Global Agriculture – A Powerful Long-Term Theme, but Near-Term Concerns Abound

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES 

Rob Campagnino/Graham Copley

203.901.1624/203.901.1629

rcampagnino/gcopley@ssrllc.com

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Sunday, March 23, 2014

Global Agriculture – A Powerful Long-Term Theme, but Near-Term Concerns Abound

  • The price of agricultural commodities directly and indirectly impacts a large number of equity sectors, including protein, restaurants, machinery, chemicals, and packaged food. An understanding of both the long and short-term drivers of commodity prices is an important tool that will be used to support SSR’s mission of multi-sector analysis and portfolio weighting across sectors.
  • There are a good number of people on the planet – and the number is growing. That isn’t particularly new, useful or actionable information (Thomas Malthus had it figured out, sort of, in 1798), but what might be new information is that world population growth peaked in the period 1965-1970 at just over 2% annually (+2.1%) and has slowed steadily since (+1.2% annually in the period 2005-2010).
  • Along with population growth, global caloric intake increases along with increases in per capita GDP. In developing countries, as economies grow and income levels rise, diets undergo a fundamental change with the associated positive effect of, generally speaking, making fewer people food insecure. Essentially, the world’s population is in the process of gaining the ability to acquire greater amounts of food and, initially, greater amounts and varieties of nutritious foods.
  • These two long-term trends – population growth and increases in per capita GDP – combine for a favorable, multi-duration tailwind for equities with leverage to the global agricultural complex.
  • However, a combination of shorter-duration factors related to issues such as valuation, short-term supply disruptions and elevated prices for certain commodities keep us on the sideline for certain sub-sectors. At present, the prices for several agricultural commodities remain elevated versus historical levels. There are multiple factors contributing to these prices, but most directly we have water stress in certain key agricultural regions as well as geopolitical concerns impacting crop transportation infrastructure. While these shorter-term disruptions certainly represent trading opportunities in both commodities and equities, our long-term mantra with respect to commodity prices is that there is always another crop, and to be mindful of the long-term trend in most commodity prices, which is generally lower.
  • Sector Commentary:
    • Protein – there is a long-term investment case to be made for global protein consumption. Having said that, it appears to us that margin and earnings expectations are extremely robust in the names that are most levered to this theme – TSN and SAFM and we would therefore look elsewhere within the investable agricultural universe for opportunities on the long side and we could, in fact, abide by investors being short TSN particularly as we expect that corn prices will continue to drift higher and soybean prices are already elevated.
    • Agricultural processors – we believe that a fundamental mismatch exists between where the growth in consumption of agricultural commodities will be (global population growth) and where the crops are actually grown. Both ADM and BG represent compelling long-term plays on this theme. However, at the moment, we do not see a favorable risk/reward profile in either name and both names are expensive based on our preferred valuation metric.
    • Fertilizers – While we see upside to corn prices, and recognize that fertilizer prices are tightly correlated with corn prices (as the most fertilizer intensive crop) our inclination would be to fade any significant positive moves in fertilizer stocks as we believe that any expectations of a return to the halcyon days of $900 per ton potash prices are extremely unlikely.
    • Seed and Ag Chemicals – We are more positive on seeds and Ag Chemicals – on the assumption that farmers will seek to maximize yield regardless of commodity prices (balancing demand by planting fewer acres).  We add MON to our favorite list as a result, and this adds to our conviction on DD.  It also puts us more on the fence on DOW, particularly if the company is serious about exploring options to establish a market value for its AG business.
    • Agricultural machinery – we remain cautious on machinery – despite almost compelling trough relative values – as we see no near or medium term positive catalyst.  Farmers will buy seeds and chemicals when margins are low, but not machinery.  The risk is a broad rotation into Capital Goods.
“The power of population is so superior to the power of the earth to produce subsistence for man, that premature death must in some shape or other visit the human race. The vices of mankind are active and able ministers of depopulation. They are the precursors in the great army of destruction, and often finish the dreadful work themselves. But should they fail in this war of extermination, sickly seasons, epidemics, pestilence, and plague advance in terrific array, and sweep off their thousands and tens of thousands. Should success be still incomplete, gigantic inevitable famine stalks in the rear, and with one mighty blow levels the population with the food of the world.”

  • Thomas Malthus, An Essay on the Principle of Population

There are a good number of people on the planet – and the number is growing. That isn’t particularly new, useful or actionable information (Thomas Malthus had it figured out, sort of, in 1798), but what might be new information is that world population growth peaked in the period 1965-1970 at just over 2% annually (+2.1%) and has slowed steadily since (+1.2% annually in the period 2005-2010). While the absolute number of people is a staggering one, the data suggests that Malthus’ rather dire prediction may continue to prove incorrect. The most optimistic scenario set forth by the United Nations Population Fund has the global population peaking as early as 2049, with a base case estimate of 2100 (Exhibit 1).

