Contrarian buy idea: nufarm

My first rule with takeover targets is that the stock must be a worthy investment in its own right. Speculating on a takeover, let alone getting the timing right, is a mug’s game.

The goal: to buy quality companies trading below their intrinsic value and offering a high margin of safety. If the market cannot see the value, global or local competitors will, knowing that the takeover target would be more valuable under different ownership.

Which brings me to Nufarm. The crop-protection and seeds company has had a horror year. The one-year total return (including dividends) is down 57%, in a rising share market.

The three-year annualised return is minus 18% and over 10 years it is minus 7%. That’s terrible for a company that has a valuable market position and exports to 100 countries.

Nufarm cannot take a trick. The share price was hammered this month after the company updated the market on the implication of three jury verdicts in United States courts against chemicals giant Monsanto, which produces controversial glyphosate-based products.

Glyphosate-based herbicides have been used in farming for more than 40 years and are the world’s most widely used crop-protection products. Nufarm does not manufacture glyphosate; it and hundreds of other companies buy the active ingredient from Monsanto.

Monsanto’s parent company, Bayer, disclosed last year that there were more than 13,000 pending claims against it in relation to glyphosate. Critics believe Monsanto’s Roundup causes cancer, but numerous independent regulatory agencies, including in Australia, have reviewed glyphosate-based herbicides and found them to be safe.

In its June 3 announcement, Nufarm said it was satisfied that glyphosate-based herbicides are safe when used in accordance with the label. But it added that corporate risks relating to glyphosate have increased and that Nufarm, as a supplier of such herbicides, is exposed to potential litigation risks after the US court cases.

Nufarm has different exposure to Monsanto. It is a supplier rather than a manufacturer of glyphosate and not the subject of intense, long-running campaigns from activists who want to bring Monsanto down. Also, all three US judgements are subject to appeal.

Glyphosate-based products account for 12% of Nufarm’s profit. The risk is that growing legal and public pressure on the use of glyphosate herbicides affects future sales for Nufarm, even if Monsanto wins its appeals.

Nufarm says the science has consistently shown there is no link between glyphosate and cancer and that the data will ultimately prevail. But this risk is significant for investors and hard to quantify; it’s impossible to know how Nufarm would be affected if more cases against Monsanto proceed.

If that was not enough, the Australian drought has affected demand for crop-protection products and seeds. Nufarm said at the Macquarie Investment Conference that it is considering a partial plant shutdown rather than slowing manufacturing this year.

Wet conditions and a late start to the planting season in North America and supply disruptions in Europe, have also hurt Nufarm. As an agriculture-related stock, unpredictable weather events affecting Nufarm earning is not new, but the company has less room for error now.

Nufarm’s balance sheet is stretched: net gearing was 69% at the end of FY18, Morningstar data shows. Net interest cover was 2.3 times. Nufarm is deleveraging its balance sheet and said its April 2019 leverage levels were not a risk to the availability of its banking facilities.

Still, the market fears Nufarm will have to downgrade earnings against and possibly raise equity capital if its problems worsen – an event that could be highly dilutive if Nufarm raises funds when the share price is on its knees.

To top it off, Nufarm is among the market’s most shorted stocks. About 13% of its stock was held in short positions, according to the latest Australian Securities and Investments Commission (ASIC) data. The shorts who bet on a falling Nufarm price have done well. They believe further pain is ahead for the company.

That’s the bad news. The good news for prospective investors is that Nufarm’s share price has fallen from a 52-week high of almost $9 to $3.76, a five-year low.

About $400 million has been wiped off Nufarm’s market value since the first court case award against Monsanto in August 2018, notes Macquarie Group. The market has factored in plenty of bad news about glyphosate-based herbicide demand, judging by the share price.

At $3.76, Nufarm is on a forecast Price Earnings (PE) of about 11 times forecast FY19 earnings. This is a 10-year low compared to its listed global competitors, notes Macquarie. Nufarm has fallen 47% since August 2018, versus an average 15% for its peers.

In absolute terms, Nufarm traded on an average PE multiple of 18.4 times in FY17 and around 15 times for the three prior financial years. So there’s been a massive de-rating in the market’s assessment of Nufarm’s growth prospect given its various challenges, and rightly so.

Short term, Nufarm said in April it has maintained its guidance (downgraded earlier this year) and that the fourth quarter is traditionally its biggest. Management expects earnings in Australia and Europe to recover and provide a meaningful lift to cash flows in FY20.

There’s latent upside to the business when weather conditions normalise and Nufarm has control of its European supply chain. The company should come out of the drought stronger and more efficient after its improvement initiatives.

Longer term, Nufarm is exposed to the best megatrend of them all: the boom in middle-class consumption in emerging markets. As incomes grow in China and later India, and diets change, higher crop productivity will be vital. Nufarm has well-established distribution platforms in major global agricultural markets, including Asia.

For all its recent problems, Nufarm still has an estimated one-third share of the Australian crop market and is a number one or two player in many crop-protection categories. It also has a valuable seeds technology business that could probably be sold on a higher PE multiple than that applied to Nufarm, judging by recent acquisitions of global seed companies.

An average share-price target of $7.78, based on the consensus of 13 broking firms, suggests Nufarm is materially undervalued at the current $3.76. Macquarie values the stock at $6.38; Morningstar’s fair value is $7. Broker price targets range from $6 to $11.

In the background is major shareholder Sumitomo Chemical Company with a 19.2% stake. Sumitomo Mitsui Trust Holdings emerged as a 6.8% shareholder in Nufarm in March, no doubt attracted by the low share price.

Nufarm is strategically important to Sumitomo because it sells a lot of its products and provides a strong distribution platform for the giant Japanese trading house. Sumitomo would be unlikely to let go of Nufarm without a fight if another suitor emerged.

Nufarm, to its credit, has conditioned the market to expect another tough 12 months and is working hard to get through its nightmare.

I can’t see Nufarm’s share price rising in a hurry, absent a takeover. Further falls are likely in the near-term as the market frets over Monsanto’s issues and the drought. Prospective investors might wait for a base to form in Nufarm’s price before buying.

There is value in the stock for experienced investors comfortable with higher-risk turnaround plays and who understand the vagaries of agricultural-related companies that face uncertainty in soft-commodity prices and the weather, and are mostly price takers.

Still, as Warren Buffett says, “be greedy when others are fearful”. It’s hard to imagine a point this decade when there was as much fear about Nufarm’s prospects. When it traded above $9 in May 2017, analysts talked it up as a play on the “dining boom” in China.

Now, Nufarm stock is badly out of favour. Contrarian ideas are never easy when bad news abounds about a company. The over-reaction is what creates opportunity for those who can see through short-term problems and focus on value.