Wednesday, 21 June 2017

Grains & Canes; Adecoagro (NYSE:AGRO): Investment Case: Part I

If you want to find an unloved sector look no further than soft commodities. Agricultural products in particular grains look cheap having been in a cyclical bear market for several years now. With most stocks and financial assets looking decidedly pricey I wanted to set out my investment case for my recent purchase of Adecoagro. 

Adecoagro is a Latin American agribusiness venture centred in Brazil and Argentina. 
The company is a scarce pure play on agricultural commodities as most stocks in this sector gain exposure through fertilizers, equipment or single commodity businesses like Indonesian Palm Oil stocks.

Adecoagro Presentation

Initially Adecoagro was focused in acquiring farmland in Argentina following the 2001 crisis and growing grains. In the past few years the company has expanded strongly into sugarcane and ethanol production in Brazil. 

Why Soft Commodities?

Well as I noted in my thesis on CMP they currently look cheap - soft commodities in particular are in a multi year bear market; Bloomberg Grains Index

Somehow we need to feed the world with a growing population of people. Now obviously over the past century crop yields have achieved fantastic improvements - but structurally more farmland and higher outputs will be required to keep pace with the growth of mouths to feed. Only Africa and Latin America have substantial untapped and underdeveloped land.

Adecoagro has the scale, diversity and capital to be able to change crops to suit market conditions and also to grow the business in the direction of demand. At present they produce Rice, Soy, Wheat and Corn. Aside from grains they also produce dairy. 

However the main business is sugar. They have grown scale in sugar substantially in recent years and much of the cane is crushed by Adecoagro and used for producing ethanol. In Brazil ethanol is a common additive to fuels and is used extensively.

Company Presentation: Ethanol & Sugar production
Now sugar too has been in a cyclical bear market although prices rose substantially last year; Bloomberg Sugar Index

So with generally depressed pricing for their major products how has the share price done?

Well it has been stable, rising about 6% over the past 5 years:

Google Finance
I think the reason for this is that underneath the lower prices for their products Adecoagro has expanded production massively. The underlying volumes and capacity of the company have increased greatly meaning a cyclical turn in pricing could lead to an explosive financial performance:

Company Presentation

Note how production has increased in the past 5 years. Farming area +15%, farming production +41%. Then see sugar planted +109% and sugar crushed up 165%. But sales in farming have been flat and sugar sales up only 58% due to weak pricing. Despite all this the company has improved the EBITDA margin by 710-bps in the meantime. Corporate expenses are down every year for the past  5 years. This to me has the hallmarks of a very good operation.

What is Adecoagro's sustainable competitive advantage?

Agriculture does not lend itself to 'moats' generally due to commodity pricing and high competition. However the company does have a few good resources;

Land is scarce and irreplaceable. 

Good farmland more so. They acquired a lot of land in Argentina after the 2001 crisis when it was cheap. They own most of their farmland in Argentina. Today due to foreign ownership rules enacted in 2011 this would not be possible. 

More recently they have expanded into Brazil where they lease most of their land. The book value of land is presently $122m whilst an independent appraisal now values that at $871m. Adecoagro develop and enhance land that they acquire for agriculture. They tend to sell small portions of the developed land bank each year and acquire new areas.

Farmland in Brazil and Argentina is incredibly productive. For instance the humid pampas in Argentina allow farmers to plant two crops a year due to the excellent growing conditions. This means Adecoagro are a low cost producer - wages are low and productivity is high in these areas. Transport logistics are a headache but in Argentina at least access to the Rio de la plata mean shipping is relatively economical.

Note also that the company itself is a scarce asset. It is highly unusual to find a listed agricultural producer. Most methods to gain exposure to agriculture require investing in fertilizer companies (Potashcorp/Mosaic), seed/GMO stocks (Monsanto) or farming equipment stocks (John Deere.) Most farms are disparate and privately owned - therefore Adecoagro is somewhat unique and unusual as a pure play on Agricultural commodity prices.

Other things of note

Adecoagro also are building scale in sugar and a ready home market for bio ethanol in Brazil. Much of their sugar cane is crushed to produce bio ethanol fuel. Since 1976 the government has mandated that all vehicles must run on a minimum amount of ethanol. Between 20 and 25% of fuels are ethanol based. The ethanol in Brazil is grown from sugar rather than Corn which is used in the US. Sugar is a much more efficient crop for producing ethanol due to the extremely high photosynthetic energy efficiency of the crop.

This means the economics of bio ethanol production are good in Brazil - the ethanol is already in the country reducing transport costs and a ready and substantial home market exists. This is of course government policy and could change but it has been in place for over 40 years.

Ethanol prices generally trade at a discount to gasoline due to the lower energetic content of the fuel - therefore with low oil prices we would expect weaker returns from Adecoagro's ethanol division. 

The company has an all star management team; The venture was originally driven by George Soros and the company was managed by Alan Boyce. Alan Boyce remains on the board today and is an amazing authority on all things agricultural despite having a background originally as a fixed income trader. You can watch his videos on Realvision if you are a subscriber. The company has extensive local directors and a good track record of managing crisis.

The Qualitatively important points

There is so much to say about this stock - the 20F filing alone is a nearly 200 page treasure trove of data. But to my mind the key drivers for the stock will be:

  • Sugar prices
  • Brazilian ethanol prices, demand and oil price
  • Soft commodity prices/ USD strength
  • Localised weather events and yields
  • Argentine & Brazilian macro events

So having established this, is the stock cheap?

Valuation & Risks

Please see part II for my discussion on valuation and risks - coming shortly.

Disclaimer: I am long NYSE:AGRO at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

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