The outlook for the agricultural sector has changed significantly since the first quarter of this year. While talk was of record corn plantings and a bumper harvest, adverse weather has made drought the word of the summer. As Archer Danields Midland (NYSE:ADM) transitions from the old crop year to the new crop year, the drought is likely to hit this business in a significant way. The long-term potential of ADM is still worthwhile, and investors ought to keep an eye open for overreactions on the down side, but the next few quarters are likely to be difficult at best.
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Ending the Year on a Down Note
For all the talk of the drought and its potential impact on agriculture companies like ADM, it's important to remember that this quarter's performance was largely driven by the old crop. Revenue fell 1% this quarter, though processing volumes rose almost 5%. That volume number is a little misleading, though, as oilseed volume rose 11% while corn and milling/cocoa volumes were flat and down. Profitability was poor. Operating profit fell 46% as reported and was slightly worse if LIFO gains are backed out. Relative to expectations, oilseed processing was the biggest disappointment (down about one-quarter), while corn processing had the bigger year-on-year decline (down about 37%). Agricultural services profits were also down sharply (about three-quarters).
SEE: Harvesting Crop Production Reports
Conditions Likely to Get Worse Before Better
There isn't a lot of good news right now for ADM. Ethanol has become a very tough business, as margins have plunged on lower gasoline demand, lower exports, a so-called "blend wall" and input prices. While industry margins weren't great exiting ADM's fiscal third quarter (in the negative low teens), they've since dropped further to the high negative 20s. While producers are starting to cut back ((Valero (NYSE:VLO) idled a plant in Nebraska recently)), it's going to be a while before this market gets healthy. ADM is also likely to see a tough time with its agricultural services business. Just as the large corn crop was expected to allow the company to leverage its extensive assets (ports, silos, ships, et al.), the drought is now going to strip away that leverage.
SEE: Top Agricultural Producing Countries
Today Vs. Tomorrow
In the near-term, it's hard to argue that Bunge (NYSE:BG), Ingredion (NYSE:INGR) and Alliance Grain Traders (TSE:C.AGT) don't look like better options. Bunge has a better geographical balance, a better relative position in oilseeds and no ethanol, while Ingredion has better leverage to ongoing global starch and sweetener demand. For Alliance Grain Traders, corn doesn't even enter into the picture at all; it's all about seeing better margins in pulses. Longer term, ADM has a few things working in its favor. The company has restructured its operations in logical ways, and the company's efforts to build out a portfolio of branded proprietary products for wholesale customers ought to pay off in the long run. Nevertheless, this is a company that will likely always struggle to earn strong returns on capital, as was the case this fiscal year where ROIC looked to be about 6%.
SEE: Natural Resource Investing
The Bottom Line
I liked ADM at the beginning of the year, and it outperformed in the first calendar quarter of this year. I was significantly more cautious after that quarter, and the stock has been weak since then. At this point, I'm still highly cautious, as I don't think anybody knows just how bad this drought is going to be, and conditions for ADM's ethanol and service businesses are likely to be poor.
On a cash flow basis, ADM shares look undervalued, but the volatility in year-to-year margins and returns make this a challenging valuation methodology. Looking at this more practically, ADM shares usually hold above book value, but can drop as much as one-quarter or more below that line in periods of peak pessimism. Consequently, while I think these shares are probably undervalued today, sentiment is likely to make share price appreciation an uphill climb and I would wait for a plunge into the low $20s before stepping up to buy.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.