Food and fuel: This company benefits from higher prices for both
The biggest tech companies in the US have grabbed all the headlines this reporting season. Disappointing quarterly results from Amazon and Meta have seen their stock prices plummet. Investors are often drawn to tech behemoths. But focusing on them risks missing out on opportunities in other parts of the market. For instance, a holding in the Firetrail S3 Global Opportunities Fund, Archer Daniels Midland, doesn’t get the attention that the mega cap tech companies do, but the agricultural powerhouse is benefiting from the growing demand for biofuels, with its stock price up 42% in 2022.
Archer Daniels Midland (ADM)
Archer Daniels Midland (NYSE: ADM) is a US-listed global distributor and processor of soft commodities. Think wheat, corn, and most importantly, soybeans. ADM can be thought of as a soft commodity supply chain expert. It takes the raw product from growers and converts it into over 60 different end products that are useful to consumers.
The company has a market cap of $48 billion USD, trades on a forward PE of 13x, and has a free cash flow yield of 6%. ADM sits within our ‘Sustainable World’ theme. We see an excellent current opportunity for the company as demand for its products exceeds industry supply capabilities.
Our research on ADM focuses on the two things that matter: 1) protein and biofuel demand, and 2) soybean crushing capacity.
Protein and Biofuel Demand
Demand for ADM’s products is being driven by structural tailwinds.
The first is the increasing demand for protein, particularly plant-based protein. A soybean seed contains around 34% protein, making it one of the most protein-rich soft commodities. This is a valuable trait. Other soft commodities with higher production rates, such as wheat and rice, have high carbohydrate content but contain minimal protein.
The more protein we consume, no matter whether it is from animals or from plants, the more demand there is for soybeans. Soybeans are used to feed livestock, especially when it comes to beef, dairy, and chicken production. They are also eaten directly by humans in the form of tofu, soymilk, and other products.
The second demand driver is the use of soybeans (in the form of soybean oil) as feedstock for biofuels. ‘Renewable diesel’, a 100% replacement for fossil fuel-derived diesel, can be produced from refined soybean oil. In addition, ‘biodiesel’, which is a blend of fossil-fuel diesel and up to 20% sustainable sources, can be produced using soybean oil.
In the US, around 50% of biodiesel is produced using soybean oil. This has been a recent driver of growth in soybean demand. Comparisons can be made to the mid-2000s when ethanol blending (using corn) became commonplace. Ethanol blending drove a structural increase in the price of corn.
The long-term growth in soybean demand can be seen in Figure 2 below.
Now that soybeans are used to produce biofuels, there is a high correlation between the prices of soybean oil and traditional energy forms, such as crude oil. This allows us to access a similar exposure to crude oil moves in the Firetrail S3 Global Opportunities Fund (Managed Fund), minus the high level of associated greenhouse gas emissions.
By displacing fossil fuels, ADM is one of the largest decarbonisers in the portfolio and has a high level of avoided emissions.
Soybean Crushing Capacity
In their raw form, soybeans are crushed to produce soybean oil and soybean meal, the two most usable forms of soybeans. Soybean meal contains most of the protein, while soybean oil contains a lot of the energy (carbohydrate) which can be turned into biofuels. The crushing process for soybeans involves cracking, soaking, distilling and heating. This process requires specialist facilities.
As a soybean crusher, ADM’s profit is the margin between the price it pays for raw soybeans and the price it receives for selling the soybean meal and soybean oil. This is known as the crush spread, and the value of this is shown in Figure 3 below:
A 2% move in the soy crush spread results in a 1% move in ADM’s EBITDA. It is a key driver of changes to the profitability of the entire business.
We believe we are entering a period of strong soy crush margins that will drive higher profitability for ADM. The reason for this is that it takes time for new crush capacity to ramp up, typically 2-3 years from the announcement of new capacity.
We are currently in a period where the bottleneck in the soybean commodity complex is not the volume of soybeans that can be grown, but rather the crushing capacity coming online to process the soybeans into their most useful form.
No significant capacity is being added in the US until 2024. If all new plants are on time, it would still only equate to ~3% per year capacity demand growth over the next three years. This is less than the demand growth that we forecast for the end products.
In addition, it is not as simple as just building a plant and earning the soy crush margin. The capital cost of the plant does matter, but more important to profitability are the relationships with suppliers (growers) and the logistical networks in and out of the plant. Incumbent players have a large advantage here. Three players (ADM, Bunge, and Cargill) control around 75% of the total US crushing capacity. The scale of these players enables them to earn a higher return than a new entrant or smaller competitor would likely make on any new capacity.
3Q 2022 results
ADM reported earlier this week and materially exceeded consensus expectations. Management revealed sustained cyclical strength bolstered by continued operating execution and a step-up in cash return to shareholders. We expect that continued acceleration in North American renewable diesel production will underpin domestic soybean crush margins and strong edible oil refining margins. ADM CEO Juan Luciano described the business as “hitting in all cylinders… I would say the three parts of the business will be very robust into Q4, bigger than last year, certainly”.
Positive tailwinds show a strong investment case for ADM. As always, it is just as important to consider valuation. Earnings have already started to rise but the valuation remains attractive. At a 13x price-earnings multiple with long-term earnings growth, we are excited about the prospects for ADM.
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James is a Portfolio Manager for the Firetrail High Conviction Fund and the Firetrail Absolute Return Fund. His primary sector responsibilities are Transport, Gaming, Infrastructure and Contractors. 12+ years’ experience investing in equity markets.