Interactive Investor

Harvesting profits from agribusiness

7th November 2014 17:30

Harriet Mann from interactive investor

The agri-food industry hasn't had the easiest of rides over the last couple of years. The horse meat scandal ruined consumers' confidence forcing companies to adapt. And after recovering from poor weather, crop supply now outstrips demand, pushing prices down. But investor interest has picked up in what is proving to be a resilient market and talk is we are on the cusp of a turning point.

On a macro level, the long-term investment case for the agri-food industry is based on rising demand amid uncertain supply. The Food and Agriculture Organisation (FAO) reckons the global population will have swelled by 30% to 9 billion in 2050. The UN reckons it could be 9.7 billion. Food production will have to surge by at least 60% to cope, equivalent to a farm the size of the USA, according to Plant Impact's chairman David Jones. But with industrialisation in emerging markets shrinking the land available to farm, how will the planet cope?

"The expectation is that without investment to increase production yields and growing capability overall, there will be a supply shortage putting pressure on prices," warns Shore Capital's agri-food analyst Phil Carroll.

Pricing in oversupply

For now, however, it's the reverse. We are now in a food deflationary environment, Carroll explains, as supply outweighs demand after two good growing years. Globally, corn production is set to grow to 991 million tonnes in the current season and wheat production to 721 million tonnes, both record levels. But with production outstripping consumption, prices are suffering, with wheat down 27% on the year and corn down 20%.

But Sion Roberts, a senior partner at European Farming & Food Partnerships argues that global wheat prices have moved into their third trading range in 100 years, despite the recent fall.

UK and Irish feed companies historic PER valuations

"What is happening in the markets at the moment is that we are fishing for the bottom of that trading range," he says.

The UK environment mirrors that of the global stage, with wheat production expected to increase by nearly 40% to 16.6 million tonnes this year, which Carroll says is "well-above" average records. This trend continues in other crops too, with potato production expected to have recovered from its worst crop in 30 years in 2012, to over 6 million tonnes in 2014.

Risk

Clearly, some short-term equity investors will be worried about industry volatility. Not only does the weather dictate performance - too wet and the crops will rot, too hot and they will dry out - but there are geopolitical risks, too.

"The Russia/Ukraine situation is ongoing, despite the little media coverage at present. It is important because as a region they are becoming increasing important grain exporters in the global market. We also note that there are forecasts now of falling production due to the currency depreciation they have experienced, which will lead to higher costs for seeds and agri-chemicals and likely lower use impacting yields," explains Carroll.

EU sanctions on Russia have also hit exports and common agriculture policy implementation in the UK, which is going on into 2015, is also causing uncertainty. The retail environment is an issue, too.

"The landscape is changing with the growth of the discount channel and the increase of the convenience channel, we also expect the market leader Tesco to implement its new strategy and for pricing to be a key element," Carroll adds.

But agri-businesses have been fairly resilient. UK agri-food industry valuation multiples had been helped by favourable market conditions and increased investor interest, although they have undergone a gradual de-rating this year, which has caused an increase in M&A activity.

Cheap oil marks turning point

An exposure which the agri-food industry is currently benefitting from is its close relationship to oil prices. Before the recent sell-off, increasing oil prices increased the cost of food production. The recent fall could be a very important driver in whether the industry is currently at a turning point, says Roberts.

"Are we at a turning point? I think on the supply side agriculture prices are undoubtedly getting lower. But our view would be that we are in a new, higher trading range, for a range of reasons about cost of production and productivity and there is going to be big volatility within those trading ranges. On the demand side, I think potentially we will look back and see that after six years of retail food prices increasing in real terms we are now at a turning point this year and going back to the old situation with retail food prices coming down in real terms."

"There are really big changes going on in 2014. I think agri-food is still a very attractive sector, but the next year is not going to be the same as the last six years," he adds.

Investment opportunities

"I think there are challenges ahead for the industry," says Carroll "the significant increase in supply has driven prices lower and I expect the pricing environment from both the input side and with the weak consumer environment also the retail side to remain soft.”

“I see the key risk being the transfer of value through the supply chain to the consumer in what is an uncertain and evolving through retail landscape. However, I think this should provide some good investment opportunities."

The analyst reckons investors should focus on those companies that have reduced volatility in their businesses and have stabilised earning profiles - though how the company has diversified to achieve this is crucial, he warns. He favours companies with a strong balance sheet, pricing power, those that have outperformed their own market and have exposure to structural growth markets. Roberts adds that investors should keep an eye out at how business models are changing to capture value and look at what stage of the cycle the industry is in.

Four stocks to consider

Interactive Investor takes a look at four agri-food companies to feed your hunger for industry exposure.

