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Genus continues to outperform

Genus' scarcity value means its shares are expensive, but long-term investors could still do well from owning them
Genus continues to outperform

Genus has many of the hallmarks of a very good business and that goes for the value of its shares as well. They can still reward investors with a long-term perspective.

 

Genus continues to outperform

When I look at a company for the first time these days, I increasingly ask myself a very simple question: Why does it exist? Companies with a purpose – other than making money – to make their customers' lives better in a way that not many others can copy often make good long-term investments.

Animal genetics company Genus looks as though it fits the bill in many ways. Its aim is to use genetics to help farmers breed better pigs and cattle so that they can sell better quality meat and milk. Genus is the world leader in this kind of technology and is the only listed business practising it. Its competitors are mainly private companies and farmers’ cooperatives with a regional rather than Genus’s global focus.

Genus exists to solve a growing problem in the world of animal farming. Despite the growing trends of vegetarianism and veganism, the global demand for pork, beef and milk is expected to grow steadily at around 1-2 per cent for the next decade.

The problem with this is that to fulfil this demand will put more strain on the environment in terms of land and water use. Farming therefore needs to be more efficient and do more with less. Consumers also want higher quality meat and dairy products that are not pumped full of drugs. This is where Genus comes in. Genetically superior animals can produce more efficient and better quality animals that can sustainably meet the demand.

Better quality means several things:

  • They need less food to produce the same quantity of meat and milk
  • They grow better and faster.
  • Are more resistant to disease.
  • Have better protein and fat content
  • Have better fertility.

Genus employs a team of scientists to analyse animals’ DNA and then selects animals with the right genetic profile to be used on its own and partners’ herds to breed better quality offspring. A successful gene technology can also be leveraged across different breeds to maximise its commercial potential.

 

How the business is set up

Genus is a global business with a leading presence in the major pig and cattle breeding markets, including North America, Latin America (especially Argentina and Brazil), the UK, France, Denmark, Russia and China.

The business is split into three separate divisions. Its porcine (pigs) business trades under the PIC name, while the beef and dairy business trades under the ASB name. The company also has a substantial research and development (R&D) division.

 

 

PIC

PIC is the global leader in porcine genetics. The business is underpinned by a substantial number of biological assets in the form of genetically superior pigs located across the world. 

PIC has 10 elite pure-bred pig lines with more than 40,000 boars and 500,000 pigs. The animals are owned and looked after by PIC at stud farms or contracted out to third-party multiplication farms (these are farms with grandparent sows).

Revenue is generated by selling genetically superior sows, boars and semen to farmers so that they can breed better pigs with better meat and protein quality. Sales are made directly or through third parties. A large chunk of revenues are now linked to multi-year royalty contracts. Here the pricing of contracts is explicitly linked to the value added to the farmer and gives PIC a better quality of revenue than a one-off sale. The royalties are linked to performance measures such as:

  • Pigs born per litter.
  • Litters per sow.
  • The slaughter weight of animals born. 

Royalties also give a degree of resilience to PIC's revenues. When pig prices are weak and farm profits are low the level of investment by farmers tends to fall, which can mean lower sales of animals, semen and embryos. With royalties, PIC still receives an income stream from the ongoing production at a farm.

As well as investing in new genetic technologies, Genus has been building up PIC by partnering with other pig-breeding and genetics companies in recent years. In 2017, it entered into a strategic partnership with Hermitage – one of Europe’s oldest pig breeding and genetics companies – by purchasing its genetic rights and intellectual property. 

In 2018, it partnered with Mollevang of Demark to distribute PIC's products while incorporating its genetics into its existing business. This has significantly enhanced PIC's European distribution capacity and has enabled it to take a bigger slice of the market in recent years.

In PIC, Genus has a business that has very high barriers to entry with high levels of product differentiation selling into a consolidating customer base. The business is very difficult for a new entrant to copy as not only does it need cutting-edge genetic technologies, but also scale and distribution capability.

These characteristics mean that PIC is a very profitable business. In the past couple of years it has benefited from taking market share, setting up new multiplication farms and the fallout from African Swine Flu (ASF), which has decimated pig herds in China and other parts of Asia.

ASF has led to a shortage of pigs in the Chinese market. The rebuilding of stocks has created significant demand for Genus’s products as the increasingly large Chinese pig farms look to build up their herds with genetically superior pigs.

