ArborGen Holdings — Favourable balance of risk

ArborGen delivered FY21 EBITDA progress that was in line with its year-end guidance. This was despite some COVID-19 related market disruption to revenues during the year. The company also reduced net debt by US$2m to US$27m at the year end. ArborGen remains focused on capturing the value from its portfolio of advanced genetics seeds/seedlings through both increasing the volume of sales and improving the business mix.

Exhibit 1 clearly shows a typical heavy H2 trading bias to ArborGen’s reported results owing to the timing of the seasonal selling and planting season in the US market, which is ArborGen’s largest. This is partly balanced out by the New Zealand/Australia seasons, while South America typically has a more even selling period. At the EBITDA and EBIT levels, the revenue skew is counter-balanced to some extent by recognition of the appreciation in value of seedlings in the ground at ArborGen’s facilities (chiefly in the United States) during the growing season in H1 and this is substantially reversed in H2 when the seedlings are lifted and sold, realising actual proceeds. The COVID-19 pandemic did have some operational implications in both the US and South America, but the natural underlying seasonality of the business remained dominant.

Operational model: ArborGen’s seed orchards planted with its genetically superior trees produce seeds that are subsequently sown in nurseries, cultivated into seedlings and then lifted and sold to forestry owners to coincide with regional seedling planting seasons. Achieving seed orchard tree maturity to the seed-bearing stage can take around seven years. The selection of the parent trees and the degree of control over the pollination process is critical to yielding seeds and seedlings with superior properties. Mass controlled pollination (MCP) selects parent trees with the best genetic characteristics and controls the fertilisation process by isolating tree flowers (through bagging) and introducing pollen from a known parent. This contrasts with open pollination, occurring naturally where the flowers are not isolated and the other pollen parent tree is not known.

Activity in North America is concentrated in the US south-east where loblolly pine in particular is the prevalent forestry species supplied. ArborGen’s operations stretch from eastern Texas to the Eastern Seaboard with 10 seed orchards in five states – each with at least one nursery operation also – and a larger number of distribution locations together providing sales coverage in nine states in total.

US operations sold 294m seedlings in FY21, which was almost 12% below the prior year. In Q4 (13 January) management had flagged the twin issues of delayed log harvest levels and a shortage of site preparation/planting labour among customers arising from COVID-19 visa restrictions on migrant labour, which had a pull-through effect on seedling supplier sales. Nevertheless, North America revenues were only down by 4.9%, which indicates that average seedling selling prices firmed. The proportion of higher value (MCP and varietal) seedlings sold increased slightly to 31% of total loblolly sales and, by implication, the average price of those seedling types must also have risen such that the overall revenue impact of lower year-on-year seedling sales was dampened. This may have been partly due to the launch of the new MCP 2.0 variety during the year. As previously noted at the interim stage, prior year seed production had been affected by hurricane damage sustained at one seed orchard, but, in any event, the impact on FY21 seedling sales was probably less punitive than it might have been given that end market seedling volume requirements were themselves constrained. US operations were substantially sustained throughout the year partly due to the support of the government Paycheck Protection Programme (with income net of COVID-19 related additional costs included under other in Exhibit 1). Discretionary operating costs were otherwise closely controlled.

MCP seed activity undertaken during FY21 to benefit future periods was reported on favourably. Specifically, MCP seed harvested in Q3 increased significantly and could support a 30% year-on-year uplift in sales of this seedling category in FY22. In addition, the bagging and pollination of MCP producing mother tree flowers in the company’s seed orchards rose by 35% and this should feed through into further seedling production/sales volume increases in FY24. ArborGen has regularly referenced both an increase in seed/seedling production volumes and an improving mix with a higher proportion of advanced genetics and it is very encouraging to see the company report positively on tangible leading indicators in generating this outcome. The visibility this provides together with conversations with forestry customers, approaching half of which in revenue terms are under multi-year contracts, supports the company’s confidence in its strategy and outlook.

