The chicken or the egg-which is more expensive?
Shining the spotlight on… Quantum
This article is not an attempt to answer the question on what came first between the chicken and the egg.
We merely wish to take a rough look at Quantum’s fundamentals and give an opinion on what we think of its current market capitalization;
whether we think its overvalued or not.
This is a tale of four charts:
Quantum foods is a South African company listed on the JSE (QFH).
The company’s financial performance can be summed up in 4 price charts:
Yellow maize, and
The company operates in South Africa, Mozambique, Uganda and Zambia and produces the following:
Egg laying chicks and broiler* chicks, and
*Broilers are chickens that are bred to produce meat.
We will take a look at and give our opinion on some of the following regarding the company:
Key risks management,
Production record and
A. Data obtained from the annual reports
The company’s executive management has not changed from listing in 2014.
The CEO & CFO have been at the company since Quantum foods was a division of Pioneer foods.
The company's 3 key risks are
(1) Raw material price increases (see annexures at BOTTOM of document)
maize and soybean are used in the company’s animalfeed process, most of which is fed to chickens and the rest sold externally.
shortages in maize and soybean lead to price rises and lower profits for the company.
the 2016 drought in South Africa led to maize and soybean reaching record highs and 20% rise in the company’s material cost .
profits fell by 28% compared to 2015.
(2) Financial volatility due to exchange rate instability
(see annexures at BOTTOM of document)
soybean meal is purchased in US dollars.
when the ZAR depreciates against the USD, soybean becomes more expensive to purchase and profits can be expected to take a dive.
(3) Poultry disease
the company had an outbreak of Avian Influenza in 2018 killing some of its chicken stock.
more severe outbreaks have the potential to severely reduce production of eggs and chicken meat, and loss of reputation.
Quantum’s management receives annual bonuses based on:
Meeting headline earnings before tax per share targets,
Growth in economic profit and
Achievement of farming production efficiency targets.
Management also receives share options as follows:
50% is based on growth in Group headline earnings per share and
50% is subject to continued employment.
Quantum has from 2016 paid dividends of R304 million and R87 million in share-buybacks up to the end of the 2018 financial year end.
The company has made free cash flows* of R560 million from 2014 up to the end of the 2018 financial year end.
*Free cash flows is the cash remaining in a business after sales,expenses, purchasing the equipment and licenses necessary to operate the company.
The Balance sheet and Trade receivables
(1) PPE and Intangible assets
Quantum’s accounting policies have to an extent remained the same as its former parent: The Pioneer food group.
By comparing depreciation rates with industry peers such as Astral food, Zeder investments and RCL:
· Quantum appears to be a little aggressive on writing down its buildings over 25 years when other entities are using 50 years.
However, as per the accounting rules, useful life is entity-specific and should be based on long the company expects to use the property.
No further comment will be made on this.
(2) Trade receivables are made up as follows:
National customers (chain retailers) and
National customers are made up of nation-wide retail chains such as Shoprite and Pick ‘n pay.
-These customers have historically settled their debts on time with the company.
Other customers consisted of much smaller retailers and companies.
A small portion of other customers has previously defaulted but subsequently paid their debt.
The company’s takes out 50% credit insurance on the South African portion of its other customers receivables balance.
Quantum overall maintains a strong balance sheet.
The company’s long-term and short term liabilities are covered by its current assets alone.
The company is currently trading at around its net current assets (current assets less total liabilities).
A buyer of its securities is in effect getting its non-current assets free.
Production has seen slow growth in the 5 years the company's been public.
Egg production has remained flat in the years from 2013 to 2018 (see below).
however, the decline in 2018 from 2017 figures is as a result of the outbreak in Avian Influenza and the loss of some egg-laying birds.
were it not for the outbreak of Avian Influenza, the 2018 egg production would have been somewhere around 84 million.
The big jump in Animal feed production between 2015 and 2017 was due to the purchase of Olifantskop feed mill in 2015.
Quantum Foods production figures as sourced from Annual Financial Statements:
B. My thoughts on the above
On risk management...
I think the directors have not done enough to deal with the key risks the company faces.
The company is to a large extent still exposed to the same risks as in 2014.
Take for example the below:
(1) Maize prices
-The company sources maize locally @ SAFEX prices on the JSE.
-I expected that the company should have by now perhaps, have looked into owning or leasing a farm where they can grow their own maize and reduce their input costs.
(2) Soybean prices and innovation
-Management has no control over international prices of soybean and the USD/ZAR exchange rate.
-I however expected that management would look into alternative ways, such as finding soybean substitutes which could be sourced locally cheaper.
-The company has spent R68 million on research and laboratory costs between 2014 and 2018.
-The R68 million spent up to date is either too little, or the company is researching activities that contribute little to reducing input costs.
-Perhaps a disclosure of research activities in the annual report would give shareholders
-One thing for sure, I am tired of opening the integrated report year on year and hearing the board complaining about risks of rising supply costs and exposure to the USD/ZAR exchange rate.
On the Remuneration policy...
While I agree that management should get bonuses bases on farming efficiently,
I am not happy with bonuses being based on headline earnings.
Quantum’s headline earnings is largely controlled by the price of maize, soybean and the USD/ZAR exchange rate.
These factors are outside of management’s control.
The 2018 headline earnings more than double compared to 2017 as:
1. Lowered production costs as a result of an improved USD/ZAR exchange rate during Ramaphoria, flat soybean prices and marginal increases in the price of maize.
2. Increases in egg prices and chicken meat after Avian Influenza caused shortages.
A more suitable measure of company growth that management can control would be increasing production and sales units.
We have already stated our stance on the company’s use of headline earnings.
Nothing is more shocking regarding the awarding of share options for mere continued employment.
These incentives are meant to motivate the board to make the company sustainable in the long term.
More suitable performance measures that can possibly be used include:
Increasing production and unit sales.
Backward integration by acquiring its own farms and controlling the cost of its key inputs (maize and soybean).
As mentioned before that the company has made cash flows of R560 million and returned R391 million to shareholders via buybacks and dividends.
Of the remaining R169 million
R96 million has been used to acquire other businesses:
-Olifantskop feed mill,
-Galovos egg business – Mozambique and
-Safe Eggs – Pasteurised eggs.
· R73 million has been retained to strengthen the financial position.
Quantum's profits from the income statement contain capital profits which occur infrequently and must be removed in analyzing the normal day-to-day operations.
Adjustment of profits for exceptional items.
Exceptional items are gains/losses on disposal of PPE, share of associates’ profits, finance income and finance costs.
The aim of adjusting for these exceptional items is to get an idea of how much the operations can produce.
From the above we see that Quantum can produce an average net profit of R124 million in net profits based on the 5 year data used.
At the current market capitalisation of R760million (as at 08/11/2019) the company is trading at 6.22x average earnings.
Personally the maximum that I am willing to pay for any company is 10x average earnings.
With regards to Quantum food:
The company’s financial performance is largely tied to maize and soybean prices and the USD/ZAR exchange rate.
The company has also not helped its cause by finding substitute inputs and attempting to backward integrate and produce its inputs cheaper.
I would value the company somewhere around 5x earnings (R620 million).
At the market price of R760 million ,the company is overpriced and will not make the purchase.