One encouraging sign of a successful business is one that can grow by selling more (volume) rather than raising prices (but it helps if it can do both). PIC’s long-term record of volume growth is consistent, and in recent years has been very good.

After a flat year in 2019 with the fallout from ASF, strong Chinese demand saw the business deliver very strong growth in 2020.

Profitability also surged last year with the business continuing to produce very strong margins.

 

 

PIC: Revenues & profits

£m

2016

2017

2018

2019

2020

Revenues

207.5

249.5

247.7

253.7

298.8

Op Profit

71.7

87.7

88.7

93.1

113.3

margin

34.6%

35.2%

35.8%

36.7%

37.9%

Source: Annual report

 

ABS

ABS makes money by selling bull semen and embryos for artificial insemination to breed better cattle. ABS’s principal assets are its more than 800 elite dairy and beef bulls located across the world’s major breeding markets.

This business is not as attractive as PIC. It has lower barriers to entry and sells to a more fragmented customer base that struggles to make money from time to time.

Dairy farmers across the world have long struggled to make decent profits. Volatile milk and animal feed prices have squeezed many of them, which has led to consolidation into superfarms.

Beef farming has also had its ups and downs. The ongoing Covid-19 pandemic has wreaked havoc on meat processing facilities across the world and led to an oversupply of beef cattle and a falling beef price.

ABS’s sales volumes have been more volatile than PIC's and the business is nowhere near as profitable.

Like PIC, Genus has invested in the business to enhance its competitive position and improve its offer to customers. It has good control of its genetics thanks to its partnership with de Novo, which gave it the ability to produce genetically superior bulls.

It has also benefited from the strong sales of sexed semen – sold under the Sexcel brand – which is attractive to dairy farmers as it gives a greater probability of producing a female calf and therefore improving the efficiency of the herd.

This welcome development has not been without its problems. Up until 2014, ST, a US company had a monopoly in the sexed semen market in the US. Genus used to have a commercial relationship with ST, but since it started its own production there has been trouble between the two with both suing each other. Genus took a £15m hit to its profits last year as a judge ruled in favour of ST.

Genus is still continuing to roll out its Intelligen technology, which enables farmers to produce Sexcel across the world.

ABS is also successfully rolling out its beef-on-dairy genetics products. This is where beef genetics are used to maximise the quality and profitability of dairy calves for beef production. It can significantly increase their value compared with conventionally bred calves.

 

ABS: Revenues & profits

ABS £m

2016

2017

2018

2019

2020

Revenues

172.8

195.9

210.6

222.6

237.6

Op Profit

23.3

22.3

26.1

29.9

32.5

Margin

13.5%

11.4%

12.4%

13.4%

13.7%

Source: Annual report

 

R&D

Genus has been spending increasing amounts of money on research and development each year. This has not only protected and enhanced the existing competitive position of its genetic herds, but also paves the way for new products to deliver future revenue and profit growth.

The main areas of R&D focus are:

  • Gene editing to create disease-resistant breeds.
  • Genome science. 
  • Biosystems engineering.
  • Reproductive technology.

Genus expenses the vast majority of its R&D spending in its income statement. Annual spending has increased significantly from £34m in 2016 to £65m in 2020. R&D as a percentage of revenues has increased from just under 9 per cent to nearly 12 per cent over the same period.

 

Financial performance

If you were using a stock screener to find businesses with a high return on capital employed (ROCE), then Genus would be unlikely to feature as one of your candidates. 

This is because if you calculate capital employed (my definition is total assets less non-interest-bearing current liabilities) from its balance sheet you will include the value of its biological assets stated at fair value. Fair value is based on the future cash flows its pigs and cattle are expected to produce discounted back to a present value. The figures concerned are substantially higher than the cash paid for them – their historical cost.

Genus’ return on operating capital employed (capital employed less goodwill paid on acquisitions, or ROOCE for short) was a very modest 10.8 per cent in 2020, which many people would view as not particularly good and the sign of a solid rather than very good or exceptional business.

This could quite easily see the less diligent investor using balance sheet numbers dismiss Genus as a potential investment. This could be a mistake as the fair value of biological assets is more than £300m greater than their historical cost. When ROOCE is calculated on historical money invested it comes out at a far more impressive 20.7 per cent for 2020.

