ArborGen Holdings — Green shoots appear in the spring

ArborGen has evolved into one of the most advanced developers and suppliers of pine and eucalyptus seedlings in the US South and Brazil, and is increasingly looking to develop a presence in the high-growth carbon markets. Its technology-driven genetic development programmes are now producing seedlings that are significantly more productive (tons/acre) and valuable (higher % of sawtimber) versus lower gen trees. These latest-generation MCP seedlings deliver significant step-change gains to forest owners and command price premiums, 2–4 times that of earlier-generation OP seedlings. Volume growth in the US and Brazil and increased MCP seedling sales growth in the US is expected to drive c 15% pa revenue growth on average and is expected to drive margins and profits materially higher over the medium to long term. We expect FY24 to be a record year for ArborGen, with further growth thereafter.

ArborGen is one of the largest commercial global seedling suppliers and a leading provider of advanced genetics seedlings for the forest industry. Its operations are focused on the high-growth markets in the US South and Brazil, as well as on the new and emerging high-growth carbon markets.

In the US, ArborGen is focusing on converting customers from lower value OP seedlings to much higher-value, advanced genetic loblolly (pine) MCP seedlings, which yield materially greater volumes of higher-value wood at an earlier stage in the growth cycle and are therefore generating step-change value gains for forest-owning clients. ArborGen is building its MCP seed inventory to meet anticipated future demand and mitigate supply risks. Furthermore, it is looking to leverage its recent expansion of container production facilities and is evaluating other expansion opportunities. The benefits of the expansion projects are expected to be seen in the current financial year, including increased sales, cost savings from increased production efficiencies and incremental margins from the additional volumes sold.

In Brazil, ArborGen is looking to build on its market-leading position in eucalyptus and loblolly pine seedlings and leverage its ‘best-in-class products’ to drive profitability. It is also integrating its recently acquired and leased nurseries, while also continuing to investigate other potential production expansion opportunities.

Planting trees for high-growth carbon markets is an emerging expansion opportunity for ArborGen. Carbon project developers are actively pursuing large-scale afforestation and reforestation projects in the Southern US. ArborGen is actively engaged with several of these companies to provide both advanced genetics pine seedlings and hardwood seedlings; it has executed a long-term seedling supply agreement with one such company and is working to execute others.

ArborGen is one of the largest commercial global seedling suppliers and a leading provider of advanced genetics seedlings for the forest industry. OP seedlings are produced by taking seeds from the best available mother plant and fertilising them naturally with pollen from an unknown father tree. ArborGen sells different grades of OP seedlings ranging from advanced to elite, and MCP seedlings ranging from Advanced to 2.0, each more productive and more valuable than the previous grade.

MCP seed is produced from crossing specific elite mother and father parent trees to generate seeds with the highest genetic potential. The process involves pollen from ArborGen’s highest performing father trees being applied to flowers of ArborGen’s best mother trees in a controlled manner. MCP seed is more expensive to develop and produce but generates significantly more value to the forest owner and hence commands higher pricing. This continuous development of seedlings to produce bigger, faster growing and more disease resistant seedlings is how ArborGen hopes to retain its leading position in the field of loblolly genetics.

Exhibit 2 highlights the attractions of advanced genetic seedlings in terms of the shorter duration of time to first thinning, the higher yield at that point and the significantly higher yield at final harvest. As well as developing seedlings that develop greater sawtimber percentages, the phenotypic (relating to the observable characteristics of an individual resulting from the interaction of its genotype with the environment) variation is much reduced, which means that the size and characteristics of the trees are similar, which helps with processing the sawn timber at harvest and results in reduced waste and increased yield.

The increase in anticipated timber volume per seedling is reflected in the average price per seedling. The average price of OP bareroot seedlings in FY23 was c US$0.07/seedling, while the average price for MCP bareroot seedlings was c US$0.20, nearly three times as much. Over the last four years, ArborGen has been switching from OP to MCP volumes. In FY20, MCP and Varietal accounted for c 30% of loblolly sales by volume, and this has since grown to c 41%. The company expects the proportion of MCP seedlings to increase over the medium term. While seed production costs are higher for MCP seed, due in part to the increase in manual labour required, seedling production costs are the same for both OP and MCP.

