Business plan

Archer-Daniels-Midland: Adapting its business plan to inflation (NYSE: ADM)

SimonSkafar

Investment thesis

Archer-Daniels-Midland Company (NYSE: SMA) has gained about 39% in the stock price over the past year and almost 22% since the start of the year.

ADM returns 1 year

Looking for Alpha

The stock is now priced at $82.77 per share, outperforming the market due to his excellent strategies and management. The stock has gained almost 39% against the market, which has lost around 6% over the same period.

ADM's performance relative to the market

Looking for Alpha

Over the past three years, the company’s turnover and net income have grown steadily. Even in difficult economic times characterized by runaway inflation, ADM performed well, as evidenced by its strong performance relative to the broader market.

The company’s strong performance has led to higher earnings estimates for fiscal 2022 and 2023, displaying a bullish attitude amid a turbulent market, which should boost investor confidence in the company’s stock.

The company

The Archer-Daniels-Midland company buys, transports, stores, processes and sells agricultural products such as barley, oilseeds, corn, milo, oats and wheat all over the world. The Company’s three main segments are Agriculture and Oilseed Services, Carbohydrate Solutions and Nutrition. In addition to the above important functions, the company offers many other services and products in the field of agriculture.

The chart below shows the revenue contributions for each of the segments.

ADM revenue by segment

Statistical

Productivity and innovation: the secret to beating inflation

When inflation hits an all-time high, the prices of agricultural products rise dramatically due to rising production costs. This poses a challenge for companies operating in the agricultural sector.

Agricultural price index

world Bank

ADM aims to overcome the challenge posed by inflation and to keep its prices relatively low by minimizing production costs. The company relies on productivity to achieve this objective. Here is a quote from CEO, Juan Luciano:

Productivity is how we improve our execution and optimize costs, is key to our long-term success, but just as importantly, our productivity work helps us mitigate the impact of inflation. We have a very good pipeline of productivity initiatives and I will update you regularly.

The company executes this strategy in two ways: production and financial productivity. For output, they employed mechanization. During its first quarter 2022 transcript call, the company said it had completed a modernization project at its Minnesota corn facility, increasing productivity through improved automation, control systems and analytics. The investment returned double digits. Returns result from increased volumes, safe delivery and more efficient operations.

On the financial productivity side, management is working on the “billion dollar challenge,” which includes increasing ROI and monetizing assets with the goal of generating $1 billion in cash reserves. On their Q1 2022 call, the CEO reported that he had already made over $400 million, which further helped push ROI to 10%.

This initiative should benefit them for the following 2 reasons:

  • Mechanization brings efficiency and lowers production costs. With costs rising across the board, their revenue per unit sold and operating expenses will increase. If they can control the increase in operating costs through initiatives such as mechanization, their margins will increase.
  • Revenues made from the billion dollar challenge can be reinvested in the business to fund available opportunities or even fund more mechanization in the business. Alternatively, they can be kept in the business to improve its liquidity. Either way, the business will benefit.

With these strategies, ADM is able to increase net income, return on investment, as well as cash reserves. It is important to note that the strategy will not eliminate inflation, but:

  • It will reduce production costs and reduce inflation-related price fluctuations for ADM products.
  • Increased efficiency increases productivity, so the business can deliver more for less and stay competitive.

Acquisition of Deerland Probiotics

While many reasons exist for acquisitions, ADM seems to aim for more than one ranging from diversification, increased synergy and greater market share.

Juan Luciano on the call said:

Deerland, with a broad portfolio of probiotics, prebiotics and enzymes, offers a wide range of commercial, R&D and operational synergy opportunities to help us meet this demand…”

Below is an overview of the probiotics market.

Market and demand for probiotics

The probiotics market size was around USD 49 billion in 2019 and is expected to reach around USD 95 billion by 2027, growing at a CAGR of around 8%. Growing buyer awareness of preventative healthcare and demand for natural and safe healthcare products is driving growth. Demand for the products has grown steadily since 2016, as shown in the chart below.

Probiotics market size

Fortune

ADM estimated that annualized revenues for ADM’s Health and Wellness segment would exceed $500 million with the acquisition of Deerland. With this growing market, this figure may be an underestimate. Investors should expect the company to exceed these estimates as the market expands rapidly due to increased awareness of preventive health care and demand for natural and safe health products.

Risk management: derivative instruments and hedging activities

Agricultural markets are subject to price fluctuations leading to risks; ADM operates in many countries, thus facing currency exchange problems. Unresolved, these issues could have negative consequences. ADM’s management has successfully adapted to these issues.

The Company uses several derivatives as hedging mechanisms. They use exchange-traded futures and options contracts to mitigate the price risk induced by changes in the agricultural commodity market and foreign currencies.

Net cash flow and investment derivatives

AOCI delays hedging gains and losses from net investments until they sell the underlying investment. The company uses currency swaps and forward exchange contracts as net investment hedges for a foreign subsidiary. As of June 30, 2022 and December 31, 2021, the company has entered into fixed currency swaps in USD against fixed euros worth $0.8 billion and $1.2 billion, and foreign exchange contracts at term worth $2.5 billion and $2.6 billion. As of June 30, 2022 and December 31, 2021, the company reported after-tax AOCI of $125 million from net investment hedging activities. AOCI deferred until sale of investment. The Company’s structured trade finance uses interest rate swaps to hedge certain bank letters of credit.

The company uses futures or options contracts in commodity trading to hedge future purchases and processing of grain. This hedging arrangement reduces the fluctuation in cash flow related to the company’s grain imports. Last year, the company hedged 17-33% of its monthly grind. As of June 30, 2022, the company has hedged 1% to 32% of its monthly corn milling.

The recent weakness of the euro against the US dollar poses a problem for companies that sell in Europe and need to convert the euro back into USD. This unique hedging style shows that management is aware and trying to address this issue, but investors should still be aware of low foreign sales revenue when converting back to USD.

Evaluation

The company appears undervalued despite strong results. Almost all price ratios are below the industry median, sometimes by more than half.

ADM valuation multiples

Looking for Alpha

ADM valuation multiples

Looking for Alpha

ADM’s P/E, P/S, P/B, P/CF and PEG are below industry medians. FWD-based valuation ratios also find the stock attractive. This low valuation gives a cheap breakthrough to a company with strong development potential.

Conclusion

It is clear that ADM’s management has performed a thorough environmental scan and is aware of the threats and opportunities in its industry. To the company’s credit, the administration has taken a proactive approach to preparing for current and future issues. Thanks to the company’s good long-term and short-term plans, investors can expect growth in revenue and net income, especially with the acquisition of Deerland. Investors looking for business expansion and certainty of growth should consider taking a position in ADM.


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