Description

Idea: Genus is an orphaned security, having no direct publicly traded comps, which we believe has led in the Company becoming mischaracterized and underfollowed. Genus is listed as an “agricultural producer” even though its core operations more closely resemble a high growth, capex-light, biotech company. We estimate roughly 65% of operating profit is contracted with little correlation to any livestock cycle (the Porcine division).

With this background, you may ask, why own this now?

The Company won a lawsuit against Sexing Technologies (“ST”) at the beginning of April which granted Genus the ability to launch its sexed semen product immediately (~3x the price of traditional products). The market was previously monopolized by ST, which placed onerous volume and research restrictions on licensees of its technology. Genus should be able to grow volumes in-line with its current traditional product market share (13% to 20%) and potentially license out its superior tech to other players. We believe this opportunity could be worth £3 per share, though the market has largely not reacted to this event (sell-side does not model any incremental volume).

Furthermore, short-term poor performance in the Bovine division (due to the dairy cycle) has masked positive results in the Porcine division (which has seen operating margins expand ~350bps). Normalizing the Bovine division’s margins to the mid-point of the dairy cycle, adjusting for “growth” R&D burdening consolidated results, and flowing through costs savings (but no incremental volumes) from the results of the lawsuit reveals a business trading for 14x earnings. Bifurcating the relatively attractive Porcine division against the Bovine division at a 20x and 15x earnings multiple respectively implies 29% upside.

Business Explained:

Genus owns and continuously develops genetically elite pork, beef, and dairy breeding herds whose genetic material (through supplying “straws” for artificial insemination, partnering with porcine “multipliers,” and distributing embryos) are then sold to farmers for implementation into their own herds.

The Company develops superior livestock by managing small herds in which a team of 90+ PHD’s monitor the genes, breed, and will soon directly edit the genes of to continuously select for the highest performing animals.

Why is this business attractive?

1. Virtuous Cycle: Genetic enhancements compound on themselves. As a species is improved over its non-enhanced peers, this genetic enhancement can be continuously selected for in subsequent generations to increase the gap. Over time, Genus’ competitive advantage should grow as its proprietary genetics become even more valuable.

2. Branded Distribution Network: Genus sells products under its own brand names and is known for its quality within the farming community.

3. Limited Working Capital: Unlike a traditional agricultural producer, most of the working capital is tied up within the customer’s operations. About £360m of herd inventory is needed to develop their genetics and is relatively fixed. As sales volume grows over time, increased working capital requirements are taken on by the multipliers and customers themselves.

4. Proprietary Genetics: Genus has long term contracts for its Porcine customers. The genetics supplied to Porcine customers are proprietary and are retained by Genus at the end of the contract.  

5. Limited Competition: Genus is the largest player, with 20% market share in the genetically advanced bovine market and 29% market share in porcine (within the genetic market). The Company primarily competes against local co-ops whose incentives are limited to their localities. This results in competition lacking scale to make meaningful investments into R&D and little ambition to grow to scale.

6. Secular Tailwinds: Increased global populations, urbanization, and wealth drive consumption of protein in the long term. Given fixed land and water supplies, Genus’ technology will become increasingly vital to the global agriculture supply chain.

7. Significant Pricing Power in Porcine: It is simply uneconomical for farmers to not use Genus’ products. Currently, farmers earn an incremental £2.83 in profit per pig from Genus’ pigs vs standard pigs (on average). Genus supplies pigs at cost and seeks to share in one-third of the incremental profits their technology provides. The result is no upfront costs to farmers to use Genus’ pigs and the retention of two-thirds of the benefit. The only opportunity cost is not using a competitor’s pig offering. Studies in Russia and China showed that Genus’ pigs beat out competition by £5 and £1.7 respectively. This dynamic enables Genus to increase it’s take rate directly in line with the economic benefit it supplies farmers.

Porcine Division: Genus supplies genetically superior boars and sows that are engineered to have desirable characteristics, such as leaner meat, more feed-efficient growth, and higher disease resistance. The genetic intangible asset is entirely proprietary within the Porcine division. Genetics are sold to farmers by supplying live animals and semen from Genus’ “nucleus” herd to third-party “multipliers,” who then multiply the pigs over four generations to deliver “slaughter” pigs. This process takes less than an initial 10 “nucleus” pigs, and are multiplied up to the 1000’s by partners (or the customers themselves) to create the end “slaughter” pig. Most of the revenue is received under royalty (detailed below) that is a function of the number of pigs per sow weaned by the farmer times Genus’ take-rate.

