American Vanguard: Panic Selloff Makes Shares Attractive (NYSE:AVD)

American Vanguard Corporation (NYSE:AVD) presents a favorable buying opportunity after what I consider to be an overreaction, and a panic-driven sell-off following their Q1 2024 earnings report.

AVD has good financials, with significant double-digit growth (YoY) in their adjusted EBITDA and operating income. The insider buying activity following a 27% drop in share price, along with a major transformation initiative focused on improving operational leverage, demonstrates management’s confidence in the business and the future direction of the share price

American Vanguard Corporation Business Overview

AVD is a holding company, operating through a network of subsidiaries, with a presence in 19 countries, and 5 continents around the world according to their latest 10-K annual report.

Their operations are divided into 3 segments:

• The U.S. crop business focuses on providing agricultural chemicals used in the cultivation of crops. This segment includes products like insecticides, herbicides, fungicides, soil fumigants, and plant growth regulators.
• The U.S. non-crop business targets markets outside of traditional agriculture, including turf, ornamental plants, public health, and pest control sectors. This segment includes products for nurseries, greenhouses, and professional pest control services.
• The international segment covers the sales and distribution of AVD’s products outside the United States. This segment is operated primarily through AMVAC Netherlands BV, and its network of subsidiaries

I have included a table below to represent the weight of each segment to AVD’s annual net sales, as well as their variation in the past 3 years.

Click to enlarge

Table 1. Net sales per segment in the past 3 years (source, latest 10-K).

AVD operates in the agricultural chemicals industry, which is highly sensitive to supply chain disruptions, regulatory challenges, environmental regulations, inflationary pressures, and weather disruptions. Below, I will discuss how some of these factors impacted the share price in Q1 2024.

Share Price 27% Down Post Q1 Earnings Results

On May 9th, 2024, after market close, AVD published their Q1 2024 earnings results. The next day, the share price fell by a notable 27%, indicating a panic sell-off.

In my view, the magnitude of this drop in share price is not justifiable, and I expect the share price to recover to pre-sell-off values within the next 6-12 months.

Let me walk you through my rationale. First, I will dive deep into the reasons that motivated the sell-off, and then I will provide some arguments that support my belief in the company’s strong financial position.

Sales Of Dacthal Suspended In The US

Dacthal is a herbicide primarily used for cold crops and onions. Previous supply chain issues during Q1 & Q2 2023 have been resolved in Q3 2023 by securing two different supply sources for Dacthal’s raw materials and intermediates.

At the same time, AVD initiated in-depth discussions with the US EPA (United States Environmental Protection Agency) regarding regulatory concerns about this herbicide. Preliminary data indicated that Dacthal affects thyroid function at lower doses than previously understood, posing potential health risks.

To meet EPA’s requirements, AVD submitted in May 2024, a revised, significantly narrower product label. This new label is expected to comply with the regulatory standards but, as mentioned by the CEO in the Q&A during the Q1 earnings call, it would likely reduce the market share previously held by Dacthal due to the limitations imposed by the new label.

As a precautionary measure in Q1 2024, AVD voluntarily halted Dacthal sales in the United States while awaiting the EPA’s response to their revised label submission.

Considering this decision, sales of Dacthal were excluded from the full-year 2024 forecast results. Below are the adjusted values provided by management:

• Net sales to increase between 6% and 9% compared to 2023.
• The adjusted EBITDA is forecasted to increase between 9% and 27% compared to 2023.

To provide you with a perspective on the magnitude of this event, according to the CEO during the Q1 earnings call, sales of Dacthal contributed about $15 million to the company’s annual revenue.

Although not insignificant, this figure represents just 5.6% of their annual US Crop segment and only 2.6% of the total net sales in 2023.

For this reason, I strongly believe shareholders have overestimated the negative impact of suspending the sales of Dacthal in the US due to EPA regulations.

This, along with the following point, is the primary reason I consider the 27% drop in the share price to be unjustified.

Higher Interest Rates And Debt In Q1 2024

AVD’s interest rate increased from 6.8% to 8.3% year-over-year. I think it is clear to all readers that the primary reason for the increased interest rate was related to changes in the Federal Reserve rate. However, there’s an additional factor: the company made modifications with its bankers to gain more flexibility on leverage and fixed charge coverage ratios. While these changes provide more flexibility, they added about 0.5% to the interest rate, as mentioned in the Q1 earnings call.

