|Why Bunge Is a Buy Now|
JAN 20, 2012 1:40 PM
Bunge is one of the largest companies involved in the purchase, storage, moving, processing, and sale of agricultural commodities worldwide -- and that's not going to change.
With consumers in the US and Western Europe under so much financial pressure these days, most every branded consumer staple product is under severe economic competition from private label.
Additionally, consumers likely face pressure from the effect of a sovereign debt-related recession in the US and Europe. And in a worst-case environment of a Chinese recession, worldwide consumers are going to be in even worse straits. In a situation where, for instance, Pepsico’s (PEP) Frito-Lay division -- the king of junk food -- is losing market share on price to regional companies that do not even have national distribution or credible advertising budgets, there are not many safe harbors that are also undervalued.
On a longer-term basis, no matter what happens to the other consumer stocks’ earnings, I believe that the consumers in the emerging markets will spend more money on better food, whether more protein or just more calories. On that basis I recommend purchase of Bunge (BG).
Bunge, Archer Daniels Midland (ADM), Cargill, and Louis Dreyfus are the largest companies involved in the purchase, storage, moving, processing, and sale of agricultural commodities worldwide. While there are numerous other companies involved and I have never seen any figures on actual market shares (I doubt they exist), I believe that these companies are slowly taking market share, if for no other reason than because they have the infrastructure needed to source (at lowest cost) and transport huge amounts of commodities from and to all parts of the world. They also have the capital needed for further development of African agriculture in the next decade. Because of that, I believe that there will be a mild degree of oligopoly power developing over the next five to 10 years for these companies.
I believe Bunge’s normalized earnings level to be $7 per share, but the company’s sell-side earnings per share estimates are $5.89 for 2011 and $6.68 for 2012. The low estimate for 2012 is $5.75, which assumes that soybean crushing and sugar will come back slowly.
Bunge has not been earning at its cost of capital in soybean processing and sugar. Soybean processing returns are under pressure from overcapacity in North America. The utilization ratio is about 82%, which is not good for pricing. There have been two closings announced, one by Archer Daniels Midland and one by Cargill.
Based on long-term worldwide food consumption estimates, consumption should grow by 2% annually through 2050, and given soy’s uses for higher proteins (animal), it should grow faster than that. Consumption should be greater in the earlier years of that long-term forecast, if for no other reason than worldwide population growth is slowing.
So, let’s say production has to grow 3% to 4%. If production of soybeans grows 7% over two years, the utilization of processing facilities should be around 89% before any plant closures. A 90% operating rate generally, in my experience for most companies, corresponds to a normal operating rate and normal pricing.
Sugar is a business somewhat new to Bunge. However, it is an agricultural commodity with the same characteristics of the other commodities that Bunge is in. Bunge entered the sugar business about two years ago, using proceeds from the sale of its fertilizer production business. Bunge has been guiding sugar processing to 17 million to 19 million tons for 2012 versus 14 million to 14.5 million tons in 2011, 21 million tons being full capacity with higher crush margins.
Bad weather in Brazil was the culprit in the last two years' low sugar crush. Again, I believe that it could be two years until the business reaches a normalizable level. But, as with soybean processing, I believe that a bottom has been passed, especially with a third-quarter earnings disappointment that cut Street estimates of next year's earnings by about $1 per share, and cut the stock price, too.
Valuation metrics could and should change longer term.
At $58, Bunge stock discounts zero growth forever from a sell-side average estimate of $6.68 for 2012. That assumes a 4% risk-free rate (30-year T-bond + 1% for too-low rates now) and a 7% -- yes, a 7% -- risk discount. Okay, now just adding an infinite 2% growth rate warrants a $70 price, up 20%. But that assumes a loss of market share. So how about with about 3% to 4% revenue growth via some growth in protein consumption and some mild market share gains for a five-year compound annual growth rate after 2013? That results in a 5% growth rate and a $79 price for 36% appreciation.
But a 7% risk discount is absurd! This company is an industry leader in one of the most basic industries there is: food commodities. The commodity companies get this 7% because their earnings are volatile, and the analysts cannot model their earnings, especially quarterly EPS.
But stock market volatility is indicative of risk only for a trader. Real business risk is whether the company will go away in five or 10 years, or if its returns will be much lower at that time. These companies are not going anywhere, even if analysts and portfolio managers foolishly waste their time trying to put a Wall Street-like trading result and almost a linear program of returns from processing plants’ options into a quarterly Excel model!
This is a good place to interject that I have learned from following Archer Daniels Midland that you cannot get bogged down in the quarterly trends and activities of these companies. You cannot predict them; they change too often, and it takes up way too much analysis time. I decide what I believe the normal earnings level is and what the long-term growth rate is. Then I look for changes in these underlying metrics. You buy when the valuation is significantly below deserved valuation and mostly forget about catalysts, many of which you cannot predict. You sell when you get to normal valuation.
Downstream, the food processors are assigned 4% by the market. I believe that there is a good chance that this situation could finally change in favor of the commodity-related companies because the processors are losing share to private label, and the commodity companies will be experiencing growth from better diets demanded by people in developing countries. The process may be slow, but using a 6% risk discount would increase the target price to $90, as 54% appreciation.
One final thing bearing on risk is a bad debt situation coming from loans to farmers in Brazil to buy Bunge’s fertilizer from the 2006 crop year. Lending to farmers was something that the Brazilian banks did very little of back then. A number of factors, including poor weather, bad market conditions, and unfavorable movement of the real versus the dollar, caused the problems.
Farmer financing comes less from the agricultural supply companies than it did back then, and payment terms are much shorter now, so I do not see this happening again. Sell-side analyses I have seen and that seem to be reasonable put the risk of further write-offs (they have been feeding into earnings for some years now) at $3 to $4 per share, which would take place over maybe the next five years.