Russia: blue ocean or exaggerated expectations?

In 2011, after it has depleted all the worthwhile opportunities for development in the Ukrainian market, Kernel has entered the neighboring country of Russia by acquisition of Russkie Masla Group. In the September of 2012 the company has strengthen its position by acquiring Taman Transbulk terminal and announced its strategic goals in

Russia.

However, the results of their implementation is still involves a considerable deal of uncertainty. The situation is deteriorated by the results of FY2012 which wasn’t as successful as anticipated and missed the management guidance by 6% in sales and 13% in net income.

There are several points of concern in the company’s entrance to the new market of Russia, that is, although quite familiar to Ukrainian one, is still new for the company. Yet, management is rather optimistic about the growth perspective, expecting to double grain sales and significantly increase oil output by creating new crushing capacities.

However, our analyze suppose that the company may face several significant obstacles, such as:

· Lack of seed supply. As the company expands to the Russian market the primary objective is to find the suppliers of the raw material needed for production. Considering the fact that seed is usually sold by small farming households, ensuring their willingness to work with the company becomes the issue of major importance. The worst case scenario may lead to smaller than expected sales of grain and insufficient oilseed supply which results in waste of crushing capacities

· The high pressure of the competitors who have already been established on the market. The previous item may be worsened by the fact that there are several companies which will protect their share in the resource market. These competitors in the Black Sea region, such as RosAgro, Black Earth Farming and Pava will not easily give their business ties which provide them an access to grain and oilseed.

· Reduce in EBITDA margin is expected. The growing capacities require additional costs to maintain them. Given the aggressive plan of their acquisition and creating, we expect the EBITDA margin to fall in the subsequent years. This fact increases the requirements to the company’s sales performance and decreases cash flow available for future investments.

· The demand may be weaker than anticipated. The fall in EBITDA margin may be successfully be compensated with the increase in revenues. However, if the sales won’t grow with the faster rate than capacities, the result may be quite deplorable Even if we assume the full utilization of new capacities, the menace may be located on the consumer side: Kernel may not be provided with enough demand to realize its production.

According to our estimations, the future Russian projects accounts for approximately 31% of the target price obtained using DCF method. The evaluated price is situated near the one we’ve got using peers comparison. We also made a sensitivity analysis of the target price with respect to the percent of completion of Kernel’s goals in Russia (figure…)