MPC - Ultrawide Moat Great Valuation Dividend Growth: Archer-Daniels-Midland Has It All

2023-12-27 07:00:00 ET

Summary

• We focus on high-quality businesses with good valuation and healthy balance sheets.
• Archer-Daniels-Midland Company is a global agricultural supply chain manager with an ultrawide moat.
• Archer-Daniels-Midland stock offers stability, income potential, and potential annual returns of close to 20% through 2025.

This article was coproduced with Leo Nelissen.

If there’s one thing I have consistently talked about this year, it’s my focus on high-quality businesses that have both a good valuation and a healthy balance sheet.

A healthy balance sheet requirement is almost obvious. However, especially in times of elevated rates and risks of a second wave of inflation, I cannot emphasize enough how important it is to buy healthy companies. While inflation is currently coming down, Apollo Global Management highlights the risks of a second wave of inflation, similar to what the market witnessed in the 1970s and 1980s. This could happen again if the Fed starts to ease too quickly, causing inflation to rebound from higher economic growth expectations and new money flows into areas with subdued supply growth (like commodities). This could give us a prolonged period of elevated rates .

A good valuation is as important as a healthy balance sheet.

That is based on the fact that valuations have become stretched.

As we discussed in a recent article for our Investing Group, valuations have become quite lofty, which indicates a high likelihood of subdued longer-term returns. In other words, we focus on both dividend stocks and deep-value stocks, which means we're protected if a bigger part of the total return comes from dividends (total returns are capital gains plus dividends).

On top of all of this, we want companies with wide moats, a term originally coined by Mr. Warren Buffett.

As discussed by Picture Perfect Portfolios, the term "economic moat" is central to Buffett's investment philosophy, drawing inspiration from medieval castles' protective trenches.

For Buffett, economic moats are integral to his investment philosophy, signifying a company's ability to generate and sustain above-average profits.

Thanks to his value investing background, Buffett sees economic moats as indicators of a company's future profitability and intrinsic value.

That’s where Archer-Daniels-Midland Company ( ADM ) comes in. This company is one of the world’s largest agriculture corporations with a moat that can be seen from space.

An Ultrawide-Moat Giant

The Archer-Daniels-Midland Company is a global agricultural supply chain manager and processor with a diverse range of roles.

From being a key player in the agricultural industry to pioneering solutions for healthier living and sustainability, ADM's influence includes human and animal nutrition, innovative alternatives to petroleum-based products, like ethanol, and a related commitment to sustainability.

While it does not produce agricultural crops, the company's strategic positioning and extensive capabilities allow it to address global trends related to food security, health, and sustainability.

ADM's operations are categorized into three reportable business segments : Ag Services and Oilseeds, Carbohydrate Solutions, and Nutrition.

Author.

1. Ag Services and Oilseeds: The segment manages the global supply chain of agricultural raw materials, including origination, merchandising, transportation, and processing. It plays a crucial role in producing oilseeds-based products for various industries, with notable equity interests in key ventures worldwide.
2. Carbohydrate Solutions: Engaged in corn and wheat wet and dry milling, this segment produces a diverse range of products for the food and beverage industry, including sweeteners, starches, alcohol, and animal feed ingredients.
3. Nutrition: Serving diverse markets such as food, beverages, nutritional supplements, and animal feed, the Nutrition segment manufactures and distributes a wide range of ingredients and solutions, including plant-based proteins.

Going into this year, the company had roughly 750 facilities, 64 innovation centers, 300 food & feed processing locations, 440 crop procurement locations, and more than 40 thousand employees to manage all of this.

This makes the company, which was founded in 1902, an ultrawide moat player, as it is nearly impossible to copy this business model.

While this is a low-margin business dependent on pricing, it has survived every recession for more than 120 years, thanks to the fact that its services are literally needed to feed the world.

Farmers need to be connected to buyers. Crops need to be turned into value-added products. That’s where ADM comes in.

The company's ability to source, process, and distribute agricultural raw materials efficiently provides a competitive advantage that is not easily replicated. This includes its relationship with more than 200 thousand farmers.

To give you a few more details, the company has the capacity to store 20 million tons of grains and crush more than 40 million tons.

It owns 10,000 railcars, 3 oceangoing vessels, 1,200 semi-trailers, and 1,800 river barges. This alone is enough to turn it into one of the biggest transportation companies on the planet!

On top of all of this, the company is expanding. Earlier this month, Bloomberg reported that ADM is taking over Revela Foods, a company focused on food ingredients.

We believe this is a smart deal, as it does two things:

• It allows the company to expand its footprint in a fast-growing area, further widening its moat.
• It helps the company boost margins, as I expect that a focus on products that go further up the value chain can enhance total profitability.

