Avarga Limited (SGX: U09) | Building Blocks of Value

Updated: Jun 30


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Key Points

  • Avarga is an investment holding company with 3 business segments

  • Avarga derives 96.3% of overall revenue from its stake in Taiga Building Products, a Canadian company operating in the lumber market

  • Taiga’s performance is strongly correlated to lumber spot prices, which are dependent largely on the housing, furniture, and construction sectors

  • Lumber prices are at unprecedented levels, and may continue to remain above historical averages due to the various demand and supply factors

  • Other business segments have underperformed due to political unrest and business shutdowns because of the pandemic, but have a brighter outlook ahead

  • Avarga is providing value to investors through a higher dividend payout and share buybacks, indicating management’s confidence in future performance

Company Overview


Formerly known as UPP Holdings Limited, Avarga Limited, an investment holding company, operates mainly through three reportable segments – Paper Mill segment under UPP Pulp & Paper Sdn. Bhd. (Malaysia), Power Plant segment under UPP Power (Myanmar) Ltd, Building Products segment under Taiga Building Products (Canada and USA). The Group is headquartered in Singapore, with business operations and assets in Malaysia, Myanmar, Singapore, Canada and the USA.

Taiga Building Products


The main driver of revenue for Avarga is its 71.9% share in Taiga Building Products Ltd, a wholesale distributor of building materials in North America. Taiga Building contributed to 96.4% of revenues in 2020, and 95.2% in 2019.


Taiga’s distribution process is detailed as below, where the sawmills and lumber manufacturers sell to Taiga to distribute the wood products down the value chain. This means that Taiga is in the upstream segment of the lumber market, and can pass on the high costs of lumber down the value chain.

Taiga’s main business is in North America, namely Canada and USA. The revenue by geographies is highlighted in the chart below, which shows an increasing percentage of revenue coming from the US segment.

Lumber Price Movements:


Lumber spot prices dictate the current cash cost of lumber for immediate purchase and delivery. Meanwhile, Lumber futures reveal the cost of lumber that will be at the date of settlement. In the case of Lumber futures, the settlement date is one month from the present. Additionally, research reveals that the lumber futures market plays a dominant role in the discovery of future prices, and helps stakeholders manage risk and make decisions under uncertainty. This forward looking metric is also helpful in discerning the earnings of the various stakeholders. Therefore, it is reasonable to assume that the use of lumber futures is a common practice in the industry.

Operating in the lumber market, Taiga has benefited from lumber prices skyrocketing in the past year. Historically, lumber futures traded around $400 per thousand board feet, but prices rose to above $1670 in May and are currently at around $900. This is a result of a confluence of supply and demand factors, which shall be explained below.


Lumber End Products:


Taiga’s sales are mainly in 2 segments; dimension lumber and panels, as well as Allied, engineered and treated wood products.


Taiga’s sales of dimension lumber and panels made up 58.5% of its revenue in 2020 and is used for framing members and plywood or oriented strand board (OSB) for sheathing materials. A range of grades and dimensions of dimension lumber is used in light-frame construction as an economical choice for the construction of low- and mid-rise buildings.

Allied, engineered and treated wood product sales made up 41.5% of Taiga’s revenue in 2020, and include glue-laminated timber (GLT or glulam), laminated veneer lumber (LVL), and OSB. These products have an increasing usage in construction and furniture applications.

As housing and construction picks up, the demand for such engineered and treated wood products increases. Hence, both of Taiga’s sales segments are intrinsically intertwined with the housing, furniture and construction markets, especially within the North America region.


Supply constraints of Lumber:


The shortage of supply in the lumber market was due to years of underinvestment after the housing bust in 2008. This diminished capacity was further exacerbated as mills decreased production and dealers liquidated their inventories at the onset of the COVID-19 pandemic, over concerns that home-building demand would decrease. This reduced the amount of lumber that could be produced and sold, resulting in a shortage when the demand for lumber increased more than expected.

Meanwhile, sawmills have been stocked up to the brim with raw timber that has to be milled. Tree growers have been disappointed that the soaring lumber prices have not had a significant impact on their product prices. This means that there is an abundance of raw materials for Taiga, and low chances of a margin squeeze from their raw material costs.

Demand for housing (and thus, lumber) shot up unexpectedly:


The demand for housing greatly influences the demand for lumber. A confluence of factors have spurred the demand for housing despite the pandemic, resulting in a demand shock, which then translated into the increase in demand for lumber. These factors include the mitigated impact of the pandemic, people’s increasing willingness to spend on real estate, the de-urbanization trend, and the record low interest rate levels.


