Waiting for the Green Shoots...

What is exactly up with the Agrochemicals sector and why are most good companies performing underwhelmingly? Let’s understand.

This article will :

1. unveil the diverse forms of pesticides,
2. the scientific underpinnings of their development,
3. my understanding of valuations for agrochemical companies,
4. and the unique situation the industry is in presently.

We will mainly discuss generic agrochemical companies, their valuations, and the opportunity this crucial situation brings to the table for investors.

Introduction to the Industry

Pesticides are divided based on the type of pest it is meant for. I have listed the major types below.

One of the major other types is Rodenticides, that protect crops and stored agricultural produce from rodents. There is also a new market for Bio-pesticides but they are not used much yet and it is just another ESG product-line that is nice to have in the annual report.

The significant disparity between the types of pesticides used in India and the rest of the world, particularly the high usage of insecticides in India compared to the global prevalence of herbicides, can be attributed to a combination of factors:

• Crop Diversity: India's agriculture features diverse crops, often grown together, making pest control complex. Insecticides are versatile, targeting various pests on different crops.
• Weed Management: Manual weeding is common in India due to small farms and available labor, reducing herbicide demand. Lower labor costs favor manual weeding over herbicides for cost-effectiveness.

Diving deeper into understanding the industry, there are two major players in the agrochemical value-chain - the innovators and the generic manufacturers.

The innovators are at the forefront of research and development and introduce novel active ingredients to the market. They hold patents and solely sell the molecule until it goes off patent. If, after going off patent, the innovator loses more than 10% of the market share, the molecule is called a generic molecule.

Generic manufacturers on the other hand, only deal in off patent molecules.

The discrepancy in the R&D investment between these two groups is pronounced. Innovators allocate a noteworthy portion of their revenue, typically in the range of 6-10%, to fund active ingredient (AI) discovery and development. In contrast, for generic companies, the emphasis is more centered on product development, optimization, and formulation, rather than scientific discovery.

You will see R&D expenses in the books of generic companies like UPL, Best Agrolife, etc. and you may also find patents in their names, but they are for formulations and of no significant utility. To understand this better, we need to understand the entire value-chain of agrochemical molecules.

The innovators dedicate substantial resources to R&D endeavors, with a singular goal in mind: to conceive novel AIs for agricultural applications and patent them.

In stark contrast, we find generic players who primarily specialize in the sale of technicals or formulations. These generic companies operate within a different paradigm, as the patents they hold are for specific formulations rather than the active ingredients themselves. This translates into a shorter research timeline and reduced complexity, which results in a less resource-intensive approach. In the broader context of their financial statements, the R&D expenditure for generic companies barely registers as a significant line-item on the income statement.

While generic players and innovators serve distinct segments within the agrochemical market, they are intertwined, fostering the dynamism that characterizes the industry.

Generic players play an instrumental role in delivering accessible, cost-effective agrochemical solutions to a broad spectrum of agricultural stakeholders. Their extensive product portfolios serve as the bedrock for addressing diverse agricultural challenges, ensuring that essential solutions are within the reach of farmers, regardless of the scale of their operations or available resources.

The evolving nature of pests adds a layer of complexity to this narrative. Pests continually adapt, rendering a once-effective molecule obsolete within a few short years. This underlines the imperative for sustained investments in research and development to birth innovative products capable of addressing the ever-evolving challenges in agriculture. This shows us the harmonious partnership between the innovators and the generic players.

Now that we understand the major players, Let’s understand the value-chain of the entire industry in short.

• Basic & Applied Research: This initial step involves extensive research to develop and refine new chemical compounds or biological agents with pesticidal properties. Basic research explores novel substances, while applied research focuses on developing practical solutions for pest control. This is the role of the Innovators.
• Identification: After successful research, promising candidate molecules are identified. Knowledge of regional market conditions help in identifying the molecules that’ll perform well in a region. Maintaining extensive research dossiers, databases, etc. helps to streamline molecule identification and gives an edge over competition. Very few companies talk about this as an important aspect, publicly, and one of them is Sharda Cropchem. They maintain dossiers of their research on molecules and regions to identify molecules that go off patent and have a potential market in a certain region.
• Registration: To ensure safety and efficacy, agrochemicals must be registered with regulatory authorities in each target market. This process involves submitting comprehensive data on the product's composition, usage instructions, and potential risks. Approval is granted once safety and environmental standards are met. Having an experienced team is important to get hassle-free registrations for molecules but having contacts in the system definitely gives you an edge.
• Active Ingredient Manufacturing: The active ingredients (AIs) are produced on a large scale in specialized manufacturing facilities. These AIs are the core, pesticidal components of the formulations. AI manufacturers are usually forward integrated to manufacture the technicals of the molecule, as well. Some companies, who don’t want to worry about marketing and just want to operate in the B2B segment, focus mainly on AI and technical manufacturing. Some examples for the same are, India Pesticides Ltd, contract manufacturers like Punjab Chemicals & Crop Protection Ltd.
• Formulation & Packaging: The AIs are combined with other components to create the final pesticide formulations. These formulations are designed for ease of application and effectiveness. The products are then packaged into various containers, such as bottles, bags, or drums, suitable for distribution and use by farmers. Formulation is the end-product that the farmer buys, so packaging and branding becomes an important factor. Some companies like Dhanuka Agritech Ltd, Best Agrolife, etc., though are backward integrated for their technicals, mainly focus on branding and marketing their formulations.
• Marketing & Distribution: Agrochemical companies promote their products to farmers, agricultural cooperatives, and distributors. Marketing efforts include educating customers on the product's benefits, application methods, and safety precautions. Distribution networks ensure that the products reach end-users efficiently, often involving local retailers and agricultural supply chains. For formulation manufacturers, their distributor-count matters. The more touch points they are present in, the better their topline.

