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Does the Disposal of its Cocoa Division Make Archer Daniels Midland Company (ADM) a Buy?

Archer Daniels Midland Company (NYSE:ADM), one of the world’s largest agricultural trading houses has decided to sell its cocoa and chocolate business, as cocoa prices fall and profit margins are all but wiped out. Indeed, due to conflicts, oversupply and other irregularities in the cocoa market, the price of cocoa has fallen around 50% from its high of 2011, which has damaged Archer Daniels Midland Company (NYSE:ADM)’s profits.

Surprisingly, the fall in cocoa prices does not correspond to rising chocolate sales around the world. Chocolate sales rose 8.3% during the last quarter of 2012, while the global market for cocoa sales and production on expanded 1.1%.

The world’s largest company for cocoa processing is Barry Callebaut, which predicts that cocoa prices will stay low throughout the rest of the year putting further pressure on margins. In comparison, Archer Daniels only handles about a fifth of global supplies –the third largest company in the world for cocoa bean processing.

Archer Daniels Midland Company (NYSE:ADM)It is reported that Archer Daniels Midland Company (NYSE:ADM)’s cocoa business is worth around $2 billion.  However, it would appear that offloading the business would be beneficial to Archer Daniels, for while the process of cocoa processing raked in $3.6 billion, or 4% of Archer Daniels Midland Company (NYSE:ADM) total $89 billion revenue during 2012, the company actually made a $22 million loss on cocoa operations during the first quarter (Q1) of this year.

Barry Callebaut is also forecast to suffer over the next few months and the company’s earnings projections have been consistently downgraded by analysts covering the company over the past year. Analysts earnings projections for 2013 have been downgraded 22% from 55 Swiss Francs (CHF) per share to 43 CHF and projections for 2014 have suffered has well, down 18% from 62.5 CHF to 51.5 CHF, despite rising demand for chocolate around the world.

Meanwhile, Mondelez International Inc (NASDAQ:MDLZ), the well-known Kraft spin-off, is also concerned about the cocoa industry’s fate. A recent trend has developed around the world due to falling cocoa prices, as farmers find that it is no longer profitable to farm cocoa. You see, cocoa is often grown in regions where the coca plant also grows well. The coca plant must not be confused with cocoa.

The coca plant is the main ingredient in cocaine and for obvious reasons, is worth more than cocoa. So, farmers are turning to coca over cocoa to make more money. In an attempt to stop the exodus away from cocoa, Mondelez is putting forward $100 million to help cocoa farmers.

Fortunately, Mondelez International Inc (NASDAQ:MDLZ) does not do much cocoa processing and the company should benefit from falling prices. Indeed, the consensus analyst estimate for Mondelez’ gross margin is 12.2% for 2013 and 12.8% as cocoa prices continue to suffer. Additionally, as margins widen, income is expected to rise around three times faster than revenues – revenues are expected to rise 5.5% 2013-2014 while net income should expand 16%.

So should Archer Sell?

A sale of the division would be profitable for Archer Daniels Midland Company (NYSE:ADM). While the company would be able to offload a loss-making division, it would be able to use the funds to fund additional acquisitions of grain and other agribusiness’, at a time when demand from emerging markets is driving sales higher in the sector.

In addition, a sale of the business would improve profitability for Archer Daniels and the loss making cocoa division was one of the reasons for the company reporting a first quarter profit that was 33% below the same period last year. Without the cocoa divisions losses this decline would have only been around 27%.

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