Maintaining $70 FVE as Corteva Remains On Track for Long-Term Profit Growth; Shares U
Maintaining $70 FVE as Corteva Remains On Track for Long-Term Profit Growth; Shares Undervalued
Analyst Note | by Seth Goldstein Updated Feb 02, 2023
We maintain our $70 per share fair value estimate for Corteva following the company's fourth-quarter results. Our wide-moat rating is also unchanged.
Corteva shares were down around 5% at the time of writing as the market reacted negatively to management's guidance for 9% adjusted EBITDA growth in 2023 at the midpoint, down from 25% growth in 2022, despite continued favorable agriculture conditions. However, in our view, the company remains on track in transitioning its portfolio toward premium seed and crop protection products. Given our strong long-term outlook for Corteva, we view the selloff as unwarranted. With shares trading in 4-star territory, we view Corteva as undervalued.
Our favorable long-term outlook for Corteva is partially driven by our outlook for a rapidly growing biologicals market, which uses natural active ingredients, such as bacteria, to kill insects, weeds, and fungi. These products help farmers fight pests that are resistant to some traditional crop chemicals. We continue to expect biologicals will take market share from traditional crop chemicals as more new products are launched.
This should bode well for Corteva as the company is the market leader in biologicals, and management guided to over $1 billion in biologicals revenue in 2023 from existing products. Further, Corteva expects to close both of its biologicals acquisitions in the first quarter of 2023, which should boost the company's market-leading position. From a profitability standpoint, Corteva's biologicals are higher-margin products, so increased sales should boost profits and margins. We forecast crop protection EBITDA margins will expand from nearly 20% in 2022 to 25% by 2027.
Business Strategy and Outlook | by Seth Goldstein Updated Feb 02, 2023
Corteva is an agriculture pure play that was formed in 2019 when it was spun out of DowDuPont. The company is a global leader in seeds and crop protection products. In 2022, seeds and crop protection each generated around half of total company profits. Corteva develops its pipeline through the investment of around 8% of sales in research and development, which should allow sales and profits to grow from new products even as patents expire and generic products come to market.
Corteva's seed portfolio is skewed toward corn, which generated 66% of 2022 seed sales, and soybeans, which generated 20%. Although Corteva's market share in seeds is second to Bayer (Monsanto), the firm has worked to close the gap through the development of its proprietary genetically modified seed platforms, Enlist, Qrome, and Conkesta. GM seeds make crops resistant to damaging insects. Over the next decade, Corteva plans to launch 10 new corn and soybean seed products. While anti-GMO consumer sentiments may limit Corteva's growth into developed markets such as Europe, the need to improve crop yields globally should lead to eventual GMO adoption in emerging markets.
In Corteva's crop protection segment, a little over half of sales come from herbicides, which complement GMO seeds and should see increased demand. Conversely, we see demand for insecticides, which made up 22% of crop protection sales in 2022, falling over the long term due to an increase in GMO seeds. However, Corteva's new insecticides will use new modes of action to target resistant bugs, such as environmentally friendly biologicals. Corteva aims for biologicals to generate 25% of crop protection sales by 2035.
Corteva is rebuilding its crop protection portfolio after having to sell a sizable portion of premium legacy DuPont's crop chemicals products to FMC in order to gain regulatory clearance for the DowDuPont merger. Corteva has launched new products and will continue to commercialize its strong pipeline. As a result, in 2021 50% of crop protection sales came from premium products, up from 14% in 2018, the year before Corteva was spun off. We forecast premium products will eventually generate 60% of segment sales.
Economic Moat | by Seth Goldstein Updated Feb 02, 2023
We award Corteva a wide economic moat rating based on the company’s portfolio of patented biotech seeds and crop chemicals. The company's patented products command pricing power as they protect farmer yields and reduce other expenses such as insecticides. Corteva's intangible assets stem from the research and development spending required for the continual development of proprietary seed and crop chemical formulations. As patents expire and bugs develop resistance to current products, seeds with new traits and new chemical formulations must be developed. As a result, moaty businesses in this space must continue to invest in R&D. Corteva's R&D as a percentage of sales tops all major competitors, with the company investing roughly 8% of sales in new product development each year. This level of investment is in line with peers including Bayer (Monsanto historically averaged around 10%), Syngenta (9%), and FMC (7%), which gives us confidence that Corteva is investing enough to continue to successfully develop new products.
