Agriculture – Likely At A Low, Seeds And Fertilizer Look More Interesting Than Equipment

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 22nd, 2016

Agriculture – Likely At A Low, Seeds And Fertilizer Look More Interesting Than Equipment

  • Global agriculture is a growth industry with fundamentals currently at or near cyclical trough
    • Growth will continue to be driven by population increases as well as changing diets associated with economic development
    • We have touched upon various subsectors of the Ag industry in prior research – seeds and chemicals (MON, DOW/DD), equipment (DE), and fertilizers (CF, MOS)
    • In this report we take a holistic view of the industry to assess relative opportunities
  • Corn and Soy prices have come off their lows but are only now at or approaching 10 year averages – pricing gains, with room to go higher, are broadly positive for ag related equities
    • Strong three months driven by:
      • Lower USDA estimates for US and South American ending stocks of soybeans
      • Expected La Niña impacts which generally reduce yields and support prices
  • Fertilizer pricing continues to be pressured however, hovering near 10 year lows, but history suggests recent price movements in energy and Ag commodities could provide a boost
    • Inventories of potash and phosphate grew in Q1, weighing on prices
    • Affordability metrics have improved – fertilizers are about as affordable as they have been at any time in the last 10 years
    • On prior occasions (since 1990) when crop and crude prices have seen 20% upward price moves over six months (as is the case six months into 2016), forward fertilizer price changes have been positive ~70% of the time, with an average price gain in those instances of more than 40%
  • Implications for fertilizer, seed, and equipment equities:
    • Fertilizers – we reiterate on positive stance on this group – upside from pricing, valuations
      • MOS best positioned from balance sheet perspective
      • CF could be pressured by the flattening of the urea cost curve (rising natural gas)
    • Seeds – even after rising on speculation surrounding the Bayer bid, MON looks cheap on historical valuation relationships versus fertilizers and machinery stocks
    • Equipment – we are more cautious – relative valuations are elevated as are debt levels
      • Ag equipment trade balances with China and the rest of the world have poor recent trends – China equipment production is growing quickly
      • Used equipment inventories remain elevated and farmers have the most discretion and the most cost at stake when considering equipment purchases

Exhibit 1

Source: USDA, SSR Analysis

Overview

There is a widely held, almost consensus view that we are at the bottom of a protracted Ag cycle. Stocks have begun to bounce off the bottom in most sub-sectors, despite what might not yet be a floor in earnings for many. Grain prices have bounced back from 10 year lows this year and this has been part of the catalyst for more optimism (or less pessimism), but grain prices are not moving because of inventories, which remain at or above comfortable levels.

The question which few if any have a good answer for is “what will drive the sector up”, even if we have now reached a bottom, and which segment will benefit the most. In Exhibit 2 we show what a farmer spends his money on and where our stocks fit in the picture. In Exhibit 1 we showed the relationship between cost and farmer discretion. The more negative perspective is that grain inventories are not high, seed productivity (yield improvements) remains ahead of demand growth – suggesting that crop yields should be sufficient to keep the market oversupplied even with trend demand growth. The other, not insignificant, negative sign, is that if we are at the bottom of the cycle then why is (arguably) the smartest guy in the room (MON) a seller?

Exhibit 2

Source: USDA, SSR Analysis – stocks shown in green are our preferred choices today

Of course it is possible that MON has no intention of selling today, but it is posturing as if it is trying to maximize a bid. If MON would take $130-135 per share today it does imply that the internal view does not expect a quick bounce back from the bottom, or it suggests that the company fears that it does not have what it takes to remain the leader going forward.

These concerns aside, it is likely that we have “picked the low hanging fruit” with regard to yield enhancement for corn, soy and other seeds, suggesting that the rate of productivity gain has probably peaked. This should allow demand to catch up to supply without either greater acreage planted or more to increase productivity. This will only happen with higher grain pricing and perhaps what we are seeing in the grain markets today is a speculative move around this idea.

Fertilizer consumption, crop protection chemical consumption and some increase in better seed usage will be the first move as farmers react to higher demand (and with it higher pricing).

