After A Strong Recovery, What Moves ADM From Here?

By Stephen D. Simpson, CFA | June 12, 2013 AAA

I've had a love/worry relationship with Archer Daniels Midland (NYSE:ADM) for a while now, as I do believe that the Street is often too negative about a business that is admittedly very low-margin and unpredictable. With the stock up more than one-third from its November 2012 lows, though, it is harder to argue that the stock is unfairly neglected by the Street. Longer-term opportunities in Asia will take time to materialize, which makes a strong U.S. crop and the speedy close and integration of GrainCorp all the more important.

SEE: A Primer For Investing In Agriculture

GrainCorp Deal Done … Sort Of
It took a while, but ADM managed to bring around the board of directors at Australia's GrainCorp and got them to agree to a $3.2 billion deal for the roughly 80% of the business that ADM didn't own.

This could be a highly significant deal for ADM. While quite a lot of U.S. grain goes to China (and ADM handles a meaningful share of it), the company had no presence in Australia – an even bigger exporter (on a relative basis) to China. So not unlike Peabody Energy's (NYSE:BTU) decision to invest in China's long-term coal demand by buying into Australia, ADM is buying a major Australian grain handler to better leverage China's growing grain demand.

GrainCorp owns about 21 million metric tons of grain storage capacity in Australia, 280 grain handling sites, and seven of eight eastern ports. With those port holdings, GrainCorp handles about 90% of the bulk grain exports of eastern Australia.

With growing Chinese demand and a growing presence in Asia from rivals like Bunge (NYSE:BG), Cargill, and Louis Dreyfus, this is an important deal for ADM. Moreover, at around 8.5x 2013 EBITDA, it's not a bad price given the potential for long-term cost reductions and synergies. All told, ADM should be able to earn a return a couple of points above its cost of capital – not a scintillating return, I'll grant, but not bad for the industry.

All of this assumes that the deal goes through. China and Australia's farmers certainly have a say and Australia will not alienate such a big customer (nor its own citizens) by ignoring their concerns or input into this deal. While ADM management has been saying the right things, the fact that it agreed to pay GrainCorp shareholders an extra A$0.035 per share per month (until close) if the deal doesn't close by October 1st, 2013 shows there are some doubts.

SEE: Biggest Merger and Acquisition Disasters

Will The Harvest Deliver, And In The Right Places?
Last year was a tough one for grain processors and handlers, as the drought significant reduced available supplies. Companies like ADM, Bunge, and Ingredion (Nasdaq:INGR) have a somewhat convoluted relationship with annual harvests.

Historically, ADM's revenue does correlate pretty well with grain prices, so it would sound like a robust 2013 harvest (planting intentions were at near-record levels earlier this year) would be bad news. On the other hand, ADM's margins depend upon good facility utilization and good local supplies. Consequently, I would say that on balance ADM should be rooting for a good crop year to keep those corn processing and oilseed processing facilities running at optimal capacity.

Location also matters, though. With about 1.8 billion gallons of capacity, ethanol is a big business to ADM and about half of that capacity is located in Iowa. If the Iowa corn harvest is poor, it will cost ADM at the margin line. This is broadly true for the business in general – ADM has an extensive network of storage, processing, and handling locations, but it is better for margins if local harvests come in strong.

More M&A On The Way?
At more than 15% of shareholder equity, it's not like the GrainCorp deal is insignificant. Still, I have to wonder if the company needs to do more international M&A to really compete effectively for the long term. I don't see the company trying to acquire Adecoagro (NYSE:AGRO), Cresud (Nasdaq:CRESY), or Cosan (NYSE:CZZ), but further acquisitions in Latin America could make sense given how significant Brazil and Argentina are in the global soybean (and to a lesser extent, corn) trade. Likewise, if the U.S. makes it easier to import Brazilian ethanol, sourcing more production there could make sense.

I also would like to see ADM think and plan for the long-term. Although Eastern Europe and Africa are under-achievers today in terms of crop production, I believe that could change in the future. Getting assets on the ground today could position ADM well for that future, as could exploring opportunities in areas like Asian oil plantations (typically palm oil).

SEE: An Evaluation Of Emerging Markets

The Bottom Line
I don't see much likelihood that U.S. (or global) consumption of high fructose corn syrup, corn starch, and vegetable oils are going to go into real decline. Likewise, I believe management will execute on its cost savings targets over the next couple of years. While I do have some concerns about the ethanol business (given uncertain U.S. policies and gasoline prices) and near-term feed demand (as protein producers reduce herd/flock sizes), I don't think they really impact the long-term value that much.

For now, I see low single-digit revenue growth and the possibility of mid single-digit free cash flow (FCF) growth for ADM. Those projections come with the warning that ADM's free cash flow history is both poor and very erratic. If ADM can deliver, fair value of about $35 seems fair – a decent price at which to hold shares, but not a compelling buying opportunity today.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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