Before the merger between Dow and DuPont, DuPont’s agriculture business was second to wide-moat Bayer in biotech seeds and had built a solid position in the market, controlling a strong germplasm, or seed bank, and a capable distribution and marketing operation. DuPont had even bested Bayer in recent years on the marketing front with its more regional strategy.
Additionally, Corteva's Enlist (soybean) and Qrome (corn) genetically modified platforms set the company up for long-term success as GM seeds are adopted in emerging markets. The GM seeds have also had two key product wins over Bayer in the last couple of years. In 2018, Qrome corn seeds were the first GM corn approved for import into China. In 2019, Enlist soybean seeds were approved for import, before a Bayer soybean received the same approval. We think import approval is the first step toward eventual GM adoption. Although Corteva has yet to leapfrog Bayer on the technology front, it is beginning to close the gap and maintains a portfolio of patented traits that are difficult to replicate. As a result, Corteva should maintain its position as a clear number two and formidable competitor to Bayer.
Further, Corteva has begun to license its Enlist platform technology to other seed companies, which sets up the seed business for a steady stream of profitable licensing royalties. In addition to the royalties, Corteva's licensing strategy will reduce competition. As potential competitors license a Corteva technology instead of developing their own, they are more likely to spend R&D toward enhancing the base technology rather than invest in products that could usurp market share from Corteva's seeds.
Fair Value and Profit Drivers | by Seth Goldstein Updated Feb 02, 2023
Our fair value estimate of $70 per share is based on a discounted cash flow valuation. Our weighted average cost of capital for Corteva is 8.2%. Our Stage II EBI growth rate is 5%, which reflects Corteva's pricing power from the development of new patented products that underpin our wide moat rating. Our valuation includes the $1.2 billion acquisition of Stoller, which we forecast will boost crop protection sales and profits.
We forecast mid-single-digit average annual sales growth during the next five years as the firm successfully develops new seed and crop chemical technologies. As Corteva sells a greater proportion of patented and differentiated crop protection products and seeds, we expect companywide EBITDA margins to expand from 18.5% in 2022 to nearly 24% by 2027.
Over the next couple of years, we see a step change for Corteva's margins and cash flow as the licensing agreement with Bayer expires. Under the current agreement, Corteva pays Bayer a minimum of $1 billion per year to license the latter firm's Roundup Ready 2 soybean technology. However, Corteva is transitioning the vast majority of soybean seeds to the Enlist platform, which should expand profits as Corteva will not have to pay royalties. Further, Corteva will sell licenses of its seed and crop chemical technologies, which should increase profits.
Our base case assumes that Corteva pays a total of $640 million in PFAS-related litigation and cleanup expenses, which is the maximum liability under the agreement with DuPont and Chemours. We assume the first $210 million is paid over the next eight years through 2028, in line with the agreement to fund a PFAS liability escrow. Due to the unknown timing of PFAS payments, we assume the remainder is paid over the subsequent 12 years, which is in line with the 20-year agreement.
Although we forecast PFAS cleanup and litigation to cost $40 billion industrywide, we assume Historical DuPont (which includes today's DuPont, Corteva, and Chemours) faces a total of $6.5 billion in PFAS-related costs, with most with expenses coming from former Historical DuPont chemicals plants. We assume DuPont and Corteva pay a combined $2 billion over the next 20 years based on their agreement with Chemours. Based on the DuPont and Corteva liability-sharing agreement, the two companies will split the first $300 million in PFAS-related costs evenly. For all expenses above $300 million, DuPont pays 71% and Corteva pays 29%, which results in around $640 million in total litigation for Corteva.
