Drought Casts A Pall Over Nufarm Earnings

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Drought, increased inventory in the channel and a delay in product approval have caused Nufarm to sharply downgrade FY18 guidance and the issues are expected to linger into FY19.

-Increased competition and high inventories signal margin pressure
-Headwinds largely seasonal so is this an entry opportunity?
-Omega-3 considered a long-term driver of the business
 

By Eva Brocklehurst

The inevitable consequences of the prevailing drought in Australia have caught up with Nufarm ((NUF)), which has heavily downgraded FY18 guidance. Moreover, after a poor winter cropping season the Bureau of Meteorology is currently forecasting a dry spring.

As a result the company expects low levels of demand in the Australian market may also impact FY19 earnings. Nufarm company has lowered FY18 operating earnings (EBIT) guidance to $255-270m.

The reduction to guidance was not completely unexpected by brokers, given recent downgrades by others in the sector, but it was worse than forecast. Morgans notes, while Nufarm usually benefits from geographic diversity, setbacks in Europe and adverse currency movement in Latin America have also had an impact.

The earnings downgrade, down around -16% at the low end of the range versus FY17, is attributed not only to the dry conditions in Australia but a lack of derogation from French authorities for the company's neonicotinoid seed product. While, typically, seasonal conditions are confined to the period in question, the extent of the dryness has also elevated inventory, creating another headwind.

One of Australia's driest autumns in almost 100 years has led to a poor winter crop and crop protection markets are down around -10-20%. Consequently, increased competition and high inventory levels have resulted in significant margin pressures.

The quantum of the downgrade was more than expected and, contrary to the rest of the brokers on the FNArena database, Deutsche Bank sticks with a Sell rating. Nufarm has guided to a $200-300m increase in working capital requirements and the broker calculates net debt will be around $1.35bn in FY19, with 2.5x net leverage. FY18 estimates are reduced by -30% and FY19 by -18%.

The impact on FY18 guidance was worse than Citi expected and high channel inventories are now likely to hit FY19. Nevertheless, the share price is observed to have more than captured the reduction in earnings potential, while investors are getting the Australasian and Omega-3 businesses for free. Hence, the broker reiterates a Buy rating.

Morgan Stanley's FY19 estimates are downgraded by -11%, taking on board the weakness in the Brazilian real against the Australian dollar as well, which will affect the translation of Latin American earnings. Still, the share price has declined -21% over the last two months as the seasonal issues became increasingly apparent.

Hence, Morgan Stanley estimates the retracement is broadly consistent with downgrades to FY18 net profit and, while recovery will take some time, still forecasts around 40% growth in operating earnings in FY19. The broker believes the share price undervalues the base business, let alone the upside from Omega-3 and an Overweight rating is maintained.

Credit Suisse also maintains a Outperform rating, believing the company is well-positioned to benefit from expansion of its footprint in North America and the recent acquisitions in the European portfolio. The broker's FY19 Australasian forecasts includes a partial recovery of the impact of the poor winter crop conditions and a full recovery for Australasian contributions to earnings by FY20.

Credit Suisse acknowledges the elevated inventory in the shift to lower-margin products in the second half of FY18 will reduce the likelihood of a complete recovery in Australasian earnings in FY19. Macquarie also suggests a two-year recovery path in Australia and lowers its FY18 estimates consistent with guidance.

Neonicotinoid Ban

The French government is yet to grant approval of the company's application for the use of its Nuprid 600 seed treatment. Hence, Nufarm will likely miss the grower application window for the season and has signalled a risk to earnings to the tune of around -$12m in FY18.

The European Commission has banned the use of neonicotinoids (insecticide) for indoor uses and Nufarm is seeking a declaration in France to enable the use of substitute products. Citi expects, in FY19, gross margins of around -$15m are at risk, although the company's Century substitute may provide an offset.

Credit Suisse assumes the loss associated with the Nuprid 600 product is recovered over FY19 and FY20 by sales of substitutes through the European operations.

Ord Minnett believes Omega-3 is a long-term driver of the business and the headwinds currently battering the company are seasonal, not structural. Although risks remain, the recent share price declines suggests an entry opportunity.

Additional US approvals for Omega-3 are expected in the first quarter of FY19 and an earnings contribution is slated from 2021. Omega-3 canola has secured regulatory approval in Australia and is on track for commercialisation in 2019.

Heightened Competition

Bell Potter envisages heightened competition in agricultural chemicals in FY19-20, as Elders ((ELD)) has acquired Titan Ag with a desire to lift its internal sourcing of such products.

At its May briefing, Nufarm suggested this could have an impact on gross profit of -$10-15m in FY19. The broker's forecasts assume that some of the void is filled by Nufarm products within the recently-acquired European portfolio.

Bell Potter, not one of the eight stockbrokers monitored daily on the database, expects the company to return to a period of growth in FY19-21m, as recent acquisitions are consolidated and the investment in Omega-3 begins to contribute. However, in the near term the structural change in Australian industry is likely to drive a step down in returns and the broker maintains a Hold rating. Target is $8.30.

Traditionally, Morgans suggests the best time to buy agricultural stocks is during a drought. The broker believes the stock has been oversold but, given the lingering issues into FY19 and the fact Nufarm has a lot to prove, any re-rating is expected to take time.

FNArena's database shows six Buy ratings and one Sell (Deutsche Bank). The consensus target is $9.01, suggesting 22.4% upside to the last share price. Targets range from $6.75 (Deutsche Bank) to $10.65 (Morgan Stanley).

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