1) The Impact of the Pandemic


The pandemic did not affect the economy uniformly. Blue-collared and lower middle class being disproportionately impacted. The middle class and wealthy were able to cope with the pandemic relatively better by adapting to the constraints of a lockdown using technology. This ensured that they had a steady source of income. Coupled with unprecedented levels of household savings rates, North Americans experienced an elevated level of purchasing power, creating both a willingness and ability to make big ticket purchases.

At the same time, nation-wide lockdowns left people with less activities and items to spend their money on. This increase in the number of hours spent at home, combined with the higher savings and stimulus checks from the government resulted in people tackling home renovation projects or looking for new homes.


2) De-urbanisation Trend


There has also been an exodus away from metropolitan areas to less risky, less dense areas. The demand for real estate in the suburban area has been driven mainly by the work-from-home (WFH) capabilities that have evolved drastically over the past year. The chart below depicts the results of a survey asking builders if they have a higher share of clients who live in the city and want to purchase a property in the suburb or rural areas, compared to January 2020 (pre-pandemic). Meanwhile, the bar chart on the right shows the location of home purchases in 2020 in the U.S. Here, we can see that there is indeed an increasing number of clients moving to the suburbs.

Communication and information technology continue to establish the WFH as a norm as compared to a perk in the not-so-distant past, bolstering the shift out of the city areas. Suburban areas also offer houses with more space and are relatively cheaper. This meant the higher prices of housing due to high demand was not limited to the cities, but also present in the suburban areas. This de-urbanization trend shows no signs of stopping as home builds and permits in these areas are still high.


3) Low Mortgage Rates


The government has been pumping money into the economy and interest rates are at an all-time low to stimulate the economy and prevent a steep economic recession. Low interest rates, and by extension, lower mortgage rates, are causing a housing boom as people are willing to take loans to buy houses.

Consumers realise that the mortgage rates will not remain this low in the long run, and that they can have lower monthly payments by jumping in early, creating a feverish pace for real estate purchases. This increase in demand was illustrated by an increase in housing permits and housing starts.

Juxtaposed to this heightened demand were homeowners that were staying at home and not selling. With this mix of low housing inventory and demand for new home ownership, the housing market transitioned into an investment upcycle.


As such, the above-mentioned points encapsulate the factors that have led to a housing boom, which translated to an explosive demand for lumber. However, the outlook from here could be very different.


Outlook From Here


As mentioned above, the demand for lumber corresponds with the movements in the housing market. In this section, I shall analyse the various factors that could affect the housing market, and then determine the overall impact on lumber prices.


Factors affecting the demand for housing:


Due to rising home prices and increasing interest rates, demand for housing may experience a decline. However, with the peak home-buying season approaching, and existing demographic trends, the demand may remain elevated for some time.


1) Overheating Material Prices


In the last month, the soaring prices of lumber and other commodities, has added nearly $36,000 to the price of an average new single-family home, and nearly $13,000 to the market value of an average new multi-family home. This increase in building cost is being passed on, in part, to the consumer. This may cause the demand for new houses to slump as the purchase price becomes exorbitantly more expensive.

The S&P CoreLogic Case-Shiller 20-city home price index in the US soared 13.3% yoy in March of 2021, following an upwardly revised 12.0% growth in February and way above forecasts of a 12.3% rise. It is the largest annual price increase since December 2013.


As such, if demand for houses slows, the demand for lumber would decrease, causing lumber prices to drop and negatively impacting Avarga’s revenues.


2) Rising Interest Rates


Last week, Federal Reserve Chairman, Jerome Powell, indicated an unexpected increase in the Federal Reserve’s projection of inflation rates. This would lead to 2 interest rate hikes by 2023, translating to an increase in mortgage rates too. Hence, the cost of financing a loan becomes more expensive and monthly installments will increase.

At the same time, lead time for housing has increased significantly (in some cases up to 15 months). As houses take a longer time to be built, there is significant interest rate risk on the consumer, which may cause a decline in demand for homes, resulting in a corresponding decrease in demand for lumber.


3) Peak Home-building Season


Studies have shown the busiest moving times of the year occur during the summer, with June being one of the busiest months and July 31 the single busiest day, meaning people are likely shopping in the housing market at the end of the school year and as the summer draws to a close. Peak home remodeling season also lies around May through September, as these months tend to have the nicest weather, which makes it easier to finish projects quickly.

This means that the demand for housing and remodelling projects could increase, elevating the demand for lumber and preventing lumber prices from falling further.


4) Demographic Trends


Millennials make up almost 25% of the population, the largest section of the population, and will be turning 30 this year. At this age, they are reaching different milestones in their lives, such as starting a family. Polls have found that owning a home is considered amongst the most important things in life to them. As such, a significant increase in demand is being expected, as millennials will look to purchase homes. As such, there should be an influx of demand for new homes and home ownership in the short and mid-term.


