We recently researched Elders (ASX:ELD) in The Dynamic Investor after the Company reported its interim results for the six months to 31 March 2022 (1H22). A combination of favourable external conditions and internal initiatives have continued to underpin earnings upgrades. In turn, this has underpinned the strong gains in the shares since the start of the year. However, with the share price having retreated over the past month, do current levels present an opportunity?
Elders is one of Australia’s leading agribusinesses, with a national distribution network with over 450 points of presence throughout Australia. ELD’s geographic and product diversification is key strength of the business.
The Company supplies rural farm inputs (e.g. seeds, fertilisers, agricultural chemical and animal health products) and provides agency (livestock, wool and grain marketing), real estate, financial and feed and processing services. Livestock prices and volumes, as well as retail product sales are key earnings drivers. Seasonal conditions play a significant role in determining the trend of these drivers.
ELD has a number of reporting segments, the main segments being Rural Products and Agency Services. Together they account for over 80% of group margin. The Company’s revenue and earnings base has expanded significantly following the acquisition of 100% of the shares in Australian Independent Rural Retailers (AIRR) in July 2019.
Key Fundamental Drivers
Earnings Upgrade Cycle Continues
The Company reported a better-than-expected interim result. This factor, coupled with continuing strong near-term outlook (underpinned by high levels of demand and tailwinds in fertiliser and agricultural chemical pricing prices), has led to ELD upgrading its EBIT growth guidance for FY22. It has been revised from +20-30% to +30-40%, or from $200-217m to $217-233m. The upgraded guidance implies 2H22 EBIT growth of -10% – +8%.
There are two key external factors that are supportive to short-term earnings growth:
i. Favourable weather conditions: Soil moisture profiles and rainfall outlooks remain positive for the 2H22. Conditions across both the eastern and western wheat belts are better than a year ago. Flows of fertiliser and agricultural chemicals into Australia are also continuing to demonstrate year-on-year growth. This implies that suppliers are optimistic for the season ahead and are supportive of a strong upcoming winter cropping season.
ii. Cattle Prices: Despite falling from recent highs, livestock prices are expected to remain high. Higher prices benefit the Agency business and also act as an offset against anticipated lower volumes from feed availability and restocking. According to Meat Livestock Australia, the EYCI is expected to hit 998c/kg on 30 June 2022. However, ABARES forecast cattle prices to continue to fall in FY23. Average rainfall will slow pasture growth, herd rebuilding, and demand for younger cattle in FY23, resulting in higher production.
Medium-Term Growth Opportunities
Whilst the interim result was been buoyed by favourable market conditions, the Company attributed only ~42% of the gross profit improvement to market conditions (i.e. price and volume. The remainder is a mix of acquisition (12%) and organic growth (46%), which was defined as market share and margin expansion.
ELD’s ability to generate earnings growth from internally-driven measures (i.e. by further backward integration benefits, cost efficiencies and benefits from its systems modernisation program) is an important factor underpinning the potential for earnings growth in FY23+. This is especially given the loss of earnings as seasonal conditions normalise.
The backward integration strategy across crop protection and animal health products involves the Company selling more of its own branded products at higher margins. In essence, this entails replacing 3rd party products with its own internally produced offerings across crop inputs and animal health.
ELD has grown its mix of own brand products from 24% in FY20 to 29% in 1H22. The Company has a long-term target of 70% and ongoing execution of the backward integration strategy is likely to result in the proportion of own brand products increase. In turn, this is expected to underpin margin expansion as ELD captures more of the supplier margin pool.
Additional Bolt-On Acquisitions Targeted
The strong balance sheet and typically solid cashflow performance provide ELD with flexibility for future bolt-on acquisitions and further CAPEX investment. At the FY21 result, the Company acquired nine businesses and indicated a strong pipeline of 27 bolt-on acquisitions. Given that ELD made five acquisitions in 1H22, there is potential for further acquisitions. To this end, the Company identified 17 potential targets at the 1H22 result, which positions the Company well for continued expansion of the Rural Products and Agency networks. In particular, there are a large number of independents in the Australian market, with a steady stream of founders now looking at succession plans and/or exit opportunities.
These targets can be funded through debt and are typically small-scale acquisitions (A$0.5m-5.0m EBIT) and allow market share (currently low) to increase. ELD can typically undertake bolt-on acquisitions at attractive EBIT multiples of 3-5x, which should enable the delivery of revenue and cost synergies and generate a high Return on Capital (ROC).
The key investment consideration for ELD is whether its earnings have peaked, which is a key factor in the share price decline (and de-rating in the multiple) since the release of interim results. ELD shares are currently trading on a 1-year forward P/E multiple of ~14x, which we contend is unappealing in the context of estimates of pre-tax earnings growth of ~11% from FY21-24 on a CAGR basis. This rate of earnings growth is underpinned by the combination of: i) Ongoing tailwinds of fertiliser and ag-chem pricing, ii) Organic growth (i.e. market share gains), iii) Acquisitions and iv) Benefits from the backward integration strategy and cost savings.
We contend that these factors are likely to offset the headwinds from the loss of earnings as seasonal conditions across agricultural inputs, cattle and real-estate normalise.
We looked at the ELD chart in mid-March and commented that the gap up from the sideways consolidation was a buying opportunity. ELD continued to trend higher, but it then suffered a big reversal at the end of May. There is large support around $12.50. If ELD can hold onto these levels and then start moving higher again on volume, then that would be a buying opportunity.
Michael Gable is managing director of Fairmont Equities.
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