Citigroup: Noble Group - 11 Apr 2008

Buy: Confidence Corroborated in Call

* Follow-up from our investor call with Noble Group - Our confidence in Noble's ability to manage financial market conditions and capture the upside from the positive demand environment in hard and soft commodities remains unabated.

* Financing in place to deliver growth; no constraint - Noble management remain highly focused on working capital (the lifeblood) requirements for their growing business. Despite rising commodity prices, the cash conversion cycle has been reduced from 21 to 19 days with growth very much in place.

* Higher turnover of products and low inventory holdings add to flexibility - Noble has little necessity to hold more that 20-25 days inventory in its major commodities: iron ore, coking coal, coal and grain. Higher turnover in these markets enables greater flexibility and lower risk, in our opinion.

* Mixing the sources of finance is essential and to be expected - Noble will continue to optimize the balance sheet and the market to their advantage. Currently the debt capital market is a closed window, however bank facilities are available. Investors should expect the use of continued equity financing as part of a balance capital structure where deemed conservative and prudent.

* Higher margin calls and credit constraints are forcing greater rigor - CFO Steve Marzo commented that there are positives from the markets constraints in that the company is applying its talents more rigorously to ensure the most efficient use of funds is employed within the trading operations.

* Inelastic demand observed generically across end-markets - Feedback from management on whether price inflation could impact demand was reliant on the supply and demand dynamics of each industry. However, in the past two years, demand had proven to be inelastic to prices, and this trends continues.

* Thesis intact, no change to Buy recommendation - With markets tight, 2008 continues to look to be a strong year for earnings. The valuations of the hard assets within the business structure continue to increase, highlighting the value that we believe lies within Noble Group.

Company description

Noble Group operates a global supply chain supporting agricultural products (coffee, cocoa, sugar, soybeans and other grains), industrial materials (iron ore) and energy products (ethanol, clean oils, coal and coke). Founded in 1990, the company is headquartered in Hong Kong and has 70 offices in 35 countries serving over 4,000 customers. Major competitors include Cargill, Glencore and Bunge.

Investment strategy

We have a Buy / High Risk rating (1H) and S$2.39 target price on Noble Group shares. Noble is completing the build-out of its supply chain for agricultural grains from South America to China, including sourcing, loading, transportation, discharge, crushing (three plants in China, three in India) and distribution. The full-year impact of this strategic move will be seen in 2007. Furthermore, by 2007/08, Noble is likely to control over 1bn gallons of ethanol for US distribution (~14% market share). Our valuation inputs incorporate the relatively high risk nature of Noble's underlying businesses. Compared with supply chain managers that handle more stable, visible products, Noble's fair value price-to-book multiple is significantly lower. Nevertheless, this is already more than discounted by the market, in our view. Intrinsic visibility at the company level is improving significantly.

Valuation

Our S$2.39 price target is derived from our two-stage (high-growth and stable growth) Gordon Growth Model, which we believe should be used as the benchmark model for valuing regional supply chain managers (SCMs). Our high-growth period assumptions include: payout ratio of 25%, ROE of 19.7%; our stable-growth assumptions are: payout ratio of 80% and ROE of 12%. Our model uses cost of equity of 10.5%, risk-free rate of 4.5% and beta of 1.50. We use the output of our two-stage model to arrive at a valuation of FY07E 3.0x P/B, which gives a valuation of S$2.15. In addition to this we are adding the incremental value of the iron ore asset at S$0.12 and the coal assets at S$0.13. While Noble Group is inherently a relatively high risk stock, owing to poor industry visibility, our analysis implies that the market has overestimated the risks inherent in the underlying business. VaR is indicated by management to be around 2% of book equity.

Risks

We rate Noble Group shares as High Risk owing to poor industry visibility and the inherent risk in its trading business, although our quantitative risk model, which tracks 260-day share price volatility, would imply Low Risk. Noble Group's business model is exposed to a multitude of risks
including market, credit, liquidity, operational, legal and execution risks. Noble has incorporated a comprehensive risk framework to capture and minimize its exposure. However, it is inevitable that some residual price, credit and execution risk will remain, in our view. Investors must understand the inherent risks of the business and consider these against the underlying market valuations of the stock. Any of these risks could impede the shares from reaching our target price.