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A Vanguard Among Small Caps?

By Stephen D. Simpson, Simpson, – Updated Nov 16, 2016 at 12:46PM

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This chemicals company has an intriguing business model, but the valuation is in the weeds.

Nobody likes pests or weeds. That's why we call them "pests" and "weeds" instead of bugs and plants. But farmers like them even less. And as farmers work to get ever more production out of their land, they increasingly have to rely on pesticides and herbicides to help out. That's where small-cap chemical company American Vanguard (AMEX:AVD) comes into the story.

American Vanguard is a niche player in agricultural chemicals, and that's by design. The company focuses on acquiring proven products that larger players such as Bayer (NYSE:BAY), Syngenta (NYSE:SYT), BASF (NYSE:BF), and DuPont (NYSE:DD) no longer want. In this case, American Vanguard is hardly living off table scraps; these are solid products that have allowed the company to build a good business for itself in cotton, potatoes, corn, and other vegetables and fruits.

Some weeds sprouted up in the second quarter, though. Revenue climbed by 18% for the period, but gross and operating margins both declined, and operating income grew by only 12%. Net income, meanwhile, grew by 14% over the prior year's quarter, and the company reported a slight deficit in operating cash flow for the first half of the year.

Two things stand out to bug me about this stock right now. First, management devoted one-third of its three-paragraph performance commentary to talking about recognition in popular business magazines. Now, while I understand that a small and largely unknown company might appreciate the attention, I'm utterly unconvinced that it builds any sort of long-term value for shareholders.

Frankly, though, that's a petty concern. The larger concern to me is valuation. True, this company has grown for 25 consecutive quarters, and I calculate a robust long-term growth history of about 18% for earnings. But with this quarter's earnings, the stock is still trading for about 25 times trailing earnings and more than 30 times trailing free cash flow. That's a steep price for an agricultural chemicals company -- even one with a solid differentiating strategy and a solid return on equity.

On the other hand, Syngenta trades at 31 times earnings, Scotts (NYSE:SMG) trades for 24 times earnings, and other large chemical companies trade in a P/E range from the mid-teens to the mid-20s. So on a relative basis, it's not so out of line.

There's a lot to like about American Vanguard. Even with recent sales, management and directors own a lot of stock. The company has its SmartBox distribution technology, and returns on capital have been pretty good relative to the industry. Valuation will keep me lurking in the weeds on this one, but I think it's a worthwhile company to get to know, just in case the stock someday goes on sale.

Do you like chemical companies? Check out more Takes from the Fool:

Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).

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Stocks Mentioned

E. I. du Pont de Nemours and Company Stock Quote
E. I. du Pont de Nemours and Company
DD
The Scotts Miracle-Gro Company Stock Quote
The Scotts Miracle-Gro Company
SMG
$49.95 (-1.71%) $0.87

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