Why ADM Is a Buy Right Now

By Ronald Thomas, CFA  MAR 26, 2012 11:20 AM

A number of factors make $32 an attractive price for ADM, including the prediction that consumers in emerging markets will soon be spending more on food.


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 it's more protein or just more calories. On that basis I recommend purchase of Archer Daniels Midland (ADM).

Archer along with Bunge (BG), Cargill, and Louis Dreyfus, are the largest companies involved in purchase, storage, moving, processing, and sale of agricultural commodities, worldwide. While there are numerous other companies involved in these functions -- and I have never seen any figures on actual market shares (I doubt it exists) -- I believe that these companies are slowly taking market share, if for no other reason than the fact that it takes massive infrastructure to source (at lowest cost) and transport huge amounts of commodities from and to all parts of the world, and much capital will be 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 if this is not already the case.

Archer’s $32 stock price, using my calculated consensus calendar year EPS estimates of $2.80 and $3.35, respectively, for 2012 and 2013, implies a 1% infinite growth rate, using a 4% risk-free rate and a 7% risk discount. While EPS can be very volatile for companies in these businesses, these are good numbers. Normalized EPS is above $3, and, just hitting the three biggest segments, is based on an average Ag Services pretax profit before tax since 2008, Oil Seed Processing pretax profit when in the middle of a normal $.60-.80 per bushel range, and Sweeteners and Starches pretax income averaged from 2008 through 2010.

But that 1% growth rate is only equal to worldwide population growth. An increasingly prosperous world -- with GDP growing at about 4% overall and at much higher rates in areas with the worst diets -- is going to grow its food spending at higher levels, mainly from greater consumption of higher proteins that convert feed to calories less efficiently than grain consumption (ex. chicken, pork worse, beef worst). Hence a 3-4% gain or agricultural volume growth rate seems warranted. Possibly another 1% in growth rate could be added for new crops that these companies were not in before, such as cocoa for Archer and sugar cane for Bunge. Crop yield disparities from year to year in different areas create a need for storage and shipping from place to place and a need for economies of scale to do that. There are economies of scale in these businesses, and that almost guarantees that there will be market share gains by a number of bigger players in the industry. So, add 1-3% growth for increased market share for Archer and other big industry players. Therefore, give Archer a 5% five-year EPS growth rate and the stock deserves 24% appreciation to $39.

Now let’s go back to the 7% risk discount. It is absurd! This company is an industry leader in one of the market's most basic industries: 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 their returns will be much lower at that time. These companies are not going anywhere, even if analysts and PMs foolishly waste their time assigning a Wall Street-like trading capitalization onto what is almost a linear program of returns from processing plant options, just because they cannot represent what these companies will do in their quarterly Excel models.

This is a good place to interject what I have learned from following ADM: 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's 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 $45 instead of $39. Some, or more likely none, of that risk re-rating may come in a 9- to 15-month holding period. But I believe that it will be coming.

There are a number of catalysts to get the stock up. The first is more productive capital investments. The company, over the last 25-plus years and three CEOs, has had a history of over-investment as it has made investment in extra large processing plants and ended up waiting years for demand for the processing to grow into efficient capacity utilization. This has happened in ethanol and most lately in soybean processing in the US. Archer has also spent too much of its CAPX in the US, for instance not going heavily into Brazil when Bunge did.

On the company's earning conference call, management talked about higher hurdle rates for capital expenditures generally and even higher ones on businesses that it's less experienced at. It said that the total of capital and merger & acquisition (small stuff) expenditure for the fiscal year ending in June would be 15% less than originally planned. It further said that 70% of growth investment would be either international or in US-based operations oriented to international end markets. The CEO said that she wanted to again get ADM’s return on invested capital back up to 2% over their cost of capital. Sounds good to me.

Soybean processing is one of the businesses that saw too much expansion by ADM among others and in the wrong place, the US. Using USDA estimates of 5-6% long-term worldwide demand for soybean processing, the 82% operating rate quoted by Bunge should get to 90%, which should be somewhat normal, within two years. Two small closures in the US were recently announced, hopefully with more to come.

Finally ethanol, which has contributed more than its deserved share of ADM’s earnings to investor worries and a volatile stock price, is now competing without a tax incentive.
No positions in stocks mentioned.

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