In terms of overall US seedling revenue over the same period, loblolly OP revenue has declined from c 42% of total US seedling revenue to c 31%, with the percentage expected to continue to decline over the medium term as MCP volumes and revenues increase.

ArborGen has three strategic growth initiatives: the United States, Brazil and the emerging carbon markets. Some of its initiatives relate to growth, while others relate to reducing external risks as well as maintaining ArborGen’s leading proprietary genetics advantage.

In the United States, ArborGen’s core growth initiative is driving increased adoption of advanced genetics across the US South as the leading commercial supplier of advanced genetics loblolly seedlings, leveraging years of investment in developing best-in-class proprietary MCP products and growing the supply of proprietary genetics. In order to achieve this ArborGen is:

In addition to the drive to grow MCP adoption, ArborGen is expanding container seedling capacity where appropriate: in FY23, ArborGen successfully completed the commissioning of a new container facility at its Bullard nursery in Texas, and the expansion of its existing container facility in Bellville, Georgia. The benefits from these projects are expected to be seen in the current financial year, including increased sales, cost savings from increased production efficiencies and incremental margins from the additional volumes sold.

In Brazil, the eucalyptus pulp market has become very well established and the market has collectively announced plans to expand total pulp production by c 30%, which implies annual demand for eucalyptus seedlings of c 1.2bn pa. ArborGen estimates that c 500m seedlings will be supplied by the integrated pulp companies, and a further 500m+ will be supplied by a network of seedling suppliers. This leaves an imbalance of c 100–200m seedlings pa, which ArborGen could address. In FY23, ArborGen sold 80m seedlings into the Brazilian market, implying material potential for growth. Furthermore, the domestic supply market has been shrinking for several years due to a weak market, poor management and weak capitalisation of independent nurseries, and yields have fallen. ArborGen’s genetically superior seedlings, which produce higher yields, should be in high demand in these circumstances.

In order to address this opportunity, ArborGen has already rolled out its successful US strategy in the Brazilian market, which has seen it develop best-in-class products, establish a network of both in-house and contract nurseries and establish operating and logistical systems that allow it to offer reliable service and high-quality products across several regions and production sites. This implies that ArborGen has established itself as the preferred partner to both suppliers and customers.

To address the growth opportunities, over the last 18 months, ArborGen has acquired a 10m seedling pine nursery in Santa Catarina and leased a fourth eucalyptus nursery at the end of FY23, bringing the total internal capacity up to nearly 50m seedlings pa, and in H124 it leased a fifth eucalyptus nursery adding c 5m seedling capacity. FY24 has started well, with the company having already sold all of its budgeted eucalyptus seedlings for the current year and 80% of its budgeted pine seedling sales.

As the role that trees can play in the capture of greenhouse gases becomes increasingly accepted, global carbon markets are emerging and ArborGen is uniquely positioned to take advantage by supplying its genetically advanced pine and hardwood seedlings to carbon project developers. ArborGen is already engaged with various carbon registries and carbon companies with a view to supplying seedlings to large-scale afforestation projects, particularly in the Southern US. It has already agreed one long-term supply agreement and is hopeful that others will be forthcoming.

FY23 group revenue increased 17.9% to US$56.1m, principally driven by strong revenue growth in Brazil. Revenue from the US was down slightly versus the previous year. Gross profit edged up 2.2% to US$18.2m, which implied a 500bp drop in the gross margin driven largely by some volume production losses and higher one-off MCP seed production costs. The increase in administration costs, largely due to the inclusion of an FX gain of $1m in FY22 relating to the disposal of the New Zealand operations, also led to a lower underlying operating earnings (ie profit before exceptionals and therefore a measure of underlying profits) figure of US$1.6m, down from US$2.7m in FY22. ArborGen reported an operating profit before financial expenses of US$2.2m, compared to a loss of US$1.3m in FY22, primarily due to net exceptional expenses in FY22 of US$4m, compared to an exceptional income of US$0.6m included in FY23.

