Monday, May 16, 2011

Harvest the agriculture theme for profits

Aarati Krishnan

While there are several options for investors wanting to go with the ‘agro' theme, makers of agricultural inputs present a particularly ripe opportunity.

Even as India's population burgeoned by 17 per cent in the last 10 years, its farm output expanded at just half that rate. Despite growing demand for food, the land devoted to agriculture has dwindled in the last 20 years.

With extra money to spend, Indians are including more pulses, milk and meat in their diet, but the output of these products is simply unable to keep pace. There's not much you can do about all these alarming trends. However, you can hedge yourself and make money off them, by owning stocks that play on the agriculture theme.

The money is in agro-inputs

While there are several options in the listed space for investors wanting to green their portfolio with the ‘agro' theme, makers of agricultural inputs present a particularly ripe opportunity owing to three factors. For one, earnings for such manufacturers tend to be less volatile than those for agro-commodity companies, which are subject to the vagaries of weather and commodity price swings.

Two, companies manufacturing agricultural inputs are a better way to play on the “rural consumption” story than FMCGs, two-wheelers or retailers. Rural incomes have, in recent years, been rising fast on the back of large hikes in support prices for key food crops and social schemes such as the NREGA. However, aren't rural folk likely to plough back their higher income into quality seeds, fertilisers and other farm inputs, ahead of looking to splurge on shampoos, skin creams or SUVs?

Three, the markets for agro inputs feature relatively few listed players, making for fairly strong companies that dominate each segment. Scanning the listed universe yields 93 sugar makers and 155 tea processors, but only 20-odd fertiliser makers, 13 large manufacturers of pesticide and three companies producing seeds.

If the above points have convinced you to invest in the agri theme, here's what you should look for.

Fertilisers: More friendly policy

Fertiliser stocks have begun figuring in the portfolios of institutional investors in the past year, after being cold-shouldered for many years. And why not?

Despite whimsical monsoons in this period, the ten leading listed fertiliser makers delivered a 16 per cent compounded annual growth rate in profits and a jump of 12 per cent in sales over the past three years.

Prospects for companies in the sector have turned brighter on the widening gap between domestic demand and output of fertilisers and greater affordability as farm product prices have galloped ahead of fertiliser selling prices. There has also been a decided shift from a fluid to a facilitative policy environment.

Phosphatic and complex fertilisers have been moved to a nutrient-based subsidy scheme, prompt cash disbursals of subsidy have replaced delayed payments by way of bonds and the subsidy element is also being dynamically benchmarked to global prices.

The higher earnings visibility has been duly noted in the markets and fertiliser stocks have been marked up to double digit PE multiples.

From here, fertiliser stocks may not turn out to be multi-baggers, but they still offer scope for healthy gains given that valuations (average PE of 10 times trailing earnings) are still at a big discount to the broader market.

So if you are looking to add fertiliser stocks to your portfolio, which ones should you buy? One, the phosphatic and complex fertiliser makers appear more attractive for a 2-3 year time-frame than the urea-makers.

The current policy stress on balanced fertiliser use means that Indian farmers need to replace some of their urea application with phosphatic and complex fertilisers, which means stronger demand prospects for the latter.

A sure indication of the unsatisfied demand for complex fertilisers comes from the 33 per cent shortfall between their domestic output and consumption, which is met by imports (the gap is 20 per cent for urea).

Two, players with strategic tie-ups for sourcing of inputs or, better still, those integrated backwards into production of feedstock (natural gas, rock phosphate and phosphoric acid) may be better placed to hold on to margins.

With the nitrogen component in fertilisers directly linked to the crude oil price table, raw material volatility is likely to punish margins, particularly as the industry moves from a cost-plus subsidy to a flat subsidy regime.

Three, the producers with the lowest costs (that come from scale and procurement advantages) are likely to emerge the winners as the policymakers take baby steps towards decontrolling fertiliser prices.

Agrochemicals: Thriving through diversification

With no pricing controls, a thriving market in contract manufacture of ingredients and quick adoption of new brands by Indian farmers, Indian agrochemical makers have been in a sweet spot in recent times.

That reflects in the really strong 26 per cent CAGR in sales and profits managed by the clutch of 14 leading agrochemical companies in the past three years.

The PE multiples of agrochemical companies, however, haven't improved across the board. The re-rating in this segment has been confined to two sets of players. One, the Indian arms of multinational companies such as BASF and Bayer CropScience that have recorded scorching growth mainly by building good brands and products targeted at lucrative niches and crops.

Two, very large Indian players such as United Phosphorus and Rallis India, which accelerated growth by diversifying across crops and regions.

While United Phosphorus has aggressively expanded exports by using its low-cost manufacturing strengths and acquiring products overseas, Rallis has leveraged its extensive distribution reach in India, rapidly diversifying its domestic product by churning out new formulations.

A third set of Indian agrochemical companies have notched up strong growth by contract manufacturing and supplying products to the huge global market for off-patent agrochemicals. These stocks continue to languish at single digit PEs, as they are perceived as commodity plays; but may hold scope for gains linked to profit growth as well as expansion in valuations.

Investors in agrochemical stocks, however, should look to avoid just one key risk — that of concentration. While concentration in one or two products exposes earnings to the risk of a ban or phase-out of that particular product (endosulfan, for instance), concentration on a crop (for example, cotton), makes earnings vulnerable to technological advancements. The dent created by Bt cotton in the demand for insecticides have forced many agrochemical makers to scramble and diversify into other target crops.

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