Saturday, 24 June 2017

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

After my qualitative discussion in Part I it is time to explore some risks and the valuation of Adecoagro:



Although the Brazilian Real and the Argentine peso have suffered huge devaluations in recent years the local inflation rates play a part. This means that in real terms with 40% inflation in Argentina for instance costs have been rising in USD as the currency depreciates below that rate.

Adecoagro earns most of its revenues in dollars through commodity exports or in items linked to commodities and dollar prices such as Ethanol. This means the company does better when local currencies depreciate against the USD as it reduces their local costs.

The worst case macro scenario for the company would be a strong dollar driving down commodity prices in combination with also stronger BRL and AR$ rates driving up costs. This is an unlikely scenario and would require particular macro conditions in Brazil or Argentina to prevail that made their currencies appreciate with the dollar.

The debt of the company is split around 3/4 USD and 1/4 BRL:

Company Presentation

Lending in AR$ is essentially only short term due to very negative real interest rates. The debt seems fairly well matched in terms of currency given the domestic exposure to Brazil and predominantly USD derived revenue. Note also Net debt has been declining as the company pay down debt following a major expansion in sugar capacity (some of which is still ongoing.) 

Generally the debt levels are unconcerning to my mind at sub 2x EBITDA. Given that the appraised market value of the companies land holdings alone is $870m and they carry net debt of $600m it is effectively collateralized (but note the debt is mostly for the Brazil plants rather than Argentina farmland). It would be imprudent for a commodity company to carry high financial leverage due to the existing operating leverage and instability of the business. Still they do pay interest in excess of 6% on these debts (in part due to high rates in BRL) although interest coverage was around 3.5x last year which is reasonable especially given that net debt has expanded recently in part to finance the expansion of capacity which is now coming on stream.

Foreign Ownership Rules

Country and ownership rules mean it can be difficult to acquire land or hold onto it. Both Brazil and Argentina have foreign ownership rules and restrictions on land. 

Argentina has foreign ownership rules which restricts individual foreign owners from owning more than 1,000 hectares of land in the core area of the country. These were implemented in 2011. Presently Adecoagro have more than 200,000 hectares of land in Argentina but the restrictions are not retroactive however they do limit the ability of the company to acquire additional land in Argentina. This is however also a significant barrier to entry for competitors (or at least foreign ones) to build scale in the country.

Brazil has similar restrictions for similar reasons although the operations of the company are different there as they lease most of the sugarcane land and are instead more focused on industrial production of sugar and ethanol than actual land acquisition.

Obviously environmental disasters/problems can cause significant problems for production. Floods, droughts etc can mean entire crops are lost. One advantage is the diversity of crops that Adecoagro produce but still their geographical concentration is high. Environmental problems elsewhere can however be a boost due to raised global price conditions for a given commodity.

Is it cheap? How can we value it?

This has been a major headache. The reason being the predictability of earnings is hard as the company is something of a black box - by which I mean beyond say 1 - 2 years who can say what they will be planting - Soy or Corn? and what they will be producing? Ethanol or Sugar? As these decisions are all market condition dependent. This makes it very difficult to make a relevant and accurate DCF model.

This is further complicated by the accounting. Farmland is recorded at book value, crops to be harvested are carried as biological assets and there is a complex cash flow hedge accounting arrangement between the debt and expected revenues. Therefore the earnings look awful at +200x trailing PE! But the best thing is to focus on cash flow in my opinion.

What I can say is I think the stock is cheap for the following reasons:

Free cash flow:

Company Presentation

The company made positive free cash flow last year of $133m ($85m inc expansion capex) following several years of heavy investment and this gives gross and net FCF yields of 10.6% and 6.8% respectively. Note also 6 years of continued strong growth in operating cash flow, with the heavy investment of 2011-2015 in sugar capacity growth which is now operating. 

Remember this positive cash flow growth is during a generally depressed period in agricultural commodity pricing.