These one-off costs account for the increase in EBITDA (US GAAP) from US$7.6m to US$10.3m, and a decline in adjusted US GAAP EBITDA from US$10.1m to US$9.2m. Net debt in the period increased from US$11.5m to US$13.0m for several reasons, including the late receipt of US$2.4m of COVID-19 related grant payments (received since FY23 year end.), higher costs associated with the US container expansion project (partly due to greater than expected capacity), a working capital increase in Brazil due to the expansion of nurseries and lower earnings in the US.

The volumes of seedling sales in the US and Brazil took materially different paths in FY23. In the US, the total volume of seedlings sold fell 3.9%, from 284m to 273m, for two reasons: 1) production losses at agriculture sites (due to yield issues with hardwood species and some operational issues with loblolly on a nursery site where ArborGen had not grown pine but chose to do so in FY23; this has been stopped); and 2) lower sales in National Accounts year-on-year because of customer specific issues but this was largely offset by private landowner sales. It is worth noting here that ArborGen has been successful in raising average selling prices in each of the last three years, and we anticipate that this trend to continue as it sells a greater proportion of high value seedlings.

In Brazil, the volume of seedlings sold rose 35% to 102m and included 80m eucalyptus seedlings and 22m pine seedlings. The volume increase was driven by increased production capacity and increased sales of advanced genetics volumes and pricing was positively supported by a strong demand profile. It is also benefiting from an increased proportion of sales from its internal production capacity.

Revenue in the US has been fairly static at c US$40m in each of the last four years, largely due to the impact of the COVID-19 pandemic. This highlights the resilience of the markets in which ArborGen operates. In Brazil though, growth in FY23 has been material and especially so in the most recent period. This reflects the operation of newly leased nurseries and a return to better pricing following an extended recessionary period, exacerbated by the effects of the pandemic. The outlook for both geographies is encouraging, as illustrated in Exhibit 8 below, reflecting our estimates.

Despite the increase in both revenue and gross profit over the last two years, gross margins came under significant pressure in FY23 due to some lost production and increased production costs. Management believes that this is a temporary phenomenon and that the anticipated increase in volumes and prices in both regions will lead to a recovery in gross margins in FY24. We believe that these trends are reflected in the material increase in EBITDA (adjusted US GAAP) in both FY24 and FY25 in our estimates.

Management is expecting a ‘materially’ improved performance in FY24, driven by increased volumes of seedling sales in the US (including MCP seedlings) and in Brazil from sales of eucalyptus and pine seedlings, higher seedling sales in carbon markets and improved gross margins from lower MCP seed costs and recent expansionary activity. This confidence is based on the knowledge that despite being in the early stages of the current financial year, ArborGen has already sold over 70% of its budgeted seeding volumes (including c 85% of budgeted MCP volumes) in the US and in Brazil it has sold all its budgeted eucalyptus seedings and c 80% of its budgeted pine seedlings.

ArborGen does not expect the overall market in the US to grow this year due to the tightening monetary policy, but it does expect internal actions such as the increase in internal container seedling production and higher sales into carbon markets to boost sales, and that lower MCP seed costs and other cost initiatives will combine with higher selling prices to boost the gross margin and overall earnings.

In Brazil, ArborGen anticipates that the strong underlying market will persist, driving stronger sales of both eucalyptus and pine seedlings. Successful integration of a 10 million capacity pine nursery located in Canoinhas, Santa Catarina, and of ArborGen’s fourth eucalyptus nursery in Brazil, which brings ArborGen’s internal eucalyptus production capacity in Brazil to nearly 50 million seedlings per year, will drive volumes. It also anticipates higher sales prices and better margins.

