AVD - American Vanguard: Mixed Agriculture Outlook Don't Gamble

Summary

• American Vanguard is a cyclical investment on the agricultural industry.
• However, the current data is mixed and mostly suggests downside.
• Due to the risks, I would not recommend holding a position at the moment.

Introduction

American Vanguard ( AVD ) is a specialty agriculture product supplier, primarily with a wide range of chemicals for pest prevention and crop health. The company is diversified across most agricultural products and operates around the world, although most revenues are from the US. As a supplier to a commodity industry, agriculture, the company’s historical financial and shareholder return performance are cyclical. Therefore, the investment is not for risk-averse investors and timing is quite important.

In this article, I will highlight the mixed bag of data that shows uncertainty about whether the company is facing a bull or bear cycle, and how this increases the risk substantially. The main issues are that current commodity prices, such as corn and soybeans, are trading at all-time highs in expectation of the world's pandemic recovery increasing demand, geopolitics impacting supply, and inflation. However, some commodities are already in a bear market leading to significant losses. Also, financial performance is weakening, perhaps highlighting an early signal of a bear run.

Some may believe that the long-term demand for food and other agricultural products is a valid reason to invest in the long-term. I believe that patience may be a virtue and other buying opportunities will present themselves. Therefore, due to the uncertain short-term outlook and lack of a clear buy opportunity, I will not be taking the bet on American Vanguard. However, as a cyclical, the market changes quickly so I will discuss indicators that may suggest a better outlook and opportunity.

Biggest Risk

The biggest risk to American Vanguard is the collapse of agricultural product prices, primarily the main commodities of soybeans and corn. In the chart below, both corn and soybean prices are at all-time highs, and essentially flat over the past year. A rapid decline in prices has historical precedence as evident by the rapid commodity market decline of 2014-16 .

The unique mixtures of factors a decade ago will not be replicated, but similar factors in 2023 may lead to a similar collapse. The image below highlights the various reasons, but issues with slowing global growth, falling energy prices, a strong US dollar, and interest rate tightening are all scarily similar indicators. The problem is that demand and prices are remaining stubbornly high, particularly with major crops and energy, primarily due to political factors. If tensions ease, the spring planting season sees favorable weather, and inflation subsides with higher interest rates, I expect significant downward pressure on commodities.

The bear cycle is already beginning to affect some areas of the agriculture market. In fact, canola, oats, cotton, rubber, and palm oil are already down at least 20% over the past year, with many down further. While it is unknown whether the crops that are remaining expensive fall, I would hesitate to bet on higher prices any time soon unless further black swan events occur. Due to American Vanguards’ diversification, they have some ability to reduce weakness from these crops that are seeing weakness, but as I will discuss next, revenues are beginning to be impacted. As discussed by Gro Intelligence , the uncertainty of the next year is hard to predict, but expectations are skewed towards downside rather than upside:

As the world enters a third year of high food inflation, there are glimmers of hope that price increases for some core food commodities will ease, at least by the second half of the year. While prices for many staples are still well above historical levels, they are down sharply from their peaks reached last spring. Prices of fertilizers, essential for maintaining adequate levels of crop production, also have subsided, though they too remain elevated. And global inventories of a few key commodities — notably soybeans and palm oil — are looking more promising than at this time last year.

For the US, Gro’s US Food Price Index — which has proved to be predictive of inflation trends as much as six weeks ahead of official government reports — indicates that price pressures on food and beverage companies may start to moderate in the next 3-6 months.

Financials

AVD’s historical financials reflect the cyclicality of the commodity market, but certainly not to the same extent. This is primary due to diversification, the sale of innovative products that remain in high demand despite market weakness, and price controls. However, as evident by financial performance during the 2014-15 commodity shock, revenues declined rapidly and remained suppressed for years. Although, the commodity bull market of the past 5-7 years has allowed revenues to grow rapidly. But, good times can’t last forever.

Despite prices remaining high across many crops, revenue growth has been falling over the past year on a YoY basis. Therefore, it is expected that revenue growth will fall negative due to the tough comparables of 2022. It is just unknown whether a 2014-16 decline will occur, although the sentiment will be poor regardless. Permabulls can take solace in the underlying organic growth of the company as they increase their global presence, expand revenue segments, and find new customers. Also, upward momentum can be seen as certain due to the everlasting demand for food and rising populations that need to eat. However, cyclicality will be far more influential regardless of the secular opportunities.

Due to the cyclical nature of the investment, fundamentals can often be put on the backseat. For AVD, this means that during good times, the current leverage of 2-3x can be overlooked. However, when times get tough, the leverage will lead to sharp losses. We can also see that investors won’t be likely to see major buybacks or cash flows to be redistributed. Therefore, whether in for the long by steadily accumulating or looking for a capital gains trade, there are few financial catalysts or benefits in the short term.

Valuation Does Not Help

If the market was anticipating a decline in revenues, an investment in AVD could be viable, but the data does not suggest this. While the valuation looks low, even below the 20 year mean, this is due to the strong results of the past year. If and when revenues decline, the valuation will not be as low. If a reversion to the mean occurs, AVD would rise 33%, but revenues and earnings could fall by an equal percent, nulling the upside. I prefer to look for a true sell-off and record low valuations before investing. Also notice how despite the strong revenue growth during the GFC in 2008-2010, AVD’s valuation fell due to poor market sentiment. This is just another factor that suggests downward pressure on the current share price.

With cyclicals, historical patterns are quite useful to use in anticipation of a buy. One particular situation is the period before the 2014 commodity shock. In that time, the shares had risen over 900% in just a few years during the bull cycle, but then fell by over 70% over the next few years. AVD has yet to return to those highs, and a breakout seems unlikely.

American Vanguard of 2022 and 2013 look similar, i.e. falling revenues and a high valuation, and this may be an indicator of a sharp fall to come. This risk is hanging heavily over the stock, but the lifeline is the potential breakout above the $25-30 price range, which would be the result of prolonged sales growth and no commodity price crash. The problem is that the upside would only be 30-40%, and revenues are not expected to grow this much, leading to overvaluation and further downside pressure.

Conclusion

At the moment, I expect two scenarios for AVD shares. First, the downside is limited due to remaining high crop prices and lowering supply chain expenses. While this may lead to some upside, I believe the probability of this occurring is low. With the risks, the upside is not presenting a favorable reward position. Therefore, the second scenario is that revenues and the valuation will fall, and this will lead to far better investment opportunities. I would prefer to invest when the outlook is poor and AVD bottoms out. Therefore, I will remain on the sidelines, and will look for crop prices to fall, the valuation bottoming out around 2015 lows, and this would correspond to a significant reduction in share price. For now, I will put a notification for when American Vanguard’s price falls below $15 per share, or a fall of 30%.

Thanks for reading.

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