A Goldilocks year for agriculture

Ramoun Lazar

Firetrail Investments

2021 is fast becoming a Goldilocks year for soft commodities, and there are two companies in particular that are set to benefit from the imminent boom. 

The first is Nufarm (ASX:NUF), which is primarily exposed to crop protection chemicals such as herbicides, fungicides and insecticides, which farmers use to treat and protect crops throughout the growing period. The second is Incitec Pivot (ASX:IPL), which manufactures fertilisers that are used to boost yield. 

Both companies are dependent on seasonal conditions, and the level of grain prices which dictate the level of demand and selling prices for their products. In this wire, we highlight the key reasons for a more positive ag outlook throughout 2021.

A recovery finally within sight 

The COVID-19 vaccine led recovery is fuelling positive sentiment for cyclicals, and the agriculture sector is not being left behind. Stronger demand is expected for key grain crops in 2021. This is being exacerbated by supply-side constraints in key growing regions, made worse by COVID-19 related delays and impacts. 

A tight inventory backdrop for key crops such as Corn and Soy is resulting in a squeeze in pricing, with prices up +40% respectively over the last three months. These key crop prices are the highest since 2016 (see chart below), and remain well above production costs, helping to increase farmer optimism and incentivise acreage expansion. 

As farmers plant more acres the expected demand for inputs such as fertilisers and crop chemicals are also rising. This helps to fuel prices and creates a virtuous cycle for agriculture-related names such as Nufarm and Incitec Pivot. 

Why Incitec Pivot (ASX:IPL) is a buy

Fertiliser prices for Urea/Ammonia and Phosphates are rallying. Incitec Pivot’s earnings are significantly leveraged to movements in fertiliser prices given its upstream manufacturing capabilities in Australia and North America. 

Every $10/t change in ammonia and phosphate prices results in a 6% change in annualised EPS estimates for Incitec – creating significant leverage! 

At the same time, Incitec’s valuation is undemanding and does not factor in much for its cash flow generating potential, at a time when fertiliser prices are improving. Holding current spot prices would see Incitec’s net debt fall from 2x to roughly 1x over the next year as cashflow lifts significantly. As a result, we have increased conviction in the outlook for Incitec and have recently increased our long position in the portfolio. 

Why Nufarm (ASX:NUF) is a buy

Nufarm has been a key holding for the Absolute Return Fund over the last couple of years. Earnings have disappointed during this time due to severe droughts in Australia, and Europe, alongside a major flood-impacted season in North America in 2019. Looking forward, we expect a much better year for Nufarm in 2021 as the company benefits from an increase in planted acreage and better demand for crop protection products. 

After three years of poor seasonal conditions, it appears 2021 may be a Goldilocks moment for farmers globally. Alongside better planting conditions for growers, we also expect supply tightness for key crop protection materials sourced from China to ease. 

The price of key Chinese raw materials has been rising in recent years due to a forced government clampdown on suppliers with poor safety/environmental track records. This transition appears to be over, with new supply replacing what was lost in recent years taking the pressure off supply costs.

Source: Supplied.

Nufarm’s recent trading update pointed to a ~40% lift in group revenues over the four months to November. This was led by Europe and Australia. While it remains early in the year, the signs are encouraging. We expect earnings to follow the sales improvement, further underpinned by Nufarm’s $20-25m cost-out program, improving raw materials pricing, alongside operating leverage. 

So why agriculture?  

While earnings for both these stocks are inherently volatile, Firetrail has a positive outlook for both these companies through 2021. After consecutive poor seasons, and a prolonged earnings downgrade cycle, we believe we are past the trough and expect Nufarm and Incitec to continue to re-rate over the near term. 

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Ramoun Lazar
Analyst
Firetrail Investments

Ramoun is an Equity Analyst at Firetrail Investments. Ramoun’s primary sector responsibility is Resources stocks. Ramoun has over 17 years relevant industry experience.

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