Avarga Limited (Part II)

Avarga Limited (Avarga) has generated significant interest after the first article was posted. This is a follow-up on the company with a discussion on corporate actions (some confirmed some speculative) and the impact on shareholders.

In late-June 2020, Avarga declared a dividend policy with a target dividend payout of not less than 40% of net profit attributable to Shareholders excluding non-controlling interests and non-recurring, one-off and exceptional items, with effect from the second half of 2020.

Based on the back-of-envelope calculation in my previous post on Avarga, this translates to a dividend per share of 1.63 Singapore cents. Based on the counter’s closing price of 26 Singapore cents, this represents a whooping 6.38% dividend yield for 2H2020!

But what I think is more important, is the fact that management has delivered on what they had promised. Referring to page 5 and 6 of Avarga’s 2019 Annual Report on Chairman and CEO’s Statement:

“Going forward, barring the occasional major capex needs and opportunistic acquisition deals, we would ideally like to have a dividend payout policy of 40-50% of net profit, to be paid out on a quarterly basis. This will provide shareholders with a constant and regular stream of dividends.”

Basically, management is exhibiting credibility and following-up on what they had earlier preached. This is a rare commodity for a listed company with small capitalization on the backdrop of shenanigans going on with some other small capitalized companies.

A careful read-through on the annual report also details the return on investments. Avarga had grown from a single paper manufacturing business to include a power plant in Myanmar and Taiga in Canada and USA without stretching the balance sheet. The company have also distributed a staggering $80MM back to shareholders in total dividends in the past eight years.

What can we expect going forward?

Firstly, I think the probability of periodic share buyback is high. Avarga stopped buying back shares in FY2019 as cash flows from UPP (Power) were used for major overhauls. With the next major overhaul due in mid-2024 to 2025, new capital expenditure requirements will be low. An exceptional performance that looks likely to roll over into 2021 for Taiga also guarantees ample arsenal for conducting share buybacks.

Secondly, management has also shared on 24 August 2020 that it is reviewing opportunities and are implying plans for capital recycling in the short-term. I think this is a fantastic endeavor. As previously mentioned, Avarga as an investment holding company suffers a holding company discount to the summation of its investments’ value. As good as the constituent investments are, the holding discount is detrimental to shareholders. A track record of realization of value through asset disposals (be it through an outright sale or listing), will compress future holding discounts.

While management had implied that their investment criteria is based on stable businesses producing steady cash flows, the synergy derived from these 3 disparate companies are not immediately noticeable. This could have resulted in a larger holding discount.

A capital recycling exercise can return some cash back to shareholders and allow management to further sharpen their investment criteria to facilitate lower investment holding discount.

Which investment is likely to go?

Please refer to the following from Avarga’s reply to SGX query.

“As an investment company focused on creating value through strategic investments, the Company is constantly considering possible corporate actions and exercises to increase shareholder returns.

At present, the Company is exploring opportunities relating to its paper manufacturing business. These opportunities include the expansion and/or a potential listing of this business. However, such exploration is still at a preliminary stage. There is no assurance as to whether any transaction will materialise or as to the structure of any such transaction. The Company will make appropriate announcements in the event that there are any material developments in this regard.

The Company has also been considering a possible transaction which will allow it to monetise its investment in the power plant located in Yangon, Myanmar. The terms of such possible transaction are still not finalised and are still under consideration. Again, there is no assurance as to whether any transaction will materialise or as to whether any definitive agreement will be reached. The Company will also make appropriate announcements in the event that there are any material developments in this regard.”

Based on the wording of the reply, it is evident that monetisation of UPP (Power) is in a more advanced stage as compared to UPP (Paper).

The merits of the monetisation of UPP (Power) are as follows:

1. Reduce Avarga’s exposure to the fluctuations of foreign currency exchange rates of a developing nation.

2. Return partial cash proceeds from monetization back to shareholders and recycle capital into higher yielding assets.

3. UPP (Power)’s exemption from income tax had ended in 2019. While cash flows from UPP Power remain steady, the absence of a tax-free status causes it to look less shiny an increase in revenue from higher utility usage in Myanmar will not be 100% passed down to Avarga. (While getting taxed in a business is the normal course of affairs, I reckon management will also agree that not getting taxed will be better. The monetization of this business at this current juncture is great timing when interest in investments in ASEAN infrastructure is heating up.)

Based on the above, I think the motivation to drive monetization of UPP (Power) to completion is present.

The merits of the expansion and/or potential listing of UPP (Paper) are as follows:

1. Listing of UPP (Paper) will inject fresh capital into the business with no need to depend on existing retained earnings. Reliance on retained earnings can mean that expansion is slower. UPP (Paper)’s listing will also provide it with an additional avenue for capital whenever it requires expansion; it can do its separate equity or debt issuance with little or no reliance on Avarga to grow.

2. Listing of UPP (Paper) immediately provides investors with a market value of UPP (Paper) removing ambiguity to its valuation which creates a more stable share price for Avarga.

3. Listing of UPP (Paper) can result in partial monetization of shares and result in bumper one-off dividend for shareholders. We are seeing companies like Wilmar International Limited taking this route.

4. UPP (Paper) can expand its brand recognition through a listing exercise.

5. Nine Dragons Paper (Holdings) Ltd (2689 HK) had announced their results last week, and they had performed above analysts’ expectations. Analysts from HSBC, Credit Suisse, Daiwa and Goldman Sachs had lifted its target price on the back of the positive surprise and expectations of improving performance going into 2021. This bodes well for paper manufacturing businesses looking to seek a listing as they are able to achieve a higher valuation.

Listing is a process that needs to run its course and based on Avarga’s reply we know this is still in its preliminary stage but certainly provides more upside than downside for investors.

Avarga has a strong track record of returning cash to investors when they dispose assets, this allows investors in Avarga to share in the fruits of the company’s success. The plans for UPP (Power) and UPP (Paper) will likely catalyze further upside to shareholder's dividends.

Following up on Taiga, I noticed plenty of news flow in USA on lumber prices staying elevated despite a down season for home improvement and building activities. This is beneficiary for Taiga as higher lumper prices typically translates to higher selling value for Taiga’s products.

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