There is obviously always scope for some natural variation to occur in the pollination to seedling production cycle (shown in Exhibit 2), but where possible management is taking steps to strengthen business resilience to external events. Having a spread of operations across states is one example, as is managing the maturity profile of seed orchards and building inventory buffers over time. Continuous improvement of nursery management procedures and practices is also designed to optimise seedling output. At the same time, ArborGen continues to invest to further advance the performance characteristics of its advanced genetics seedlings (ie adding more value to forestry owners measured through quality and growth of planted trees) in order to reinforce its leading market share position in this segment. The progression of our estimates, in which US GAAP EBITDA is expected to double from FY21 to FY24 (see below), is substantially driven by ArborGen’s US operations and the projected uplift in advanced seedling sales.

ArborGen also has an extensive, vertically integrated seed orchard/nursey/distribution in New Zealand, which is the largest part of the Australasian operations. This is primarily focused on radiata pine species, again founded upon proprietary advanced genetics.

Of the 32m seedlings sold in Australasia in FY21, c 60% were controlled pollination (CP) types, so while the volume is obviously smaller than the US, the local market has already migrated further along the adoption of advanced seedling types. That said, total volume sales were down by c 17% versus the prior year; as reported at the interim stage, a lower demand pull-through from land owners under the NZ government’s one billion trees programme was the explanation for this. As the decline occurred in the lower value open pollinated (OP) seedling categories, the impact on Australasian revenues was limited to a c 7% y-o-y reduction in local currency (and c 4% in US dollar terms). Exhibit 1 shows that the regional seasonality is almost opposite to that in the US, and the financial performance was substantially generated in the first half of the group’s financial year. ArborGen NZ is developing its horticultural services reach into consumer crops such as hops and blueberries. This constitutes another revenue stream for the local operations, but is unlikely to be material in a group context in the near term.

ArborGen’s South American operations are entirely located within Brazil, with around three-quarters of seedling sales being eucalyptus and the majority of the remainder pine species.

FY21 sales volumes of c 65m seedlings was in line with FY20 levels, which was a reasonable outturn in our view, though ArborGen commented that sales were ‘materially affected’ by the COVID-19 pandemic. We believe that local currency revenues were down slightly – inferring no significant mix changes – but this was amplified to a c 24% drop in US dollar terms due to adverse FX movements. While a broadly similar mix would ordinarily feed into a comparable local gross margin, the company noted that some operational structural changes were beneficial. Specifically, bringing more nursery capacity under in house management reduced the cost of goods sold compared to the use of third-party nurseries. As importantly, this also brings greater control over the full seedling production process. In addition to its own proprietary advanced genetics offering, ArborGen has agreements in place to develop and commercialise eucalyptus clones from three separate vertically integrated industrial customers with in-house forestry operations (ie International Paper, Gerdau and latterly Vallourec). We presume that this means that ArborGen will be able to sell seedlings directly to these companies and also a broader range more widely to third parties. So, in conjunction with increased in-house production capacity, we see these developments as broadening ArborGen’s platform in Brazil and facilitating increased business momentum, subject to successful value-added seedling output development.

ArborGen is seeing positive indicators for future sales – including a c 70% uplift in orders and increasing end consumer capacity investment – though we note wider news reporting regarding low COVID-19 vaccination levels and still high mortality rates. Consequently, while many of the ingredients are in place for a sustained uplift in volume sales for ArborGen in Brazil, some near-term caution seems appropriate in our view.

At the end of FY21, ArborGen had a c US$27m core net debt position, which was lowered by c US$2m year-on-year. This was achieved in a challenging year and after significant investment in seed inventory, reflecting both increasing yields from maturing seed orchards and a strategic objective to build buffering against adverse climate events.

The rise in operating profit shown in Exhibit 1 together with depreciation edging up pushed FY21 EBITDA (on an NZ IFRS basis) up to almost US$15m, US$3m above FY20 levels. EBIT adjustments for non-cash items, including deferred grant income and FX, enhanced ‘cash profit’ by a further c US$2m. In operational terms, this was partly applied to an overall working capital absorption of US$7m for the year, dominated by c US$5m into inventory. Of this movement, seed investment (both finished goods and work in progress for sale as seedlings over the next three years) accounted for 70% of the total and the remainder was split broadly equally between the equivalent seedling categories. Consequently, operating cash flow in FY21 was US$10m and was just over twice the level seen in FY20.

