Yuri Gagarin ($4PX:BU)

Yuri Gagarin ($4pX:BU), named after the first man to fly in outer space (around the Earth in 108 minutes on Vostok 1), is a cardboard and paper printed packages and cigarette filters and tubes manufacturer located in Plovdiv, Bulgaria.  Although Plovdiv is my hometown, I generally don’t pay much attention to the Bulgarian Stock Exchange (BSE-Sofia).  I have a friend on the buy side (@dpbakalov) to thank for bringing the company to my attention.  I will do a separate post on the BSE for those of you who develop an interest.  Now, back to the company.

Company History and Business

Yuri Gagarin was established in 1964 as a part of the state-owned tobacco monopoly Bulgartabac ($57B:BU), which was one of the largest tobacco companies in Europe in the second half of the 1900s.  The company was manufacturing packages and filters for the group.  Its production was, and still is, mostly placed with the tobacco manufacturers within the consortium.  From its website, we learn that:

Today Yuri Gagarin Plc is a leading manufacturer of multi-color cardboard and paper printed packages and labels for the cigarette, food-processing, cosmetic and other industries and a leading manufacturer of cigarette filters for the cigarette industry.

Overall, printed packages make up about 60% of sales, filters – 30%, and spare parts and other – 5%.  The company has a solid market position in both its major product lines.  Market share date is not available, but Yuri Gagarin is among the leaders in cardboard and paper packages, competing with Unipack ($3U9:BU) and Dunapack Rodina (privately held).  It has a virtual monopoly on cigarette filters and tubes.  The only competition comes from imports from Romania and Poland.  The company has a modern production base, an established market position, and secured demand for its products.

In 1993, when Bulgartabac was transformed into a holding company, Yuri Gagarin became one of its 22 subsidiaries (12 tobacco processors, 9 cigarette manufacturers, and 1 packaging plant).  In 1998, the company’s shares started trading on BSE.  It was one of the first listed companies on the recently reinstated (after the breakdown of communism in 1989) stock exchange.

On October 3, 2006, Bulgartabac Holding auctioned off its whole stake of 80.57% of Yuri Gagarin in two tranches: a majority stake of 672,616 shares (67%) – candidates for which could bid only on the whole block of shares – and a minority stake of 136,220 shares (13.57%).  After some changes in the equity capital, shares outstanding have numbered 1,003,904 since 1999.  The new majority owner, and only bidder, Baranco, an offshore company registered in Cyprus, paid BGN 27.6 million for the stake, or BGN 41.04 per share, valuing the whole company at BGN 41.2 million.  The minority shares went for BGN 36.71 per share.  Back then, the US dollar bought the same 1.55 Bulgarian levs it buys today.

Book value at yearend 2006 (introducing some hindsight bias since this information was not available at the time of the auction), was BGN 40.1 million (40/share).  Net current asset value was BGN 7.8 million (7.75/share).  Sales in 2006 were BGN 37.4 million (37.3/share) with a net income of BGN 1.5 million (1.53/share).  Investors were valuing the company at around 1x book, 1x sales, and over 25x earnings.  The earnings multiple stands out, so it is important to note that 2005 earnings per share were nearly double, reducing the multiple to below 15.  The deal is considered one of the most successful privatization deals in the 14-years-and-counting procedure of breaking up and privatizing Bulgartabac.

Currently, the company employs 340 people.  The number peaked in 2005 at over 700.

Financials and Management

For your convenience, I am providing the most pertinent financial data here, because, apart from some scant summaries, it is available only in Bulgarian.

Several things to keep in mind:

  • the company uses IFRS for its statements (although I have re-arranged them in US GAAP format for convenience)
  • the currency is Bulgarian Lev, denoted BGN (used to be BGL before the denomination in 1999)
  • Bulgaria has a 10% flat tax rate

On the income statement, it is visible that while the top line didn’t grow during this 14-year period, the company navigated well the turbulent years of the new century.  Moreover, the new owners initiated a restructuring plan, after the privatization in 2006, with the following objectives:

  • refocusing the company around its core competencies
  • getting rid of all non-core businesses such as the spare parts business
  • limiting the dependence on Bulgartabac as a major customer
  • increasing exports
  • stimulating growth

The new CEO, Ivan Sharlandjiev, who replaced Ventsislav Kaymakanov in 2009, has been successful in carrying out the plan.  The company focused on packages and filters.  The spare parts and other extraneous operations were ran off and the vacated plants sold or rented out.  Bulgartabac’s share of production sold was shrunk from 80% to 63%.  Exports more than doubled from 7% to between 14-16%.  The icing was the introduction of cigarette tubes as a source of growth for the company.  The graph below shows the month by month sales for the two major product lines from April 2010 to July 2012.