As I mentioned in Part I production capacity has expanded greatly in the past 5 years even while commodity prices have tumbled and the stock price has been broadly flat that whole time. So cyclically there should be great latent earnings capacity during a cyclical upturn.

Book value adjustment:

The company has a lot of land recorded at book value especially in Argentina which was acquired cheaply following the 2001 crisis. The book value is $122m -If we take the company's independent land value appraisal of $870m this means the accounts understate the value of the business by ~$750m. Currently the stock has a market cap of $1.2bn and book value of $671m meaning Price/Book is 1.8x but adjusting for this market value would increase book value to $1.42bn making the Price/Book 0.85x. 


Now yes stocks can trade below book value and not be cheap - it depends on the return on assets and the value of the assets underlying the business. But most of the other assets other than the revalued farmland are also tangible ~$500m+ of plant, machinery and buildings (recently built) from the sugar operation and ~$600m current in cash, inventories, unharvested crops and receivables offset by debt and current liabilities. No significant intangibles ($17m), deferred tax balances ($38m assets and $15m liabilities) or other difficult to realise assets.

Now those sugar / ethanol assets are very productive. In the segmental analysis the company notes the following assets in that business; 

2016 Annual Financial Statements

The Sugar/Ethanol segment generated EBIT of $142m last year on assets of $831m ~ 17% EBIT / Asset return. Even subtracting a proportional $40m in interest and taxing that at 34% gives net $67m and would give an ROA of 8%. Now lever that with the $298m of equity in this segment and you get an ROE of 22.5%. 

Note also the ROA +20% in farming but this is really much lower if we adjust the farmland to market value - because farming has low productivity of assets. If we take the farming EBIT of $49m less $10m in interest and taxing at 34% this gives $25m. Divide this by the assets of $245m + $750m MV = $995m and we have an ROA of just 2.5%. Now lever that with the $893m of equity in this segment and you get an ROE of just 2.7%. 

What does this tell us? Well farming has a poor ROE compared to the sugar and Ethanol business. But there are a few important reasons for this:

  • The farming assets are owned outright with very low leverage (adj for market value) hence the low ROE. This is a good defensive strategy for selling commodities as your operating leverage is already high.
  • The Brazilian lands for sugar cane are mostly leased so are off balance sheet driving up the ROA - also industrial assets should be inherently more productive due to greater capital efficiency
  • The Brazilian assets have higher leverage and hence a better ROE (but they are now paying down debt)
  • Remember the farming assets were acquired at very low prices meaning their ROA and ROE base level is extremely high. If we back out the market value adjustment ROA and ROE are 10.2% and 17.5%. This is an unrepeatable feat and is a 'mini moat' shall we say...
Now also remember that sugar pricing has been better in the past few years while grains have remained depressed - so there is cyclical upside in the farming business.

The Bottom Line:

So what is it worth? I will be conservative and say 1x adjusted book value or ~$12 a share (+20% from current levels). This is however not factoring in cyclical improvements in commodity prices and other improvements in efficiency and scale. 

Why 1x Book? Well that seems a fair and conservative price to put on the business assuming one wanted to start from scratch to make a similar business. Given the tangible nature of the assets a low multiple seems warranted but it does also provide some bearing on the realisable value of the assets of the company. 

As a quick excercise combining the two segments of the business we get our pro forma earnings post tax of $67m + $25m = $69m. Now subtract $20m in overhead at 34% tax means ~$56m in earnings. The equity value of the business is $440m + $750 MV adj =  $1.19bn which is a 4.7% ROE. 

I would not pay a lot more than 1x book for a business with a 4.7% ROE - but I feel this could be improved in future by better profitability from improved pricing. Also remember this is the adjusted ROE - if the business actually could revalue the land and release some of that adjusted equity the equity base would be lower meaning a more capitally efficient business.

I can't help but wonder how much the founders have made from this business before the IPO in 2011 - buying up farmland which with improvement is now worth 8x more! However I still see value here for a patient investor such as myself betting on a longer run improvement in commodity prices and happy to take a cash cow option on that for the future which trades below its book value.

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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