Exhibit 1: Global Population

Virtually all of the forecasted population growth is expected to take place in developing regions of the world (97.9%, Exhibit 2), with fully one half of the global population growth between now and 2050 expected to occur in Africa (53.7%). Notably as well, Europe, in aggregate, is expected to see population declines – fertility in almost all European countries is below the level needed for population replacement and the United Nations data that we have used as a source actually contemplates an increase in European fertility over the forecast period, so the population declines may actually be more significant than these numbers suggest. The United States is expected to experience population growth, but largely by dint of immigration as the U.S. fertility rate is just below the 2.1 children per woman rate needed to replace ageing adults in the population over time.

One issue we won’t delve into at this time but is certainly worth mentioning for its economic and policy implications is that as fertility rates decline and life expectancy increases, the average age of the population of a given country or region (or planet, eventually) increases. We have seen this in developed regions where the percentage of the population under 15 (younger) when compared to the percentage of the population over 60 (older) has changed from

  • 27% younger vs. 12% older in 1950 to;
  • 16% younger to 23% older in 2013;
  • Estimates for 2050 are 16% younger to 32% older

Exhibit 2: Global Population Growth Estimates by Region

What Malthus got wrong, and it is a forgivable mistake given when he lived, was that many developed countries have undergone a demographic transition (no country had experienced this transition in Malthus’ day) – this expression refers to the move, over time, from the pre-industrialized condition of high birth rates and correspondingly high death rates to low birth rates and low death rates. In just about five decades, the global rate of natural increase (crude birth rate less the crude death rate) has declined from 18.1 per 1,000 population to 11.6 per 1,000 population.

As we know, averages are generally made up of multiple data points and in the case of a broadly declining natural rate of population increase, there are areas that are declining less rapidly or declining from a greater height. In the case of the natural rate of increase, Africa is the clear outlier in our chart, explaining that continent’s anticipated significant contribution to global population growth over the next four decades (Exhibit 3).

Exhibit 3: Rate of Natural Increase

Malthus was Wrong, but the Population is Growing…What’s Next?

Make no mistake; the global population is almost certainly going to continue to grow (zombie apocalypse or alien invasion aside). Presumably, everyone will need something to eat, at some point, even if it is just a little gnosh.

Some perspective is needed at this point – the global population has doubled in the 40 years between 1960 and 2000. Yet, during that period, global per capita food consumption (measured in kcal/person/day) has increased from approximately 2,300 kcal to 2,800 kcal and the percent of the global population consuming less than 2,200 kcal per day has declined from nearly 57% in the mid-1960s to just under 10% today (Exhibit 4). Malthus aside, the world has done a pretty bang up job feeding itself over the course of the past couple of generations.

Of course, this hasn’t been accomplished without cost – for example, water consumed globally for agriculture now represents approximately 70% (based on United Nations data) of total consumption as population increases and changes in eating habits requiring more water consumption per capita (increased protein consumption, for example) have accelerated the total amount of water consumed for agricultural uses. Certainly, the increased production of biofuels has also had a significant impact on water demand, blurring the lines between agriculture and energy.

We won’t go too far down the water rabbit hole at the moment, but one need only examine the current impact of “water stress” on Sao Paulo and California and those regions’ contributions to the global agricultural complex to see that water consumption and water stress will almost certainly be key, global themes for the next several decades.

Exhibit 4: Population and Food Consumption

Growth of the Global Middle Class and Urbanization

Wealth (and poverty) has a significant impact on diet. In the U.S., changes in income levels translate into increased consumption of prepared foods and increased consumption in food away from home (dining out). In developing countries, as economies grow and income levels rise, diets undergo a change as well. Generally, speaking, caloric intake increases along with increases in per capita GDP (Exhibit 5) with the associated positive effect of, generally speaking, making fewer people food insecure. Essentially, the world’s population is in the process of gaining the ability to acquire greater amounts of food and, initially, greater amounts and varieties of nutritious foods. One final point to consider is the very real possibility that the curve in Exhibit 5 curves back as greater levels of income translate into a healthier lifestyle and lower levels of caloric intake.

However, earlier, we referenced the concept of demographic transition, but there is also the concept of the “nutrient transition”. In less developed countries, as the rural population transitions to urban environments (Exhibit 6) and per capita income increases, diets become fundamentally less healthy over time. Rural diets that were once high in complex carbohydrates and fiber transform into diets with a higher proportion of saturated fats and sugars – per capita consumption of vegetable protein declines, replaced by consumption of animal protein. The long-term trend of urbanization will continue to drive the growth in global agricultural trade even as the population consumes more animal protein – hogs and chickens have to eat something, after all, as those animals grow up to be meals.

Exhibit 5: GDP and Calories

Exhibit 6: Urbanization

We expect the world will fall short of the Judge Dredd Mega-City/Cursed Earth dynamic, nearly 10% of the global population lives in 23 urban centers, with that number expected to increase to nearly 14% by 2025.

