Archer-Daniels Midland Earnings: Ag Services Business Remains Strong While Nutrition
Archer-Daniels Midland Earnings: Ag Services Business Remains Strong While Nutrition Falters
Analyst Note| by Seth GoldsteinUpdated Jul 25, 2023
After updating our model to incorporate Archer-Daniels Midland's second-quarter results, we maintain our $70 per share fair value estimate. Our no-moat rating is also unchanged.
ADM's stock was up slightly on the day as management raised its full-year adjusted earnings per share guidance to $7, from the prior midpoint of $6.50. At current prices, we view ADM shares as overvalued, with the stock trading around 20% above our fair value estimate and in 2-star territory.
In the near term, ADM's ag services and oilseeds business, or AS&O, should continue to benefit from crop prices at above midcycle conditions, which should support increased farmer selling. While this should help ADM generate above-midcycle profits in the AS&O segment, we see profits down slightly versus the peak of 2022. As crop prices moderate, we expect the AS&O businesses profits will moderate as well, leading profits to fall back to midcycle levels over the long-term
While the AS&O business is generating strong profits, the nutrition business continues to falter, with a third straight quarter of year-over-year double-digit profit declines. The weakness is largely due to profit declines in the animal nutrition business amid falling amino acid profits and slowing feed demand. Additionally, while the flavors business is growing in human nutrition, plant protein demand is slowing, further weighing on segment profits. Management revised its guidance for nutrition profits to be flat in 2023, versus the 2022 level of nearly $740 million, but still remains confident in its 2025 segment profit target of $1.25 to $1.5 billion. However, given that ADM is cutting the size of its animal nutrition business, we think the slowing demand will likely remain in place. Accordingly, we're skeptical of management's 2025 profit targets, absent additional acquisitions.
Business Strategy and Outlook| by Seth GoldsteinUpdated Jul 25, 2023
Archer-Daniels Midland buys, processes, and sells agricultural commodities. The firm purchases crops from farmers and then transports, stores, and/or processes the crops before selling them to food, feed, and energy buyers. The commodity products ADM moves around the world are readily available from competitors, and the company has little pricing power over the products it buys and sells, making for slim margins. In addition, the capital intensity of its operations makes it difficult, but not impossible, for ADM to generate economic profits.
ADM is a major processor of soybeans and corn. Soybean oil and meal are the firm's primary soybean products, with oils sold mainly to food customers and meal to feed customers. As such, ADM’s ag services and oilseeds segment is exposed to the soy crush margin, or the difference between the price of soybeans and the prices of soy meal and oil. The soybean trading business has benefited from increased Chinese soybean consumption. We expect demand will increase as China's population and income per capita advance.
Corn processed by ADM makes its way into sweeteners and starches or ethanol. The sweeteners and starches business sells primarily commodity-grade products, such as high-fructose corn syrup, which have little pricing power. In response to declining demand for high-fructose corn syrup, the company has been developing more starches. ADM's ethanol business, called Vantage Corn Processors, has been aided by an important U.S. mandate for ethanol use in fuel, which provides a floor for demand. Expansion into biofuels for aviation should provide a long-term growth opportunity for the business.
ADM has expanded its nutrition business primarily through acquisitions. ADM acquired Wild Flavors in 2014, Neovia in early 2019, and has made multiple tuck-in deals as well. Specialty flavors and ingredients are value-added, requiring additional processing and, in many cases, proprietary formulations. As ADM continues to invest in the development of new products, we expect the nutrition business to grow from 11% of profits in 2022 to nearly 25% by 2027. This should provide ADM with a more stable earnings base over time.
Economic Moat| by Seth GoldsteinUpdated Jul 25, 2023
We assign a no-moat rating to Archer-Daniels Midland. As one of four dominant players, the company holds a solid position in global agribusiness. The company owns a massive network of processing plants, storage facilities, mills, port operations, and transportation options that would be difficult to replicate from scratch. That said, the capital intensity of Archer Daniels Midland's operations and the generally razor-thin margins generated in the ag-services business have historically made it difficult for the company to generate returns on invested capital above our estimated cost of capital.
The specialty sweeteners and starches business in the carbohydrate solutions segment as well as the specialty ingredients products in the nutrition segment deliver higher margins, likely due to intangible assets and switching costs. Intangible assets are related to proprietary formulations stemming from research and development spending for the development of new specialty products. Customer switching costs come from consumer packaged goods companies’ unwillingness to jeopardize the brand equity of their products by changing specialized ingredients that are critical to the consumer experience. That said, the majority of Archer Daniels Midland's products are commodities where the company does not benefit from any particular moat source. As such, we do not have a high degree of confidence that the company as a whole will be able to outearn its cost of capital over the next decade.
Fair Value and Profit Drivers| by Seth GoldsteinUpdated Jul 25, 2023
Our fair value estimate is $70 per share. We assume a weighted average cost of capital of roughly 8%.
In the ag services and oilseeds business, which generates the majority of profits, continued increases in crop yields and new land brought under agricultural production, particularly in South America, are likely to lead to an increase in crops transported around the globe. This bodes well for the ag services business; however, better global pricing information for farmers and stronger, more consistent crop yields should also reduce crop price volatility over time, which will limit the trading desk’s arbitrage opportunities. The ag services business is all about capacity utilization, and weather can cause fluctuations in operating rates year to year--as seen with the 2012 drought.
