Ag Growth International Inc T.AFN.DB.J

Scotia Report - Very Bullish

[SunsetGrill]

• Pertinent Data
• Pertinent Revisions

Valuation: 8.5x EV/EBITDA on our 2023E
Rating	Sector Outperform
1-Yr. Target	C$52.00
AFN-T	C$30.56
1-Yr. Return	72.1%
Div. (NTM)	C$0.60
Div. (Curr.)	C$0.60
Yield (Curr.)	2.0%
ESG Score	NA

Capitalization
Market Cap. (M)	C$575
Net Debt + Pref. (M)	C$930
Enterprise Value (M)	C$1,505
Shares O/S (M)	19

Agriculture

Ag Growth International Inc.

• AFN-T: C$30.56
• Target: C$52.00
• Rating: Sector Outperform

Poised to Deliver on Deleveraging

OUR TAKE: Positive. Recent market weakness has been somewhat punishing for small caps with elevated leverage. However, ag names have held up and AFN’s strong backdrop, record backlog, and healthy pipeline should sustain its profit growth through our forecast horizon. Combined with lower steel prices (and shorter lead times), we believe its FCF is poised to accelerate (>$110 million in N9M). For a name with a relatively depressed valuation, where FCF generation and deleveraging is a primary catalyst, we see an opportunity here.

While we appreciate the risks to a slowdown in capital goods spending, higher crop prices and the need for better food security (globally) are likely to buoy incremental spend in grain infrastructure. As such, we think the backdrop remains supportive for positive earnings surprises. From a share price perspective, at a minimum, the ~$6/share of FCF we forecast in the N9M should help drive an increase in equity value; further upside can materialize assuming deleveraging and cycle strength drives multiple expansion.

KEY POINTS

Let’s talk about cash flow. As the war in Ukraine immediately expanded steel lead times, the company pre-bought steel late in 1Q to ensure the timely execution of its backlog. We think easing steel costs and lead times will enable it to unwind the majority of its 1Q WC investment ($80 million; ~$4.25/share) through 2022 (primarily in the 2H22). We believe a combination of higher profits and strong FCF conversion (we forecast ~$215 million through 2023, excl. provisions) will provide investors with incremental visibility on AFN’s deleveraging.

It’s more secular… than cyclical. Farmer incomes may have peaked in North America, but that is not the main driver for AFN. Based on its backlog/pipeline (and outlook, based on our discussions with mgmt.), its positive market share trends in the U.S. and Brazil, the multi-year investment cycle (secular) in food/grain infrastructure, we believe AFN’s profit growth can extend through a macro slowdown. Near-term sales momentum and margin expansion initiatives (and lower steel prices) could drive positive earnings surprises.

Sticking to our guns. We upgraded AFN early in 2022. Our thinking was: (i) the backdrop was favorable, (ii) following several years of heavy capex/M&A investment, AFN is going into harvest mode, (iii) the bin failure issue has been contained, and (iv) profit growth, WC efficiencies, and lower steel prices, would accelerate FCF and delever the B/S. We believe such drivers should move AFN shares from its 10-year low multiple of ~7x EV/EBITDA on our 2022E to a multiple closer to its historical average of ~9x. We forecast FCF (excl. provisions) of $215 million (or ~$11.50/share) through 2023. Debt repayment and multiple expansion should accrue significant gains for shareholders.

• Quarterly Financials
• Yearly Financials

Historical price multiple calculations use FYE prices. All values in C$ unless otherwise indicated.
Source: FactSet; company reports; Scotiabank GBM estimates.

Note: The payout ratio is calculated based on dividend as a percentage of FFOPS.

Qtly Adj EBITDA (M)	Q1	Q2	Q3	Q4	Year	EV/Adj. EBITDA
2020A	$26	$44	$52	$28	$149	9.0x
2021A	$39	$46	$46	$45	$176	8.1x
2022E	$41	$57	$61	$46	$206	6.8x
2023E	$39	$62	$62	$50	$213	6.5x

Of the U.S. large cap equipment/machinery/industrial names, the ag names (AGCO-US and DE-US) stand out as some of the best performing YTD (see Exhibit 1). Agriculture equipment names often outperform when the market starts to worry about recession risks. Higher crop prices and healthy farmer incomes are also helping. While a small cap name, we argue the backdrop for AFN remains highly supportive for a strong/extended sales cycle given the need for countries to invest in food/grain infrastructure due to the heightened food/grain security issues in several regions. Combined with its strong FCF and anticipated deleveraging, we believe AFN shares can outperform.

