested in the building products business and feel that it is undervalued, perhaps a direct investment on the listed entity will offer a more direct exposure. This is in the light that Avarga suffers from a holding discount as an investment holding company.

Avarga has excellent disclosures which provides many useful information for investors. Management have also made efforts to educate investors on their various businesses and how to look at them. These can be accessed through their corporate website and annual reports. Detailed disclosures are a real help for an under-covered stock like Avarga. In my opinion, this should be encouraged by the exchange and emulated by other stocks which feel that they are similarly unnoticed by analysts.

I think this willingness to disclose and educate investors is in no small part influenced by Mr Tong Kooi Ong, the Executive Chairman and CEO of Avarga.

Mr. Tong is an entrepreneur and an analyst. 

He has business interests in media, property development, digital technologies and other businesses in Singapore, Malaysia and Canada. He is on the board of M+S Pte Ltd, a joint venture between Khazanah Nasional Berhad and Temasek Holdings (Private) Ltd. 

He is a director of Taiga Building Products Ltd., a wholesale distributor of building products, listed on the Toronto Stock Exchange and Non-Executive Chairman of 3Cnergy Limited, listed on the Singapore Exchange. 

He has interests in the media companies that publish The Edge Singapore, The Edge Malaysia. The Edge Financial Daily, TheEdgeSingapore.com and TheEdgeMarkets.com. He also has interests in the property portals EdgeProp.sg and EdgeProp.my.

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