From an investor’s eye, what is wrong with the industry right now? What is the reason behind sluggish numbers and beaten-down valuations?

The current price-crunch

The agrochemical industry has been navigating through a period of pricing volatility in the wake of the post-COVID lockdown phase in China. A confluence of factors, particularly the oversupply stemming from China's overstocking during the COVID-19 pandemic, has significantly impacted the agrochemical markets. In parallel, geopolitical tensions in Europe, compounded by an inflationary environment in Latin America in the last year, adverse weather conditions in North America, have introduced further layers of complexity to the global agrochemical landscape.

The oversupply issue from China reverberated through international markets, contributing to pricing pressures and unsettling the equilibrium. However, the tide would soon turn, and we’ll witness a gradual and natural normalization of Chinese inventories and the corresponding recovery in prices towards pre-COVID levels.

While in India, the domestic inventory scenario has achieved some degree of stabilization, the global agrochemical markets may require several more quarters to fully adapt to the changing dynamics, due to the additional factors mentioned earlier.

The forthcoming uptick in the toplines of agrochemical companies, driven by rising prices with unfavorable factors gradually fading in LATAM and NAFTA and the normalization of inventories, is expected to restore balance and unlock new opportunities for growth and investment in the sector.

Valuing Agrochemical Companies

For agrochemical companies, transparency regarding capacity and sales volume data remains a rare commodity. While access to such data is sometimes granted, its utility in assessing and valuing these companies is significantly hampered. The reason for this challenge lies in the inherent complexity of the agrochemical industry, where prices can fluctuate wildly, not only based on the specific molecules but also according to branding and various market factors. As such, attempting to evaluate agrochemical businesses as commodity-driven enterprises, akin to generic manufacturing companies, is fraught with pitfalls and limitations.

Amid this informational opacity, it's better to turn our attention to alternative metrics that offer a more robust and holistic view of an agrochemical company's health and value. In this context, asset turnover emerges as a beacon of insight. Asset turnover, alongside metrics such as Return on Capital Employed (ROCE) and the determination of minimum sustainable profit margins, forms the cornerstone of a more nuanced and realistic valuation methodology for agrochemical businesses.

Asset turnover serves as a powerful indicator of how efficiently a company utilizes its assets to generate revenue. It essentially quantifies the relationship between a firm's total sales and the assets employed to achieve those sales. In the context of agrochemical manufacturing, where moderately capital-intensive processes are the norm, asset turnover becomes particularly meaningful.

A good capital allocator and a management team that possesses technical acumen are crucial attributes for a successful agrochemical company. By scrutinizing historical turnover ratios and profitability trends, investors gain valuable insights into the management's ability to efficiently allocate capital and navigate the complex landscape of agrochemical production.

This comprehensive approach to valuation provides us with a sense of confidence regarding the company's future capital expenditures (CAPEX). It enables us to assess whether forthcoming investments will yield a reasonable return, both in terms of top-line revenue and bottom-line profit. This forward-looking perspective facilitates the evaluation of an agrochemical business not just in the short term, but with a focus on long-term sustainability and success.

Also, it is crucial to grasp the inherent nature of this industry as a working-capital-intensive business. The urgency of agriculture demands that products be readily available when needed, as delays can lead to severe consequences for crop protection. Consequently, agrochemical companies often find themselves in a position where they must maintain substantial inventories of their various product SKUs.

These high inventory levels are not indicative of inefficiency but rather a strategic necessity. They serve as a crucial buffer to ensure that customers' demands are met promptly and without interruption. With the unpredictability of agricultural seasons and pest outbreaks, agrochemical manufacturers must be poised to deliver their products on short notice. This readiness, however, comes at a cost, manifesting as extended working capital days.

Current valuation trends

In recent quarters, pricing pressures and low volumes in key regions like NAFTA, LATAM, and the EU have translated into subdued top-line growth and razor-thin margins for the companies in the sector. Consequently, investor sentiment has soured, leading to a sharp decline in stock prices across the board

While not all agrochemical companies have gone undervalued, the prevailing negative sentiment has created opportunities for astute investors. With a keen eye, one can identify golden opportunities amidst the turbulence. As the market for agrochemicals stabilizes, there's potential for a substantial bull run in these stocks. However, it's essential to tread cautiously, as not all companies in the sector are safe bets.

It's crucial to seek undervalued companies with a solid margin of safety for a comfortable investment. This period offers prime opportunities, but traditional PE, EV/EBITDA and other relative valuation metrics may not suffice. Instead, focus on individual companies to gauge their financial well-being. Focusing on the valuation metrics I mentioned earlier, would meaningfully safeguard investors from downside risk. The company’s position in the value-chain, the markets it caters to, the level of operating leverage and its ability to capitalize well on the tailwinds of the normalizing markets, would define its outperformance compared to the other players.

Now that I've pointed out a promising sector, it's time for you to roll up your sleeves and dive in. Go on, explore, and find that hidden gem stock. Happy hunting!

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