Factors affecting the supply of Housing:


On the supply side for housing, there is currently an unprecedented shortage of land lots. This supply crunch is further exacerbated by builders slowing down production and sales. However, supply may increase as the backlog of home remodelling and building orders start to be filled.


1) Developed land shortage


The sheer lack of lots of developed land has resulted in a literal land grab, and an 11% increase in the price per single lot YoY. The process to develop land is a time consuming one, which may result in a sustained low level of housing starts, and hence, further aggravate the housing supply crunch. This may lead to a lower demand for lumber, and hence cause lumber prices to fall.


Land has to be developed into appropriate lots and quality in order for building to take place. The process is broken down in roughly 5 steps:


1) Economic feasibility

  • Lot developers assess if developing the land will yield their desired level of ROI.

2) Land acquisition

  • This includes a bidding process and the eventual purchase.

3) Zoning

  • Designing the lot of land and creating the blueprint to what types of properties can be built based on the specific area’s zoning laws.

4) Financing

  • Raising capital, including obtaining loans from banks etc.

5) Construction

This shortage came about because the housing boom was unprecedented and unexpected. Lot developers were caught flat-footed and waited till they were certain that the housing boom was here to stay (due to the significant investment necessary, developers did not want to commit too early). Hence, the 1-to-2-year delay between the time the lots are developed and ready for building has resulted in record low levels of lot inventory and sees no respite in the short term.


In the medium term, however, the lots that have been bought and developed over the past year would be ready for development and help to alleviate the shortage. This means that while construction of houses may wane in the short term, it should increase thereafter, and hence lumber prices should follow the same trend.


2) Lower Housing Inventory


Builders are finding that the cost of production for new homes is increasing. These are, in part, due to the soaring prices of commodities, such as steel, gypsum (drywall), lumber. Another major input for builders is labour costs, which have been driven up due to a labour shortage for the housing market.


Hence, builders are slowing down production while waiting for commodity prices to cool off. This was seen by reports of builders refusing to list properties for sale, and the lead time from a housing start to completion has been increasing. This lower inventory of houses means that lumber demand may decrease, negatively impacting Taiga’s, and Avarga’s revenues.


3) Backlog of Projects


As mentioned above, builders are delaying projects as lumber prices continue to fall. The same trend was also observed in the home remodelling segment, as many Do-It-Yourself (DIY) and home improvements projects were delayed.

All these delayed DIY projects, as well as building projects, could act as a floor for lumber prices: As lumber costs drop, sidelined buyers could jump into the market thus delaying a larger correction.


Supply of Lumber:


Due to the increase in demand and prices of lumber, sawmills have outperformed greatly last year. Names such as West Fraser, Interfor and even Taiga showcased one of the best results in their history. These manufacturers have since announced plans to expand capacity significantly. However, consensus remains that this increase in capacity will not be available till early 2022.


An increase in the global production capacity should alleviate the lumber shortages that caused lumber commodity prices to skyrocket. As such, lumber prices may return to historical average levels, in the medium term.


What this means for Lumber prices:


The above-mentioned demand and supply factors have a material impact on Lumber prices. In this section, I shall evaluate how these factors interact with each other, and my projections of lumber prices from here.


With major players emphasizing on increasing capacity, there will be an increase in global supply of processed lumber. However, oversupply is unlikely due to the strong demand from the incoming millennials. At the same time, despite inventory shortages in the near term, consumer demand has continued to remain strong as builders note high customer retention rates. As such, when materials become cheaper, inventories will be replenished, and new housing sales should pick up.


A significant risk to demand is increasing mortgage rates. However, in contrast to historical data, mortgage rates remain significantly lower than historical averages. Despite the 2 interest rate hikes projected in 2023, mortgage rates must make a big move to return to historical averages. As such, this risk is somewhat mitigated.


On the other hand, an important risk to supply lies in the low lot inventory. A deeper dive reveals that in the long term, this risk is largely mitigated. Currently, there are plenty of lots that are prime candidates for development. However, these lands lack utilities and thus, demand from people to move there is relatively weak. This can change in the long run as the de-urbanization trend persists, and housing prices remain too high for the millennials who are looking to purchase their first property. In the future, we could see the outskirts of cities and suburban areas expanding, helping to reduce the current housing shortage.


Hence, in the short term, I would expect a much more gradual decline in lumber prices, before reverting to historical average levels in the medium term. Consensus remains that $800 could be the new norm for the next year before supply of lumber and mortgage rates increase, and the housing market cools. This means that Taiga may enjoy supernormal profits on the back of higher-than-average lumber prices, which could open up many value accretive options for Avarga’s growth.


Other Business Segments


UPP Pulp & Paper (M) Sdn Bhd


The paper manufacturing business constitutes about 2.7% of Avarga’s revenue in 2020. The segment purchases discarded wastepaper and recycles them into brown paper that is used for making cardboard. The Group's pulp and paper mill in Ijok, Malaysia, is one of the five largest in Malaysia and produces almost 10% of the country’s domestic annual production of industrial brown paper.