Interest costs of US$2m were below the prior year and, as seen in previous years, no cash tax payment was made. As we have already seen, R&D spend (capitalised under NZ IFRS) was slightly lower year-on-year and ArborGen kept tangible fixed asset capex to US$1m. The latter figure was well down on the FY20 level (which itself was inflated by the US head office property acquisition) but also around half of what we would expect as a normal ongoing spend due to tight control of projects in the light of COVID-19 disrupted markets. As a result, group free cash flow after the above items was just above US$3m.

Lease principal repayments were just over US$1m in FY21 and, for the record, ArborGen had US$5.9m of IFRS 16 leases on the balance sheet at the year end. This was marginally up year-on-year and compared to right of use assets at the same date of US$5.8m.

Cash flow outlook: the primary and common features factored into our model across our three estimate years are rising profitability/EBITDA being more than sufficient to fund further investment in inventory (for the same reasons as above) and a normalisation of tangible fixed asset capex at around US$2m per annum. As a consequence, we have modelled net cash inflows slightly above US$4m for the next two years before a more material uplift in FY24 as increased availability of higher-value seedlings kicks in. Hence, we expect the core net debt profile to continue to trend down further to around US$11m by the end of FY24, which would represent net debt:EBITDA (US GAAP, after central costs basis) well below 1x.

Company guidance is for FY22 US GAAP EBITDA (before central costs) to be between US$13.0–14.5m. There are no material changes to our FY22 headline profit estimates, which are consistent with guidance and show a good uplift versus FY21. We have, however, varied the composition and this has a more significant impact on our previous FY23 estimate, as shown in Exhibit 3.

Behind these numbers, we have trimmed revenue and gross profit expectations, primarily driven by the commercial decision to flatten near-term OP pricing in North America. Consistent with the company’s Acquire, Build, Convert and Defend (ABCD) strategy, this is designed to encourage further market penetration as a precursor to migrating existing and new customers onto higher-value MCP and varietal seedlings as availability increases.

OP seedlings continue to represent over half of annual seedlings supplied in our three-year estimates and hence the revenue reduction feeds directly into gross profits. In FY22, this change is effectively offset by lower than previously expected opex costs. Moving into FY23, the OP pricing change has a larger impact at the gross profit level and a smaller proportion is offset in the opex line, resulting in a more material adjustment to our FY23 estimate. It is important to note that total expected North American seedling sales in our model in FY22 and FY23 are unchanged and some uplift in the absolute and proportionate number of MCP/varietal seedlings is already factored in. We should also state that there have been no other seedling category price changes apart from OP as described earlier, so our revenue and gross profit adjustments are almost entirely driven by this. We introduce FY24 estimates and, with an improving mix of MCP/varietal seedling sales in North America, expect another step up in profitability. We do not currently incorporate dividend payments into our model; based on our estimates we believe that the declaration of dividends is becoming a more realistic expectation based on increasing earnings and reducing net debt. That said, the company may have further growth ambitions – such as adding further US nurseries or expansion in South America – which would influence broader capital allocation decisions. We will revisit this issue with management during the current financial year.

ArborGen’s published chart for expected MCP supply availability forms the foundation for the relatively near-term estimate assumptions above. The bar chart (reproduced in Exhibit 4) shows projected MCP seed availability in seedling equivalents, noting that the corresponding seedling sales are in the following year.

Particularly noteworthy is the jump in seed supply from FY22 to FY24 – based substantially on flowers pollinated in FY20 and FY21 – supporting rising seedling sales. It is also worth pointing out that ArborGen’s eastern and western regions both contribute to this uplift; orchards in the former region were most affected by historical weather events and this is considered to be where supply is tightest relative to demand such that these forestry markets can absorb the volume increases expected beyond our current estimate horizon.

Updating our discounted cash flow (DCF) analysis for our latest estimates, rolling forward our 10-year illustrative estimate period and using the 10.6% discount rate employed in the company’s intangible asset investment and impairment modelling (see FY21 results note 16, page 14) generates a group equity value just above US$200m. This equates to a value per share of NZ$0.59 compared to the prevailing NZ$0.22 share price (270%).

While we do not have full visibility of the company’s assumptions, from the published information, we believe that our US sales volumes (and market share) are a little ahead of the company’s modelling, but with a lower proportion of MCP and varietal seedlings.