Additionally, AVD’s borrowings were up by approximately $10 million YoY due to increased investment in working capital.

I don’t find this increase concerning at all. As noted in the excerpt below from the Q1 2024 earnings call transcript, the CFO views it as part of their normal operations due to seasonality in their sales.

The company has a pronounced annual cycle of building inventory at the start of the calendar year in order to fuel global sales, particularly during the second and third quarters. It is usual for working capital to expand in the first quarter and Q1 2024 is pretty much in line with the same period of the prior year. We use our revolver debt to fund working capital expansion at the start of the year and pay down as swiftly as possible as the cash cycle completes usually later in the year. David Johnson, CFO, Q1 2024 earnings call transcript.

Increased Inventories And Working Capital

As I mentioned above by the CFO, AVD follows a recurrent annual cycle of building inventory at the start of the calendar year to fuel global sales, particularly during the second and third quarters. For this reason, it is usual for working capital to expand in the first quarter.

At the end of Q1 2024, the company had $13.7 million in cash compared to $19.6 million the previous year. The reduction in cash was part of an effort to reduce debt and interest expenses.

The motivation to reduce debt is primarily due to higher interest payments (compared to Q1 2023), and to maintain a healthy balance sheet.

Despite the absolute increase in inventory, the company managed a lower increase compared to the previous year, investing about 39% of net sales in inventory with a year-end target to lower inventory levels to around 34% of net sales.

In my opinion, some investors might have interpreted the increase in working capital and inventories as a slowdown in net sales, which could have further contributed to the drop in the share price following the Q1 2024 earnings release.

Weather Disruptions In The Northwest

In Q1, the company faced challenges due to wet conditions in the Northwest, which affected the application window for soil fumigants. These bad weather conditions delayed the usage of certain products, impacting sales and revenue for the quarter.

I need to mention that bad weather, such as storms, doesn’t necessarily have a negative impact on the company. For example, in Q1 2024, the anticipation of strong tropical storm activity boosted sales of mosquito adulticides in the US Non-crop segment.

Decline In Net Income

In Q1 2024, the company experienced a slight decline in net income despite improved operating performance. The net income decreased from $1.9 million in Q1 2023 to $1.6 million in Q1 2024.

This decline was primarily due to higher interest expenses, as already explained above, and a significant increase in tax rates, which I will explain below.

AVD faced a higher effective tax rate of 158%, compared to 31% in the previous year. This substantial increase in the tax rate was primarily due to the losses incurred by their entities in Brazil. Essentially, US GAAP rules required the company to fully reserve against any potential future tax benefits from these losses, given the uncertainty around their realization.

This lack of tax benefit from the Brazilian losses led to a higher overall tax burden for the company, contributing to the decline in net income despite improved operating performance.

Operating Expenses Increased Marginally

Operating expenses in Q1 2024 increased to $36.3 million from $35.3 million in the same period of 2023. This represents an increase of approximately $1 million year-over-year.

The increase was primarily due to $1.2 million invested in digital transformation and other strategic initiatives that are expected to increase business performance mainly from 2025 and 2026 onwards.

I view this increase in operating expenses as positive because the investments in digital transformation are expected to enhance operational efficiency, improve data integrity, and enable faster, and more informed decision-making.

Healthy Financials And Room For Growth

Despite the negative response in the share price following the Q1 2024 earnings release, all three business segments experienced year-over-year sales growth during this quarter: US Crop up 9%, US Non-crop up 28%, and International up 2%.

As a side note, I prefer using year-over-year figures, and not quarter-over-quarter, as the demand for their products tends to be highly seasonal, influenced by factors like growing patterns, weather conditions, geography and pest pressures.

The company’s adjusted EBITDA increased by 35%, and operating income was up by an impressive 87% compared to the same period in the previous year.

Net sales also grew from $125 million to $135 million.

I also like the fact that total gross profits improved by 10%.

Below, I discuss some of the reasons behind these increases.

