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In Agriculture, It’s Good to Be Strong

The sector is still largely cyclical, but companies with moats will be in the best position to take advantage of long-term secular trends.

Philip Guziec, 02/19/2013

Over the past three years, corn prices have doubled, soybeans have climbed more than 66%, and wheat has jumped 50% as challenging conditions in major growing areas in the United States, South America, and Russia have kept farmers from satiating growing consumption. Over the near to medium term, Morningstar’s agriculture analysts believe that normalizing weather and slowing demand will drive crop prices lower. But looking beyond the next five years raises important questions about farmers’ abilities to produce enough food to meet global demand. To find out what the outlook is for investors, we asked two analysts to discuss the challenges facing the agriculture-related companies they cover. Adam Fleck is an associate director of research, and Jeffrey Stafford is an equity analyst who covers agriculture and chemicals. We talked Dec. 13.

Philip Guziec: There’s been a lot of discussion about high food prices in the news. Can you get us up to speed? What’s going on there?

Adam Fleck: The food-price run-up in the U.S. is largely due to the terrible Midwestern drought, among the worst in several decades. Year-to-year changes in food prices are largely driven by weather. Demand growth—outside of corn-based ethanol, which is unique to the U.S.—is relatively steady in developed markets. So, as supply is either crimped or abundant, depending on growing conditions and how much was planted based on prices in the beginning of the year, we get situations like 2012, where reduced supply will lead to exorbitant price increases. But we can also get situations like 2009, when we saw reduced demand, partly because of the recession, but we also had a bumper crop that drove prices down.

Guziec: Why is the ethanol situation unique?

Fleck: In the early 2000s, we started to use corn for ethanol production. Before that, we didn’t use any of our crops in fuel production; today, anywhere from a third to 40% of our corn crop goes into ethanol. This has had the result of driving up demand, perhaps artificially, in the past eight to 10 years.

You know, corn is the not even the best biofuel out there. Sugar cane is much more efficient to use for energy. Nonetheless, we saw an abundant crop and a desire to become energy independent, so using corn to make ethanol seemed like a good idea at the time. However, it’s had the consequence of driving up corn prices. Before ethanol, corn would bounce around in the low-single-digit range, around $2 to $3 per bushel. Now, it’s at $7 to $8.

But here’s the interesting thing: We think that the growth rate of ethanol production is likely to slow, given that we’ve reached blending limits here in the U.S. So, we’re probably going to return to a situation where demand growth for corn, and other products such as soybeans and wheat, is more population-driven. There might be an increase from exports, but generally, we see demand slowing.

Guziec: What about the arguments that developing economies will increase the demand for food and put a strain on our food-supply system?

Fleck: One of the biggest arguments you hear is that China will continue to import vast amounts of food—that a rising middle class in China will consume more protein, which has a multiplicative effect on grain demands. China already imports a large amount of soybeans. Their soybean planting acreage has declined dramatically in the past several years.

They basically turned to the U.S., Brazil, and Argentina for their soy production. But according to the U.N., China already consumes more calories per person than Japan and more protein per person than South Korea. The growth that was expected largely has already happened. For more than 20 years, China has been a developing nation. They’re not close to the U.S. in meat consumption, but I think there are some cultural differences that will prevent them from ever catching up to our levels.

Brazil is another country that gets talked about, but they already eat more calories per person, on average, than Sweden, South Africa, the Netherlands, and any other neighboring South American country. The big wild card is India. They have a huge population, but since 1990, their per-capita caloric intake has grown only 3% total—versus 13% in Brazil, 16% in China, and even 7% here in the U.S. There’s just not the economic framework there that is going to suddenly result in a rapid increase in middle-class demand growth.

Instead, I think we’re going to see a slowing demand growth rate and, I hope, some sort of normalized weather conditions in the near to medium term. And that will probably result in continued cyclicality.

Guziec: Given the path food consumption has followed, how have the stock prices of agriculture-related companies reacted?

Fleck: I can speak to the equipment manufacturers. AGCO Corp. AGCO, CNH Global CNH, and Deere DE are the three largest farm- equipment manufacturers in the world. Their stocks will react to weather conditions, but generally, the cash receipts of farmers are what drive equipment purchases. So, if crop prices fall, it could lead to lower planting the next year; if prices remain low, that could lead to a decline in equipment order rates.

When the drought started to take hold in 2012, there was concern about the effect on the farmers. We hadn’t seen anything like these conditions since the late 1980s. But the stocks have come back quite a bit as farmers have continued to spend in the marketplace.

So, right now, we see these stocks largely as fairly valued; we don’t see a lot of opportunity and margin of safety in those names. I think you can paint a picture that isn’t so pretty, given the very strong markets we’ve had in recent years, especially in North America.

Jeffrey Stafford: I cover a few companies that are in the agricultural input space, and probably the most interesting out of those right now are some of the fertilizer producers.

The bad weather in the U.S. actually is a net positive for fertilizer producers. In 2011, the weather in North America was bad but not horrible. In 2012, it was horrible with the drought. So, crop prices were already elevated going into the 2012 season, and then they went even higher after the drought over the summer months. So, there is support for fertilizer prices, because farmers’ incomes are up enough from higher crop prices that the volume deterioration we’ve seen from lower yields hasn’t totally offset the higher prices. So, the story in North America is still pretty good.

