Agriculture consolidation offers food for thought

On the list of the year’s largest mergers and acquisitions we find a number of companies from the agricultural sector, particularly within seeds and pesticides. Food production globally needs to increase by around 70 percent by 2050 to support the world’s population.

The German company Bayer is bidding for the US company Monsanto, the Chinese are trying to acquire the Swiss company Syngenta, while in the US they are working towards merging the chemicals giants Dow Chemical and DuPont.

At SKAGEN, we have followed the agricultural sector with interest over the past few years, because it benefits from attractive, long-term demand and a good selection of quality companies, amongst other things.

The world’s population is expected to increase by 32 percent from today’s level to almost 10 billion people in 2050. We know too that the combination of higher income and urbanisation, like we are seeing in Asia, Africa and South America today, increases the demand for food. This comes both in the form of a higher calorie intake and a change in diet to include a larger proportion of animal protein.

Food production must increase

The result, according to calculations from the UN, is that food production globally needs to increase by around 70 percent from 2007 to 2050 to be able to support the
world’s population. To put it simply, there are only two ways to increase production – more cultivated land and greater efficiency.

The challenge is that global farmland is scarcely expected to grow between now and 2050. There will likely be a careful increase in developing markets, mainly in South America and sub Saharan Africa, but there will be a decrease in developed markets. We will therefore need to produce significantly more with around the same resources. This means that those who can offer products and services that contribute to improving efficiency are well positioned for the future. However, from an investor perspective, good growth prospects are not sufficient. The companies must also have a strong enough competitive edge to avoid falling victim to ruthless attacks from other participants. In addition, the valuation must be such that we get more than we pay for.

Good companies within the pesticides industry
We have found a number of good companies within the pesticides industry. Globally the industry is concentrated around the six largest companies, which jointly control
around three quarters of sales. Furthermore the current wave of consolidation will lead to an even higher market share for the largest companies.

As a result, farmers and distributors have limited negotiating power in meetings with global producers like Syngenta or Bayer. Such relative strength gives greater scope for price hikes and attractive margins over time, which is of course positive for us as investors in the companies.

The large market participants also beneft from economies of scale, which in turn create important barriers to entry for potential competitors. Product development, for example, is demanding, time consuming and requires substantial resources. It can take up to ten years and cost as much as EUR two hundred million to develop
and gain approval for a new pesticide.

In addition, a signifcant amount of global experience and capacity is needed to get the necessary legal permits in place to sell the products as well as a substantial network to distribute to a large number of farmers and distributors on different continents.

Given that the large companies have broad product portfolios adapted to a number of crops and geographies, we see that potential competitors must overcome large
obstacles before they can be a serious threat to the established players.

These types of economies of scale and entry barriers have resulted in extremely good return figures for the market leaders. Operating margins of over 20 percent and
return on equity well above average for listed companies are not uncommon.

The challenge with these quality companies is that they are often priced accordingly. Monsanto, the world’s leading seed company and a notable player within
pesticides, was for example priced at between twenty and fifty times earnings from 2005 to 2015.

An interesting sector
The reason that we as value-based investors have taken an interest in the sector now is that the prices of important agricultural products such as corn and soybeans
have fallen significantly over recent years. Lower income has forced farmers to cut investment, while agricultural suppliers’ earnings have slowed and share prices have fallen.

Just over two years ago SKAGEN Kon-Tiki bought a share in the global generic crop protection, chemicals and seeds company, UPL , headquartered in India. The company was not among the 50 largest in India and so did not make it onto the radar of many large investors. In addition, UPL is generally compared with its Indian peers, even though it has a global reach and only 20 percent of its sales come from India.

Despite very good growth, growing margins and an attractive positioning as a generic supplier of pesticides at good prices, the company was extremely low
priced. With a P/E of less than 10x and EV/EBIT of 6x, there were no expectations of future success.

Two and a half years later, UPL has grown faster than all of its competitors and delivered increasingly high margins. We still have a signifcant holding in UPL, and have spent time getting to know the industry and the competitors. In the wake of the consolidation that is currently underway, we believe that vigilant investors will be able to find interesting investment opportunities in the time to come.

Erik Landgraff, portfolio manager at Skagen

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