In the near term, we see a favorable grain merchandising environment for ADM, as its North American footprint should benefit from high crop prices that encourage farmer selling, albeit below the cyclical highs of 2022. This should support near-term segment profits to remain above midcycle levels, but below 2022. Longer term, we forecast 1% sales growth for the segment with an average operating margin of roughly 4%, slightly above the trailing 10-year average as growing grains demand should result in higher midcycle capacity utilization in the grain merchandising and processing operations.
We expect the starches and sweeteners business and the nutrition business to benefit from the continued development of new products. Over the long term, we expect specialty ingredients will continue to make up a greater portion of the business. In nutrition, we forecast operating margins to expand from roughly 10% in 2022 to nearly 13% by 2027 as the company sells a higher volume of premium-priced specialty products. While we forecast growth in the business, we expect 2025 operating profits will be well below the bottom of management's target of $1.25 billion to $1.5 billion. However, we assume no additional acquisitions. If the company makes acquisitions to expand the nutrition portfolio, it would likely put ADM closer to meeting management's targeted range.
ADM's ethanol business, Vantage Corn Processors, has been a potential divestiture candidate as management focuses on the nutrition business. While it could be sold or spun off in the future, we include it in our explicit forecast until a deal is announced.
In a scenario where crop prices remain elevated and grain merchandising conditions stay favorable, we would expect to see higher revenue growth and profit margins for ADM. In this scenario, our fair value estimate would increase to $100 per share.
In a scenario where crop prices fall below our base-case forecast and grain merchandising conditions remain unfavorable, we would expect to see little revenue growth and lower profit margins for ADM. In this scenario, our fair value estimate would fall to $40 per share.
Risk and Uncertainty| by Seth GoldsteinUpdated Jul 25, 2023
We assign a High Morningstar Uncertainty Rating to ADM.
In many cases, ADM is an intermediary between farmers and food companies. The company is subject to large profit swings if agricultural commodity prices move quickly. The availability and pricing of agricultural products are subject to unpredictable factors such as weather, planting, disease, and government programs. Maximizing capacity utilization is important in ADM's high-fixed-cost operations, and droughts and other supply disruptions can negatively affect operating rates, although this is partially offset by improved arbitrage opportunities in grain merchandising. Conversely, in multiyear periods of large harvests, volatility is reduced, which limits profit opportunities in grain merchandising.
Government regulations can have a material impact on ADM's business. For example, modifications to the renewable fuel standard in the U.S. could harm the company's ability to generate ethanol profits.
As a producer of soy-based meal and oil products, ADM is exposed to soy crush margins. If the soy crush spread remains compressed for a prolonged period, ADM’s oilseeds processing profits would probably be impaired.
ADM also faces several key ESG risks. The biggest risk we see comes from concerns about ADM's supply chain. Growing consumer concerns about deforestation could result in ADM's customers requiring stricter certification from the company, resulting in higher costs to ADM that it may not be able to pass along. Similarly, growing consumer concerns about human rights abuses in some countries where ADM sources crops could result in stricter certification requirements that result in higher costs. We see a moderate probability that these occur and a moderate impact to ADM.
Another ESG risk comes from the carbon emissions in ADM's operation resulting in higher costs. However, we think this would equally affect ADM and its peers, resulting in cost increases being passed along to customers and little impact to ADM.
Capital Allocation| by Seth GoldsteinUpdated Jul 25, 2023
We assign an Exemplary capital allocation rating to ADM based on our framework that assesses the balance sheet, investment decisions, and shareholder distributions.
We rate the balance sheet as sound. ADM's revenue is subject to low cyclicality, but the company has high operating leverage, resulting in medium unleveraged business risk. However, with a healthy balance sheet and few near-term debt maturities over the next few years, ADM should be able to meet its financial obligations.
We view management's investments as exceptional. We are in favor of the decision to invest in the nutrition business as we view this business as having both the highest profit margins and the most traces of an economic moat across all of ADM's portfolio. We expect ADM to continue looking for avenues to increase the nutrition business. Management's 2025 target of $1.25 billion to $1.5 billion in operating profit for the nutrition business likely will require some more acquisitions. Historically, acquisitions in the nutrition business have been made at reasonable prices, which have created shareholder value, in our view. The company’s continued investments in the nutrition business should generate solid returns.
We credit management for being willing to walk away from past investments that have not generated high returns, such as the goal to divest the corn ethanol business. Along these lines, we are also in favor of management's investments in the gradual transformation of its sweeteners and starches capacity away from high-fructose corn syrup into more specialty ingredients. Further, ADM has divested itself of a number of noncore assets, such as cocoa and fertilizer, which should allow management to focus on its core businesses.
Finally, we credit management for executing well in the volatile, low-margin ag services and oilseeds business. In recent years, ADM has outmaneuvered rivals such as Bunge, leading to relatively more stable profits.
We see shareholder distributions as appropriate. Dividends have averaged just over 40% of net income of the past decade. At this level, ADM should be able to continue to grow its dividend each year.
Juan R. Luciano became CEO in 2015. Luciano joined Archer Daniels Midland in 2011 as COO following a 25-year tenure at Dow Chemical. We think Luciano's operational experience has served ADM well as the company looks to expand the nutrition business and improve profitability and returns on invested capital in relatively mature industries.
Management is compensated based on return on invested capital, total shareholder return, and nutrition segment profit growth. We are in favor of the ROIC metric, as it encourages management to invest in value-added areas of the business.