Genus (1,280p)

By developing better livestock, global animal genetics company LSE:GNS:Genus looks to make farmers more productive by applying advanced science to natural breeding techniques.

"Genetics define the fundamental biological limits of what you can get out of a farm system raising livestock," said group financial director Stephen Wilson. "There are many other factors... but if you don't have the right genetics you are always going to be limited to what you can achieve." He notes that this is especially important as more of the population gravitates towards cities, forcing farms to be more scaled and efficient.

The group has an 8% share of the £786 million milk market, 26% share of the £114 million pork market and up to 24% share of the £68 million beef market, but Wilson reassures that it still has plenty of opportunities for growth especially in the Chinese market, which has half of the world's pigs.

But the 12 months to June 2014 were difficult, with its investment in China hitting group adjusted operating profit, which was down 7% on the year, but flat on constant currency rates. Excluding China, operating profit was up 7%, or double that when currency headwinds are stripped out. The dividend was up by nearly 10% at 17.7p.

Head of research at VSA Capital Edward Hugo puts the stock on a price/earnings ratio of 22.8 times and EV/EBITDA multiple of 15.1 times, expensive compared to the sector (see chart). However he reckons that improvements to its end customer markets should benefit the business.

Plant Impact (33.8p)

"A small company with bags of attitude and I hope bags of promise" is how Plant Impact chairman David Jones describes the company. It makes and sells chemicals to boost the yield performance of crops by focussing on crop stress relief. It plans to expand through three channels; sell apple sprays direct to the market to "pay the bills" (estimated market size of (£120 million), globalise and scale (around £75 million) and then develop full-season portfolios for global crops (around £375 million). The last stage centres on creating 15 new products in five years.

As part of the second stage it is working with Bayer to improve the yield of Brazil soy and after its pilot launch has up to 1,000 customers tied to the product.

UK food and processing companies historic PER valuation

"Plant Impact's technology has demonstrated material improvement to crop production and the deal with Bayer now provides the company with the opportunity to build a material revenue stream in a key crop in a large market," said Charles Hall, an analyst at Peel Hunt. "This is just the start. Our 50p target price is based on our DCF forecast, which risks future product launches and uses a 12% discount rate. Our unrisked NAV is 102p."

The analyst expects Plant Impact to make a net profit in 2016, when it will trade on a price/earnings multiple of 18 times.

Carr's Milling (1,640p)

Compared to the other companies profiled, Carr's Milling has a more diverse business model, which CEO Tim Davies says manages volatility.

It is split into three businesses; agriculture, engineering and food. Its aim is to become a truly global company through its employment, innovation, M&A and investing in its assets, even though nearly half of its pre-tax profit was generated internationally last year.

Its products include feed blocks and AminoMax in its agriculture arm, flour production in its Food division, which has enjoyed large investment, and German engineering.

On the new management team, Charles Pick, an analyst at Numis, says: "One senses a greater readiness to contemplate international growth opportunities, especially for the feed block and engineering operations: this could necessitate M&A in the £10-20 million region compared to the largest move in recent years of around £5 million."

Ahead of its financial results on Monday, Numis reckons Carr's will report revenue of £446.9 million, pre-tax profit growth of 8.8% to £16.7 million, giving EPS of 127.6p.

Trading on 13 times 2015 diluted earnings per share, Pick says the valuation is "undemanding", "whilst even on a prudent basis the current market capitalisation looks more or less ‘covered’ on a SOTP analysis." He puts an 'add' recommendation on the stock with a 1,800p target price.

Cranswick (1,394p)

Cranswick's recent acquisition of Benson Park has expanded its reach into cooked poultry as part of its growth strategy. The company's largest market is pork processing, and its global reach allows it to capitalise on as much of the carcass as it can.

In the UK, three-quarters of the pig processing market is made up of its four main players, and Cranswick takes up 24% of this share.

In the last 10 years revenue has grown by an impressive 270%, reaching £994.9 million in 2014, pre-tax profit growth has been strong too, at £52.5 million and shareholders have enjoyed 24 years of unbroken dividend growth.

CEO Adam Couch does anticipate more volatility in global food prices. "We have got to be extremely mindful that we maintain the relevance of our products in that market place. Pork along with poultry is ideally placed in that market to win valuable market share owing to its relative price proposition in the market place.

"The versatility of pork is absolutely key to our development and how we will move our business forward," he added.

As part of its growth plan to become a "global" company, Couch has "four pillars" of growth; market penetration, channel development, diversification and international expansion.

On Investec's guidance, Cranswick is trading on 14.7 times forward earnings and the broker rates it a 'buy' with a target price of 1,390p.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.