Archer-Daniels-Midland: We Are Again Right On Target, Slowdown Is Part Of Normalization

Investment Thesis

Review

We initially covered Archer-Daniel-Midland at $89.41 in February this year with a “Sell” rating, and it subsequently realized an 18% decline to $72.62 by June. At that point, we changed our rating to “Hold”, expecting the price movement to be range-bound with a chance of heating up in the summer but won’t last long. Fast forward four more months to now, ADM’s price behaved again exactly as we expected. It climbed up to $84.98 in August briefly and fell back down to $69.47 currently, almost right where they were in June. Our thesis was based on not only the financial health of ADM but also the commodity risk that drove the stock price.

Updates

Archer-Daniel-Midland had just released its earnings a day ago. The company’s EPS of $1.63 has beaten the expectation by $0.09, but topline missed by $1.94 billion or almost by 8.2%. Its presentation of adjusted segment operating profits tells more about the direction of its growth as we dig further.

As we previously predicted, this slowdown in revenue and operating profits came as no surprise. The company stressed it was coming down from a “very strong” result of last year. The volume from Ag Services in this quarter was high, but mostly driven by the record crop from Brazil. We also mentioned this in June. With its significant exposure to the commodity market, which trending back to the historical norm subsiding from the effect of the Russian-Ukraine war, this quarterly result in fact shouldn’t be seen as a “slowdown” but a return to normalcy.

Its adjusted segment operating profits for the latest quarter have gotten back to where it was in Q3 2022, mostly due to the decline in the Ag Services and Oilseeds (A&O) segment. This segment’s Q3 profits declined by about 20% compared to Q3 2022, due to the fact that it has the most direct impact from the commodity prices normalization as grain processing and crushing dominate its profits. However, this decline was compensated by the expansion of its Carbohydrate Solutions (CS) segment, which grew 35-40% QoQ and YoY. As the company noted in its presentation, it has not only achieved higher profit growth for this segment but also delivered carbon reduction in its Decatur complex, where its North American headquarters is located and it holds the single largest location and employee base for the company. This is when the CS segment’s revenue has declined YoY both quarterly and YTD by almost 9-14%.

To see how ADM has been able to achieve this, look no further than its efforts throughout this year. Most of the company’s newest efforts were made in sustainable farming and production through alternative protein sources and carbon reduction. Its Regenerative Agriculture Program continued to expand from 2 million acres to a target of 4 million acres in 2025 to cover more farmers in the States and Canada. It has identified important factors in building out an alternative protein ecosystem and made north of $30 million investment in Spain to develop probiotics production, which aims at boosting its smallest segment, the Nutrition segment’s revenue from currently just under $500 million to $2 billion in 10 years. These efforts that used to be seen as alternatives have indeed driven the newest profit margin for it.

To avoid being the function of commodity market swings, ADM not only needs to continue these efforts for the smaller segments but also ramp up their impact in its largest segment, the Ag Services and Oilseeds. As a starter, the company has tried to scale up growing low-carbon-intensity crops for biofuel generation in partnership with Syngenta Group. This could eventually deliver higher margins with a lower cost sustainably.

As we continue building out the investment thesis based on not only ADM’s specific development but also the influence of the commodity markets, we see that from here on, falling grain PPI could bring down another 30-40% of the company’s earnings, although with a slim chance of staying at or around current profitability.

For its free cash flow, we expect lower Grain and Oilseed Milling PPI could bring out even larger volatility both on the upside and the downside. The swing could widen to more than $1 billion from quarter to quarter. For the grain markets, the latest development isn’t just about weather but also geopolitical events. The uncertainty isn’t just about potential supply constraints but also shocks to demand.

The initiatives ADM undertook this year to upgrade its network and production to aim at carbon reduction and expansion of alternative food sources sustainably have become more than just alternatives. The need to stabilize its revenue and earnings from the impacts of commodity markets will continue to call for more value-added projects in its growth. We see this as a great start, although for the near term, the effect will not be enough yet.

Financial Overview & Valuation

Currently, we maintained our previous fair valuation, which was described initially in “The Commodification of Archer-Daniels-Midland” in January, and reiterated in “Archer-Daniels-Midland: Price Fallen Into Our Target Range As Predicted” in June. In the initial coverage, we already predicted there would be a slowdown of growth in 2023 in our base case. We would only be bullish if the volatility of its cash flow had been smoothed out, and that hasn’t happened so far. We originally expected a YoY decline of 30% in its free cash flow in our base case, but so far this retracement is set to decline more than that. Q4 is usually the seasonally weak quarter for ADM. So we don’t expect large upside surprises from here on till the end of the year. In the chart below you will find our initial fair valuation, which was assessed ten months ago. Contrasted with this, we are now more inclined toward between the base case and the bearish case.

Conclusion

What we want to stress is the current quarterly result is a reflection of normalization instead of a sudden slowdown. Investors should not expect ADM to climb back to previous highs any time soon. As we warned the summer highs were not going to sustain, for the investors who have bought in the summer, it will probably take a while to get back to that level. Our expectation is ADM’s stock price will stay at or below its current levels into early next year. It is still a hold for us right now.