Monthly Sales of Yuri Gagarin 2010-2012In the short 28 months for which this breakdown is available, cardboard and paper packaging sales decreased from BGN 4 million to BGN 2 million while sales of cigarette filters and tubes grew from BGN 0.25 million to BGN 1.1 million.  This is after the sharp drop last month, more about which later.  Comparing the first 12 months to the last 12 months in this period of a little over 2 years, the packaging business shrunk by 13% while the filters and tubes – expanded 127%.  The mix between the two product lines changed from 15.5:1 to just 2:1.  The company found a gold mine in the cigarette tubes business.  Even more importantly, 80% of the tubes are being exported.  Exports of cigarette filters and tubes together peaked at 38% of total sales of these products in 2010.

The successful restructuring is further visible in the expanding margins.  Operating margins have averaged 11% in the past 3 years, net margins – around 9% while in the years before the change in ownership in 2006, operating and net margins averaged around 3%.  Average returns on assets and equity have nearly doubled post-sale.  The new management doesn’t pay a dividend, but there is a good reason for this.  Retained earnings are channeled towards modernizing the plant and equipment, with the goal of making Yuri Gagarin one of the best and largest companies in its field on the Balkans.  Over the past 14 years, capital expenditures have totaled close to BGN 60 million and were mostly covered by cash flows generated from operations.  On top of that, BGN 6 million of dividends were paid out over the period.  The company is using debt very sparingly and the financial leverage ratio is only 1.3.  The spike in bank loans in the second quarter of 2012 will be explained later.  The balance sheet is solid.  There are no off-balance-sheet arrangements and no operating leases.  Keep in mind that under IFRS long-term assets are revalued and the property, plant and equipment account that you see is stated at current prices.  The last revaluation was carried out in 2010.

Valuation

As of the second quarter of 2012, Yuri Gagarin has around (per share, in BGN):

  • 63 tangible book value
  • 16 net current asset value
  • 4.5 long-term debt (including current portion, capital leases, and pension liabilities, and adjusted for a BGN 11.7m bank loan which was taken out to fund an acquisition that was later cancelled (more about it later))
  • 6.5 TTM income from operations
  • 5 TTM EPS

All this, suggests a valuation in the BGN 50-70 range.  The last traded price was BGN 28.  Serious upside, but first let’s look at the downside.

Risks

Bulgaria is a frontier market, meaning it has lower market capitalization and liquidity than more widely known emerging markets.  The market capitalization of BSE-Sofia is short of BGN 8 billion (about 10% of 2011 GDP of BGN 75 billion) and daily volumes are well under BGN 500,000.  Most often, large institutional investors account for most of the trading.  Public companies are mostly majority owned, limiting free float.  Capital markets are nowhere near as popular among individuals as they are in the US.  The portion of people’s savings invested in the market is negligible.

Bulgaria was a communist country from 1945 to 1990.  Capitalism and free markets had to be re-established over a slow and painful transitional period.  In 1997 a bout of hyperinflation brought about by a corrupt government, wiped out virtually every Bulgarian’s savings.  After this dark period, the economy grew at a healthy rate of over 5% annually until 2009.  Inflation has been subdued, averaging around 5.5%, after the introduction of the currency board, tying the Bulgarian lev first to the German mark and then to the Euro.  Currently, the exchange rate is fixed at 1.95583 levs to the Euro.  You can see these developments on the graph below.

Although Bulgaria is a member of NATO since 2004 and joined the EU in January 2007, widespread corruption and lack of reform in the judicial system are ongoing problems.  Political risk is relatively high.  In the case of Yuri Gagarin, it manifested itself in a law change which, on June 19, 2012 banned the manufacturing and selling of cigarette tubes – the company’s growth engine.  At first, only sale was banned, which was not as damaging since most of the cigarette tubes are being exported, but soon an amendment banned production as well.  This ruling, probably with no precedent worldwide, seems uniquely aimed to maim the company as there is no other company manufacturing cigarette tubes in Bulgaria.  In interviews, politicians who voted in favor of the law gave lame excuses such as fighting the black market for cigarettes.  The real motives and lobbies behind this remain hidden.  But it is a cautionary tale of how tangible political risk really is.