What’s been holding down fertilizer prices, especially potash, has been uncertainty in the global market. China and India have slowed down their purchases of potash over the past six to 12 months. We think that this has created a buying opportunity for some of the names we cover in the space, Potash Corp. POT and Mosaic MOS.

But on the other hand, nitrogen producers such as CF Industries CF are really doing great right now in North America, because corn prices are high and natural-gas prices are low. Natural gas is a key input to nitrogen fertilizer.

So, we can’t paint all the fertilizer makers with the same brush. Right now, we think potash producers are more attractively valued than nitrogen producers.

Guziec: What are the risks these companies could face?

Stafford: We’ve looked at possible constraints on agricultural inputs that might limit the ability to feed a growing population, and one of those is the situation in phosphate. Phosphate is a fertilizer that is mined out of the ground. Plants need phosphate to grow. It’s estimated that we have about 100 or so years of reserves left, based on assumptions of production growth, demand growth, supply growth—things like that. But the interesting thing is where those reserves are controlled. Morocco — a monarchy — owns about 70% of global phosphate reserves, putting King Mohammed in a position to wield monopoly power down the road. It creates a situation where geopolitical factors could have an impact on the global food supply. On the other hand, if you’re Mosaic or CF Industries—companies that control phosphate reserves in North America—your reserves could become very valuable.

Guziec: So, the potential for an upside tail is there.

Stafford: Right. Another potential risk is soil erosion. Some of the practices in modern agriculture are leading to rapid soil erosion. To combat that, more farmers are moving to no-till farming, which means they don’t plow. A natural cover builds up on top of the soil that helps prevent erosion. Cover crops—such as alfalfa—actually infuse nitrogen into the soil. So, with no-till, farmers have less of a need to use commercial fertilizers. But the transition to no-till farming in the U.S. has been very gradual; it’s not that big of a risk for fertilizer producers in the next few years. But it has implications for tilling, which means that it’s going to have an impact on some of the equipment makers.

Fleck: Another thing that gets talked about a lot is water shortages. The first question we have to ask, of course, is, do we have enough water? And the answer is, resoundingly, yes. Humanity uses about 4,000 cubic kilometers of fresh water every year. About two thirds of that is for agriculture. But we have about 42,000 cubic kilometers of annual runoff from rivers and things like that. So, there’s a lot of fresh water that we’re not using right now.

The problem is location and accessibility. The Amazon River flooding doesn’t help farmers in the Midwest. By 2025, the U.N. estimates that nearly two thirds of the population could face water shortages because of accessibility issues. There are solutions, but they are expensive—things like additional storage, changing irrigation techniques to sprinkler systems from flooding systems, and even desalination. Nonetheless, if the accessibility comes down to no water or expensive water, people are going to pick expensive water.

So, overall, again, we see costs going up in the farming complex. But like I said earlier, in the near to medium term, this is still a very cyclical industry. There are going to be peaks and troughs, and the one thing we don’t want to do as investors is buy at the top of the cycle. We still want to buy companies with a margin of safety, but with the knowledge and the comfort that there is a nice, secular tailwind in the market.

Guziec: What are some signs to look for to determine where we are in a cycle?

Fleck: Farming in the short term is typically a self-correcting industry. So, in situations where we’ve got extremely low yields across the world that are driving up prices, like any commodity, farmers should continue to plant until the price reaches their marginal cost.

We see the marginal cost of corn in the U.S. anywhere from $4 to $5 per bushel. At $7 to $8 per bushel, we’re much higher than that current marginal cost. So that’s going to drive farmers to plant a record amount of corn again next year, and that could drive down the price. When you see the stocks really run up and trade at rich multiples versus historical averages, on top of abnormally low corn, wheat, and soybean yields here in the U.S., that says to me this is probably going to be corrected somewhat next year.

On top of that, in the farm equipment space, you can look back. The broader equipment cycle is a little more nuanced, but we’ve had three to four years of extremely strong growth rates of farm-equipment tractor and combine sales. Those are starting to flatten out now. We’re seeing that year-over-year growth rate trail. You can look at used-equipment prices and see that prices have come down. Maybe this is starting to top out a little bit.

Guziec: You’re saying that buying companies that have a moat is not enough.

Fleck: Having a moat is not enough to battle the cyclical nature of the industry. But we’ve talked a lot about the positive secular trends in this industry over the long term. You’ve got to get there first. So, it’s really important to have a moat to be able to fend off competition and have the balance sheet to be able to survive to enjoy those secular tailwinds in up cycles. Valuation becomes critical, because we don’t want to be investing at the top of the cycle.

I think the important thing to remember is that in the near to medium term, this is a reversion- to-mean type of industry. You could argue, probably correctly, that that mean has been reset due to things like ethanol and the emergence of China. And there are secular tailwinds that will push that mean up over time slowly. But we see the prices of crops and the sales in these industries move up and downward much more quickly than probably what that mean suggests.


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