Feeding the World

The world has managed to accomplish (by and large) the fairly basic act of feeding itself without significant inflation (until 2008) in the price of most agricultural commodities. Of course, there have been shorter-term supply/demand disruptions (in some cases multi-year in duration, and we will discuss the current situation in greater detail below), but for the most part agricultural commodity inflation has been rather benign relative to the broader measures of inflation (Exhibit 7).

At present, the prices for several agricultural commodities remain elevated versus historical levels. There are multiple factors contributing to these elevated levels, but most directly we have water stress in certain key agricultural regions as well as geopolitical concerns impacting crop transportation infrastructure. While these shorter-term disruptions certainly represent trading opportunities in both commodities and equities, our long-term mantra with respect to commodity prices is that there is always another crop, and to be mindful of the long-term trend in most commodity prices, which is generally lower.

How did the world feed itself?

As with most things in life, there is no single, simple answer. In this case, we can point to several factors that, combined, have led to decreases in the percentage of the global population that is food insecure:

  1. Lack of continued growth in kcal/person in developed countries. As more and more countries reached the 3,500 kcal/person/day level, incremental demand becomes much more muted and may, at some point, decrease given our comment that these diets have become fundamentally less health over time (the hypothetical curve back displayed in Exhibit 5).
  2. Expansion of arable land, predominantly in developing countries, partially offset by small declines in arable land in developed countries. Of course, arable land per capita (hectares per capita, approximately 0.20 in 2012) has been declining steadily for decades, mostly due to substantial increases in the denominator and more modest increases in the numerator.
  3. Increase in crop yields– agricultural yields have risen consistently throughout the history of human cultivation, with particularly steep increases seen during the 20th century. Future global food security will rely heavily upon the rate of gains in yield for the major cereal crops. Bear in mind that there is historical evidence that suggests that yield plateaus do exist.

The “Green Revolution” – advances across multiple disciplines that combined to significantly increase agricultural production worldwide – fundamentally transformed agriculture in developed markets and largely created the companies that today make-up the investable universe of agriculture-related equities across seed, fertilizer, pesticides, equipment and transportation. To one degree or another, each of these inputs has contributed to increased agricultural productivity over time in developed markets and has the capability to do likewise in those of the world (Africa, for example) where the output rates from each unit of land are below world averages.

Even during the current period of elevated agricultural prices, we are of the opinion that there is sufficient food globally to meet the dietary needs of the world’s population. However, according to the Food and Agriculture Organization of the United Nations, the price inflation of 2008 meant that an additional 200 million people globally were hungry (from a base of 800 million). In terms of global hunger, we are of the belief that much of the remaining challenge is economic, distributional and political in nature rather than constrained by the ability of the world’s farmers to meet current demand.

Exhibit 7: Agricultural Commodity Prices

The Current Situation

We mentioned above certain factors that have contributed and may continue to contribute to elevated prices among certain commodities at certain points in time. For example, wheat prices are hovering near $7 per bushel over concerns about the political crisis in the Ukraine and the impact it may have on that the prospects for that country’s grain exports. Additionally, the U.S. winter wheat crop is facing the prospect of “winter kill” after what was obviously an unseasonably cold winter.

Similarly, corn prices have climbed back up toward $5 per bushel as it appears that the uncertainty surrounding the cold weather in the U.S. creeping into the corn planting season and the relative price between soybean and corn futures (a key influence in farmers’ decision making process) may combine for fewer corn acres planted versus 2013. Recall that the ‘12/’13 and ‘13/’14 crop years saw substantially elevated corn prices, prompting farmers to plant corn fence post to fence post. With that incentive removed or decreased on the margin, we do expect that planted corn acreage will decline (our forecast is for a decline in planted corn acreage to 93.5 million acres), but that, barring adverse weather conditions, yields should remain near the long-term trend line (Exhibit 8).

Soybean prices are elevated as well, primarily over concerns regarding the Brazilian crop. As mentioned above, U.S. soybean plantings will likely reflect the relative strength of soybean pricing, with U.S. farmers planting more beans relative to corn on a year over year basis.

Milk is another commodity where prices have firmed and remain elevated (a bit of an understatement) based on a combination of weather factors (California is the largest milk producing U.S. state) and robust foreign demand. Milk prices have recently hit all-time highs and to the extent that some of the price action stems from incremental (foreign) demand (rather than a supply shock), we expect milk prices to remain elevated. Some relief may be forthcoming in the second half as drought conditions improve (lowering costs as hay is currently being shipped into the state) and herds that were culled over the course of the past several years due to higher corn costs slowly return to more normalized levels. Elevated milk prices tend to be bad news for DF, a name that we like on an eventual return to normalized levels of profitability, but have been early with respect to our view – we suspect that 2H ’14 will be kinder to investors in the commodity milk company and continue to believe that DF will be an excellent long at some point, just not today.

