Genus breeds success

A rocky outlook for pork prices in China caused producers there to cut back their sow herd in response, thus reducing significantly the demand for Genus’ palette of porcine semen genetic material. The relative uncertainty over the outlook caused us to row back on our buy tip in September. However, with the share price rolling back significantly from its year highs, it looks like a good point to reassess the situation and ask whether Genus could now benefit from investors looking for a quality share with good relative value. Genus’ shares have never been cheap and, unless you were able to pick them up in the aftermath of the financial crisis, the premium the company has always attracted reflects its command of the vital, and technology demanding area of animal genetics.

China is key

Genus’ end markets are notoriously inflexible, as anyone with any experience of agriculture can testify. Supply is largely inelastic, while prices and demand can be highly volatile. Genus benefited in the early part of 2020 from a huge undersupply of pork in China, along with associated price rises, which resulted in large producers upping their stocking rates after a serious bout of swine fever in 2019 decimated some herds. The resulting oversupply this year has meant that prices fell from a high of 35 yuan per kilogram to just 15 yuan per kilogram in October. The response from producers has predictably been to cut back their breeding sow herds to clear the backlog, which has fed through into reduced demand for Genus’ genetic material.

However, it is worth noting that since Genus reported its last annual results, pork prices and futures in China have risen. In the past month, prices for deadweight pork have started to recover and now stand at 18 yuan per kilo, although still below the cost of production for smaller producers. China has the world’s largest commercial pig herd and its importance to Genus cannot be understated. For instance, volumes at Genus’ PIC pork genetics business grew by 11 per cent in 2021, but if China is excluded this falls to 5 per cent. This has a double impact in that PIC’s profit contribution to Genus is three times greater than the ABS bovine business. As a result, analysts have shaved their estimates for adjusted pre-tax profits by an average of 6 per cent for 2022 to reflect the disruption in China. The overall impact on Genus is likely to be headwinds into 2022, before a return to decent growth the following year, given the inflexibility of the supply and demand cycle.

There is also no doubt that there are some rotational factors at play that have had a technical impact on Genus’ share price. For instance, the relative underperformance of emerging markets versus the US, particularly, has caused a general rotation from companies that generate a significant proportion of their earnings in the region – and Genus is not alone in discovering the collateral impact of hot money investment strategies that care little for fundamentals.

The moats are wide

The barriers to competition for this kind of business are less a moat and more a small inland sea. The company’s 16 per cent global market share of pork genetics is the size of its next three competitors combined. Meanwhile, in bovine genetics, Genus ABS is number two in the global market going head-to-head with the likes of Semex, primarily in the large dairy herd markets of the US, Europe and New Zealand. Research and development (R&D) is as time-consuming and intensive as in any precision industry,as achieving fine-tuned genetic improvements can mean measurable productivity gains for farmers at a time when achieving greater efficiency is becoming ever more difficult in the industry.

Much effort must go into breeding and researching the genetic traits that pig, beef and dairy farmers will pay serious money for (semen per gram is worth more than gold) in order to boost their production. As an example, the highest price ever paid for an Aberdeen Angus bull was $1.5m in 2019 with the owner, probably a syndicate, able to draw thousands of straws of semen over the productive life of the animal. Prices per straw vary hugely, but some preserved examples from particularly prized animals can go for $6,000 each.  

At the last results, Genus reported that its R&D spending was £62.9m a year, with a focus on areas that require high levels of technological capability and expertise, such as gene editing. For instance, Genus can edit its semen so that farmers can control the ratio of male to female animals within the herd. Alongside the latest in biotechnology capability, it also must maintain large herds of animals around the world as part of its breeding program – a series of bull points, it might be said – either directly owned or via joint venture or partnership agreements. In agricultural businesses, relationships matter above all else and being first with an established reputation can ensure repeat business over decades, which is yet another moat that competitors would have to cross.

The central operation is very lean given Genus’ global reach. The company only has 40 employees at its administrative core and operating costs have been only about a fifth of the total over recent years. Therefore, it seems able to generate high levels of operational leverage from a very narrow base, which also places the high level of R&D spending into context.  

A game of monopoly

Genus’ current forward price/earnings valuation for 2022 of 51, falls to 43 in 2023, according to earnings per share forecasts from broker Numis, which compares favourably with a peak valuation this year of 66 times earnings for the year. Genus’ share price has similar characteristics to the flashier sort of technology share. While there is a superficial similarity between industries that are R&D heavy, the main reason for the common high valuations is that investors recognise a quasi-monopoly business when they see one.

Another consideration with Genus’ high reliance on intangible investments, such as R&D, is that profits tend to be understated. This is because unlike tangible investments in things like property and machinery, most intangibles are treated as day-to-day costs. Tangible investments have their costs matched to the benefits they produce over their productive life. This is done by capitalising the tangible investment as an asset and depreciating it.

Fortunately, we can crudely adjust for the accounting discrepancy by treating  intangibles as though they were tangibles (we “capitalise” and “amortise” R&D along with a third of operating costs as advocated by accounting academics). This rough-and-ready adjustment suggests Genus’ reported profits last year would have been about49 per cent higher were it not for the weird accounting quirk. From this perspective, we’re arguably looking at a stock priced in the low 30s based on forecast, intangible-adjusted earnings. 

For what it does, Genus has few serious challengers and its main problem, as exemplified by China, is dealing with the inelastic supply issues that are part and parcel of modern agriculture, and which has always been the case. The base investment case has not changed and since the share price and valuations have now returned to the levels of our original buy advice we have no hesitation in backing a porky valuation for Genus based on the idea that the wheel will turn again next year. Buy.