Ag processing can be difficult on a year-to-year basis, but companies like Archer Daniels Midland (NYSE:ADM) and Cargill have built solid businesses through scale and diversification. It's an open question as to whether Canada's Alliance Grain Traders (OTC:AGXXF) can achieve the same sort of long-term success. While Alliance is a global leader in the processing of pulses (lentils and the like), the company's lack of diversity and poor asset utilization have hampered results in recent years.
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Recent Results Highlight the Margin Challenges
Arguably the biggest problem for Alliance Grain Traders, apart from a generalized lack of demand, is its inability to leverage the assets it already has.
Revenue rose almost 18% on a year-on-year basis in the first quarter, but more of the company's volume came from commodity operations instead of processed pulses. Making matters worse, utilization remains low--50% versus a historical average closer to 65%--and that helped push margins down more than five points to just about 7%. That weak gross margin flowed through the rest of the income statement, and operating income fell more than three-quarters, while EBITDA dropped 60%.
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Stuck in the Middle
As a processor, Alliance Grain is a middleman that can do little to influence either production (which has been too high of late) or demand. Making matters worse are developments in emerging market economies and currencies. While the company gets a substantial amount of its supply from Canada, most of the demand for pulses (about 90%) comes from developing countries.
With worsening economic conditions and adverse currency moves, demand has been weakening. What's worse for Alliance is that the company is seeing lower demand for higher-value products. Where Alliance has prospered in the past is through processing pulses and separating them out by grade, but with demand for higher grades declining (because of affordability) that is definitely harming margins.
Unlike ADM, Bunge (NYSE:BG), Cargill and Ingredion (NYSE:INGR), Alliance also lacks a more diverse base of business and more value-added processed products. Whereas crops like corn and soybeans can be alternatively processed into starches, meals, oils and biofuels, those same options aren't really available to Alliance.
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Too Much Capacity for Its Own Good?
With 29 facilities and approximately 1.5 million tonnes of processing capacity a year, Alliance clearly has a significant presence around the world. Unfortunately, that may be too much capacity for its own good right now. The company has been relatively ambitious and aggressive when it comes to acquisitions and organic capital expansion, and that has put debt on the balance sheet. Unfortunately, the markets have not really cooperated over the past few years and the company has had to pay more in interest without really getting much benefit for that additional capacity.
The Bottom Line
It seems hard to imagine that the major consumers of pulses are going to change their habits anytime soon. While countries like India and Pakistan will likely consume more animal protein if and when improvements in per capita income allow it, pulses are going to be a major part of the diet for the foreseeable future. On a shorter-term basis, the supply-demand imbalance seems to be slowly improving for Alliance, and management seems confident that results will start improving in the second half of the year.
Valuation is tricky right now, and stocks like these don't lend themselves to free cash flow based models. By and large, buying processor and ag stocks below book value works out as long as the company isn't too highly leveraged.
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Looking at EV/EBITDA highlights some of the challenges. On the basis of expected 2012 EBITDA (a level which hasn't really changed for four years), these shares are slightly undervalued. Most analysts expect a significant improvement (50% growth) from 2012 to 2013, though, and even with a lower projected multiple (to discount for the additional year), these shares look perhaps 60% undervalued on that basis.
While ADM is a more attractive stock today and likely a safer bet, Alliance is at least worth a spot on a watch list. Alliance needs to improve its asset utilization and margins, but if demand improves, these shares could outperform.
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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