Nufarm Has A Competition Problem

This story features NUFARM LIMITED. For more info SHARE ANALYSIS: NUF

-New entrants affect pricing power
-More positive when drought ends
-Company's measures considered modest
 

By Eva Brocklehurst

Mounting challenges from new entrants, and the loss of the distribution contract for a major product like Roundup, provoked Nufarm ((NUF)) into reviewing its Australian operations. Brokers welcomed the $13m in annual cost savings the company expects to achieve but remain concerned about a number of headwinds, including the erosion of market share coupled with a drought in eastern Australia.

Critical to the performance ahead is a break in the weather. Recent rain in Australia's cropping regions has provided some hope but brokers do not expect any benefit on that front in FY14. Macquarie observes the second half is the big season for the northern hemisphere and that's where most of the positives for the company lie for FY14. UBS, too, observes a significant skew to the second half earnings, with that broker's estimates implying a ratio of as much as 25:75.

The bulk of the Australian savings will come from the closure of two plants, one in Western Australia and one in Queensland, and the transfer of production to Victoria. Six out of 13 regional service centres will also be closed. The company is embarking on a review of the New Zealand operations as well. The Australian restructure is expected to improve the profitability of sales and reduce both working capital and a rather inflexible fixed cost base. The company has decided to target annual earnings of $70-80m going forward.

The restructure highlights a key concern for JP Morgan, in that new players have affected the company's pricing power and margins in Australia. The company has acknowledged this, noting an increase in the number of new product registrations. Management previously expected, after the announcement of the loss of key distribution contracts, that margins should remain stable, or even increase, given the higher margin generated on house product, along with the absence of royalty payments. JP Morgan assumes around 35% of the $13m of cost savings that are forecast will be retained in FY17, with the residual 65% being whittled away by competition.

UBS thinks this ramp up of competitive margin pressure could just be the start of continued inroads into the company's business. Australia has been the key profit centre in recent years and market share has been consistently over 30%. UBS notes the full impact of Sinochem's behaviour, after it attained full distribution rights to Roundup in September 2013, is yet to be seen. Moreover, BASF will take its products back in house from this month. UBS estimates a total sales loss of $165m and assumes 50% of lost sales are recovered.

The broker has raised the rating to Neutral from Sell, acknowledging the stock looks relatively cheap, but remarks it's difficult to become more positive. The company has levels of gearing that are uncomfortable. Total debt facilities are around $1.45bn and full year forecasts mean the company has around $500m in annual head room through FY14-16. What aggravates the situation for an agricultural company such as Nufarm is the problem of maintaining cash flow in line with earnings. Suppliers extend credit to growers and are paid once the crops are sold. Some of the mismatch is temporary but there's one issue that UBS thinks will persist as long as growth is pursued in South America. Here, the market dynamics are radically different to other regions. Instead of the typical 90-day creditor period the terms are over 200 days, particularly for Brazil. This situation needs to be incorporated in growth forecasts, in UBS' view.

BA-Merrill Lynch does not expect Australian earnings will return to the peak levels of $106m seen in FY12, largely because of a reduction in market share following the loss of Monsanto and BASF product distribution rights. The broker cites estimates of Australian pesticide sales, growing at a compound rate of just 0.5% which is the slowest among the developed world. Merrills expects Nufarm's Australian earnings will recover to only $60-70m beyond FY15. Merrills retains an Underperform rating.

CIMB considers the stock presents an attractive buying opportunity. The company will endure a second consecutive year hampered by adverse seasons but these internal initiatives will increase the leverage, in the broker's view, once normal conditions return. The broker concedes historical peak profits are out of reach, given the structural shifts in domestic crop protection, but thinks the review initiatives should help – along with some rain – to achieve the medium-term gross margin target of 23%, versus the 19% experienced in FY13.

Credit Suisse thinks the restructure is sensible to achieve the cost savings but is cautious about the ability to convert this to the bottom line. The broker suspects savings may be reinvested to protect market share but sees value in the stock beyond FY14 and the vagaries of the Australian weather, enough to raise the rating to Outperform from Neutral. Working capital management is likely to improve with fewer warehouses to stock. What's unclear to Credit Suisse is whether a reduction in the regional service centres will actually improve customer service. Nufarm expects to make more deliveries direct to the customer rather than from factory to warehouse to customer. The broker observes Nufarm has a strong reputation for same-day supply, having installed its multiple distribution centres in the past to enhance customer service.

FNArena's database reveals three Buy ratings, three Hold and one Sell. Price targets range from $4.10 (Merrills) to $5.55 (CIMB). The consensus target is 4.68, suggesting 13% upside to the last share price. 

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