The Middle Market Review Insights on the Middle Market.
It’s not everyday you hear the Secretary of Agriculture Tom Vilsack wishing he knew a rain dance. Then again, it’s also not everyday you see an upward trend in commodities prices and a drought that has worsened the outlook for the next 6-9 months.
The rising commodity prices are not only going to shift margins over the next several months, they will potentially shift business valuations as well. In compiling our 1H 2012 Consumer Activity Report, Brian Boorstein of Granite Creek Capital explained to us, “There’s a double edged sword around commodity prices. It makes the company in someone’s portfolio look artificially better, especially if the company can pass on the commodity price increases. If you only look at the near term revenue and earnings and not the unit sales, people can look like heroes because commodities prices are supercharging the rise. Whenever an industry posts substantial increases, no matter the drivers, it attracts more buyers clamoring for increasing yields.”
We were intrigued by the influence commodities held over the valuation of agricultural products companies and wanted to learn more. We spoke with Bob Bresnahan of Trilateral, Inc to gain more insight. Bresnahan, who provides purchasing and risk management advisory support to commodities-related businesses, explained how a company can maximize its valuation by arranging itself into a “golden position”. We have included our discussion below.
We have seen commodity prices rising recently. As a middle-market company, how would you protect yourself against some of the issues expected to appear in the next 6 months?
Bob: “You have to change your business model. Many smaller companies have a short term approach to purchasing in which they stay just one quarter or 60 days out. If they use up the crop they buy more. You have to be more strategic in the current environment and understand your inherent market position. For example, if you’re a food manufacturer or feed supply company you are inherently short because you are pushing a product out the backdoor. As a result, your job is to protect the upside. However, that doesn’t mean you have to be a flat-priced buyer. You can utilize options that put you in the best of both worlds. We call this the golden position because it protects you from crisis if prices go up, and you can participate in the downside allowing your margins to expand.”
“If I had to project what this year will look like for food manufacturers and fast food restaurants, margins will be squeezed. As board prices and feed prices increase, it’s going to be a slow ripple to fast food companies. Since these businesses are ultimately sellers of protein, the shortage in corn will be felt. Corn is a major feed and it affects all your proteins – pork, chicken, beef, and even dairy for cows. Cheese, milk, ice cream will be affected as well. All of the prices will ripple because of the cost of feed. The end result, which we may see in 3-6 months, will be the liquidation of herds because of the price of feed. This liquidation will initially cause a dip in prices before all of the meat is sold. In the longer run, we will start to see prices go higher. If the feed ratios aren’t correct for dairy to make a profit, the ranchers are going to start selling off cows and all of a sudden tightness develops. That puts cheese at $2.50 per pound and butter at $2.50 per pound, forcing menu prices to go up.”
What has caused the ongoing run up of corn prices?
Bob: “There are most likely four reasons why corn prices have increased over the past several years.
1. Commodities tend to have a very distinct cycle. They tend to rally for 10 years and then drop for 20 years. They rallied from 1970 to 1980, peaked in 1980, and then went down for 20 years. All commodities bottomed between 1998 and 2002.
2. A new class of investors has appeared since 9/11. After 9/11, Alan Greenspan lowered interest rates to near zero in an effort to keep the economy from cratering. As a result, portfolio investors decided to invest 3-5% of their assets in commodities to protect against inflation. Very quickly, the commodities market went from zero dollars invested [by this class of investors] in 2002 to about $420B at the peak. That’s an incredibly large amount of money for markets that aren’t necessarily designed to handle that type of influx. That money has put an artificial floor in the market. For example, a pre-2002 normal low in corn would be $2-$2.50. Now the low is more likely somewhere between $3-$4. This year the low will be around $5. There are now long indexed funds where they maintain long position and where they do not liquidate. If you look at a commodity like Chicago wheat, they basically have two years of production in their position. That’s a lot of wheat.
3. Another contributing factor to the price increase has been the crop failure in South America. South America went through a similar crisis to what we are now experiencing. Their weather systems were dry and their production of both corn and soybeans dropped. Specifically, corn in Argentina and soybeans in Brazil were less than anticipated. The underperformance allowed world stocks to drop, and put an upward pressure on price right away. The next chance to build was the northern hemisphere crops, but we’ve had a crop failure. Russia and the Ukraine have had a disappointing crop as well, so stocks are not building. That has put more pressure on price.
4. The last issue is the use of food for fuel. For ethanol, if we grow a crop of 11 billion bushels, 3 to 4 billion bushels are required for ethanol. That’s not an efficient use of food.”
Will this use of food for fuel endure if commodities prices continue to rise?
Bob: “You would think it wouldn’t be used, but it’s going to last through this year at least because it’s a political year. Nobody wants to change anything in this environment. However, we have seen bills that try to adjust the mandate based on the price of corn, but nothing has been passed and nothing will get passed. We have to hit a crisis before anything dramatically changes.”
“If we look at December prices for corn right now, which are at 7.89 1/2, I could see that trade down to $7 or $6.80. With harvest coming on, that would represent 50% retracement, which can be expected. With prices in that area, I would expect them to trade back up somewhere to $9, $10 or maybe even $11 depending on how the crops in South America develop.”
How do you see the drought in the US impacting harvest?
Bob: “The drought has affected the harvest dramatically. We started this year with the expectation of a 14 billion bushel corn crop. The last report, which was rounded down estimated a corn crop of 10.5 and 11.5 billion bushels. That’s a significant decrease. The same drop may be seen for soybeans. Yet, soybeans may have been saved because they tend to pollinate in August and weather patterns are changing. They could actually come out a little better than anticipated. With corn, it’s over. No matter how much rain we get now, it’s not going to change.”
As a mid-sized company who has taken the right precautions, is this the time to take over less prepared firms? Or would it be better to wait for them to experience significant loss?
Bob: “The table is set right now for acquisitions because of the visibility. You can look at any ingredient and see the future prices for 2-5 years, depending on the commodity. As a result, you can know what prices you are going be paying forward and you can quite accurately tell what your future is going to look like. If you haven’t prepared yourself yet, you’re playing the hope game, always hoping prices will go down. If you are in a good position, I would be looking at companies now. There are interesting opportunities, many of whom would be interested in being taken over. If you want a firesale price it might be worth waiting 6-9 months.”
With commodity prices being pretty variable right now, how can I protect myself if I’m buying a company right now? What protections can I put in place to ensure my profits going forward?
Bob: “You want to be certain of their coverage and to fairly price their inventory. If the company only has inventory for 30 days out, that is nothing. If it is 6 months out, it could be worth a lot. When looking at a company where their sweet spot for profits is with corn at $7, the relative state of the market is an important aspect of the ongoing basis for negotiation. If the market is at $8, I would determine what a $7 call costs – probably around 50 cents. You want to negotiate that cost out of the price of the company.”
“It would also be valuable to analyze market share. It is going to be challenging for a publicly traded company to make many changes to take advantage of the situation. However, in a private company, the owner can take a knock to salary and can actually use the current situation to gain market share from public companies or private companies unwilling to change. I think private companies may be the way to go, whereas public companies are going to be more or less locked into their current position.”
“Overall, I’m not sure there is a great environment for expansion of the entire market. This is more an environment for consolidation of firms, not a market where everything is growing. Although there is still opportunity, it is not inherently an expanding environment.”