Exhibit 8: Corn – Historical Acreage and Yield

Coffee is yet another commodity that has headed higher in 2014 due to weather-related issues, this time in Brazil, which accounts for about half of the world’s total arabica coffee production. Significant production declines are anticipated due to drought conditions in key growing regions. There have been substantial downgrades with respect to forecasts for the country’s harvest later this year. The same concerns have provided fuel for rallies in sugar and orange juice markets (Where in the hell is Beeks?).

Pork, beef and chicken prices are similarly elevated, for a number of reasons as well. In the case of pork, hog futures have spiked because of a nasty virus (PEDv), a disease that can be devastating to swine herds. What is unclear to us is whether or not the reality of the disease is sufficiently negative to justify what has been a significant move up in hog futures. Strong demand from export markets across proteins will likely keep prices elevated as animal populations continue to be rebuilt following active culling over the past several years due to higher feed costs.

Keep in mind, there is a long-term investment case to be made for global protein consumption as well, based upon the same analysis that we conducted earlier. Having said that, it appears to us that margin and earnings expectations are extremely robust in the names that are most levered to this theme – TSN and SAFM and we would therefore look elsewhere within the investable agricultural universe for opportunities on the long side and we could, in fact, abide by investors being short TSN particularly as we expect that corn prices will continue to drift higher and soybean prices are already elevated. Based on our quick summaries, it is clear that consumers around the world are feeling or will soon feel the pinch of higher food prices (Exhibit 9).

Exhibit 9: Global Food Price Indices

With respect to commodities, our view is to be long corn at these levels – not so much based on the concerns surrounding lower acreage year over year and the late start to plantings (certainly valid, however), but rather because corn has become relatively inexpensive versus other feed components and we expect that we will see increased feed consumption of corn in both U.S. and foreign markets. Additionally, export demand for ethanol (discussed in greater detail below) could drive higher corn use for domestic ethanol production. While we believe that the rebuild of corn stocks that began with last year’s harvest is restoring “normalcy” to corn stocks (Exhibit 10), we can make a case for incremental demand through 2014. In Exhibit 11, we see that bullish bets on the price of corn haven’t reached a point where the commodity looks “stretched.”

Additionally, we also see an opportunity to be short wheat, but believe that may be more of a 2H ’14 trade.

Exhibit 10: Stocks to Use – Corn

Exhibit 11: Corn, Price and Sentiment

Bio-Fuels – Driving Agricultural Commodity Prices Since 2006

We have written somewhat extensively as to what we see as the uncertain future facing corn-based ethanol in the U.S., due to a number of concerns. By way of background, we want to review the pattern of legislation that was the genesis of the ethanol industry in the U.S.

The Renewable Fuel Standard (RFS) was created under the Energy Policy Act of 2005, and expanded and revised by the Energy Independence and Security Act of 2007 and ultimately created a renewable fuel volume mandate in the United States. Beginning in 2008, the RFS legislation required that 9.0 billion gallons of renewable biofuel be blended for motor vehicle use in the U.S. The RFS currently calls for the blending of 36.0 billion gallons of renewable fuels by 2022. Several reasons were given in support of the legislation:

  1. Reduce foreign oil dependence (essentially a national security claim)
  2. Reduce greenhouse gas emissions (an environmental imperative) – each renewable fuel category must emit lower levels of greenhouse gases than the petroleum based fuel that it replaces.
  3. Increase rural economic activity in the U.S. (an economic rationale)

As you can see, there was a little bit of something for everyone in terms of the logic behind the RFS, and it certainly didn’t hurt to support it if you were a politician from a state that happens to have a cornfield. The ethanol industry (in its infancy at that point) was in fierce agreement (obviously) while a host of business interests have since aligned against the mandate, starting with the petroleum industry and continuing on down to include any business that uses corn as an input, either directly or indirectly.

The entire standard mentioned above does not have to be met with corn ethanol, particularly in the later years of the mandate. The four categories covered under the requirements are:

  1. Biomass-based diesel (soybeans used as feedstock)
  2. Non-cellulosic advanced (fuel other than ethanol derived from corn starch)
  3. Cellulosic advanced (fuel derived from lignocellulose – basic material of plants – crops such as switchgrass)
  4. Conventional biofuels

While cellulosic ethanol (hopefully) represents the future, the conversion process is not yet economically viable. While the 2022 mandate of 16.0 billion gallons from cellulosic is a worthwhile goal, 2022 isn’t all that far away and the technology just isn’t there yet. The bulk of the near-term RFS falls to conventional biofuels.