Over the past 20 years, the company has: reduced the amount of feed needed per kg of cattle weight gain by 40bps annually, increased the amount of milk per lactation period by 110bps annually, and increased the protein weight of pigs 370bps annually.

Bovine Division: The Company directly supplies bull semen for use in artificial insemination (“AI”) and recently expanded on its small embryo business through their acquisition of IVB. While the Company has started to transition to some proprietary economic indices within the Bovine division, pricing is largely tracked to a global, commoditized, genetic index – with Genus simply receiving the “market price” of the weightings of various traits. For instance, the semen of a bull that is 100kg above the average protein weight and of Angus pedigree is marked at $X based on the American Angus Value Index. This reduced market positioning is evidenced in the margin profile of the Bovine division (normalized 14% operating margins compared to 36% for the Porcine business).

Insights:

Niche, Monopoly-like, Porcine Business: Over the past five years, Genus has steadily shifted the Porcine business to a multi-year, royalty based model – from 62% of volumes under royalty in 2012 to 77% currently. The Porcine business has become much better as a result. In the legacy model, Genus would develop the genetics of the pigs, “multiply” chosen species based on customer demand, and deliver the elite pigs to customers, receiving one lump-sum payment. Under the new royalty business model, pigs are sold on a multi-year pricing model whereby Genus receives an upfront payment linked to the cost of production and subsequently receives a royalty linked to the volume of pigs produced. This change accrues a few benefits:

1. Royalty revenues are higher margin and have increased segment margins by ~350 bps over the past five years (sales increased only £1m in 2016, but operating profit was up £7m).

2. Multi-year contracts with profit sharing allow Genus to entrench their customers – instead of having the option each season to purchase pigs from competitors, customers would have to wait until their contracts end and make a deliberate decision to not renew.

3. Furthermore, the royalty model allows Genus to essentially supply pigs at cost to customers and take part in any incremental benefit their genetically superior pigs accrue to farmers – competitors using the traditional up-front pricing model are severely disadvantaged.

Milk Cycle Impacting Bovine Division: The Bovine division is cyclical, having exposure to the price of milk. Milk prices drive farmer profitability and their resulting purchasing patterns of new doses of semen to grow their herd. The average cycle is estimated to be 3.3 years, with Genus earning an 10% operating margin near the trough and 17% near the peak. Through the cycle (over the past five years), the company earned an average 14% operating margin. We apply this to the run-rate revenue to arrive at a normalized earnings figure for the Bovine division:

Milk prices rebounded back to breakeven in January as the cycle rebounds

Hidden Asset – GSS: Genus has been developing their own sorted sexed semen for 10 years. Sorted sexed semen is processed with the intention of supplying product which will only produce female offspring (needed by dairy farmers and to grow cattle populations faster). Genus has been unable to enter the market independently due to IP owned by Sexing Technologies (“ST”) and onerous claims within their licensing contract for ST’s technology. Namely, ST places restrictions on licensees from pursuing the development of their own sorted sexed semen while under contract with ST, required large up-front purchases of product, and limited total volumes each licensee could purchase (Genus was restricted to 1.15m units). Genus sued ST in 2014, alleging they held a monopoly in the sexed semen market through “anti-competitive means.” On April 3rd of 2017, Genus won its injunction against ST, allowing for immediate launch of Genus’ own sorted sexed semen (“GSS”). Under the old agreement, Genus received about a 50% gross margin on sales of sexed semen it sold under contract with ST (Genus makes about £24 per dose of sexed semen it sells, about 3x normal semen price, and paid ST ~£12 per dose). With Genus’ own tech, we estimate gross margin expansion to 65% and potential to more than double current volume (which was otherwise restricted under the ST agreement).

While Genus won the ability to launch its own product, the court ruled that Genus was still in violation of two of ST’s patents. Genus will pay a relatively paltry $1.75 royalty per straw (7% of sale price). Furthermore, the ruling also allowed other licensees to drop agreements with ST. This leaves Genus with the opportunity to snap up market share not only through growth in their own revenues but also through licensing to the total sorted sexed semen market.

