Push for yield gives investors food for thought

Australia's farm sector is highly fragmented with many small or family operators, while larger enterprises are often either privately or foreign owned after a wave of consolidation that has seen the likes of AWB, ABB and Queensland Cotton delisted.

Listed agriculture stocks such as AACo and Elders are recovering from the legacy of the millennium drought, when cash flow slumped and borrowings accumulated, compounded by the financial crisis, which hit anyone with high debt levels especially hard.

Branded food manufacturers such as Goodman Fielder are suffering from the supermarket wars, as discounting and the rise of home brands eat away at sales and profitability. Food retailers such as Collins Foods are battling soft consumer sentiment.

The macro view, says Belinda Moore, a Brisbane analyst at RBS Morgans, "is very supportive of soft commodity prices over the next decade-plus, driven by demand for the four Fs: food, feed, fibre and fuel".

A key question, according to Wilson HTM's James Ferrier, is whether supply can keep up with growth in demand. "Supply is driven by a combination of the area of land used for agriculture, multiplied by the yield. The land area used in world agriculture is not growing sufficiently to meet demand and is in fact declining in some regions," he says.

"Yields need to increase, through improved or increased use of fertiliser, agricultural chemicals, seed technology, or farming practices."

Hence Ferrier's number one pick for the agriculture and food sector is Nufarm, manufacturer and distributor of a range of pesticides, herbicides, and fungicides including Roundup.

For decades Nufarm was a high-growth stock and darling of the local sharemarket, Ferrier says, "an example of a small company that grew rapidly, expanded globally and had huge success".

But Nufarm fell out of favour from 2008 after Chinese competition saw the bubble burst in glyphosate (the key ingredient in the herbicide Roundup) and a string of earnings downgrades put the company at risk of breaching its debt covenants, resulting in a collapsing share price and shareholder class action run by lawyers Maurice Blackburn Cashman and Slater & Gordon, with preliminary hearings set down for next month.

Managing director Doug Rathbone, who joined Nufarm in 1973 and has been at the helm since 1999, sparked more controversy in 2010 when he sold down his stake in the company, including to 23 per cent owner Sumitomo Chemical. Between 2008 and 2010 Nufarm shares fell from over $16 to below $4.

For some investors these issues are insurmountable, but Ferrier is standing by Nufarm and Rathbone: "I think they suffered from some very tough industry conditions, but we're backing them to continue what has now been more than 12 months of very attractive earnings recovery.

"One of the key points of our positive macro view on agriculture, is the need for agricultural production to improve yield. Agricultural chemicals are a key driver."

Ferrier is not alone: brokers including Macquarie and Credit Suisse also have buys on the stock, but at RBS Morgans Moore downgraded Nufarm to a hold after the annual meeting in November, when profit guidance for 2011-12 was a little softer than she expected.

"We continue to see Nufarm as a turnaround story," she wrote in December, noting the company had successfully refinanced $625 million in debts and endorsing the $US55 million purchase of American sunflower seed producer Seeds 2000. But Moore noted Nufarm's share price had recovered, and was trading in line with its historical price-earnings ratio of 13.

"We think they're doing a good job in terms of turning the company around and making necessary changes," she says, "but they've had a decent ride."

Among the producers, Ferrier likes Tandou (for its large water entitlements in the Murray-Darling Basin) while Moore likes GrainCorp (she is tipping a surprise on guidance for 2011-12 when the company reports later this month). Of the service providers, both favour up-and-comer Ruralco, which has grabbed substantial market share from Elders.

And then there's the likelihood of more takeovers and mergers this year. Even if Australian investors haven't cottoned on to the food security theme yet, foreign investors have.