CSAN - Ever-Higher Sugar Prices Sweeten The Thesis For Adecoagro

2023-10-17 03:54:07 ET

Summary

• Adecoagro is leveraging its above-average operating flexibility to maximize sugar production and shift ethanol production toward more profitable anhydrous volumes.
• The sugar market is likely to be in deficit for the next two or three years due to weather conditions and export restrictions, particularly in India.
• After a year of serious drought in Argentina, the prospects for farming operations are brighter, and the rice and dairy operations are doing well.
• I don't believe current sugar (or ethanol) prices are sustainable, but Adecoagro could still offer an upside as it leverages higher spot sugar prices into profits and cash flows.

Flexibility is a good thing in life, and Adecoagro ( AGRO ) continues to benefit from its flexibility to switch between sugar and ethanol production as the prices within the SEE business (sugar, ethanol, and energy) continue to shift in favor of sugar production. At the same time, the company is looking forward to what should be a better year for its Argentina-based crops business in 2023/2024 on better weather.

Clearly, tying any investment thesis to the vagaries of global weather and global commodity prices involves elevated risk, but Adecoagro has shown repeatedly over the years that it can produce SEE efficiently and allocate its capacity wisely. With a large amount of ‘24/’25 sugar production unhedged exiting the second quarter, Adecoagro is leveraged to sugar prices that have headed almost continually higher since March of 2020 and could go higher yet if weather and government policies go in their favor.

Up more than a third since my last update , I can still see 20% to 30% upside from here. Again, though, I would caution investors to remember that weather and government policies have a big influence here (and neither are especially easy to predict), and I would be careful about projecting recent strength into a long-term trend.

Sugar Production Gets Sweeter And Sweeter

These are good days to be in the sugar production business. With iffy weather in Asian growing regions and India (the world’s second-largest exporter) taking a harder stand on exports, the sugar market is likely to be in deficit for this year, 2024, and quite possibly 2025 as well. With that, prices have continued to march higher – up another 40% since my last update on the company.

On the weather side, both India and Thailand (18% and 4.5%, respectively, of expected 2023-24 production) are vulnerable to lower rainfall and lower yield due to a stronger El Niño phase, though recent weather hasn’t been bad. Meanwhile, Ukraine and Russia collectively account for a little less than Thailand’s production, but with the ongoing war and related trade disruptions, that incremental 7Mt to 8Mt matters more now. Last but not least, India has been restricting sugar exports and could move to an outright ban if production underwhelms in order to meet local demand and ethanol production targets.

Not only does reduced global supply work in favor of Brazilian producers, including Adecoagro, Cosan ( CSAN ) (through its Raizen unit), and Sao Martinho (SMTO3.SA), but the same El Niño weather pattern should drive increased rain and increased yield for sugarcane, albeit with some risk of delays/interruptions to harvests and processing due to the rain.

Adecoagro exited its second quarter with about two-thirds of its expected ‘23/’24 production hedged at $0.222/lb and only about 10% of ‘24/’25 production hedged (at $0.23/lb). None of the ‘25/’26 business was hedged, and Adecoagro hasn’t often hedged that far out. With current Sugar #11 prices at around $0.27/lb, the company has definitely had the opportunity to lock in some very profitable prices for this part of its business.

Meanwhile, the company is also trying to increase its production capacity. Adecoagro managed to shift 48% of its production to sugar in the second quarter and is actively looking to increase production even further. The company has some debottlenecking efforts already underway that could add an incremental 5% or so, and the ability to shift more production toward sugar is a relative advantage compared to more capacity-constrained rivals.

Ethanol In The Doldrums For Now

High sugar prices have coincided with exceptionally low ethanol prices, making production decisions all the easier for Adecoagro, Cosan, and Sao Martinho. The most recent price for hydrous ethanol in Sao Paolo ($0.428/liter) is down about 18% from the year-ago price and the ethanol/gasoline ratio is at a record-low 0.62x.

With ethanol prices this low, even the most efficient operators (Sao Martinho and to a lesser extent Adecoagro) are producing at a loss. As such, I wouldn’t be surprised to see more producers maximize their sugar production opportunities – holding on to cane and running their sugar production facilities at full capacity 24/7 and only producing ethanol as a secondary product.

Adecoagro has been working to boost its ethanol exports, but there’s just too much price pressure in the Brazilian market to really offset. Again, management will do what it can to maximize sugar production and minimize losses on ethanol and here again, the company’s flexibility has been an advantage – the company has shifted more of its production to anhydrous ethanol, which currently still carries a roughly 12% premium to hydrous ethanol.

A Better Crop Year Coming?

In response to tougher growing conditions (including a serious drought in Argentina), management cut back its acreage (planted hectares were down 8% in the second quarter), but that could reverse in the coming quarters. El Niño should be a positive for growing conditions in Argentina, and even if the effect is less than hoped, a repeat of the drought seen this past year seems unlikely.

Broadly speaking, the rice and dairy businesses continue to do well for the company, while the crops business (soy, corn, wheat, et al) is more volatile on those weather issues. I like the basic thesis of Adecoagro owning and operating productive farmland in a world that needs more food, and I would see drivers like improved governance and infrastructure in Argentina as potential positives.

The Outlook

Higher sugar prices have been good for revenue and margins relative to my expectations, and my estimate for the next two years is higher now on the back of that strong sugar outlook and improved crop outlook. I expect 2023 revenue to be up around 7% and 2024 revenue to be up another 10% on top of that as strong sugar prices flow into revenue. Longer term, I still won’t model much beyond low single-digit revenue growth as I do think the business will normalize after this big run in sugar and there is a risk of rivals adding too much capacity during this boom.

On the margin side, I’m modeling a couple of years of a mid-30%s EBITDA margin as sugar profits are offset by challenges in the ethanol business. I do see a possibility of 40% margin if things break right for the company (a strong crop year in Farming and anhydrous production mitigating losses on hydrous production), but I’m not going to take that as a given at this point. I’m expecting Adecoagro to translate this into a few years of low-to-mid-teens free cash flow margins before margins descend back toward a single-digit long-term trend.

Between discounted cash flow and EV/EBITDA Adecoagro shares still look undervalued. Both give me fair values in the $13-$14 range, with 4.5x my 12-month EBITDA estimate giving me a $13.75 fair value. While that 4.5x is below the 5x-6x range I’ve typically used, I think that’s appropriate given that these are likely to be peak years for the company. Using my prior 5x multiple, the fair value would jump to a little over $16.

The Bottom Line

There are certainly risks to consider here. Weather could just as easily go against the company, and the production issues in India and Thailand may not come to fruition. I’d also note that while sugar prices could go even higher from here, sooner or later the music will stop. I do think there’s money to be made yet in these shares, but be careful not to get sucked into an “it’s different this time” narrative and end up losing solid gains when the cycle inevitably turns.

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