Has the earnings cycle bottomed at Nufarm?
Nufarm Limited is primarily a formulator and distributor of agricultural chemicals, but it also operates a small seed supply business. Through a number of acquisitions over the years, the company has branched out from its New Zealand beginnings to become one of the largest off-patent agricultural chemical players in the world. Its product range includes herbicides, insecticides and fungicides that keep pests under control and agricultural yields up.
Nufarm buys active ingredients from various suppliers (mainly in China), adds some solvents and then sells the formulation to local farmers in Australia, North America, Europe and Brazil. The only active ingredient it manufactures is 2,4-D, a herbicide, which it manufactures in Australia and the UK.
Separately, Nufarm supplies canola, sorghum and sunflower seeds. It also has a promising new seed development program in the late stages of trials and approvals: the omega-3 canola seed, which they claim is the world’s first plant-based source of long-chain omega-3 fatty acids (known for their heart health benefits).
What went wrong for Nufarm...?
The last year has been very difficult for the company, which has resulted in a steep decline in its share price.
Nufarm was riding high when it acquired two European product portfolios in late 2017, an opportunity that came about because of antitrust regulations on the back of consolidation elsewhere in the sector. Despite being partially funded through an equity raising at almost double today’s share price, the acquisition left Nufarm with too much debt if market conditions turned, and turn they did. In Nufarm’s case, this turn was quite sudden and pronounced.
While it is trite these days to hear a company blame poor performance on weather, suppliers of agricultural chemicals do find it difficult when there is a drought, as demand drops. That has been the case in Australia, which has meant farmers have not needed anywhere near the normal quantities of agricultural chemicals. With Nufarm’s larger manufacturing and formulation base here, this has resulted in a large build-up in inventory and even more debt on Nufarm’s balance sheet. On top of this, floods and wild weather in the US have delayed planting there, further reducing demand for Nufarm’s products.
Nufarm has also experienced some integration issues with some products from the European portfolio acquisitions, as it has had trouble with the supply of one profitable product in particular. This has reduced earnings from that portfolio this year and, like a company that misses prospectus forecasts post-IPO, some serious punishment has been meted out by the market.
In addition, trade war rhetoric and tariffs have ramped up over the course of the year. Because Nufarm obtains its active ingredients from China (like many industry players) and because its customers grow things like soybeans that are exported to China, the company could stand to lose on both sides of the trade war equation.
All of this would be bad, but there is a (very sour) cherry on top of this cake. Nufarm is a supplier of glyphosate (making up approximately 10% of its gross profits), a chemical that is now being linked by some previous users to causing their cancer. The lawsuits are currently against Bayer (which bought Monsanto, the company that patented the weedkiller known best by its brandname, Roundup) and a couple of them have resulted in large damages being awarded against that company. There may be worries that Nufarm could also face lawsuits given its status as a supplier, and when the first lawsuit’s damages bill was announced, both Bayer and Nufarm’s stock prices fell sharply.
...And what could go right?
It is at these bleak times that we often see the best opportunities. Current bottom-end of range guidance sees Nufarm’s earnings before interest, tax, depreciation and amortisation (EBITDA) at $440 million and capital expenditure (capex) of around $160 million in the future, resulting in a cash flow before interest and tax of $280 million. At current prices, Nufarm’s enterprise value (its market capitalisation plus its net debt) stands at around $3.2 billion, putting the company on a little over 11 times enterprise value to free cash flow. The market is trading at much higher multiples.
Given all the headwinds Nufarm has encountered, it is hard to believe that 2019’s earnings are not low in the cycle.
Paying 11 times reasonably depressed earnings looks quite attractive. On top of this, inventories are elevated, so an organic unwinding of that inventory position should reduce net debt considerably, which is what happened the last time the company recovered from a drought.
But an investment here is not without its risks
Nufarm’s debt is uncomfortably high and any missteps would require a capital raising, which the market may be fearing. While we hope that the company can do the hard work and get itself out of this situation the old fashioned way, a capital raising on its own would not destroy value, but would reduce the possible upside. There is also some risk around the acquisitions Nufarm has conducted recently. It is hard to know what normal earnings at Nufarm really look like as a result, and cash flows have historically been poor. High debt might result in greater discipline on that particular front.
And then there is glyphosate. We don’t know how that issue may unfold. Regulatory bodies around the world, including the US EPA recently, have approved glyphosate use based on scientific evidence. Even if there were a direct link between glyphosate and cancer, it is unclear what liability Nufarm would have, especially as a distributor of the active ingredient (as opposed to a manufacturer). Nufarm performs a similar service for glyphosate as pharmacists perform for approved medicinal drugs. Where these drugs are subsequently found to cause harm, it is not the pharmacist that is generally liable. If the chemical is banned, then Nufarm and other suppliers would need to supply other less-effective, often more expensive, chemicals in possibly greater quantities to meet the needs of farmers. One of those possible replacement chemicals is 2,4-D, in which Nufarm has a very strong presence through its manufacturing facilities
While there are risks in investing in Nufarm today, we believe the company is currently priced for many of those risks eventuating and persisting. If the company can do the hard work to restore the strength of the balance sheet without raising capital and if those risks do not persist, then investors should be rewarded.
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This extract is from Allan Gray Australia’s June 2019 Quarterly Commentary. For further insights from Allan Gray, please visit our website
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Suhas joined Allan Gray as an analyst in 2011 and has been a portfolio manager since 2016. Prior to this, Suhas spent five years at McKinsey & Co, leaving as an engagement manager. He has a Bachelor of Science with Honours from the California...