 

Exhibit 1 - Agriculture Names are Holding Up

Source: FactSet; Scotiabank GBM.

Exhibit 2 - WC Unwind to Provide FCF Windfall

Source: Company reports; Scotiabank GBM estimates.

The underlying story here: AFN is going into harvest mode. Between 2016 and 2020, AGI deployed $240 million on capital expenditures and $400 million on acquisitions to diversify its geographical footprint, expand its food platform, develop its technology segment. During this time, leverage remained elevated between 4.0x and 5.0x net debt to EBITDA. Adjusted EBITDA margins compressed from 16.3% to 14.9% as the company ramped new operations, made investments in talent, built out regional offices, automation, and incremental capacity. ROIC also compressed from 12.5% to 8.0% due to the significant amount of capital invested. With the investment phase largely complete, management is now focused on generating FCF and repaying debt. With its current platform (i.e. broad product offering and extensive geographic presence), management also believes it can drive significant organic growth and return margins to historical levels. We expect ROIC to normalize in the next several years as the company enters its ‘harvest’ stage.

• Deleveraging is a top priority. Based on our conversations with management (and investors), deleveraging is a top priority. The company is targeting a leverage ratio closer to 4.0x net debt to EBITDA by the end of 2022 with a longer term goal of 3.0x. Lower steel prices and shorter lead times will enable the company to manage inventory days back to normal levels by the end of the year, in our view. Combined with WC efficiencies, we believe AFN can unwind up to $80 million of WC in the N9M (we forecast ~$55 million). Excluding the estimated impact from the bin failure settlement (provisions account for a $65 million cost), we forecast FCF of $215 million through 2023.
• Margin uplift might come soon. Management is targeting margin improvement of 100bp to 200bp (from 2021 levels of 14.7%) over the next 18 to 24 months. Aside from modest improvements in gross margin, management expects the primary contributor of margin expansion to come from operating leverage. We believe lower steel prices and easing supply chain issues, combined with increased operating leverage in the next couple of quarters will provide margin upside and potential positive earnings surprises (versus our/consensus estimates).
• Foundation set for growth. Based on our conversations with management, there is confidence that the company can compound top line growth at a ~15% CAGR through cycles, by expanding its market share in certain regions, primarily Brazil and the U.S. The levers for share gains are particular noteworthy in U.S. Farm, where the company is aiming to go from a #2 to a #1 player in the region, and where it is gaining momentum with its expanded dealer network and technology offering. Brazil is seeing continued momentum both in terms of backdrop and share gains. Its Indian business is also expanding, both within India and the Southeast of Asia. While we appreciate the risks to a slowdown in capital goods spending, higher crop prices and the need for better food security (globally) are likely to buoy incremental spend in global grain infrastructure. Farm spending may also remain resilient (with upside in Canada in 2023).

Is the +$200 million EBITDA guidance for 2022 a low bar? We think so. When we hosted investor meeting with CEO Tim Close and CFO Jim Rudyk (on May 12th), they had noted that essentially all the company’s end-markets (except for Western Canadian Farm) were experiencing strong momentum. The war in Ukraine has temporarily eliminated the business conducted in the region (i.e. about 3% of revenues), but was quickly replaced with work/activity in North Africa as the region looked to bolster their grain infrastructure given the related risks around food/grain supply. Brazil continues to hit its stride (the pipeline is strong and backlog is expect to keep growing). As already discussed, we believe there is upside risk to margins in 2Q and 3Q driven by higher operating leverage and lower steel prices.

A few offsetting modifications. We modestly lowered our 2023E EBITDA (for conservatism) and trimmed our valuation multiple (given the recent compression across peers). Our higher FCF (and debt repayment) assumption offsets these adjustments.

 

Exhibit 3 - Deleveraging to Act as a Positive Catalyst, in our View

Source: Company reports; FactSet; Scotiabank GBM estimates for Ag Growth International Inc. For companies with FYE other than Dec. 31, we have included their results in the nearest calendar year.

Exhibit 4 - Trading at Lowest Level in a Decade

Source: Company reports; FactSet; Scotiabank GBM estimates.

Exhibit 5 - FCF to Support Higher Equity Value

Source: Company reports; Scotiabank GBM estimates.

Exhibit 6 - Financial Forecasts (in C$ million, unless noted otherwise)

Source: Company reports; Scotiabank GBM estimates.