A month ahead of the passing the new law, management decided to acquire a Hungarian company, supposedly to move production there.  On June 14, a BGN 11.7 million bank loan was taken out to finance the purchase of 100% of Fillstyle-Hungary.  On August 24, an announcement was made that due to “changes in the business environment which necessitate rethinking the investment policy and the implementation of a sustainable growth strategy” the deal was cancelled and the bank loan repaid.  Meanwhile, production of cigarette tubes has been halted and Yuri Gagarin is losing market share to its European competitors.  Currently, it is not publicly known what management’s plans are and why exactly the deal was cancelled.  Speculations abound, ranging from the new law being repealed to a large player (Bulgartabac?) buying the company at the current depressed price.

Going further into the field of red flags, back at the time of the change in ownership, I mentioned that Baranco acquired the 67% majority stake.  Bulgarian securities law requires that the acquirer of more than 50% of a public company extend a tender offer to minority shareholders at the purchase price.  Instead of doing a tender, Baranco chose to immediately sell 18% to Comso Tabacco, bringing its stake down to 49%.  This move, in itself, is a legitimate cause for concern or at least a sign of unfriendliness on part of the new owner.  But adding insult to injury is the fact that Comso Tabacco is 50% owned by the then CEO, Ventsislav Kaymakanov, with the remaining 50% owned by his brother Blagoi.  A bit of a conflict of interest.

In another puzzling move, in 2008 and 2011 the company cancelled the remaining unpaid dividends for 2002 and 2005 respectively.  The amount cancelled of the 2002 dividend was not disclosed.  For 2005 it was BGN 15,563 or BGN 0.0155 per share.  Why the 6 year delay and the decision to cancel even though the company has been profitable every year since 2002, except 2008, and the unpaid amount – trivial, I don’t know.  Retaining earnings for future growth is one thing, going back on a commitment to your shareholders is totally different.

Correction (hat tip @dpbakalov): The small portions of dividends cancelled were non-claimed amounts belonging to individuals who held shares in their name, not through an investment intermediary.  This way the dividends didn’t find their way to these shareholders and, for some reason, the shareholders didn’t bother to go to the bank and pick up the likely immaterial dividend.  Under Bulgarian securities law, 5 years after being declared unclaimed dividends become void.  Such small amounts of physical shares held in the investor’s name were created in various privatization deals as a way for the government to compensate the people for what the communists stole from them.

Another cause for concern is concentration.  Despite management’s demonstrated and effective effort to reduce the percentage of production sold to Bulgartabac, still over 60% of sales are to the companies in the holding.

Conclusion

The largest unknown at the moment is what will happen to the cigarette tubes business.  If it remains permanently banned, the company will lose around BGN 7 million from the top and its most powerful growth engine.  In a positive turn of events, if the law is repealed, the stock price is likely to start moving towards intrinsic value which will also move up considerably if growth is anything like it has been in previous years.

In case cigarette tubes remain off the table in Bulgaria, the company may be well advised to dust up the Hungarian plan.  Additionally, the cigarette filters business has shown good growth potential and may possibly be further developed.

With important unknowns and the part on risks larger than all the rest of this write-up, this situation is a good illustration of why I, and probably many other investors, have stayed away from the Bulgarian market.  True, the company offers considerable upside if events develop favorably.  But I lack the conviction that they will.  The strong balance sheet provides protection on the downside.  But unfriendly majority owners’ interests may be different than mine and balance sheet alone can’t protect me from them.

Waiting for the clouds to clear up may prove expensive, but I will pass for now and will keep an eye on the company.

Data sources

  • gagarin.eu – the company’s investor relations website offers useful information in English, but financial statements are only available in Bulgarian.
  • Company profile – summary company data and financials in English, provided by an emerging markets information service.
  • investor.bg – summary company data a la Yahoo Finance (in Bulgarian only, but the numbers are just as useful).
  • x3news.com – the latest filings with the regulator, Financial Supervision Commission (limited English functionality, filings are in Bulgarian).
  • BSE-Sofia – the website of the Bulgarian Stock Exchange stores all public company filings going back to 1999 on an ftp server (good English functionality, even some filings are provided in English).  Search is possible after you know the BSE-Sofia ticker of the company, which is different from the Bloomberg ticker.  The new tickers came with the integration with XETRA.  Both tickers are provided at investor.bg.
  • Google Translate – can help navigate Bulgarian websites, just paste the link to the site you want translated.
  • securities.com – the same emerging markets information service from #2 above, provides economic (GDP, trade balance), market (indices, currency rates), and company (top companies and industries, market movers) data.