Archer-Daniels Midland (NYSE:ADM): Free Cash-Flow to Equity Valuation
Archer-Daniels Midland (NYSE:ADM) has been in operation for more than 100 years and is one of the world’s largest processors of oilseeds, corn, wheat, cocoa, and other agricultural commodities. It is a leading manufacturer of protein meal, vegetable oil, corn sweeteners, flour, biodiesel, ethanol, and other value-added food and feed ingredients. The company has an extensive global grain elevator and transportation network to procure, store, clean, and transport agricultural commodities, such as oilseeds, corn, wheat, milo, oats, and barley, as well as processed agricultural commodities. ADM also has significant investments in joint ventures which are aimed at expanding or enhancing the company’s global footprint and product line offerings.
ADM competes to be the world's most successful agribusiness. Its primary strategic focus is on expanding unit volumes and diversifying crop usage across multiple product and service lines. The company has a substantial international presence with exports of intermediate food component products accounting for over 45% of sales in this line. As of Dec 2013, Soybean related production activities accounted for 18% of company revenues with corn and soybean meal accounting for another 9% and 11% respectively. The company’s products are distributed mainly in bulk from processing plants or storage facilities directly to customers’ facilities.
ADM's core business activities remain strong. Continued development in China and other emerging markets will represent a key source of growth moving forward. ADM's biofuel activities have taken on and will likely continue to take on a greater role in the firm's earnings picture. The firm's significant production, processing and distribution capabilities in this area is a strong point for ADM. International environmental calls for greater ethanol and biodiesel usage in fuels will support growth; earnings should benefit from rising energy prices. ADM has a sophisticated and well established distribution network of owned and leased trucks, trailer, tank, hopper cars, and boats to transport commodities and products efficiently to virtually anywhere in the world. This gives it a strong operating cost advantage over many of the smaller players.
Other key purchase considerations include:
- ADM has a significant international presence and holds strong competitive positions along multiple product lines.
- ADM's sales are well positioned to benefit from continued population growth and emerging market growth.
- ADM holds substantial purchasing and selling power in multiple markets making it difficult for smaller players to compete on cost parity.
- ADM has produced reasonable, but volatile, financials.
- The worst appears to be over as it relates to depressed commodity and energy prices.
- ADM is well supplied and rarely faces raw material constraints.
ADM's heavy and potential overdependence on corn-based ethanol processing is a source of risk. Studies have been released suggesting that sugar-based ethanol and other substitutes can be more cost effectively produced. Government incentives and trade agreements on corn versus sugar-based ethanol could also have a material impact on the firm moving forward. The secondary impacts of rising corn-based ethanol production on food prices would likely mean more open trade and tax incentives for sugar-based ethanol production, which would work against ADM. Substantial commodity price volatility will also likely mean substantial earnings volatility for ADM. Do not expect a smooth or predictable ride on this one!
Other cautionary notes include:
- ADM's ROE has been in a constant state of decline, its ROA is marginal, and ROI is mediocre (see below).
- Returns on reinvested capital have been poor, averaging about 2%, as the firm has not been able to capitalize on acquisitions and new product developments.
- Producers and suppliers of sugar-based ethanol will pose a serious competitive threat.
- ADM is experiencing some inventory build-up; investors are well advised to continue to monitor ADM's inventory position.
- Volatile commodity demand and speculative trading in commodity prices will represent a continued source of earnings volatility for ADM.
- Fundamental-based technical indicators (primarily derived through regression based models) point to overvaluation in ADM.
- Barriers to entry are relatively low.
About $90B in revenues moved through ADM's door in 2013. ADM’s revenues for the June 2005 to Dec 2013 period clocked in at an average annual rate of growth of 11%. This was fueled by steady growth in worldwide food demand and biofuels. Revenues grew at an annual rate of 4% over the last 3 years and 5% per year over the last 5 years. Year-over-year ADM continues to make substantial sums of money off revenues after subtracting costs of goods sold, with gross profits reaching $3,889M in 2013. The upward long-term trend in gross profits is mainly due to rising food volumes, food prices, and energy prices. Volatility in commodity prices did lead to some pullback in gross profits after 2009. Gross profits have fallen by 3% per year over the last 3 years and 1% per year over the last 5 years.
ADM's production costs appear well under control, with COGS rising by 4% per year over the last 3 years against revenue growth of 4%. This has helped the firm stabilize gross margins at around 4%, though they have declined from about 7% in 2005. As a general rule, we want to see consistent gross profit margins above 6% for firms in the sector, ADM has not been able to meet this requirement in any of the last 4 years. Companies with gross profits margins consistently above 6% have a strong competitive advantage working in their favour and are generally well protected from competitive attacks.
ADM spends less than 50% of gross profits on hard costs associated with selling expenses, advertising, management salaries, payrolls, advertising and legal fees. We consider spending less than 50% of gross profits on SG&A an acceptable result. Cost of SG&A have been increasing at a decreasing rate, rising by 6% per year over the last 10 year but 3% per year over the last 3 years. We consider this a reasonable outcome when viewed against annual revenue growth and is a sign that management is keeping operating costs under control.