The Blend Wall

At its core, the RFS requires that the petroleum industry blend more renewable fuels with gasoline each year. That was all well and good and refiners were able to hit their quotas as ethanol as a percentage of U.S. gasoline crept toward the 10% level. However, refiners are reluctant to blend with more than 10% ethanol because the effect of higher blends on automobile engines has yet to be determined. This wouldn’t be much of a problem in a world where domestic gasoline consumption was growing (the perils of straight-lining a trend). However, the Environmental Protection Agency (EPA) quite literally top-ticked gasoline consumption in the U.S. when it laid out the RFS back in ‘07. Gasoline consumption has declined every year in the U.S. since 2007 (Exhibits 12 & 13). While it is tempting to blame a sluggish economy for declining gasoline consumption, the primary driver has been an increase in the average miles per gallon (mpg) by model year from 20.8 mpg in ’08 to 24.6 mpg in ’13 (University of Michigan Transportation Research Institute).

Exhibit 12: U.S. Gasoline Consumption

The EPA has proposed a temporary fix to the 2014 blend wall concerns that seeks to insure “the continued growth of renewable fuels while recognizing the practical limits on ethanol blending, called the ethanol ‘blend wall’”. The lower requirements for blending renewable fuel have been met with aggressive (and predictable) opposition from ethanol interests.

Absent a significant and unlikely increase in gasoline consumption in the U.S., the blend wall is a fact of life and will need to be addressed on an ongoing basis, or torn down brick by brick by measures such as E15 (15% ethanol blend). However, E15 is facing a number of obstacles and is currently only available in a limited number of service stations across a handful of states – helpful, but ultimately we believe that ethanol is facing a significant demand problem that isn’t likely to be solved by the market on a long-term basis.

In the short-term, the fact that U.S. ethanol is competitively priced versus the global markets has boosted U.S. exports (Canada is the largest importer of U.S. ethanol, followed by Brazil) – Exhibit 14.

For our part, we happen to think that corn-based ethanol is a pretty crappy idea for a number of reasons, starting with it being energy inefficient and ending with mounting evidence that it has actually been horrible for the environment (essentially arguing against one of the cornerstone principles of the RFS), but at this point it is far too entrenched for anything other than minor tweaks in the near-term. We expect that the EPA will attempt to push ahead with higher blends (E15) and to continue to pin its hopes on a breakthrough in cellulosic (don’t hold your breath).

Exhibit 13: U.S. Gasoline Consumption – Monthly

Exhibit 14: Ethanol Exports

In the meantime, the realities of the blend wall will dictate yearly changes to the mandate as originally conceived, which should remove one source of potential upward pressure on corn prices. However, so long as the first stop on the road to the White House requires driving through a cornfield (Iowa), corn-based ethanol is likely here to stay regardless of the merits (or lack thereof, as the case may be) of the concept.

Long-Term Theme – A Fundamental Mismatch

Going forward, we continue to expect to see crop yields increase, albeit at a slower rate than over recent decades as well as continued modest expansion of arable lands in developing markets. Still, we believe that a fundamental mismatch exists between where the growth in consumption of agricultural commodities will be (global population growth) and where the crops are actually grown (Exhibit 15). What does that mean for investors? Well, it means continued expansion of the global trade in agricultural commodities and a multi-year tailwind for companies that are in the business of transporting commodities “from places of surplus, to places of need” (Cargill corporate saying) – agricultural processors.

Exhibit 15: A Fundamental Mismatch

What is Agricultural Processing?

Just as soon as that was typed that, it was regretted, because now we have to answer a question that has no simple answer. As quickly as possible, companies such as ADM and BG source agricultural commodities like corn, wheat or cocoa and transport and process it to end users for such diverse uses as food, feed or fuel (in the case of ethanol). Some agricultural processors are involved either further upstream in the value chain (own plantations, for example) or are involved further downstream (sell branded products directly to consumers). However, by and large, the companies are intermediaries between the crop producers (farmers) and consumers (packaged food companies, industrial users, etc.) that utilize a network of transportation assets and milling assets to deliver value to both ends of the chain.

Agricultural processors seek to increase volumes upstream and downstream – upstream, by deploying more assets and expanding to different crops. Downstream, volumes can be increased by diversifying product portfolios to appeal to more end users. It is a very capital intensive business and while barriers to entry may appear low (hedge funds have been known at various times to purchase grain silos), scale matters, location matters, transportation efficiency matters, marketing capability matters and diversity of end users matters. So, while one could buy a grain silo tomorrow, it would offer a far less compelling value proposition to area farmers than would the global competitors that, by the way, likely have superior local knowledge as well.

Globally, the companies’ asset bases include railcars, barges and port assets – not easily replicated and highly valuable within the context of the global agricultural supply chain. The long-term investment thesis is therefore improved returns driven by higher volumes over the company’s fixed asset base.

