American Vanguard: Pest-Free Investing

Successful investors accept the world as it is and don't try to contort situations to fit an idyll of what it should be. Consider farming: for those of us outside the realm, the economics can be as foul-smelling as an industrial cattle feedlot; what, with the subsidies, tariffs and usage quotas (think ethanol).

So what's an investor to do? Eschew the sector or deal with the world the way it is and inhale deeply. We prefer the latter action. From the inside, subsidies, tariffs and usage quotas can be as fragrant as French perfume, and we find the fragrance emanating from Newport, Calif.-based American Vanguard Corp. (NYSE:AVD) to be particularly intoxicating, though on first whiff you might think otherwise.

AMVAC is a small-cap purveyor of insecticides, fungicides, molluscicides, growth regulators and soil fumigants. Although it doesn't benefit directly from government handouts, its customers do.

AMVAC's niche of protecting soil-grown edibles from lower-form freeloaders is a fragmented, diverse market, requiring significant management input and ongoing product research. What's more, it's dominated by mature lower-margin commodity chemicals.

So what's the good news? Large chemical companies tend to be eager sellers of mature lower-margin commodity chemicals, and eager sellers create opportunity. AMVAC's strategy is to acquire these segments from multi-billion dollar conglomerates. In March, AMVAC acquired most of Bayer's cropscience assets related to its facility in Marsing, Idaho. Four months prior to that deal, AMVAC acquired the global Terbufos product line (organophosphate insecticide and nematicide used on corn, sugar beets and grain sorghum) from BASF. Over the years, AMVAC has acquired a stable of these unremarkable, but dependable, businesses.

Demand continues to grow in these putatively mature markets. In 2007, AMVAC's revenue grew to $216.7 million, a 12% increase over 2006's $193.8 million. What's more, AMVAC has been selling more of its “cides” more efficiently: gross margin increased to 44% from 43% and operating margins increased to 16% from 13%. Simple deductive reasoning would suggest that top-line growth coupled with expanding margins translates into bottom-line growth. Indeed, that's the case: net income posted at $18.7 million in 2007 compared with $15.4 million in 2006, producing EPS of $ 0.68 in 2007 compared with $0.57 in 2007.

A longer perspective shows that AMVAC's revenue and EPS growth have been as dependable as an Iowa farmworker. Revenue has grown at a 14.8% average annual rate and EPS has grown at a 12.8% average annual rate over the past four years More important, AMVAC has been just as proficient at growing investor wealth, returning over 300% to investors during that time, and that's excluding the twice-annual dividend.

Much of AMVAC's good fortune has come courtesy of the farm lobby, and the lobbyists continue to earn their keep. Congress has already authorized billions in taxpayer-funded subsidies for farmers who grow corn and the producers who turn it into ethanol. The recently passed energy bill is expected to create even greater demand for corn-based ethanol, since it requires the United States to ramp up biofuel production to 36 billion gallons by 2022 from 7.5 billion gallons today.

Don’t count on Congress amending the energy bill anytime soon, regardless of how loud the grumblings about higher food prices get. In fact, states are more likely to hop on the farm-fed energy bandwagon than abandon it. On that front, legislation proposed by Massachusetts Governor Deval Patrick and state congressional leaders last fall required 2% of all diesel and home-heating fuel sold in Massachusetts by 2010 to come from renewable bio-based sources.

Of course every risk can't be mitigated by legislative decree. Take weather, for instance. In early April, AMVAC reported that its first-quarter results were likely to be below that of last year due to adverse Midwest weather conditions. "...Over-abundant rainfall and continued cold temperatures have significantly affected preparation for and implementation of crop planting in large sections of the Midwest corn belt," CEO Eric Wintemute said in a statement that sent shares tumbling nearly 10%. (The shares have since recovered.)

Analysts who follow AMVAC (and there aren't many) view the setback as a mild summer shower. Looking further afield, the analysts see full-year EPS of $0.92 on revenue of $254.9 million. In 2009, the consensus expects revenue of $274.4 and EPS of $1.23. The forward P/E is roughly 19 times 2008 EPS — a little rich, but reasonable when considering EPS is expected to growth 35% this year and 34% in 2009.

Corn demand (legislatively generated and otherwise) is expected to push domestic consumption to 12 billion bushels a year by 2015, up from 9 billion in 2005. With corn prices levitating at an all-time high around $6 per bushel, farmers are as motivated as ever to ensure every kernel gets to the grain silo, which should continue to assure steady demand for AMVAC's output.

Disclosure: none