A significant factor is the stronger sales of high-margin products, particularly herbicides. This increase is driven by more peanut acreage and the availability of Dacthal outside the US, as well as granular soil insecticides used by corn growers. Additionally, factory performance improved during the quarter, leading to better utilization of resources. According to the Q3 2023 earnings call transcript, the CEO mentioned that each department head was given targets to collectively add $15 million to operating profit and interest savings for the 2024 budget. Based on the Q1 2024 results, I view this goal to be on track.

Another contributing factor is AVD’s deployment phase of an adaptive ERP system (QAD), which is expected to further improve factory performance once fully implemented. This digital transformation is anticipated to yield benefits by 2025, with a projected annualized adjusted EBITDA improvement of $15 million by 2026.

Management has also committed to a significant structural transformation by hiring a Chief Transformation Officer, Don Gualdoni, to enhance operational efficiency. Gualdoni brings over 25 years of experience in leadership roles and managing large, complex transformation projects, with previous positions at Teradata and McKinsey & Company.

Furthermore, there has been a slowdown in the destocking initiatives from the previous year, leading to a normalization in inventory levels across distribution channels. This normalization suggests that the market is moving past the corrective phase from last year, where distributors were minimizing excess stock, which had previously put downward pressure on new orders.

Valuation

A quick look at the EV/EBITDA (TTM) shows that AVD is 10% below the sector median. Additionally, this is 25% below the company’s 5-year average.

Their price to book value (TTM) ratio is also below the sector median (-60%) and the company’s 5-year average (-47%) value.

The dividend yield (TTM) is below the sector median by 34% and above their own 5-year average by 121%. I see this very positively, as the company has room to improve its dividends in a sustainable way.

My personal investment style favors companies that reinvest free cash flows back into improving their business, with dividends being an added bonus. I prefer small and consistent dividend yields, especially in volatile industries.

Regarding the “fair value” of the stock, my investment style does not involve obtaining a discounted cash flow analysis or any valuation method traditionally taught in financial school. The reason is that I don’t feel comfortable with the growth assumptions inputted into these models.

I do focus however on price action to optimize my entry and exit points.

In my view, there is a support level at around $9, which is close to my entry point some weeks ago.

Within the next 6-12 months, for the reasons explained in this article, I would not be surprised if the share price touches $14, which seems to be a resistance level (and a previous support level during Q1 2022).

Risks

Despite Dacthal representing only 2.6% of their 2023 annual revenue and management’s affirmation that the new revised label would reduce their market share due to the limitations imposed by the new label, a further rejection by the EPA could lead to another panic sell-off. In my view, the impact of the EPA rejecting a more limited label is small, given their diversified range of chemical products. However, the panic sell-off could be considerable, similar to the one that occurred after the Q1 2024 results.

Another potential risk is the replacement of the current chairman and CEO, Eric G. Wintemute, upon his retirement at the end of 2024. Wintemute has been with the company for 47 years and has served as CEO for 30 years. The new CEO may have different strategic priorities, which could lead to changes in business strategy and significantly affect the share price.

The appointment of a Chief Transformation Officer in Q4 2023 to lead the digital and operational transformation of the company presents risks related to the successful execution of these initiatives. Any delays in implementation could postpone the benefits expected in 2025 and the milestone of increasing annualized adjusted EBITDA by $15 million in 2026.

Additionally, given the increased debt levels to build up inventories in the first quarter of each year, if the Federal Reserve raises interest rates before the end of 2024, AVD could be negatively impacted by higher interest payments in Q1 2025.

Conclusion

AVD presents a compelling buy opportunity after a 27% panic sell-off following the publication of its Q1 2024 results. The company is in good financial health, with positive year-over-year revenue growth in all of its three segments. Additionally, adjusted EBITDA is up by 35%, and operating income increased by 87%, year-over-year.

Insiders buying after the panic sell-off contributes to my high levels of conviction in this stock. Among all three insiders who bought in mid-May 2024, the total value of purchased shares was over $0.5 million.

Their current transformation initiatives following the hire of a CTO prove that management is proactively trying to increase their operational efficiency. Even though their digital transformation is still underway and full benefits are not expected until 2025 and 2026, some signs of improvement can already be seen with their latest 10% increase in gross profit.

For the above reasons, I have high conviction about the future of AVD, and I bought and still hold shares at the time of writing this article.