Update No. 284 – 30/11/16

We have alluded to a major new position for the fund at each of the last two blogs. I have tried to keep it brief and simple for those of you whose attitude to what I do with your capital is best described as “Show Me the Money”.

We will break with our tradition of relatively modest stock specific disclosure and discuss this position at some length. This is a rarity as the stock is trading at very near our acquisition cost and I am usually reluctant to give away our intellectual property before we have profited from it ourselves. In this case, I don’t think it will present a problem as it is an especially thinly traded issue, so anyone wanting to buy it in reasonable quantity will need extreme patience if they wish to do so without affecting the price.

Our recently minted second largest position is KPT.AX (Kangaroo Island Plantations). We discussed risk in Update 281 a few weeks ago, I wrote:

“Here it is critical to remind ourselves that with investing, it is entirely possible to pay double or triple the price that a stock has historically traded at and be making a better investment decision.”

With KPT, we think we are living this idea. We have been aware of the meaningful investment upside opportunity of KPT for quite some time. We have paid over twice what we could have acquired our stake for, but we are more comfortable now with the risk/reward profile of the investment. The acquisition of the New Forest estate removed the other viable competitor for the wharf site from the equation and meaningfully increased the certainty that the substantial cash-flows the assets are theoretically capable of will be realised without some other infrastructure owner harvesting large portions of the margin at the wharf…

Until recently, the timberland the company owns was effectively a ‘stranded resource’. There was no cost-effective way to get the timber off the island. To better understand some of the difficulties the bringing of this investment to its current position, look back at this announcement from 2012 (.pdf) this gives some sense of how difficult the process has been. Stumpage was negative 60 cents per green metric tonne. You would have had to pay someone to take the timber away.

There have been a number of factors that have helped move the pendulum back in favour of KPT, not the least of which is the roughly 40% depreciation of the Australian dollar against the US$. Timber also has an extremely favourable long term economic outlook, improvement in stumpage rates over current estimates are likelier in our view than decrements in values.

At $25 per share (the price at which the capital raising was completed), the pre-raising equity was about $47.5m. The raising was a shade over $12.5m, so the present equity at circa $25 per share is about $60m. The recent presentations indicate management expect to potentially require a maximum of $37m more equity and some debt, but it is possible if pre-sales of some of the timber can be sourced that the need for some of this additional capital may be ameliorated.

In any case, assuming the full $37m of equity and $50m of debt are required, an enterprise value of circa $150m at current market prices will be underpinned by:

1. About $157m of timber (at the current estimate of $45 per tonne – I have seen estimates ranging from $38 to $63 in my research, so it seems conservative enough) which will grow at approximately 5% per annum – adding about $8m or so annually to the value of the assets ceteris paribus. I remind you of ‘Other things equal’ because this is the conservative assumption. In fact as the current crop of hardwood is a first planting, when they are harvested, they will produce an Epicormic shoot, which will in fact grow to maturity in about 70-80% of the time that the original planting took to mature. This is due to the mature root system causing the growth of the epicormic shoot to be much more rapid than the original planting. In effect, at a growth rate of say 80% of the original planting and a stumpage value of $45 per green tonne, I estimate the MAI (Mean Annual Increment) will have a value exceeding $15m per annum.
2. The circa $30m that will be spent constructing the wharf (The wharf is unlikely to be more than 50% occupied shipping the circa $30m per annum of timber off the island. Ergo once the fullest and best use is found for the remainder of that shipping capacity, it should be worth a good deal more than $30m, given the current hunger for infrastructure assets)
3. The land itself is worth something in the order of $55m (look at slides 25-27 of this presentation to get a concept of what the plantation size is)
4. The income stream once the wharf is complete will be between $25m and $35m for the 10 years post wharf commissioning (again, ceteris paribus – as I pointed out in the 6^th paragraph, matters such as currency can cause large swings in the stumpage valuations). But as we said in paragraph 7, we view higher stumpage as likelier than lower stumpage, assuming constant currency.

So there is about $240-odd millions of asset value underpinning what is unlikely to be more than $97m of equity (at current per-share prices) or less, and a maximum of about $150m if we use an enterprise value basis.

Best of all, the value of the land should have a meaningful tailwind once the full economic value of the highest and best use for all of Kangaroo Island can be found under the newly expanded infrastructure situation. By that I mean that the single port has been a meaningful pinch-point in terms of the economic advancement of the Island, which will now be released.

I would imagine it will take a few years for the new wharf facility to be optimised, but it seems entirely possible that the per capita GDP growth on Kangaroo Island will meaningfully exceed most other regions of Australia over the coming decade. I rarely make predictions, but come back to me in 2026 and remind me if I’m wrong (from this link, “Median total income (excl. Government pensions and allowance)” on KI was almost exactly two-thirds of the Australia wide average in 2013. I’d hazard it will be at least 75% of the national average come 2026, if not higher.

Finally, all of the above ignores the enormous potential carbon sequestration value of timberland, which is presently not valued in any of the workings above, but has definite prospective value given the constant drift towards a carbon reduced world.

Obviously, the foregoing comments are our opinion and should you be inclined to buy KPT for your personal account, please seek & take financial advice and check the workings I have made. If I have made any errors in my assumptions, please feel free to contact me – Tony Hansen 30/11/2016

P.S. I am currently intending to be in Brisbane to meet with some investors and potential investors for the first few days of the week commencing 12 December, if you’re in South East Queensland and interested in catching up, let me know.

^{*1 after a 31 May 2013 dividend of 2.333 cents per share (cps) plus 1.000 cps Franking Credit, a 31 May 2014 Dividend of 7.000 cps plus 3.000 cps Franking Credit and a 31 May 2015 Dividend of 8.6667 cps plus 3.7143 cps Franking Credit and a 31 May 2016 Dividend of 6.0000 cps plus a 2.5714 cps Franking Credit}

^{*2 calculated based on dividends reinvested}