According to the article:

“ADM has spent billions expanding its nutrition business since 2014 when it made its biggest-ever deal — the $3 billion buyout of European natural ingredient maker Wild Flavors — in a bid to diversify into value-added products. The Revela acquisition is the first since longtime ADM executive Ian Pinner took over the nutrition unit. The deal is expected to close early next year.”

The company is also a dividend aristocrat with a track record of 30 consecutive dividend hikes!

Currently, the stock yields 2.6%, protected by a low 20% payout ratio. Its five-year dividend CAGR is 6.1%.

On January 26, it hiked its dividend by 12.5%, which shows that ongoing business tailwinds translate to higher dividend growth.

While its yield may not be as juicy as some of the real estate investment trusts, or REITs, we often discuss, the payout ratio is very low, and the safety ADM brings to the table is certainly worth it to accept a lower yield.

On top of that, ADM has an A-rated balance sheet and a leverage ratio close to 1.2x EBITDA. It also has more than $10 billion in cash on hand.

Not only does this pave the road for growth in shareholder distributions, but it also allows the company to engage in large acquisitions without having to take big financial risks.

Archer-Daniels-Midland Is Growth Rapidly

With that said, ADM shares have gone sideways between 2014 and 2021 – including dividends.

After accelerating since 2021, shares are now weakening again.

We believe this provides investors a great opportunity, as the valuation has come down while ADM continues to make tremendous business progress.

For example, in its third quarter , the trailing 4-quarter average adjusted ROIC stood at 13.2%, indicating another strong quarter.

The company reported adjusted earnings per share of $1.63, resulting in a year-to-date adjusted EPS of $5.62, the second-best in the company's history for the first nine months.

• Ag Services and Oilseeds saw strong demand for vegetable oil, supported by the energy transition, led to a solid crush environment. ADM effectively managed Brazil's record crop and utilized its global trade franchise.
• Carb Solutions achieved a record third quarter with robust margins in starches, sweeteners, flour, and strong ethanol demand, driving impressive volumes and margins.
• Nutrition witnessed that flavors growth outpaced the market, and despite pockets of soft demand, actions in Animal Nutrition improved performance with market volume recovery.

ADM also created new growth areas, partnering with major brands like PepsiCo ( PEP ), Nestlé (NSRGY), and Carlsberg (CABGY), aiming for 4 million regenerative acres by 2025.

In production, ADM is capitalizing on the growing demand for renewable fuel sources with projects like the Spiritwood JV and Broadwing Energy.

The Spiritwood JV with Marathon ( MPC ), set to produce 75 million gallons of renewable green diesel per year, aligns with the increasing demand for renewable fuel sources.

Broadwing Energy represents a lower-emission power source, which contributes to ADM's commitment to lowering carbon emissions.

For the full year 2023, the operating profit for the Nutrition segment is expected to be around $600 million. While the company acknowledged that results in 2023 have been below expectations, there is an optimistic outlook for a return to growth in 2024.

The company plans to build on the momentum in Flavors, maintain steady performance in Health and Wellness, and drive growth in Animal Nutrition through cost actions and a pivot to higher-margin products.

So, what does this mean for its valuation?

Valuation

As we can see in the chart below, ADM’s earnings growth has turned negative.

Lower commodity prices and related pricing benefits are gone, which we expect to return once economic growth improves.

• Currently, ADM trades at a blended P/E ratio of roughly 9.7x.
• The long-term normalized valuation is 14.6x.
• This year, EPS is expected to decline by 7%, followed by a potential 9% decline in 2024. 2025 is expected to see a return to growth.
• Our opinion is that both these years will be better than expected.
• Nonetheless, even using these subdued expectations, a return to its “fair” valuation multiple would suggest an annual total return of close to 20% through 2025.
• Although it is hard to make the case that the stock can return this much in an uncertain environment, we believe the long-term fair value should not be far below $100.

Given the stock’s valuation, the company’s ability to grow its dividend, stellar balance sheet, and long-term growth opportunities, we will soon start buying ADM shares.

Takeaway

ADM, a global agricultural powerhouse, embodies my investment principles—solid valuation and a robust balance sheet.

With operations including Ag Services, Carbohydrate Solutions, and Nutrition, ADM's wide moat, dating back to 1902, reflects its resilience over a century.

The recent acquisition of Revela Foods signals ADM's strategic expansion, enhancing its footprint and profitability. As a dividend aristocrat with a low payout ratio, ADM offers stability and income potential.

Its A-rated balance sheet, leverage ratio, and ample cash position it for growth and strategic moves.

Despite recent stock price fluctuations, ADM's business progress, ventures into renewable fuels, and partnerships with major brands showcase its commitment to long-term sustainability.

The current P/E ratio of 9.7x, compared to a normalized 14.6x, hints at a potential annual return of close to 20% through 2025, which we expect to be unlocked the moment economic growth bottoms.

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