Agricultural Processors – A Globally Consolidating Industry

ADM’s recently foiled (by Australian Treasurer Joe Hockey over concerns about the foreign acquisition of a key Australian business) acquisition of Australian agricultural processor GrainCorp for $3.1 billion is the latest in a line of deals that we believe stem from the same strategic rationale. That is, the infrastructure (storage network, ports, railcars, barges, etc.) that has been built up over time by these companies are unique, not easily replicated and therefore highly desirable within the context of increased global agricultural trade. Prior to ADM/GrainCorp, Glencore International purchased the venerable Canadian company of Viterra, Canada’s largest grain handler for $6.1 billion. There was speculation that as many as four companies approached Viterra’s board independently. Just about a year ago, Marubeni (a Japanese trading house) acquired Gavilon, a U.S. based grain trader and the top U.S. importer of fertilizer.

Just recently, Temasek (Singapore’s state investment arm) bid for Olam International, an agricultural processor with some upstream as well downstream businesses and operations in more than 60 countries. Simply put, scale allows companies to be better positioned to more efficiently merge supply with global demand.

The deal making is not new – GrainCorp in 2010 bid for AWB, Australia’s former wheat export monopoly, Australian Wheat Board, which was largely deregulated nearly five years ago. GrainCorp was a bridesmaid in that transaction as it watched Agrium walk down the aisle with AWB. We could go on – Cargill/Provimi ($2.1 billion acquisition of animal feed business by Cargill), Viterra/ABB ($1.2 billion acquisition of Australia based ABB Grain). In fact, we could arguing in compelling fashion that Shuanghui Corporation’s $4.7 billion bid for Smithfield Foods is a very close cousin of this theme – growing demand for grains and protein in emerging markets.

The list of companies pursuing global scale in this industry includes Archer-Daniels Midland, Bunge, Cargill and foreign companies such as Wilmar International. Additionally, the Chinese have displayed an appetite for global agricultural assets ranging from farmland (the Chinese lease 3 million hectares of Ukrainian farmland) to crop trading assets. Cofco, China’s largest food processor and trader, recently acquired Nidera, a Dutch grain trading operation.

Ultimately, we expect that a less fragmented global industry will prove to be a positive development for the total industry’s return on capital.

Who could be next?

We are fairly comfortable suggesting that the deal making is not yet done – it’s hard to say what inning we are in, but there is plenty of baseball to be played yet. It’s a global business and the companies that we see as potential targets are all outside of the U.S. and this list is hardly dispositive of the issue, more an example of the types of assets that night be attractive to an acquirer.

Kernel Holding SA – Ukrainian company that is that country’s largest producer and exporter of sunflower oil as well as the country’s largest exporter of grains. The company owns a network of grain silos as well as a grain terminal complex located on the Black Sea (port of Illichevsk).

Nutreco N.V – Dutch company that is more focused on fish and animal feed, but certainly fits the theme.

Finally, it’s entirely possible that, at some point in the future, ADM takes another run at the GrainCorp assets.

ADM and BG, Just Not Right Now

Both Archer-Daniels Midland and Bunge represent compelling long-term plays on the growth of global agriculture. However, at the moment, we do not see a favorable risk/reward profile in either name and both names are expensive based on our preferred valuation metric (price to book, Exhibits 16 & 17).

Exhibit 16: ADM Valuation

Both companies have exposure to issues in the Ukraine and while the companies have commented that their Black Sea grain trading operations are unaffected, the situation is obviously dynamic. Further, uncertainty surrounding 2014 crop sizes due to water stress could negatively impact grain trading and processing profits. ADM’s U.S. corn ethanol operations could be at risk if we are correct that corn prices are poised to move higher and Brazilian ethanol companies have been struggling due to the combination of higher input prices (sugar) and efforts by the government to control inflation initiatives (subsidies for gasoline) that have reduced domestic ethanol demand.

Ultimately, we have concerns about the profitability of ADM’s corn-based ethanol investment and fear that the capital allocated to that business over a multi-year duration may prove out to be somewhat of an albatross for the company. It seems to us that there is a growing awareness that pumping fully 40% of the U.S. corn crop into gas tanks might not be the best idea in the world.

Longer-term, we consider BG’s investment in sugar and bioenergy (about 19% of net operating assets) to be in a superior position relative to corn based ethanol. Sugarcane as a feedstock for ethanol is a viable export business (Brazil is the largest exporter of ethanol in the world). Additionally, while increased production levels for corn ethanol in the U.S. must come largely at the expense of acreage currently being used by other crops, Brazil still has the opportunity for significant expansion of arable land and land associated for the production of sugarcane ethanol. Therefore, we prefer BG on a relative basis to ADM on a long-term basis.

Exhibit 17: BG Valuation

Farm Cash Net Income

Farm net cash income (cash receipts less cash expenses) should be down sharply in 2014 (Exhibit 18). The primary driver of cash receipts are crop receipts and livestock receipts (though government transfer payments are included, and will decline approximately $5 billion in ’14 versus ’13 based on the 2014 Farm Bill). Even recognizing the recent increases in the prices of a number of agricultural commodities, farm prices for most products declined sharply through the 2013 harvest and into 2014 as favorable weather conditions and fertilizer applications combined for a record crop for U.S. farmers.