The segment reported lower profits in 2020, as sales, production and costs were affected by the movement control orders (MCO) imposed to curb the spread of the COVID-19 pandemic. The paper mill had a temporary shutdown and was then allowed to operate on a reduced scale with restrictions during the MCO. At the same time, the segment saw increased operating and production costs. A shortage of raw materials due to inventory stocking ahead of China’s complete ban on the import of solid waste chains and lower production output also contributed to the underperformance.


However, sales volume was resilient due to the strong demand for paper packaging products from the growing e-commerce industry. Volume sales for 2020 declined only marginally by 4.9%, while turnover fell 6.3%. However, higher raw material and operating costs compressed EBITDA margins from 21.3% to 16.9% YoY.

Looking ahead, the paper segment for Avarga has a brighter outlook. The inventory stocking was a one-off event, reducing the possibility of higher raw material prices in the future. On the other hand, while Malaysia is facing some difficulties in containing the spread of COVID-19, operating cost pressures may also alleviate as vaccinations become more common in the long-term. At the same time, the ecommerce industry continues to grow as consumer habits become more entrenched, resulting in a revenue lift for the business segment.


UPP Power Myanmar


UPP Power Myanmar constitutes 0.7% of Avarga’s revenue and accounts for about 2% of the country’s total power generation. The 50MW power plant in Myanmar continues to exceed its annual production commitment of 350 million kWh under the power purchase agreement every year since inception.


In 2020, the facility experienced some downtime to complete its scheduled major overhaul of all 13 machines. Usually, these major overhauls are scheduled every 5 to 6 years, indicating that the power plant will enjoy strong cash flows again for the next few years until the next scheduled major overhaul around mid-2024 to 2025.

The major overhauls in 2019 and 2020 improved efficiency and operating capacity. The results of these improvements were clearly seen in 2020, where despite some downtime, the power plant produced 390 KWh of electricity, indicating that the overall capacity is even higher. It is reasonable to assume that the segment could make a greater contribution to Avarga’s bottom-line.

Financial highlights


Business Profitability

Taiga’s revenue is highly dependent on lumber prices. However, the management has taken measures optimise their cost structure to maximise profits, which resulted in the upward trend of the various margin ratios as seen below.

Leverage

Avarga has maintained a healthy balance sheet, ensuring that there is a strong ability to pay off its debts. This also highlights that the management is utilising leverage well to expand the business, without stretching the balance sheet.


Cash Flows

The increasing trend of Cash Flow from Operations flows indicates a sustainable business that can withstand the cyclicality of the lumber and housing market. This is further complemented by the Free Cash Flow to Firm, which signals that Avarga is capable of paying off its debts, paying dividends or conducting share buybacks.


Strong Dividends

Avarga has a strong history of paying dividends to its shareholders. Excluding special dividends, the company has either increased or maintained the total dividend per share every year since 2012 and have done so again for 2020.

On 27 February 2021, Avarga revised the dividend payout ratio policy, from 40% to 30%, to be paid on a quarterly basis, with effect from the financial year ending 31 December 2021.

Management decided this to reinvest its capital to grow Taiga’s operations, and to ensure that Taiga has the spare capital to take advantage of M&A or other opportunities. The company also felt that keeping a strong cash position will help thwart global uncertainties, a lesson that they took away from COVID last year.


Share Buybacks

The management has also assured investors that the company is seeking to actively seize share buyback opportunities, as an alternative means of returning capital to shareholders. Since June 2020, Avarga has bought back almost 35 million shares, at a price range of between $0.28 to $0.315. This indicates management’s confidence in the future of Avarga, and the price range could act as a price floor until the stock is rerated upwards.


Valuation


With a market cap of C$280 million, Taiga currently trades at a P/E of 3.1, with an EV/EBITDA of 3.5. The comparison to it’s peers reveals that Taiga is trading on par with its canadian counterparts.

Supposing an exchange rate of CAD $1 = SGD $1.09, Avarga’s 72% stake in Taiga is currently valued at S$219.7 million. Deducting Avarga’s current market cap with the Taiga segment, we can deduce the implied value of the Paper and Power segment, which is S$59.3 million. Meanwhile, the Profit Before Income Tax of the Paper and Power business units in FY2020 was S$11.7 million. This means that the market is pricing these segments with a P/E of 5.1, similar to its historical averages.


At the same time, Avarga’s policy of a minimum dividend payout ratio of 30% is attractive, considering higher lumber prices for the foreseeable future. Taiga also declared it’s first ever special dividend in 2020, due to its significant outperformance. This means that the manageme