  • Nitrogen is an annual need, but we are seeing a wave of new capacity in the US in 2016 and we think it unlikely that demand alone will drive pricing. However, we do have the added and more important impetus of increased costs – with global crude oil pricing higher and locally a recent significant jump in US natural gas pricing. CF has the leverage of the new capacity, but the negative of the higher costs. As we have shown in prior research, the top end of the cost curve for urea is based on China coal economics and oil would have to rise much further to change this – in the meantime, if natural gas rises, CF could see a margin squeeze to offset its production gain.
  • Potash – stocks are cheap, but so is potash and inventories are high and potash is not yet at cash cost, so while demand may look better, this could well be one group that does not bounce off the bottom. MOS looks like the best of the bunch to us, but this could be one group that does very little.
  • Seeds – this is where we are more likely to see action from M&A than from demand.
    • Brazil has been a major drag for all producers, with planting season issues as well as economic and currency problems. This does not look like it is going to fix itself quickly, but Brazil has seen remarkable and unpredictable volatility in the past.
    • Dow/DuPont becomes the 800 pound gorilla in this business and if – as Dow intends – the combined company can optimize seed and chemical sales through one sales team (something DuPont had not managed in the past), then the company should take share and to a degree this is what is driving the conversations between the other players.
    • We like DOW and DD, but for more than just the Ag deal and what it alone can achieve, and we like MON as a take-out target. We still believe that the Bayer combination is the best move for both companies and we think that MON probably has near-term downside if the deal falls apart.
  • Crop Protection Chemicals – we will see increased use if grain prices rise and farmers look to optimize yields and can afford to buy the chemicals. FMC is an interesting story here as it may get swept up in a consolidation wave, with BASF the more logical acquirer in our view.
  • Machinery – it is far harder to see demand recovery here and much easier to see risks. While we have been generally positive on DE in the past we are turning more cautious, with the proviso that we could still see a possible CAT/DE deal on the horizon. Farmers have relatively new equipment and the used equipment market is overflowing with prices falling, and this is not a good sign. Another concern is the trend in trade, with China adding capacity for machinery and increasing exports in what is a slow growth market.

In summary, we see the bottom, but we see few catalysts for a quick recovery and we expect that the M&A moves are a confirmation that many of the companies themselves do not see markets changing quickly either. CF has the leverage of more US capacity – unlikely to earn the returns expected when started – but likely to boost earnings. Dow/DuPont Ag could create more value than anyone else in our view and we think that MON will succumb to a better bid from Bayer – this is where we would place our bets today. The capital goods side of the business could be a value trap, but if the companies see a difficult future we could begin to see some M&A here also.

Corn and Soy Pricing

It has been a quick mover higher for soybean and corn prices over the past several months – Exhibit 3. The year to date pricing gains (+31% for soybeans, +20% for corn) have only brought levels to the respective 10 year averages – there is scope for further price improvements.

Exhibit 3


Source: Capital IQ, SSR Analysis

Export demand does not sufficiently explain the rise in prices. US corn and soybean exports in 2016 to date (data through April) have been strong, but not materially higher than the average of the past 15 years, and in fact are lower than recent years – Exhibit 4.

Exhibit 4

Source: USDA, SSR Analysis

Part of the explanation for the surge in crop pricing is weather related – La Niña conditions are generally expected to impact yields in North and South America in the second half of the year. Inclement weather has already impacted soybean production in Brazil and South America in recent months.

Below we summarize the major weather impacts associated with La Niña. Note that the US, Brazil, and Argentina account for the vast majority of global soybean production while the US and Brazil account for 45% of global corn production.

Exhibit 5

Source: USDA, SSR Analysis

Stocks-to-use figures show US and global soybean levels above historical averages, while corn levels are about in line with norms – Exhibit 6. There is some literature suggesting a relationship between stocks-to-use levels and crop pricing and the data bears this out to a certain extent, but it appears that this is only meaningful when stocks drop below a critical level – Exhibit 7.

Exhibit 6


Source: USDA, SSR Analysis

Exhibit 7


Source: USDA, SSR Analysis

Fertilizers

Fertilizer pricing has yet to respond to the gains in crop pricing – urea prices are at 10 year lows and potash and phosphate prices are not far off their troughs – Exhibit 8. We have examined the historical record to analyze the fertilizer pricing response to large gains in crop and energy pricing such as we have seen recently. Since 1990 there have been 21 instances where corn and crude pricing have gained 20% over a six month period and 16 instances where soybeans and crude have gained similarly. The associated fertilizers (potash for soybeans, urea for corn) have seen positive gains on ~70% of such occasions, with the gains averaging more than 40% – Exhibits 9 and 10.