Risk and Uncertainty | by Seth Goldstein Updated Feb 02, 2023
We rate Corteva a Medium Morningstar Uncertainty Rating.
Corteva must constantly innovate as patents expire or competitors develop new products. Weeds, insects, and fungi could develop resistance to seed traits or crop chemical formulations, rendering Corteva's technology ineffective. Demand for Corteva's seeds and crop chemicals is tied to unpredictable factors, including weather and crop prices.
Corteva, along with DuPont and Chemours, faces environmental, social, and governance risk from PFAS-related environmental cleanup obligations and litigation. Exposure to PFAS chemicals can cause adverse health effects, and we think drinking water levels will eventually become regulated by the U.S. Environmental Protection Agency, spurring additional litigation. The three companies face a risk in the ultimate size of PFAS-related liabilities, which could take decades to resolve.
Under a liability-sharing agreement, the three will share up to $4 billion in PFAS liabilities, with Chemours paying $2 billion and DuPont and Corteva paying the remaining $2 billion. DuPont will pay roughly $1.36 billion, while Corteva will pay the remaining $640 million. Chemours will indemnify DuPont and Corteva for any liabilities over $4 billion.
However, Chemours has high debt levels. Should Chemours become unable to pay, DuPont and Corteva could be on the hook for all expenses. Ultimately, Corteva remains at risk as long as there are outstanding PFAS-related lawsuits.
Additional ESG risks come from potential regulations. Products may be banned due to environmental concerns. While this risk has a moderate probability to occur, Corteva is developing more environmentally friendly products. As a result, we see a low materiality as new products would replace lost sales. Additionally, Corteva may face regulations on the emissions and waste from its own operations. We see a modest probability, but low materiality as Corteva should be able to pass along any additional costs to customers.
Capital Allocation | by Seth Goldstein Updated Dec 05, 2022
We assign a Standard capital allocation rating to Corteva based on our framework that assesses the balance sheet, investment decisions, and shareholder distributions.
We view Corteva's balance sheet as sound. We see high cyclicality risk from Corteva operating in the crop chemicals industry. However, we see low balance sheet risk as the company has generally carried cash and cash equivalents in excess of total debt.
We view management's investments as fair. Management has targeted investing roughly 8% of sales in R&D. We are in favor of this target as Corteva's long-term profitability ultimately depends on the company's ability to develop new patented products as patents expire and bug resistance increases. However, we view this level as the investment required for Corteva to maintain its portfolio of premium seed and crop protection products. Additionally, management has taken the approach to build its biologicals portfolio through a combination of R&D and smaller acquisitions. We think this strategy makes sense as Corteva can likely expand the market for the acquired biologicals products. Additionally, smaller deals reduce the risk of destroying shareholder value from overpaying for an acquisition. The Stoller acquisition was slightly larger than other deals at $1.2 billion, but we think Corteva paid a fair price. Given that Corteva was spun off from DowDuPont in 2019, we think it is still too early to evaluate the company's execution.
Finally, we think distributions are appropriate. Corteva should have sufficient cash flows to continue a healthy reinvestment in its business and maintain a healthy balance sheet. The current dividend seems appropriate. Corteva plans to use excess cash flow to repurchase shares, which we think makes sense.
Corteva has been under pressure from an activist investor to expand its margins and meet synergy targets from the DowDuPont merger and subsequent spinoffs. As a result, the company appointed four new board members. Three of the four directors were nominated by the activist investor.
Corteva CEO Chuck Magro assumed his role in November 2021. He brings a wealth of agriculture industry experience to Corteva. He was formerly the head of Nutrien, which was formed as the merger between PotashCorp and Agrium. Before Nutrien, Magro was the CEO of Agrium. Magro led the execution of the merger's cost synergies, which resulted in a solid integration of the two companies' potash and nitrogen production assets. As such, we think he is likely to focus on the execution of Corteva's strategy.
Management's long-term incentives are based on return on invested capital (75%) and operating EBITDA (25%). We are in favor of the ROIC metric as we think it encourages management to invest in value-added areas of the business.
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