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Morningstar | Nufarm Shares Suffer More Bayer/Monsanto Litigation Blow-Back. No Change to AUD 7.00 FVE

No-moat Nufarm shares continue to struggle, down 14% to AUD 4.30 since April 12. We maintain our AUD 7.00 fair value estimate, holding to the view that the drivers of weakness are transitory. On the Best Ideas List, Nufarm’s price to fair value discount has now blown out to nearly 40%. The Australian drought and teething issues with recent European acquisitions hit near-term earnings and working capital, and U.S. lawsuits against glyphosate manufacturer Bayer further weigh on sentiment. Based on the support by key regulatory agencies and the large number of scientific studies showing no causal relationship between glyphosate and cancer, Morningstar expects Bayer will prevail in most of the legal cases it faces.

Germany’s Bayer fatefully bought U.S. glyphosate manufacturer Monsanto for USD 63 billion in June 2018. The reason legal claims in the U.S. blow back to Nufarm is the Australian company sold Monsanto’s Roundup-branded glyphosate to Australian and New Zealand farmers under licence from 2002 to 2013. Monsanto switched to Sinochem as its preferred distributor, but Nufarm still sells glyphosate under its own brands. No claims have been brought against Nufarm.

This month a jury in Northern California decided Bayer’s glyphosate product caused cancer in two more people and awarded close to USD 2 billion in damages. But Morningstar expects Bayer will appeal this case, with a much more favourable outcome likely. As the majority of the damages were punitive, we also expect subsequent decisions to significantly lower the amount of damages. Morningstar’s base case projections for Bayer include EUR 2 billion in legal costs related to glyphosate litigation. And we continue to expect subsequent cases and appeals to be more favourable for Bayer based on the support by key regulatory agencies and the large number of scientific studies showing no causal relationship between glyphosate and cancer.

Based on the scientific data from America’s Environmental Protection Agency, National Institutes of Health, the European Chemicals Agency, and the European Food Safety Authority that there is no link between glyphosate and cancer; we believe most plaintiffs will be unsuccessful. Health Canada and the the Brazilian regulatory authority also recently reaffirmed glyphosate is safe and presents no risk to users if used according to label instructions.

Nufarm has tried to reduce its reliance on glyphosate over the years, going from 50% of revenues to 20%. Glyphosate made up just 12% of Nufarm’s AUD 963 million first-half fiscal 2019 gross profit, its effective earnings exposure in the unlikely event glyphosate was to be removed from the global market. This ignores any potential uptick Nufarm could earn from alternative herbicides. However, it also ignores the potential for legal claims against Nufarm.

Our Nufarm fair value estimate does not carry an explicit discount for glyphosate litigation risk. In addition to the argument of regulatory support, Nufarm is a formulator, not a maker of the active ingredients, and sells to less numerous but larger agricultural customers, not retail ones who are in dispute with Monsanto. So far, there have been no lawsuits against formulators and we think the risk to formulators is lower. Also, product labels are dictated by regulatory authorities, who do not recognise a causal link with cancer. This underlies our decision to suggest any glyphosate litigation discount in Nufarm. Our fair value uncertainty rating is already high, as it is for Bayer.

Our unchanged fair value estimate of AUD 7.00 per share for Nufarm equates to a fiscal 2023 EV/EBITDA of 6.7, and P/E and dividend yield of 13.3 and 2.1%. We assume annual average 4.7% compound growth in revenue to AUD 4.2 billion by fiscal 2023, at a 14.6% midcycle EBITDA margin. Our 14.6% midcycle EBITDA margin assumption is better than the five-year historical average margin of 11.4%, including an improved 12.1% in fiscal 2017, crediting favourable growth prospects, recent accretive acquisitions and cost-outs, and higher margin omega-3 canola.