Obviously, the short-term conditions can change on the basis of what farmers decide to plant in the spring, as well as the weather throughout the growing and harvesting seasons. In the short term, we believe that crop prices may exceed current expectations, bolstering farm net cash income in ’14. Having said that, the long-term trend (which presupposes normal weather conditions) is for only modest increases in farm net cash income in the coming years. The key takeaway for investors is that periods of excess farm income tend to be temporary in nature.

In our chart, the recent spikes of elevated income coincide with:

  1. Increased demand for corn due to domestic ethanol production (the so-called ethanol “pivot”)
  2. Increase in global demand
  3. Weather stress

There won’t be another ethanol pivot and we believe that a chance exists for a “reverse pivot” if the RFS becomes a matter of national debate. We believe that we have outlined the case for sustained increases in global demand, but that demand may be tempered by more modest growth in disposable incomes in emerging markets. We have suggested a number of times that one unintended consequence of central bank intervention in the wake of the global financial crisis was to inflate the currencies and consumption trends of emerging markets.

We aren’t weather forecasters and can’t predict weather stress – what we can do is acknowledge it as, generally speaking, a temporary regional condition that will usually trigger:

  1. A price reaction in the affected crop(s);
  2. Higher prices driving farmer actions (plant more, regionally and, in some instances, globally)
  3. Supply will increase and stocks will be rebuilt, over time
  4. Prices will come back down

Farm Input Costs – Fertilizers, Pesticides, Seed and Equipment

Farmers tend to be notoriously conservative, and with significant declines in crop receipts emerging as the likely state of nature in ’14, we should expect to see changes in how farmers manage the cost side of their business, with the larger cost buckets represented by crop inputs such as seed, fertilizer and pesticides. There are also capital spending decisions such as the purchase of a new tractor (Deere, DE) that can be considered.

Generally speaking, seed (Monsanto, MON) is not the place for farmers to cut back, or at least one of the last places. Farmers generally want the best seed technology to produce the highest-yielding, best possible quality crops. Cash expenditures for seed have increased at 7.8% CAGR since 2000, and we expect that trend to continue for one of the most critical crop inputs (Exhibit 19).

More on DE and MON in a bit.

Exhibit 18: Farm Net Cash Income (constant dollars)

Exhibit 19: Farm Income and Inputs

Fertilizers – Inexpensive, May See a Bounce, But Success of the Past Should Remain a Distant Memory

We have written at length about the decision on the part of the global, low cost potash producer, Uralkali to abandon the output limits that supported global potash prices. Back in late July ’13, Uralkali announced that it was leaving the export cartel in which it had participated (along with Belaruskali) since 2005. The cartel sought to balance supply with demand to maintain levels of profitability for the global potash market. Uralkali and Belaruskali together represent about 43% of the global export market. At the time, we suggested that the fertilizer names (particularly the global potash names, POT, for example) would likely be a source of funds for the next 3-6 months and indeed, POT was essentially flat through January ’14, with most of its recent outperformance coinciding with the recent market rally in the materials sector over the past month or so.

While we see upside to corn prices, and recognize that fertilizer prices are tightly correlated with corn prices (as the most fertilizer intensive crop) as seen in Exhibit 20, we believe that it any expectation of a return to the halcyon days of $900 per ton potash prices are extremely unlikely. In fact, even at current levels, fertilizer prices remain elevated versus corn prices, which is a determinant of how farmers will plant and nutrients will be applied (Exhibit 21).

Exhibit 20: Corn Prices and Fertilizer Prices

Bottom line, fertilizers stocks bounce if we are right about corn, and while we are obviously believers in the long-term growth story behind global agriculture that we have laid out, we don’t believe that thesis is best expressed by purchasing fertilizer stocks in a world where emerging market growth may be slowing on the margin and the cartel pricing algorithm appears permanently broken.

Exhibit 21: Retail Fertilizer Prices and Corn

Seeds, Pesticides and Machinery – Different and Divergent Views

We had begun the year cautious about all of the Agriculture names in the Industrials and Materials group because of a fear of weaker corn demand, lower prices and fewer acres planted. For the most part the stock valuations have been discounting this.

The body of this report causes us to change our position on the seed and chemical guys, while making us perhaps more cautious on the machinery names. While there is a chance that the corn market is stronger this year, we still are of the view that farm income in the US will be at or below normal for this year and perhaps into next if we get another meaningful leg down in US gasoline demand in 2015, cutting into corn ethanol demand.

