Avangardco (AVGR LI) Initiating Coverage, June 2014

Avangard (AVGR LI) is Ukraine's largest egg producer and processor, accounting for 36% of domestic output and over 90% of export of eggs and egg products. It is a mature company that has already reached its planned installed capacity and is now aiming to use hefty operating cash flows to offload debt and start paying dividends. We initiate coverage of Avangard with a BUY recommendation and a 12-month target price of USD 16.4/DR, which implies 65% upside to the current price.

Construction of two new egg farms was completed in 2013 and they boost egg production capacity to 8.6 billion pcs/year. The company plans to bring the capacity utilization close to 100% over 2014-15, fully in line with its expansion plan. That implies Avangard's revenues will simply become a reflection of prices for eggs and egg products.

Avangard has limited room for growth in the saturated domestic market, and securing new niches externally is vital for the company. Progress in expanding into foreign markets has been impressive – 40% of the company's revenues were sourced from export markets in 1Q14 (23% in 1Q13) and we expect that share will reach 46% by 2020.

The sharp depreciation of the hryvnia in recent months undermines Avangard's profitability – domestic sales are squeezed in USD equivalent, while prices for soft commodities, the key input for egg producers, remain largely unchanged in USD terms. The depreciation will serve to narrow the gross margin (cleaned of the revaluation of bio assets) by an estimated 4pp to 31%. The effect of the weaker hryvnia will be mitigated somewhat in the longer-term as a portion of the increase in grain and oilseed prices will be passed onto domestic consumers.

The likely elimination of tax benefits for Ukrainian agricultural producers is the key risk to Avangard. Specifically, the abolition of the VAT preference could squeeze Avangard's EBITDA margin by 6-7pp. We assume tax privileges will fully disappear as soon as in 2016, as per one of the IMF's key requirements. Any delays will offer substantial upside to the stock.

Avangard approved its first-ever dividends at 25% of 2013 net income to be payable in 2H14. With little financing needs in the near future, we do not rule out the possibility of a near-100% dividend payout ratio beyond 2015. The payout will likely be restrained to 25% until 2015 as the company will need cash to redeem its USD 200 mln Eurobond due in October 2015. We are confident the issuer will have no problems repaying the debt.

A lack of clarity regarding the future for minority shareholders weakens the investment story for Avangard. Ukrlandfarming, the controlling shareholder, may decide to either maintain a hefty free float in Avangard stock or offer a voluntary share swap, whereby shares of the egg producer will be exchanged into shares of ULF during an IPO in the mid-term. We assess the probability of the two above scenarios at 30% and 70%, respectively.

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