Black Crane Capital’s investment in Halcyon Agri is an example of the firm’s corporate finance-driven, deep value approach to Asian investments. Black Crane searches for deep value opportunities where returns can be generated by corporate finance activity. Peter Kennan spent 15 years with UBS as a senior investment banker in the Asia Pacific region. His local knowledge, combined with corporate finance expertise, is what drives the firm’s strategy.

Halcyon Agri was founded by the controlling shareholder, Robert Myers in 2010. Myers is of German background and grew up in Singapore. His family has historical connections within the rubber industry.

The company started by acquiring two processing plants in Indonesia in 2011 and then listed on the Singapore exchange in early 2013. Following listing, the company embarked on a series of acquisitions aimed at consolidating the processing and distribution of natural rubber. The largest of these acquisitions was Anson Rubber in 2014. Anson added 450kT of processing capacity to give Halcyon total processing capacity of 750kT. In the same year, Halcyon also acquired NCE and New Continent, which provided 500kT of distribution volume. The Halcyon strategy is to integrate processing and distribution to provide customers with an integrated supply chain solution to the sourcing of natural rubber.

The share price of Halcyon has recently been depressed due to a significant decline in natural rubber prices. In normal market conditions, processing margins are fairly stable. However, when prices decline to very low levels, processing margins need to be reduced to enable the subsistence farmers, on whom the industry relies for raw material, to earn a living. The current rubber price is not sustainable as rubber trees need to tapped for rubber regularly or they die. Prices that are too low result in abandoned and under maintained plantations. Major industry participants are concerned that current low prices are damaging the plantations which will harm future supply. The current over-supply has resulted from slowing Chinese demand but this is now recovering and new supply is limited. Thus, the underlying industry fundamentals are strong.

The low rubber price has created a very attractive entry point for investors. The current share price of Halcyon does not reflect any upside from the current depressed gross margins nor any benefits from impending industry consolidation.

Natural Rubber Industry

The industry has significant barriers to entry due to licensing requirements and buying practices of the major tire manufacturers. Processing factories are regulated as rubber is considered a strategic industry in Thailand, Malaysia and Indonesia due to its labour intensity. New licenses are difficult to obtain and foreigners are only able to acquire licensed facilities that are already foreign owned. Global tire manufacturers are accustomed to the particular properties of rubber produced at individual processing plants. Sustainable supply of natural rubber of consistent quality is critical to them.

Approximately 70% of global rubber production is used in tire manufacturing. Of this, close to 75% is consumed in the replacement market. Increasing utilisation of transport in emerging markets underpins a positive demand outlook. Thailand, Indonesia and Malaysia account for 69% of global production. Indonesia is the key supplier to the global market and Halcyon is the largest processor in Indonesia. The ownership of rubber plantations is highly fragmented and is dominated by small landowners. Halcyon has strong relationships with the landowners in the regions surrounding its processing plants.

The rubber industry has historically been fragmented and most of the players have indulged in speculative trading. Halcyon’s approach is to hedge the rubber price risk and to focus on providing a complete supply chain solution to its customers. This approach has been successfully adopted in the supply of other major agricultural commodities. The rubber industry is less developed as it has been largely run by the same Asian families for generations and innovation has been limited. There have been unsuccessful attempts by the major commodity houses to enter the industry in the past. However, recent generational change and key relationships have created the opportunity for Halcyon to consolidate the industry.

Halcyon’s End Game

Today Halcyon controls around 12.5% of the international natural rubber market and a significantly higher share of the ex-China market (the Chinese largely buy rubber from Thailand whilst international customers typically buy from Indonesia, where Halcyon is the largest player).

The company recently announced that it is in discussions with Sinochem, a leading Chinese state owned enterprise, in relation to a merger between Halcyon and Sinochem’s interests in natural rubber. The resulting company would have a number one position in the global market. This would significantly enhance value for Halcyon shareholders and secure the company’s strategic objective.

Valuation

We estimate that Halcyon stand alone has a value of S$2 per share, compared to the current share price of S$0.66/share. This is based on a return to average industry gross margins and an EBIT multiple of ten times.

The potential merger outlined above, provides further upside to our valuation and reduces financing and other execution risks in Halcyon’s strategy.

Events to Create Value

The first event is the recovery of rubber prices to sustainable levels. The associated increase in gross margin, due to operating leverage, has a powerful effect on Halcyon’s earnings. The second is the consummation of the proposed merger with Sinochem and capture of associated benefits. The intention is for the Halcyon team to lead the merged business.

Our thesis does not necessarily rely on further industry consolidation as we believe Halcyon already has sufficient critical mass to generate an attractive level of earnings relative to our stand alone valuation of S$2/share. Further industry consolidation on the right terms makes strategic sense and provides additional upside.

Key Risks

The key risk to this investment is the time taken for the recovery of sustainable rubber prices coupled with the leverage in the company. The current run-rate of EBITDA does not justify the current net debt outstanding. However, post recovery, the leverage is sustainable. The company’s bankers are very supportive and interest payments are well covered. The potential merger with Sinochem’s rubber interests would de-lever the company. There is however a chance that the the company decides to issue further equity to reduce leverage. We would see this as a good opportunity to increase our investment.