Seeds and Chemicals – A Change In Expectations

What has changed for us is that we have a higher conviction that farmers will strive for the highest yields regardless of prices because of the efficiencies gained by planting fewer acres in a weaker demand environment. The corn yield trend shown in Exhibit 8 supports the views by the seed and chemical guys in the US that they have very strong growth ahead.

If we look at the return on capital chart for Monsanto, the company has seen significant return and margin improvement since its public debut – in line with the drive for greater farm efficiencies. The stock and the market got ahead of itself in the middle of the last decade as demand peaked, but MON has come back to steep return on capital trend – which is not reflected in valuation if it can be maintained. Note that Price to Sales rose with return on capital, as you would expect, through the 2007 peak, but has not recovered from the correction – Exhibit 23. While it is likely that there is additional upside to return on capital at Monsanto, clearly the trend of the last 13 years cannot continue indefinitely. It is more likely that the rate of improvement will slow once returns exceed 20%. While the growth story may break-down at some point in the future, and rely more on volume growth rather than margin improvement, we see some near-term momentum.

Exhibit 22: MON Return on Capital Employed

Source: Capital IQ and SSR Analysis

Exhibit 23: MON Price/Sales

Source: Capital IQ and SSR Analysis

Our normalized value framework is driven by return on capital trends and consequently shows MON to be very cheap, with as much as 35% upside to reach “normal value”. Clearly the company is going to need to deliver over the next 12 months to rebuild confidence that the sales and margin growth story can be achieved, but we have renewed confidence that this is possible and would now include this in our list of favorites.

For DD and DOW the story is the same – the quest for yield should be almost indifferent to agricultural commodity prices and sales and returns should continue to improve. DuPont has been confident that its Agriculture business is in good shape this year regardless of corn pricing and we support that view. As we have discussed recently, Dow Chemical’s Ag business is a very strong and valuable asset for the company and should DOW elect to establish a fair market value for it, either through a sale or a spin (partial or total), the value created for Dow shareholders would be high.

We already like the story at DuPont, and have written extensively on the company – this more positive view of Ag only adds to our enthusiasm – we think we have positive change, earnings acceleration and valuations support at DD.

DOW is a little less clear – again something we have written about – as there is not the valuation support, as with DD and MON, but change could still be good. We would recommend both DD and MON today, and are more on the fence with DOW, moving away from our more negative position, partly because of this work and partly because of the tone of the recent strategy presentation. To get really excited about DOW also we would want to see the company address its escalating operating, R&D and SG&A costs and capital spending. Current valuation metrics for all three stocks are summarized in Exhibit 24.

  • For MON, the stock appears cheap, based on history, and valuation is discounting a fall in returns and/or growth from current level, while our works suggests that the trend can continue for a while. We could easily see 20-25% upside in MON this year.
  • For DD we have a stock that is not as attractive as it was – but still attractive – some positive catalysts for change and again an expectation that returns are going to fall – we see similar upside to MON if the company can deliver the earnings growth it expects.
  • DOW is a little different as the valuation support is not there and valuation discounts improving rather than declining return on capital over the next 12 months – i.e. Dow has to surprise on the upside to support valuation while the other two are discounting disappointments in our view

Exhibit 24: Valuation and Skepticism

Source: Capital IQ and SSR Analysis

Machinery – A Different Story – Value but No Catalyst

Both DE and AGCO are under-earning and are very cheap, based on history and using our “normalized” framework. However, the fundamentals are against them, and we are not sure what causes a re-rating given that performance is likely to be lack-luster for a while. Equipment sales are strong when farm income is strong and weak when it is not – not complicated. We do not think farm income is going to be above trend this year and this is a view shared by both analysts and the companies.

Complicating what might be a more normal equipment cycle is the interest rate environment that we been in for the last 5 years. Low rates have made financing easy and this has encouraged equipment purchases – perhaps drawing forward some demand. Consequently forward expectations are low.

Our expectation is that in a weak price or farm profitability period, farmers will buy the best seeds and chemicals and fertilizers, but they will delay purchases of machinery. We think that this is likely to be the case for 2014 and possibly 2015.

The risk to this view comes from our strong value bias and where both stocks are languishing today. Neither company is trading all time relative lows to the market – though both are close – but they are attractive relative to the rest of the Capital Goods space and in our view Capital Goods is the most undervalued Industrials and Materials sector today with the exception of Metals.

Our current discount from normal value estimates for all of the larger–cap Capital Goods stocks are summarized in Exhibit 25.

Exhibit 25: Capital Goods Valuation

Source: Capital IQ and SSR Analysis

The risk to not owning these stocks today is that we get a further rotation into Capital Goods and the rising tide lifts all.

Conclusion

The global population is growing and will continue to grow for the foreseeable future despite more and more countries moving toward the demographic transition that we mentioned earlier. We are confident that modern farming techniques are up to the task of preventing a Malthusian apocalypse, and there exists a long-term fundamental investment thesis that is supported by the need to feed a larger and wealthier global population.

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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