Shares in animal pharmaceutical specialist Eco Animal Health (LON:EAH) today crashed as much as 50% in early trade as the company revealed that the Chinese swine fever crisis would adversely impact profits, with sales in China down as much as 60%. Share price reaction was volatile:
This share price move is worthy of some discussion: the price opened at 155p, which was a huge discount to the previous close. Since then it has hit a very decent level of support. Anyone purchasing in the first hour could be sitting on quite a decent profit although notably the price is still way below the highs of this year.
Eco are an interesting company, specialising in the development and sales of pharmaceutical products for animals. Their flagship product is Aivlosin, used in pigs and chickens – two almost universal meats. This has proven to be great business so far, as the barriers to entry are high and the sale of these products are restricted. This is also evident in the company results so far which have seen growing revenues and profits as well as a dividend – it is no surprise that the share has traded at quite a large price to earnings ratio.
What’s gone wrong at Eco Animal Health?
The bad news comes in a trading update today. We get straight to it:
Whilst certain important markets for the Group have out-performed management’s expectations in the first half of the financial year, African Swine Fever (“ASF”) has continued to have an adverse impact on the Group’s trading performance in China.
The well publicised effects of the ASF outbreak in China have provided significant headwinds in our largest market. Further, the China-USA trade tensions have further exacerbated the effect due to the US swine producers having limited ability to capitalize on the anticipated export market created by the pork shortage in China leading to overproduction and depressed prices and margins in the USA. As we have previously guided, these factors have had a significant negative impact on Group revenues and in the six months to 30 September 2019 our unaudited sales in China have declined by approximately 60% compared to the same period in 2018.
60% is a huge figure, and perhaps is responsible for the initial heavy falls in price. The last update by the company came on June 19th and made no mention of this, and whilst ASF was mentioned, it was the case that China sales were flat. A look at the annual report shows that China must be a very important market: excluding inter-company sales the ‘Far East’ region was responsible for over half of sales.
We have some more detail here:
As a result of the challenging trading conditions in China, the Group’s trading results for the six months ended 30 September 2019 will be below those achieved in the first half of 2018. Despite a historical second half weighting to the Group’s trading performance, the continuing impact of ASF in China and South East Asia and the uncertainty as to timing of a market recovery in China, the Board would expect that full year trading performance will be significantly below current market forecasts if these trends continue.
This seems a certainty unless ASF disappears overnight. We have some issues regarding accounting restatements:
It is expected that changes to the accounting treatment of these items will lead to the restatement (incorporating Prior Period Adjustments) of the Company’s financial statements for the year ended 31 March 2019 and the six months ended 30 September 2018 which will be presented as comparatives in the unaudited interim financial statements for the six months ended 30 September 2019.
This sounds ominous, although at this stage it may be the case that this affects only the timing of revenues and not the revenues themselves.
Eco Animal Health: A Business on solid foundations?
Today would have been a day where early birds could have gotten in and out quickly for a good profit. On the first smell test, the business looks good. Often companies posting profit warnings are in poor shape, but we can see from Stockopedia that there is a track record of consistent profitability:
Clearly the 2020E figures are not going to be met now, but handily a broker note (available on Research Tree) puts an estimate at £62.7m, which reflects the 60% decrease in China and a small uplift in other regions. However, profit before tax is due to fall sharply from £14.7m to just £4.0m. There are a couple of reasons for this, firstly the Far East enjoys a far greater margin on its products and secondly, depreciation and amortisation costs will be similar. There may be other exceptional costs related to ASF.
Of course, the headline figures can only show one side of the story, but a deeper dive does not reveal too much to be concerned about. Cashflows are strong, and strongly related to profits. A slight concern is the accounts receivable, which has jumped from £17.3m to £29.2m. It seems that in this industry payment times lag significantly and this could be a source of woe, particularly if the ASF crisis affects places higher up in the chain, turning these receivables into bad debts. This may also relate to the accounting treatment, if revenues are booked too early.
However, the immediate position is good: a large cash position in advance of current liabilities, and a net tangible asset position. Considering that the year is still anticipated to be cash positive, there seems to be little short-term dangers.
Capital expenditures can be a concern, as pharmaceutical companies tend to have legitimate needs to capitalise these and they can be large. The case here is that with the exception of 2016 (when operating cashflow was weak) capex has remained below the level of operating cashflow at a region of around 70%, so it is not the case that everything the company earns is being capitalised away.
One quibble is the payment of dividends, which have been in excess of free cash flow, and by some way as well. Dividends cost the group £10m in the past year, and approximately £6m and £4m in the years before that. This has resulted in a cash balance which has been more or less stable and financed in part by a small issue of shares. With a reduced pot of money to play with this year I am not sure this is that viable and whether a better use of the money could be to expand operations elsewhere to not be reliant on China.
Are Eco Animal Health shares good value?
This seems to be a good, tidy company with a product with great positioning in its markets. Sadly, its share price has been on the slide for 2 years now. In the middle of 2017 it was priced at almost 700p, and has been steadily declining ever since, even before the ASF crisis hit. A logical explanation to me is that whilst the company could have gone for strong organic growth in different territories/more products, they have not and have returned money to shareholders instead and pursued a more modest path.
Whilst this may not be the wrong decision in itself, it does mean that the shares have slipped off the very high 40+ P/E rates it did command. Even after the warning today, it is still quite expensive as both parts of the equation have gone down.
The issue is, as with many warnings whether this is a temporary or structural factor and to me this does seem temporary (although an outbreak such as this at some time is not exactly a black swan event). So assuming the company can stay strong it seems likely that better times will return. A downside is that the wait might be very long: the broker note suggest that even by 2022 profits would not have recovered to last years level, and a continued dividend increase will see the cash balances depleted. 4/5.