We believe Genus’ tech is materially better than ST’s. ST uses a process known as flow cytometry (essentially squeezing) for filtering out males which has a high success rate (90%) but also damages the female cells in the process. Genus on the other hand has developed a laser based method that retains the vitality of the filtered out females (and is overall a faster process).

Our bull case volume estimates are based on an assumption that Genus could take 20% of the global sexed semen market (in-line with its current bovine artificial insemination market share) and reasonable considering Genus’ technology seems to be better.

Pipeline Underappreciated:

PRRSv: PRRSv is a disease amongst porcine that causes reproductive failure, reduced growth, and premature death affecting 60-80% of farms. PRRSv leads to losses of $1.5 billion in Europe and over $600 million in the U.S per year. To deal with this problem, Genus successfully developed pigs that are now 100% immune to PRRSv, but approval and commercialization of this technology is still five years out (subject to FDA approval). To add, Genus has also received an exclusive license to use and develop CRISPR-Cas9, a gene editing technology from Caribou Sciences, that allows for precise and controllable changes to the porcine genome. Advancements in this field have the potential to boost the quality of Genus’ livestock across divisions. If Genus eventually captured just 3% of the total loss to farmers due to PRRSv as operating profit, this would imply a value of £371m (discounted at 8% at a 15x EBIT multiple).  

IVF: Genus acquired a majority holding in IVB, the world leader in bovine in vitro fertilization (IVF) in 2015. While simple artificial insemination allows farmers to improve their stock on the male side, by using IVF technology, the farmers are now also able to exert greater control over genetics on the female side. This tech would enable Genus to improve volumes on the Bovine side as farmers are now also able to manipulate the genetic material of the female parent.

Why Opportunity Exists:

• Orphaned security.

• Mischaracterized as an agriculture producer when it more closely resembles a biotech company.

• Short term poor Bovine division performance due to milk cycle.

• GSS Hidden Asset.

• Underfollowed.

Valuation: We adjust R&D below for what we believe to be “growth” vs “maintenance” R&D. The deltas we show are: £5m for the development of GSS (which is soon to abate), £4m for IVF development (whose growth we do not account for within our valuation and had a recent uptick due to the acquisition of IVB), £5m for the development of PRRSv (five years out and not modeled), and about £9m in extraneous research expense which is the company’s gene editing program (and whose budget was recently increased with the addition of the CRISPR program). We apply a 20x earnings multiple (in-line with agriculture tech peers) on the PIC business which we view as largely contractual, royalty payments, (growing operating profit at an average 11% over the past three years) and deserving of such an attractive multiple. On the more volatile and commoditized bovine segment, we apply a 15x earnings multiple. For the consolidated research and corporate costs, we apply a blended 17.5x earnings multiple.

Note that the above case is our “base” case and does not incorporate likely incremental volumes from the result of the injunction against ST. If we were to incorporate GSS volumes growing to match the overall Bovine division share within the artificial insemination market (the “bull” case detailed above), the valuation would be £1.97 per share higher (upside of 40%).

• Risks:

• Competitors are Co-Ops: While competition mostly consists of small, fragmented, co-ops with limited ability to invest in R&D – the incentives of co-ops are largely to produce better offspring for use at their farms (and not to profit from the development of better offspring in and of itself). While we believe Genus will maintain a distinct advantage over these local co-ops, if the ability of Genus to make incremental advancements over co-ops diminishes, un-economic pricing may ensue.  

• Consumer Backlash: While the current enhancement of livestock genetics is done entirely through natural means (that is the organisms are not directly genetically modified, but bred for effect), with the Company’s shift to developing means of directly modifying the genes of their livestock (CRISPR) it is possible that protein consumers may generate a backlash.  

• Catalysts:

• Launch of Genus’ sorted sexed semen product. This will free up R&D currently burdening the P&L, increase operating margins of the Bovine division, and likely surprise to the upside in volumes.

• Turnaround in the dairy market.

• Eventual launch of other pipeline products and release of growth R&D burden.

• Acquisition by a strategic (Bayer, Dow, etc).

Catalyst

• Launch of Genus’ sorted sexed semen product. This will free up R&D currently burdening the P&L, increase operating margins of the Bovine division, and likely surprise to the upside in volumes.

• Turnaround in the dairy market.

• Eventual launch of other pipeline products and release of growth R&D burden.

• Acquisition by a strategic (Bayer, Dow, etc).