FMC Is A Value Opportunity

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About: FMC Corporation (FMC)
by: Dimitri Rearden, CFA
Summary

Company is transforming into a generator of free cash flow to be returned as dividends and massive stock buybacks.

Valuation suggests possible 20% annual return over the next 5 years.

Has competitive advantage that is reflected in higher ROE.

Sources of revenue and profits are well-diversified worldwide.

FMC Corporation (NYSE:FMC) is an agricultural sciences company that produces crop protection chemicals such as insecticides, herbicides, and fungicides that are used to enhance crop yield and control insects, weeds, and diseases. It is headquartered in Philadelphia, employs 7,300 people, has market capitalization about $10 billion and annual sales of $4.5 billion. It is the fifth or sixth biggest crop protection chemical company in the world.

Due to market meltdown and revision of FMC's earnings estimates down by many Wall Street analysts, company stock price plummeted from $95 to $78 during this year. In our opinion, such drop in stock price is irrational market overreaction. Because company financials and long-term business outlook are solid, FMC stock price, at current level in proximity of $78, is presenting a good buying opportunity.

There are few reasons why many became skeptical about growth prospects for FMC and shifted their capital to other places. The main source of demand for FMC products for long time was coming from worldwide growth of arable land. This growth has slowed down globally now (except maybe in Brazil) and thus addressable market for FMC became stable.

Another problem with FMC business is that demand for insecticides is negatively affected by increasing popularity of genetically modified seeds that made harvests more insect-resistant. FMC derives 41% of its revenue from sale of these insecticides. Here is the company's current product mix:

Image source: the company's annual report

To address the mentioned challenges, FMC plans to develop and introduce at least six new patents in herbicide and fungicides segments of its agricultural solutions. The focus on these segments has advantage that these segments experience growing demand despite decrease in growth of arable land. As existing solutions became less effective, because bugs and fungi develop resistance, there is a demand for regular updates of the solutions.

FMC business is very well-diversified geographically with worldwide manufacturing and distribution infrastructure that should provide some defense against the tariff wars and other region-specific economic headwinds. There is also costs advantage in matching revenue in local currency to expenses in local currency.

Image source: company annual report

FMC's current market position and competitive advantage are based on current patents, pipeline and R&D expenses. Management plans to spend on R&D at least 7% of annual revenue. Existence of FMC competitive advantage is reflected in its consistent high return on equity. For FMC, average ROE during last seven years was over 20% and it was 39% for the last twelve months. Such high returns usually generate residual earnings (earnings above the cost of capital) that add value to the company and get reflected eventually in its stock price.

Over the last few years, management steered the company through divestitures of various uncomplimentary businesses to a leaner business and more focused on crop protection chemicals. The latest spin-off is of the lithium production unit called Livent; it will be completely separated from FMC in March of 2019. Such transformation leads to a new economics of FMC business now characterized by higher free cash flow generation and lower capital intensity.

There is also important financial catalyst for FMC business that is not reflected in the current market price. Recently, the company's board of directors declared that total capital return to shareholders will be up to $4.5 billion in the next 5 years. This includes a massive share repurchase program, right now at $1.2 billion. This capital return commitment represents about 45% of the company's current market capitalization. The board also has increased a regular quarterly dividend and pledged to make further increases with the same rate as income grows.

All of that said, let us look at valuation numbers. My preferred model is Residual Earnings model. Here is a link to Wikipedia where the model is well explained: Residual income valuation.

In my spreadsheet, input values and assumptions are highlighted in yellow. Required Rate of Return is my personal required rate, some investors use market-based rate such as cost of equity. I normally buy only companies with return on equity over 15% and that assumes that only earnings above that hurdle rate add value to the company; otherwise its stock should trade at book value. For earnings forecast I use analysts’ earnings estimate consensus from Yahoo! Finance or Zacks, or Value Line estimates. At this time the next 5 years earnings growth estimate consensus in Yahoo! Finance is 26.40% which is way too high, so I use instead 12%. Here are my model calculations:

The model gives $104.11 fair value estimate for the stock and current market stock price of $78 implies the stock is traded at 25% discount to a fair value. Based on calculated discount and expected earnings, we can expect annual return of about 20% over the next five years.

Another simple model I often use is Earnings model, where Internal Rate of Return of cash flows is calculated. Outflow is the stock price we pay, inflows are dividends and exit stock price. Exit stock price is estimated based on P/E assumption at the time when position will be closed.

We use dividend data from Residual Earnings Model above and generate a table with returns for various levels of P/E for exit price assumptions:

To expect that FMC stock would trade at historical P/E average of 30 feels unrealistic as FMC is now a stable growth dividend-paying company. I think P/E range of 15-20 is more realistic and gives us estimate of 12-18% expected annual return over the next five years.

I would allocate 4-5% of diversified portfolio in FMC stock position. To rationalize portfolio allocation percentage, I use heuristics and Kelly formula. Kelly formula in theory ties together expected return and probability of achieving such return, thus allowing for optimizing bet size for a single investment. Here is a good description of the Kelly formula: Kelly criterion. Unfortunately, there is no exactness in calculations here as well. Historical deviation is used as proxy for probability. One of the practical approaches is to divide expected return by standard deviation of the stock price or earnings and use half of this numbers as a position target size.

We cannot think that numbers produced by models are exactly correct. Of course, it is impossible to calculate the exact intrinsic value, but when you use models to analyze 50 or more stocks, then you are able to establish some comparability across investment alternatives you have analyzed. That actually, is how Warren Buffett suggests using valuation models.

Our analysis gives us a confident feeling that FMC is undervalued and a good choice for our portfolio after looking at many investment alternatives. Investment proposition here is based on two reasons: compelling business story and attractive valuation numbers.

Disclosure: I am/we are long FMC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.