ADM shows moderate strength in its operating earnings picture and has recovered somewhat over the last 3 years growing from $1,605M to $1,871M. The long-term trend in operating income has been slightly upward but volatile, rising from $1,350M in 2005 to $2,689M in 2010 only to fall to $1,871 in 2013. ADM has earned on average about 3.4% in operating earnings on total revenues over the last 10 years. ADM carries a moderate amount of long-term debt on its books and, consequently, pays out about 22% of operating income on interest payments annually. This is an acceptable result but slightly higher than what we would like to see for a comparable firm.
Bottom line results show a slight upward long-term trend in earnings, with some volatility, growing at an average annual rate of 3% over the last 10 years. Earnings reversed sharply by 13% per year over the last 3 years on softer than expected sales in oilseeds and corn products. ADM’s moderately strong competitive position has allowed it to maintain net margins of about 1.5% over the last 3 years. Intense competition has, nonetheless, resulted in some margin compression over the long-term with net margins falling by about 0.5% over the last 5 years and 1% over the last 10 years--an expected resulted given the number of new entrants competing in its markets. ADM’s per share earnings story has been equally volatile. Diluted EPS grew from $1.59 per share in 2005 to $3.30 in 2007 then reversed to $2.02 in 2013. We dislike seeing that, since 2005, revenue growth outstripped earnings growth by 8% per year. We also dislike that the firm's share-base continues to grow, with diluted shares rising by 7M since 2005. For a mature firm such as ADM, which generates returns on investment of less than 6% per year, we would have expected to be rewarded through greater share repurchase activity.
ADM's return on equity, averaging 12% over the last 10 years and 7% over the last 3 years, is acceptable--for now. Returns on equity do need to return to historical levels, without a subsequent increase in debt, to warrant a continued investment. Returns on assets have been mediocre averaging 3% over the last 3 year and 5 year periods. Like with the firm's ROE, ROA is in a downward trend and needs to be reversed.
ADM’s stockpile of cash and short-term investments totalled $3,554M in 2013. This stockpile has grown at a rate of about 11% per year since 2005 and should be sufficient to support business operations and protect itself from any unanticipated economic shocks.
As a general rule of thumb we like to see receivables of less than 5% of revenues. ADM’s total receivables total 3.6% of revenues, which is well below our target level. ADM’s total receivables declined sharply over the last 3 years (-31% per year) and have been in a long-term downward trend, falling by 3% per year since 2005 against revenue growth of 11% per year. To us this is a reassuring sign given the positive spread between revenue growth and earnings growth over the period.
Inventory build-up remains a modest concern, with total inventories growing at an annual rate of 13% since 2005. This outstrips revenue growth by about 2% per year. This could reflect declining overall product demand, an extended deferral of capitalized costs, or a deterioration in earnings quality. In the increasingly competitive environment, investors are well advised to continue to monitor ADM's inventory position.
ADM’s current ratio, which is derived by dividing current assets by current liabilities and is an indicator of company liquidity, has consistently trended above 1.8 over the last decade and currently sits at around 2.0. Though nothing spectacular, ADM shouldn’t face any difficulties fulfilling its short-term obligations to creditors and suppliers.
Net property, plant and equipment make up a small percentage of ADM’s asset base (23%). Working capital represents the main component (65%). Because ADM faces intense competition, however, it is required to constantly update facilities to remain competitive, which helps keep expenses up. On average, capital expenditures consume more than 75% of ADM's annual net earnings.
ADM is a moderate borrower of debt with a long-term debt load of $5,347M. This is in addition to the current $1,523M in debt due in 2014. ADM’s long-term debt position has declined substantially falling by 14% per year over the last 3 years. ADM's long-term debt-to-equity ratio has remained flat since 2005 at about 1.2. For an excellent business in this sector we would like to see this fall below 0.8. Accounting for operating lease obligations and unfunded pension obligations, ADM’s debt load would require about 7.3x average annual earnings to pay-off. While we would like to see this fall below 5x average annual earnings, we still consider this an acceptable and fully manageable level of debt.
ADM had operating cash flows of $5,226 in 2013, growing by 11% per year over the last 10 years. This is well aligned with revenue growth over the period. ADM's operating cash flows have lagged earnings in 3 of the last 10 years. Free cash flows improved sharply in 2013 and have increased at a rate of about 5% per year over the last 5 years.
A company’s fair value estimate is calculated as the present value of expected future free cash-flows to equity. Free cash-flows to equity represent the amount of cash-flows available to common stockholders after all operating expenses, interest and principal payments to lenders have been paid and necessary investments in capital equipment and working capital have been made to maintain and grow operations.
Below we estimate fair value in 5 steps:
- we forecast the firm’s free-cash flows to equity for the next 10 years using econometric processes;
- we discount those cash-flows to the present;
- calculate a terminal value for the firm 10 years out based on a long-term expected growth rate and terminal discount rate and discount it to the present;
- add the discounted terminal value to the discounted value of free-cash flows to equity over the next 10 years; and
- divide the present value of all cash-flows by the number of shares outstanding.
Fair value estimates based on free cash-flow to equity were checked against estimates based on free cash-flow to the firm. Company generated estimates were also checked against estimates built using a pure Monte Carlo Simulation model using 10 years of historical financial data. The probability distribution presented in the output table represents the probability of making/losing money on the stock over a 10 year period based entirely on the Monte Carlo Simulation results.
While a Monte Carlo Simulation estimate prices ADM at $45.15, our slightly more conservative estimate prices ADM at $39.02. This suggest that ADM is overpriced by about 15%. If instead we took an average of the two estimates, this would suggest that ADM is overpriced by about 9%.