These trends are reflected in our forecasts, which show revenue increasing c 21.2% to US$68m in FY24 and to US$75m in FY25, and operating profit increasing five-fold from US$1.6m in FY23 to US$9.5m in FY25.

We believe there are a number of drivers of revenue growth that will push the top line in a positive direction, which in turn will be amplified by margin expansion, thus allowing underlying EBIT to increase five-fold over the next two years. Furthermore, the business should see cash generation improve as profits rise and the build-up in working capital eases. This should result in reduced net debt, such that balance sheet capacity increases offering increased optionality in future years. These characteristics are reflected in our DCF valuation, which implies a value for ArborGen of NZ$0.49, which is comfortably above the current share price.

Our financial model reflects a number of positive trends in both the US and Brazil that we expect will drive revenue growth, but also drive up gross margins and should result in rapidly increasing earnings.

Firstly in the US, management is concentrating on pushing sales of MCP seedlings rather than OP and we therefore expect the sales volumes of lower-price and lower-margin OP seedlings to decline at c 2% pa. We expect MCP volumes to grow at c 5–7% pa, resulting in modest growth in total volumes. However, because the MCP seedlings are on average c 3–4x the price of OP, we expect double-digit revenue growth.

In Brazil, given the positive market trends and the expansion of the nurseries discussed earlier, we anticipate double-digit volume growth of both eucalyptus and pine seedlings, as well as c 5–6% pa price growth. We estimate that these two trends will drive revenue growth of c 20% pa in Brazil. Overall, we anticipate group revenue growth of c 15% pa in FY24 and FY25, from the US$56.1m reported in FY23, to US$74.7m in FY25.

Furthermore, we anticipate that the cost of goods sold per seedling will rise at a more modest rate (ie c 1% pa) as inflationary pressures recede and volumes increase. Therefore, we forecast that gross profits will rise c 60%, from US$18.2m in FY23 to US$29.7m in FY25. The implied gross margin will increase from 32.4% in FY23 to 39.7% in FY25, ahead of the margin achieved in FY21 and FY22. We expect normalised operating earnings (ie underlying EBIT) to increase five-fold from US$1.6m in FY23 to US$9.5m in FY25.

Over the last three years, ArborGen has generated c US$23.9m of net cash from operating activities. The latest full year was held back as receivables reversed from an inflow of US$1.4m in FY22 to an outflow of US$3.2m, while there was also a deliberate inventory build-up to protect future revenues.

We are forecasting a recovery in operating cash flow to c US$9–11m pa (before interest tax, principal repayment and capex) in FY24 and FY25 as sales and profits increase and the build in working capital reduces. We also expect ArborGen to continue to invest in c US$5–6m pa in capital investment (including c US$3–4m on R&D expenditure) to ensure that its genetics research continues to develop improving MCP and Varietal seedlings for future generations.

Over the last two years, ArborGen’s net debt (excluding finance leases) has reduced from US$27.4m to US$13.0m, largely due to the receipt of disposal proceeds following the sale of its Australian and New Zealand operations. This implies that it exited FY23 with a net debt to adjusted US GAAP EBITDA of 1.5x. Given the increase in profitability in FY24 and FY25, we expect this ratio to fall to 0.6x in the current year and to c 0.3x in the following year.

This provides ArborGen with the potential to increase investment or to make modest acquisitions or lease additional nurseries in future years if the opportunities were to arise. ArborGen does not have a debt target, preferring to assess opportunities on merit.

It is worth noting that our profit and net debt forecasts only partially reflect the costs of the change in CEO, due to yet-to-be-agreed accounting treatment. Links to the relevant public statements are here and here.

Our DCF valuation points to a value of US$0.296/share, which at an exchange rate of US$0.61/NZ$, translates to NZ$0.49/share, versus the current share price of NZ$0.19, implying material upside.

Our key assumptions beyond our forecast period include:

The sensitivity table below is priced in US cents and gives an indication of the potential upside should the cost of capital fall from the 9.9% we have in our DCF model, or if the terminal growth rate was to edge up from the 3%, we have assumed to, say, 5%.