Appetisers from the agri stocks field

Listed food and agricultural companies are in vogue, with the sector recording some of the best gains over the past year. But it’s not strong fundamentals and bright outlooks that are driving buying interest in the sector. It’s merger and acquisition activity.

The question now is: who’s next? It feels like every member of the sector would make an appetising target to a foreign predator.

In fact, local food producers attract the most offshore interest of any sector as our industry lacks a listed global leader of any real significance.

But don’t be fooled into thinking that you can make easy money from the sector, as its recent strong performance belies the truth about investing in this part of the market.

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The reality is that it’s hard to make any decent returns from this group of stocks, even though they have managed to generate a total return of 56% in the last 12-months.

While few sectors can match that, the 52-week share price volatility of food producers is extreme at 35%. This is even worse than mining stocks on the ASX All Ordinaries Index, as their volatility reading is 27.5%. The irony is that the food industry is supposed to be defensive.

I wouldn’t normally recommend this as investment strategy, but if you are trying to cash in on the sector you should pick stocks for their takeover appeal as much as for their fundamental value.

Don’t get me wrong. Fundamentals should always be the linchpin of any investment decision, but valuations are particularly difficult to work out for this sector because there are just too many moving parts.

Weather, global soft commodity prices and exchange rates are just some of the factors outside management’s control that can bring a food producer to its knees. Trying to forecast these externalities six months in advance is a challenge, and trying to predict beyond a year with any confidence is near impossible.

This is why, to be a successful player in this field and to mitigate risks, a company needs scale and diversification – and this is the key rational for the recent increase in corporate activity in the sector.

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The agriculture industry is the third most active over the past year. The sector has attracted $4.8 billion in pending and completed bids, according to data sourced on Bloomberg. The biggest deal over the period is the Archer Daniels Midland $3 billion bid for GrainCorp (GNC) and TPG Capital’s $880 million play for chicken farmer Inghams Enterprises.

The most recent example is the bidding war for Warrnambool Cheese & Butter Factory Company (WCB), with Uncapped 100 member Bega Cheese and Canadian dairy company Saputo slugging it out to win over the target’s shareholders.

There are seven food and agriculture companies on the Uncapped 100, but their investment appeal is clouded by the lack of bargains as they are trading close to or above fair value.

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Ridley Corporation (RIC)

If I had to pick one stock on fundamentals and corporate appeal, it would be Ridley Corporation. The animal feed supplier is in the midst of a turnaround and is expected to return to profit in the current financial year after posting a net loss of $21.7 million in 2012-13.

The stock may not be deep in value territory after bouncing 12% since July to around 84 cents, but there is still upside if management can meet consensus estimates of $18.9 million in adjusted net profit for 2013-14.

This would put the stock on a price-earnings multiple of 13.5 times, or a 10% discount to the sector, and the stock would be the second-highest dividend payer of its peers on the Uncapped 100 with a forecast yield of over 5%.

Further, Ridley has been touted as one of the more likely takeover targets in this space, and plans by the Indonesian government to set up cattle farming operations in this country (assuming it gets the necessary approvals) will likely give it more growth options.

I have an “outperform” recommendation on the stock.

Note: Since recommending the stock, Ridley announced that a new case of avian flu is likely to impact on exports of its products, but it cannot quantify the impact as yet.

Tandou Ltd (TAN)

Cotton farming and water rights trading group Tandou (TAN) is another that could see corporate action, as the stock is trading below its net tangible asset value of 56 cents a share.

New Zealand farming investment firm H&G and its related companies (Rural Equities and Ashfield Farm) own close to 18% of Tandou and may eventually make a play for the group.

However, the trigger for corporate action could come from a correction in global cotton prices as that is likely to send the stock falling. Cotton prices are at risk from further import restrictions from China – the world’s largest consumer of the material.

“In general, there is consensus that China’s cotton imports will fall significantly – 65% year-on-year in our view in 2013-14,” Rabobank London-based analyst Tracey Allen writes in an email to Eureka Report.

“Cotton futures [prices] are due for a downward correction if import demand fails to gather pace during [the December quarter] 2013.”

If the drop in futures prices does not stimulate demand, cotton prices may slip much lower than her current forecast, which predicts around a 5% slide in the cotton price to US80 cents a pound by mid next year.

Tandou can offset the earnings volatility through water trading, which helped the company deliver a 34% increase in revenue to $65.7 million and a 16% uplift in net profit to $6 million in 2012-13.

Management has not given guidance for the current financial year, but I believe they will give an update at its annual general meeting (AGM) on October 31.

I like the stock for the good reputation of its management team, under chief executive Guy Kingwill, and its undemanding valuation. Those with a stronger stomach for risk can buy the stock, but I think it is prudent to wait to hear what guidance Kingwill will give at the company’s AGM before urging investors to buy. I have a “neutral” recommendation on Tandou for now.

Wide Bay Australia

It’s time to get more bullish on Wide Bay Australia (WBB). There are more signs that the Queensland housing market is on the mend since I wrote about the company on September 11 with a “neutral” recommendation.

The Bank of Queensland results and comments from GWA’s chief executive Peter Crowley at the RBS Morgans Queensland conference is giving me greater confidence that the mortgage lender is close to getting re-rated by the market.

Crowley had described the Queensland housing market as being “dead as a Dodo” a year ago, according to RBS Morgans, but this week he was the most upbeat the broker had seen him in a decade.

As I mentioned in my earlier article, the share price catalyst will come from the release of bad debt provisioning in 2013-14. I think the $5.4 million the company has set aside is too conservative. 

If the outlook for the state’s housing market has improved materially over the past six to 12 months, consensus estimates on Wide Bay’s net profit could be upgraded by as much as 20% plus.

This will feed through to higher dividends, as Wide Bay aims to pay out between 70% and 80% of profits as dividends. The 2013-14 expected yield for the stock is 7.3% once franking credits are included.

Even without a profit upgrade, the stock’s valuation looks relatively undemanding as its price to book value is hovering around one times when its peers, such as MyState (MYS), fetches 1.5 times.

Further, there is growing corporate interest in the sector as highlighted by Tom Elliott’s article in Eureka Report today.

These factors will likely push Wide Bay higher in the next few months and  I am upgrading the stock to “outperform” from “neutral”.

Think big, go smalls!

The Uncapped 100 is a basket of ‘small capitalisation’ stocks constantly monitored by Eureka Report. The list represents the ‘universe’ of 100 stocks from which we regularly make recommendations that may take the form of ‘outperform’, ‘neutral’ or ‘underperform’. At Eureka Report we recommend private investors active in the ‘small cap’ market might hold six to 12 individual ‘small cap’ stocks  to create ample diversification . In turn the allocation to small caps in a balanced portfolio should reflect your risk tolerance and should be balanced by holdings in other asset classes such as blue chip shares, fixed interest products, property and cash.