Sunday, 1 February 2015

Investing in agriculture

Agriculture commodity (corn, soybean etc) prices took a beating last year as increased production handily outstripped demand growth. This led to an increase in stockpiles of corn and soybean, in turn pushing down prices (for instance corn reached around $5/bu at peak in 2014 spring vs low $3/bu as 2014 progressed). On the supply side there are a number of factors at play but the most important is the expansion of planted acres. Over the last decade demand for ethanol and emerging market use of crops increased substantially, which farmers met by increasing the planted area to produce more crops.

Agriculture is a “supply story” with a relatively steady growth in demand. The key driver of demand is coming from emerging markets (increasing affluence, different lifestyle, different eating habits, more protein…nothing surprising). As it is very much a weather impacted business one bad year can leave you with low production (see the drought in 2012) but higher prices, while near perfect weather and growing conditions (as witnessed over in 2014) can cause the opposite. Despite the steady demand this introduces a lot of cyclicality. While the rational move would be to cut production it’s actually quite hard and farmers are instead rotating to higher profitability crops (to soy from corn). We are looking at potentially strong production in the next growing year as well. When crop prices reached their lows last year they were near the marginal cost of production for both corn and soy in key growing regions (US and Brazil really). On a historical basis crop prices haven’t dropped below marginal cost of production for meaningful periods.

While one or two bad years are not the end of the world from a farmer income perspective as balance sheets are quite strong from previous years, farm income is going to be down this year (potentially next) thus farmers will have to make some tough choices on how to allocate capital. The key areas for the cuts are in (i) machinery (combines, tractors) (ii) rent (where land is not owned) and (iii) some chemicals (inc. fertilisers) while the areas not high on their mind to cut spending from are (i) seeds and (ii) storage.

Ag machinery is the first place most are expected to make cuts from as they have no need for replacement (fleet is actually quite young - 7 year avg. tractor age in the US vs 30 year useful life - following years of strong capex) and they also have no budget for it. On the chemicals side, farmers are expected to keep herbicide and pesticide use as these products are needed (vs nice to have) though there could be some decline in expenditure as some crops are more heavy users of chemicals than others. On the fertiliser front (NPK), depending on crop and geography, nitrogen has to be applied every year as it cannot be stored in the soil while P/K can be skipped in a year or applied only to the scientific recommendations, so there are likely to be cuts in the application of the last two.

On the other hand, seed is the last place most farmers would cut expenditure from (as they’ll keep planting on large acres) and as a result seed companies haven’t started meaningful discounting of prices either. On-land storage is important now as farmers would rather keep everything on the farm then to sell the produce at such low prices to a trader. The above is the framework I use to look at potential investments in the sector.

In the short term crop prices are expected to remain range bound given the supply picture, while lower oil prices are also not helping (positive for farmers' energy bill, not so much for ethanol and other biofuels on a relative basis). Over the long term I feel fairly confident that for instance emerging market demand for crops and various commodities will continue to be steady and that more production will be required over time (though it will remain cyclical especially as we experience increasingly odd weather patterns). However, that new production will not come online at current prices. For instance, in Brazil to bring on additional land to grow soy – of which the majority goes to China - requires at least $12/bu prices vs the below $10/bu currently.

Perhaps the best approach in taking advantage of this down cycle is via buying a basket of stocks, perhaps of the badly hit ones. Though I do think that you've to look through at least 2015 to make money as most seem to expect 2015 to be the trough. While engaging in market prediction is as useful as a glass hammer, if it doesn’t materialise there could be some serious carnage in ag names during the year. Below are a selected few that I’ve been looking at though don’t think you are in any particular rush with these names; it could get worse before the sun comes out again.

AGCO: US listed, pure-play ag company (as the name would imply) involved in everything from farm machinery, storage to farm equipment with well-diversified global sales base. Company has about $4bn market cap, $5.1bn EV and trades around 6x EV/EBITDA (NTM) and 15x P/E. The company is carrying out cost cutting measures to increase margins, which is relatively low vs peers, initiated a $500m buyback last year (to be completed early this year) and another $500m to be carried out through 2016.

CNH Industrial: The company consists of the industrial business of Fiat and CNH Global following their merger in 2013, when it went public in this reorganised state. Since then the stock is down to around $7.7 at last read (or around 40%) as it is heavily geared towards global agriculture, LatAm trucks and European construction. Current market cap around $10bn and EV of $12bn, trading at 4x EBITDA and 14x P/E. Over the last year peer Deere & Co outperformed CNH by a wide margin, likely due to it’s buyback programme. CNH does have a buyback programme in place but haven’t used it to ensure achievement of an investment grade rating. The company laid out its “strategic vision” (consultant speak for how to come out of this mess we find ourselves in) last year through 2018 – growing sales, cutting costs, improving profitability etc. It’ll be one hard long slog though you do have Sergio Marchionne as the chairman (he did surprise investors on many occasions before) and Exor controlling 40% of the votes.

Valmont: I came across this one in a recent Third Avenue shareholder letter. It's a $3bn market cap ($3.3bn EV) US listed company that makes poles, towers for utility transmission, wireless communication and lightning equipment in addition to being one of the largest players in irrigation equipment that is used in agriculture. The ag business is under pressure as described above while the utility business faces near term pressure on pricing. It's currently trading at 6x EV/EBITDA and 15x P/E and offers a 2% dividend yield.

Cresud (highly speculative): Admit it’s an odd one but just couldn’t help it. Small ($500m market cap) Buenos Aires listed company, with ADSs on the NYSE, trading at a huge discount to NAV. The company is in the production of crops, beef, milk etc as well as farmland development (where they have a good track record) - it is essentially a play on LatAm farmland (Argentina, Brazil etc). In addition via a 65% stake in IRSA it is engaged in residential and commercial real estate in Argentina. With this you are also implicitly making a bet on the outcome of the coming elections in the country. Argentina has substantial ag production, however given high export taxes and unsupportive policy it simply becomes uncompetitive. Opposition parties have indicated more favourable outlook for the ag sector simply because of its importance for the country, so that could be a positive (though take campaign promises with a large pinch of salt).