August 11

2023 Review of the Avarga Limited share price and dividend

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If you’re a little like me, you must have wondered what happened to Avarga.

From being the media darling that had access to the media due to it being the company of media tycoon Tong Kooi Ong (who owns The Edge), it’s now been beaten down 33% from its highs of $0.30 just a year ago.

How we found Avarga

Avarga appeared highly on our Stockopedia screens because of its high quality of earnings, despite it being a largely commodities business.

Avarga share price Review
The valuations we found in July 2021

If you look at its three business segments, it sells:

  1. Paper through its paper mill
  2. Electricity through its power generation plant in Myanmar
  3. Lumber through its subsidiary, Taiga

At the time when we bought it, we also thought there was significant value from its dividend.

So one must ask, what has happened now?

And is there hope moving forward?

Avarga is not a commodities business, but a capital allocation business

Avarga largely mirrors Tong Kooi Ong, who is an investor. Read through his writings on The Edge over the past few years, and you would notice certain reflections of Warren Buffett.

They go after valuable business, which have proven quality earnings over years. That’s why they have gone for deliberate stakes in the likes of Classic Scenic ($2.8m) and Straits Energy.

It’s a little like how Berkshire Hathaway has a core insurance business, but also invests in stakes like Apple, American Express, and Bank of America.

But it does look like Avarga prefers more commodity-type businesses.

You would also notice that they deliberately restate their financial statements to show how they allocate capital.

Here they show how they have used their cash over the past 10 years.
Here they show how they have used their cash over the past 10 years.

In fact, that was what drew me into the business, seeing how Avarga was able to state its position so lucidly.

And if you look at their investments over the years, particularly the Taiga one in 2017, it seems to have played out extremely well.

The timeline of Avarga, from the 2023 AGM Management Presentation

They paid C$72 million for Taiga, and saw gross profit leaping from $18.7m to $132.4m in just one year, between 2016 to 2017.

But of course, if you’ve seen how their pre-tax profit has fallen, is it still worth holding them?

Are they a value trap, or are they truly value for money?

Some investors have argued about how their dividend policy has been cut.

No dividends, no hope?

And over the past year, their stock price has taken a beating because of two things.

  1. They axed their dividend policy in 2022, and did not pay out a dividend in 2022.
  2. They reported poor earnings for their power plant and their paper business.
Whichever way you read it, seeing the paper plant turning into a $12 million loss is not pretty reading.
Whichever way you read it, seeing the paper plant turning into a $12 million loss is not pretty reading.

They explained the removal of the dividend policy due to the need for the financing of the wholesale distribution of building materials through Taiga.

Ian explained,

A wholesale distributor of our size, with sales of over C$2 billion annually, requires a lot of financing for inventories, receivables, stocks in preparation, stocks for treated wood, etc.

Therefore, rising interest rates is a concern, given that our net margin on sales is very small.

Just look at how far lumber prices have fell.
Just look at how far lumber prices have fell.

They argue that the rising interest rates necessitate that they have cash on hand to build up inventories, and continue surviving.

On the surface, this conservatism appears a good move.

But as a retail investor, what you do have to ask yourself is whether you have time to wait for the economic cycle to turn. As Ian observed,

the steep rise in borrowing costs have already had visible negative impact on the property sector, where demand is very sensitive to interest rate changes, as well as capital markets.

It appears, at this point, that central banks may not yet be done with the current tightening cycle.

Read the last line?

Central banks may not be done.

The uncertainty around interest rates may result in the dampening of demand for homebuilding, resulting in a continued depression of the price of lumber, and declined sales revenues for Taiga.

Please don’t get me wrong.

Tong’s team has certainly done a great job in anticipating the downturn, and deciding not to pay out a dividend in the second half of 2022.

But there are certain factors that may hamper their progress.

Getting pulped in their paper business

Ian Tong, the son of Tong Kooi Ong, shared how the influx of Chinese companies has introduced severe competition to their business.

There are two aspects to this. The increased competition has resulted in increased prices of waste paper, that has reduced margins.

But what the competition has also resulted in has been a loss in business.

Avarga wrote down RM3.1 million of stock.

Write downs aren’t nice to read, and not easy to understand.

It’s management deciding that they may not turn a profit for the stock they have produced, and deciding to write it off as a loss.

Management has re-evaluated the business model and will embark on a plan to restructure the operations, including a revamp of our product range.

However, there is no guarantee of success and we must be prepared to make difficult decisions.

Avarga Annual Report 2022

Taiga’s money is not Avarga’s money

Ian Tong took the chance during the AGM to clarify how Taiga and Avarga were related.

Under our accounting standards, Avarga consolidates Taiga’s financials into our own.

For example, if Avarga has $10 and Taiga has $30 in cash, Avarga’s balance sheet will show $40 in cash.

However, this does not mean Avarga has $40 in its bank account, it has $10.

Cash generated that Avarga has access to and control over come from our paper manufacturing and power generation businesses, which are wholly-owned. This applies to earnings, liabilities, and all other financial line items as well.

Avarga only has access to the cash generated from the power plant and the power generation.

This means that if Taiga doesn’t pay a dividend, there is no cash flow through to Avarga.

It’s like how Berkshire operates. They hold minority percentages in companies like Apple, and earn from either capital appreciation of the Apple stock (if Berkshire decided to sell their Apple shares), or the dividends paid out from Apple.

Should you continue to hold Avarga?

The short term outlook for Avarga certainly looks dim, with little assurance that the management would turn around its paper manufacturing business.

The lack of dividends will also continue to weigh on its share price. Ian observed in the Annual Report 2021 that

we have been unable to achieve a market valuation that properly reflects the performance of our Company.

This has handicapped us in pursuing M&A opportunities and limited shareholders’ ability to generate a fair return for their investment.

This is despite our attempts at highlighting our Company’s performance through frequent industry engagement and a capital allocation strategy focused on an aggressive dividend policy.

They had hoped that the dividend would raise interest amongst retail investors, resulting in a positive re-rating of the stock.

But the current survival of the capital intensive commodities businesses they are in necessitate cash on hand, to weather the cycle.

It’s not going to be an easy ride.

Get strapped in, if you’re in Avarga for the long run.

 

 


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