In May 2021, Nufarm (ASX:NUF) reported an impressive set of results for the six months to 31 March 2021 (1H21). However, despite this, the share price continued to weaken. The reasons for this included:
i) Full-year guidance that implied a usually low skew in 2nd half earnings for FY21, and
ii) Concerns about the sustainability of the earnings recovery in the Europe segment.
Accordingly, we recently researched the Company to assess whether there were any catalysts to support a recovery in the share price. In other words, does the recent weakness represent an entry opportunity, or are NUF shares likely to remain subdued?
Nufarm is a leading crop protection and seed technologies company. NUF develops, manufactures, and distributes a range of herbicides, insecticides and fungicides which are used by growers to protect their crops against weeds, pests, and diseases. In crop protection, it primarily operates in the off-patent segment of the market.
Its seeds business uses proprietary technology and NUF is developing its seed treatment capabilities. The crop protection business is focused on major agricultural markets in Europe, North America, and Asia Pacific (APAC).
NUF has formulation and manufacturing facilities in nine countries, marketing operations in over 30 countries and distributes its products in ~100 countries across Australia & NZ, Asia, North America and Europe. It has a strategic alliance with its largest shareholder, Sumitomo Chemical Company (who owns 15.9% of NUF) and a sales and marketing JV in China with Fuhua Group (who owns 5.8% of NUF).
Key Fundamental Drivers
Improvement in Europe Segment Appears Sustainable
The strength of the improvement in the Europe segment in 1H21 – after suffering from rising input and manufacturing costs and margin pressure in FY20 – was the main surprise of the 1H21 result. Importantly, NUF delivered strong margins in Europe (25% and ahead of group EBITDA margin of 14%) on improved product mix, delivery of cost savings and an easing in raw material prices.
The Europe segment (which accounts for ¬47% of group earnings) is expected to benefit from favourable seasonal conditions which supported volume growth, easing raw material costs (as evidenced by a significant drop in key raw material active ingredients Tebuconazole and Prochloraz) and benefits from the cost savings program.
North America Segment Expected to Recover
The North America segment (which accounts for a 1/3rd of group sales) is expected to report a significant decline EBITDA in FY21. This is due to margin impacts associated with supply chain disruptions and heightened broadacre competition. However, it is worth noting that earnings are expected to improve in FY22/23, as these headwinds are expected to unwind over the coming years.
Seed Technologies a Long-Term Growth Opportunity
The Seed Technologies operations comprises NUF’s portfolio of seed treatment products and the Nuseed business. The seed treatment products provide protection and treatment for damage caused by insects, fungus, and disease. In September 2020, NUF secured the first commercial orders of omega-3 canola oil to a major global salmon producer. At present, the earnings contribution is negative, given record low international salmon prices due to COVID-19 and reduced food services demand. Accordingly, the previously assumed profit from Omega-3 has been deferred by around two years.
In context, the expected profit contribution in FY21 (which has now been deferred) was not a material contribution in the context of group earnings. However, it is worth noting that the longer-term demand fundamentals for Seed Technologies remain positive and is likely to be highly profitable after it achieves significant scale in around year four of commercialisation (i.e. FY25). The FDA’s recognition of the Nuseed’s omega-3 canola oil as a safe new dietary ingredient now places the Company in a better position to secure further commercial partnerships.
Balance Sheet Continues to Strengthen
NUF has progressively reduced gearing levels after a substantial reduction in net debt following the sale of the Company’s $1b South American crop protection businesses on 1 April 2020. Gearing (on a net debt to EBITDA basis) fell to 1.4x (down from 2.5x in the half prior and 1.9x in the prior corresponding period). This level of gearing is also below the Company’s target gearing range of 1.5x-2.0x. The lower gearing level was also achieved because of a reduction in net working capital, with the average net working capital (ANWC) to sales ratio falling from 48% in 1H20 to 37% (and within the target range 35-40%).
The implication here is that NUF’s strong balance sheet position (i.e. low gearing and adequate liquidity with $584m of undrawn facilities and $501m in cash) could enable the resumption of capital returns (i.e. dividends) in FY22. With the Company looking to maintain gearing within the target range, as well as resume dividend payments, there appears to be enough balance sheet capacity to pursue small-sized acquisitions. However, any larger scale opportunities are likely to require funded via an equity raising.
We consider that the recovery in earnings over the medium term appears more sustainable, with EPS growth of 34% expected over FY21-23 on a CAGR basis. Balanced against this expected EPS growth profile, NUF is currently trading on a 1-year forward P/E multiple of ~20x, which is not demanding in the context of the aforementioned EPS growth profile and the average 1-year forward P/E multiple of ~26x over the last two years.
Accordingly, we take a favourable view on NUF’s fundamentals. A key regulatory risk relates to synthetic crop protection portfolios. In particular, the ‘Farm to Fork’ paper in Europe sets out a target for a 50% reduction in use and risk of chemical pesticides by 2030.
Nufarm started downtrending in April. However, during July – early August, the decline started slowing down and the range started to tighten up and resemble that of a falling wedge. When we noted this in The Dynamic Investor report on 3 August, our advice was that we could be getting closer to the end of the slide. We noted that “If it can tighten up just a little more over the next few days or so and the give us a strong high-volume rally, then that would be the buying opportunity.” This exact scenario occurred on 11 August. With the follow-on since then, it now appears as though a low is in place and NUF should head higher from here. The share price has slipped in the last few days so another bounce at any level above $4.40 is another buying opportunity.
Michael Gable is managing director of Fairmont Equities.
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