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

As crop prices have risen and fertilizer prices have remained near their lows, affordability indices have improved – fertilizers are about as affordable as they have been at any point over the past 10 years. Intuitively, the combination of high prices for outputs (crops) and low prices for inputs (fertilizers) should encourage input demand.

Exhibit 11

Source: Bloomberg, SSR Analysis

Inventories, however, remain a weight on prices – Exhibit 12.

Exhibit 12

Source: POT Reports, SSR Analysis

Unlike potash and phosphate, which are mined, nitrogen (urea) is manufactured, which makes for a different set of dynamics. Looking at the cost curve in Exhibit 13 (borrowed from a CF presentation in early May with the assumption of US natural gas at $2.30), the risk to US based nitrogen producers is rising natural gas relative to crude oil. This would flatten the cost curve to the detriment of CF.

Exhibit 13

Source: CF Presentations, SSR Analysis

Natural gas and urea prices have shown a generally positive, but very weak historical correlation – Exhibit 14 – that has broken down significantly over the past several years as Chinese coal based production has replaced oil based production as the price setter in the urea market. Currently, from the perspective of US based producers, rising gas prices (particularly relative to crude) simply serve to trim margins. Given the significant recent move in natural gas prices, further pricing gains stand out as a significant risk for CF. The company has volume leverage associated with its capacity additions in the US – EBITDA should increase but returns on capital will likely fall.

Exhibit 14

Source: Capital IQ, Bloomberg, SSR Analysis

Ag Equipment

Of the subsectors in the Ag industry, the equipment side is perhaps most reliant on farm incomes, and in turn, crop prices. After a robust period of growth from 2010-2014, sales have slowed markedly as farm incomes have fallen – Exhibit 15. Increases in crop pricing are an incremental positive for the group, but continued high levels of used equipment inventory at the dealer level are currently problematic, and the overall mix has shifted toward smaller equipment with attendant lower margins.

Exhibit 15

Source: USDA, SSR Analysis

On normalized earnings the stocks look cheap (DE most notably) – Exhibit 16 – but on a relative basis versus other sectors in the Ag industry, the equipment group is less attractive (more on this below). CNHI does not have a long enough public history for a useful normalized valuation model.

Exhibit 16


Source: Capital IQ, SSR Analysis

Most troublesome however are the high debt levels for the Ag equipment companies, particularly DE and CNHI – Exhibit 17. This comes at a time when US farm machinery trade balances with China and the rest of the world appear to be deteriorating – Exhibit 18. This sub-sector may turn out to be a value trap if China builds equipment surpluses before demand picks up in the West.

Exhibit 17


Source: Capital IQ, SSR Analysis

Exhibit 18


Source: US Census Bureau, SSR Analysis

Relative Valuation

Comparing fertilizer, seed, and Ag machinery stocks, the main conclusions appear to be that machinery stocks are currently at a premium relative to the historical averages over the past five years. Seed and fertilizer stocks are broadly in line on an EV/EBITDA basis, with seed (MON) more attractive on price/earnings.

For example, since 2010 Ag Machinery (average of DE, AGCO, CNHI) has traded at an average premium of 42% over Fertilizers (average of MOS, CF, POT, AGU) comparing EV/EBITDA multiples. Currently the multiple for Ag Machinery is nearly twice that for Fertilizers, suggesting machinery is relatively expensive and fertilizers relatively cheap compared to recent history. The composition of the seed group is just MON, as this is the only true pure play in the space with the pending buyout of Syngenta by Chem China.

Exhibit 19

Source: Capital IQ, SSR Analysis

Exhibit 20

Source: Capital IQ, SSR Analysis

Our normal valuation models based on return on capital trends are less relevant for the fertilizer stocks due to the changing industry dynamics in the wake of the Eurasian cartel breakup. For DE, AGCO, and MON, valuation divergences on normal earnings appear less significant.

Exhibit 21

Source: Capital IQ, SSR Analysis

Exhibit 22

Source: Capital IQ, SSR Analysis

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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