With ethanol margins improving in the second quarter and investors increasingly transitioning from the old (poor) crop to the new (good) crop, Archer Daniels Midland (NYSE:ADM) has caught investor attention again, and the stock is both near a 52-week high and up almost 50% over the past year. I do believe that the 2013 U.S. crop harvest will be good for ADM's 2014 handling, milling, and crushing operations, and I do believe ethanol is here to stay. That said, this is still fundamentally a volatile low-margin business and even with the opportunities added with GrainCorp, I would be careful about chasing the shares.
Good Performance In A Challenging Environment
Probably the best news for ADM going into this quarter was that expectations really weren't that demanding. Even so, the company delivered a small (two-cent) beat versus the average EPS estimate due to better execution within its operations.
Revenue declined 1% this quarter (about 2% below expectations), with ag services down 6% and oilseed processing down 3%. With oilseed processing volume down 10% (in line with an overall 10% or so decline in U.S. crush volumes), that's not such a bad outcome. Corn processing revenue jumped 29%, helped in large part by the ethanol business.
While the gross margin was flat with the year-ago level, ADM's segment profits rose 19% from the year-ago level. While oilseed profits were down 3% (as better crushing margins were offset by weaker cocoa) and ag services profits were down about one-third on weaker volumes, corn profits more than tripled. Within corn, better results in starches and sweeteners were almost completely offset by hedges, with radically improved ethanol margins providing all of the upside.
SEE: A Look At Corporate Profit Margins
Not Much To Do In Oilseeds Or Ag Services But Wait
There is a pretty simple explanation as to why ADM's crush volumes and ag services revenues were down this quarter – last year's lousy crop just hasn't left much to process. To that end, this is also where ADM's geographical exposure becomes an issue – ADM has a modest presence in Latin America compared to Bunge (NYSE:BG) and can't take as much advantage of Argentine and Brazilian oilseed crops produced by companies like Cresud (Nasdaq: CRESY) and Adecoagro (Nasdaq:AGRO).
Although the 2013 U.S. crop is looking strong in terms of yield, it's hardly a done deal yet. In any case, investors are already transitioning to the next year's outlook where a surge of crop inventory should boost the crush and ag services operations.
Ethanol Boosting Corn, But Don't Count On It
While ADM and Ingredion (Nasdaq:INGR) are seeing pressures in the sweeteners and starches business from last year's crop (ADM's corn processing volume declined 1% this quarter), the bigger issue for ADM is the never-ending volatility in the ethanol industry.
SEE: The Buzz Around Ethanol
ADM is the largest ethanol producer in the U.S. at about 1.75 billion gallons or roughly 12% of U.S. production. All told, the top five producers (which includes Valero (NYSE:VLO)) account for about 40% of capacity, but it's not as though this scale offers much assurance of stability. Inventories are low, but Brazilian imports are cost-effective and the blend wall could start pressuring prices. Not unlike what happens in the conventional gasoline refining business, ethanol prices generally follow corn prices, but not in lockstep and there's really no way to know where margins are going more than a quarter or two from here.
The Bottom Line
The GrainCorp acquisition will improve ADM's position in Asia, but there's still room for the company to increase its global presence (in Asia, Latin America, and Africa). These opportunities have to be set against the cost of capital and so on, but the point stands that ADM still has room to grow its business. Still, this is a volatile business with razor-thin margins and cash flow generation, and that is unlikely to change.
With that in mind, I'm not in any hurry to chase ADM shares today. I like ADM just fine, but I think the stock is fairly-priced with respect to discounted cash flow and ROE/PBV. I'm happy to own ADM when Wall Street doesn't like it, but with the sentiment (and stock performance) having turned around, I think there are better opportunities elsewhere.
Disclosure: At the time of writing, the author did not own shares of any company mentioned in this article.
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