We like playing long-term secular trends, and one of the major ones of our lifetimes is the population increase and associated need for increased agricultural output. Archer Daniels Midland (NYSE:ADM) is a leader in the global diversified agriculture markets that procures, processes, and markets a variety of agricultural products. It also happens to be and is also one of the largest processors of oilseeds, corn, wheat, and cocoa; main products are soybean oil and soybean meal, high fructose corn syrup (HFCS), ethanol, and cocoa products. We think from a business and valuation standpoint, ADM shares provide a compelling opportunity for investors looking to gain exposure to this trend. Billionaire Ken Griffin boosted his holdings in ADM by 6% during the first quarter. Robert Bishop, Tom Gayner, and Richard Schimel initiated brand new positions in the stock as well.
There are a few key drivers that we outline below that make ADM compelling to us:
Oilseeds stand to benefit from favorable supply/demand dynamics in North America and South America. In Q3 we saw tight supply in South America, driving stronger North American crush demand, which we expect will serve as a tailwind into 2013 as US crops are harvested. We think that higher oilseeds processing will drive segment growth; crushing and origination profits increased substantially by $75 million from $700 million to $775 million. The company posited that South American supply would be down 15%, which will help out North American crushers as demand shifts from South America to North America. We also think good South American crop margins bode well for similar trends in FY 2013. Structurally, supply/demand has been improving; over the last three and a half years, six crush plants have been idled and demand for soybean meal is estimated to grow 3.5% this year according to the USDA.
We believe that ethanol fundamentals have hit the trough. Due to unprofitability, many plants have been closed. As excess plants are closed, corn demand will increase as it becomes harder to obtain, so this summer, we would expect to see demand and supply moving toward a more balanced dynamic. We see ethanol concerns as largely unwarranted as the absence of a blenders’ tax credit will not materially impact demand. Where ADM stands to weather the ethanol situation well, competitor Bunge (NYSE: BG) is more of a mixed bag for us. The company’s sugar/bioenergy business has run into some challenges. Progress has not gone according to plan, and the division still operates at a net loss not to mention that volumes have been depressed. Management revised guidance for volume of sugar processing downward, indicative of weak fundamentals in that industry. Then bioenergy side is mostly ethanol. The drop in the blending ceiling has hurt prices and has undercut margins in future contracts the company strikes. Though the company views this as a one-off event, we are not so certain since those fixed price contracts will be just as vulnerable now as in the near-term in the face of volatility. BG’s agribusiness division continues to do well, but we think the sugar/bioenergy business will serve as an overhang on the stock.
ADM further has restructuring initiatives ahead of it that should result in savings and additional funds for share repurchases. ADM has indicated that it intend to both improve capital returns to shareholders. We see no reason for any change in its progress in executing on these initiatives. ADM expects the cost savings to ultimately reach $125 million next year, which was revised upward by the company.
With the momentum coming off Q3 results, we think FY 2013 EPS is on-track to exceed $3 per share even in the face of any headwinds from oilseeds and ethanol. We believe ADM shares are undervalued, trading at less than 11.0x 2013 earnings (historical forward multiple is ~14.0x). Additionally, ADM trades at ~1.2x tangible book value (historical average is 1.6x). Given several potential catalysts like E15 implementation, normalization of ethanol inventories, and protein production (demand for protein meal), coupled with strong EPS growth, we think it is reasonable that the shares should revert to historical tangible book levels.