 

Genus: Key financial performance measures

£m

2016

2017

2018

2019

2020

Revenue

388.3

459.1

470.3

488.5

551.4

Adj Op Profit

48

56.5

57.7

61.9

70.2

Net Profit

36.9

42.31

46.5

46.2

55.4

Free cash Flow

14.4

23.3

23.5

6.5

23

Invested Capital

667.4

712.7

658.2

722.6

757.7

Operating Capital

581.4

608

556.2

616.3

652.1

Adj Operating Capital

269.5

284.2

244.2

328.3

339.4

      

Operating margin

12.4%

12.3%

12.3%

12.7%

12.7%

Free cash flow margin

3.7%

5.1%

5.0%

1.3%

4.2%

FCF Conversion

39.0%

55.1%

50.5%

14.1%

41.5%

ROCE

7.2%

7.9%

8.8%

8.6%

9.3%

ROOCE

8.3%

9.3%

10.4%

10.0%

10.8%

Adj ROOCE

17.8%

19.9%

23.6%

18.9%

20.7%

Source: Annual reports/Investors’ Chronicle 

 

As Genus’ adjusted operating profits exclude the movement in the fair value of its biological assets then I think this version of ROOCE is reasonable.

Where Genus does not score as favourably is on its ability to generate free cash flow (FCF) and convert its profits into cash. Poor FCF generation can be a sign of a weak business and one that is overstating its profits. When you come across a company with these characteristics it’s important to identify why profits don’t turn into FCF and come to a conclusion as to whether it’s something to worry about or something that will resolve itself in time.

Genus’s poor FCF is down to four main things:

  1. Capex is more than depreciation.
  2. Joint venture profits are much larger than the cash dividends received from them.
  3. Cash pension payments are greater than the pension expense in the income statement.
  4. Exceptional one-off cash costs.

I think these should not give undue cause for concern. The company is investing for growth and spent money last year in new Intelligen production facilities, a new bull house and a new global enterprise system. All these should make Genus a better and more profitable business in the future and so the cash outflows are not a cause for concern, but a positive sign.

The pension fund deficit is under control and was only £18m at the end of June 2020. Cash payments into the pension fund have brought the deficit down and a chunk of it has been de-risked with the bulk purchase annuities from insurance companies. Cash payments may continue to be a drag on FCF for a while, but hopefully should moderate.

The company has a strong financial position with net debt to Ebitda of 0.9 times at the end of June last year and interest cover of more than 14 times.

 

Trading continues to improve with forecast upgrades

Genus’s strong trading performance in 2020 has continued into its 2021 financial year. PIC has continued to be very strong in China and the high levels of volume growth have continued. ABS has performed well in Brazil, Russia, India and China.

The company now expects half-year pre-tax profits for the six months to December 2020 to be in the £47m-£49m range on revenues of £285m-£287m. This compares with profits and revenues of £36.3m and £270.7m last year. Profits for the full year to June are now expected to be ahead of expectations.

Looking further out, there are good reasons to think that the momentum in the business can continue. PIC is well placed to take market share and to benefit from continued strong growth in China. ABS's Sexcel and beef-on-dairy genetics also look well placed.

Real excitement could come from the company’s gene editing research into developing pigs with resistance to porcine reproductive and respiratory syndrome virus (PRRSv). Steady progress is being made with this and the hope is that a commercial product could come out of it in the next few years.

 

Genus: Current forecasts

Year (£m)

2021

2022

2023

Turnover

592.7

638.4

687.1

EBITDA

106.2

115.5

130.8

EBIT

79.8

87.7

99.8

Pre-tax profit

82.4

90.8

103

Post-tax profit

60.8

69

81

EPS (p)

96.4

105.5

118.4

Dividend (p)

31.1

33.8

37.3

Capex

30.5

30.8

32.9

Free cash flow

31.9

42

70.3

Net borrowing

80.3

64.8

7.7

Source: SharePad

 

Before this week’s forecast upgrades are taken into account, City analysts were already forecasting average annual revenue growth of around 7.5 per cent and EPS growth of just over 11 per cent, with improvements in FCF and reduced indebtedness.

Unsurprisingly, this comes with a very high valuation attached to the shares. Assuming that second-half profits grow at around half the rate in the first half then the current pre-tax profit forecast for 2022 could be met one year early. At 4,621p this would put the shares on a forecast PE of 43.8 times. This is very expensive, but Genus is a scarce stock market investment that is well placed. Long-term investors could still do well buying the shares here.