We recently revisited Elders (ASX:ELD) in The Dynamic Investor after the Company reported a strong result for the 12 months to 30 September 2021 (FY21). External factors such as favourable weather and strong livestock prices support the outlook. In addition, there are several internally driven initiatives that have the potential to augment earnings growth over the medium-term. These growth opportunities have mainly come about from the acquisition of Australian Independent Rural Retailers (AIRR) in July 2019, which has significantly expanded the revenue and earnings base.
With the shares having retraced off recent highs, do current levels present an entry 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 and 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, which together account for over 80% of group margin.
Short-Term Outlook Supported By External Factors
Favourable Weather Conditions
Above average rainfall across the east coast of Australia this calendar year has supported soil moisture and water storage levels. This followed widespread rainfall in 2020 which resulted in the largest East Coast of Australia (ECA) winter crop on record in 2020/21.
The Bureau of Meteorology forecasts above-average rainfall for the east coast grain belt between December 2021 and February 2022. Furthermore, the Bureau of Meteorology has confirmed that La Niña has officially become established. La Niña events increase the chances of above-average rainfall for northern and eastern Australia during spring and summer. This could be supportive for the soil moisture profile leading into the 2022/23 winter crop. Climate models suggest La Niña conditions will persist until late summer or early autumn 2022. This would lead to above-average rainfall across much of northern and eastern Australia.
Cattle Prices Expected to Remain High in the Medium Term
Cattle prices have continued to stay at record high levels. This is due to tight supply, favourable seasonal conditions (better pasture), and strong restocker demand. The positive spring weather outlook for most of the country will continue to allow the national herd to rebuild. Meat & Livestock Australia forecasts the national herd to grow by 5% in 2021. As supply increases, cattle prices are expected to eventually fall. Whilst this will have a negative impact on ELD’s earnings, this will be partially offset by increased saleyard volumes.
Assessing The Growth Opportunities
Aside from the benefits from favourable weather conditions, ELD is well-placed to deliver earnings growth regardless of external conditions. To this end, it is worth noting that of the 21% YoY increase in gross margin in FY21, only ~30% was driven through favourable commodity prices, ~22% came from Mergers & Acquisitions and 48% of the uplift came from organic means and/or self-help initiatives including backward integrations and AIRR synergies.
We highlight a number of initiatives that have the potential to significantly increase EBIT margin from 6.5% in FY21 to ~7.5% in FY24.
1. Market Share Growth
Market share growth is ongoing, with ELD increasing points of presence by 23 locations. In FY21, ELD grew share in six out of eight segments. The remaining segments reported flat market share growth. A key factor underpinning market share growth is that ELD benefited from AIRR’s greater buying power to the broader group and the ability to increase its agricultural chemical margins. There has also been good cross-sell of the AIRR products across the ELD network.
There is potential for ELD to generate additional market share gains in new geographies. This is given ELD’s multiple product and service portfolio and the fact that aggregate market share across all ELD’s businesses is 18%.
2. Strong Balance Sheet Provides Opportunities for Further Acquisitions
The Company has a strong balance sheet, with gearing (on an average net debt to EBITDA basis) as at 30 September 2021 of 1.4x, which is at the lower end of 1.5-2.0x target range and well below the covenant level of 2.5x. The strong balance sheet and cashflow performance provide ELD with flexibility for future bolt-on acquisitions and further CAPEX investment.
The Company acquired nine businesses during FY21 and has a strong pipeline of 27 bolt-on acquisitions. ELD can potentially bolt-on these businesses at attractive EBIT multiples of 3-5x. This should enable the delivery of revenue and cost synergies.
3. Further Margin Expansion from Backward Integration Strategy
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 to 26% (compared to 24% in FY20). 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.
Elders shares are currently trading on a 1-year forward P/E multiple of ~15x. While this is above the 2-year average, we consider that it is undemanding the context of the rate of earnings growth. To this end, the majority of pre-tax earnings growth over FY21-24 is expected to occur in FY22, reflecting earnings tailwinds and continuing strong seasonal conditions.
However, consensus earnings estimates appear to be factoring in a sharp decline in the rate of earnings growth for FY23 (+1.6% compared to +10% for FY22) on the assumption that seasonal conditions and livestock prices will revert. This appears to be the key reason for the recent weakness in the share price. However, it is worth noting some factors that could provide upside to pre-tax earnings growth over out to FY24:
i. The diversified nature of ELD’s business (by geography and product) means that its earnings are relatively defensive during periods of weak seasonal conditions.
ii. The Company is now well placed to deliver earnings growth that is more reliant on internal initiatives and organic growth, as opposed to external conditions.
iii. There is a strong likelihood of acquisitions in the short-to-medium term, given balance sheet capacity and a strong pipeline of 27 bolt-on acquisitions, which provide upside risk to earnings growth estimates. Company has a leading position within Australia’s agriculture market and its low market share also means that the Company is well positioned to benefit from rationalisation of the rural services industry.
Elders has been range bound since the start of the year. At the moment is has eased back to the bottom of the range. This means that we have a tentative buying opportunity here, but investors will need to run a tight stop under support. A big move under $11 would be a negative sign and could lead to a swift drop. However, if current levels are bought and ELD can head higher from here, then a break above resistance near $12.70 would be an opportunity to add to the position.
Michael Gable is managing director of Fairmont Equities.
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