2023-08-16 20:20:15 ET
Summary
- Archer-Daniels-Midland Company's stock has gained 18% since July 2022, when we published our first article on the firm, slightly outperforming the broader market.
- Q2 results show declining revenues and lower EBIT and EPS compared to the previous year.
- Despite the lower earnings, ADM's dividends remain safe and sustainable, making it an attractive option for dividend investors.
- On one hand, our dividend discount models indicate that ADM may be overvalued. On the other hand, a set of traditional price multiples are indicating a slight discount compared to the sector median.
- For these reasons, we maintain our "hold" rating.
Archer-Daniels-Midland Company ( ADM ) procures, transports, stores, processes, and merchandises agricultural commodities, products, and ingredients in the United States and internationally. We have started coverage on the firm in July 2022, with a hold rating. Since then, the stock has gained about 18%, slightly outperforming the broader market, which has gone up by roughly 14%.
In today's article, we are going to look at ADM's business once again, and discuss how the latest quarterly earnings results may impact our opinion on the firm going forward.
Before we start off, we would like to give a short recap of the main points discussed in our previous writing :
- ADM has not shown in the past a clear tendency of outperforming the broader market in periods, characterized by low consumer confidence
- The Gordon Growth Model, a single stage dividend discount model, combined with the justified P/E calculation indicated that the stock has been trading in its fair value range at that time
- The safe, sustainable, and increasing dividend could be appealing for dividend investors
- The fair value of the stock has been estimated to be $41 and $84, based on a required rate of return of 7% and a perpetual growth rate between 3% to 5%.
Our discussions will be primary focusing on the valuation and whether there is any adjustment necessary to reflect the latest earnings results and the changes in the macroeconomic environment.
Q2 results
ADM had a very strong second quarter in 2022, which may make the current results less appealing. Before we start with this year's results, the following paragraph explains what factors have been driving the record results in the second quarter of 2022.
Revenues in Q2 2022 increased $4.4 billion to $27.3 billion due to higher sales prices ($5.2 billion), partially offset by lower sales volumes ($0.8 billion). Higher sales prices of oils, soybeans, corn, meal, farming materials, wheat, biodiesel, flours, and alcohol and higher sales volumes of milled rice, were partially offset by lower volumes of soybeans, oils, and corn. Ag Services and Oilseeds revenues increased 17% to $21.4 billion due to higher sales prices ($4.2 billion), partially offset by lower sales volumes ($1.0 billion). Carbohydrate Solutions revenues increased 33% to $3.8 billion due to higher sales prices ($0.8 billion) and higher sales volumes ($0.1 billion) despite the loss of USD-grade industrial alcohol volumes from the divested Peoria, Illinois facility. Nutrition revenues increased 16% to $2.0 billion due to higher sales prices ($0.2 billion) and higher sales volumes ($0.1 billion).
Revenues have been declining YoY, while costs have been trending upwards compared to the prior year period. As a result, EBIT and EPS came in significantly lower than a year ago. EPS has declined by as much as 22%, EBIT has declined 25%, while revenue has fallen about 8%.
Income statement (ADM)
As ADM operates in a range of different segments, it is important to understand how each of these has contributed to this unfavourable change.
Ag Services & Oilseeds
Results have been slightly below Q2 2022 figures, contributing marginally to the declining results year-over-year.
South American origination results were higher year-over-year, as the team delivered record volumes and higher margins on strong export demand, leveraging our strategic investments in port capacity to capitalize on the record Brazilian soybean crop. Results for North America origination were slightly lower year-over-year, driven by lower export volumes due to large South America supplies.
At the same time, crushing results were significantly lower than the record result from the second quarter last year, but these have been partially offset by the "Refined Products and Other" segment results, which were meaningfully higher than a year ago, leading to a record second quarter this year.
Carbohydrate Solutions
Segment results have been strong, although they have come in below 2022 Q2 figures.
The Starches and Sweeteners subsegment, including ethanol production from our wet mills, capitalized on a solid demand environment during the quarter. North America starches and sweeteners delivered volumes and margins similar to the prior year, and ethanol margins were solid as industry stocks moderated, though lower relative to the prior year. Q2 results were negatively impacted due to unplanned downtime at one of our corn germ plants.
Nutrition
The results from the nutrition segment have declined significantly compared to the record Q2 2022 results. This has been driven primarily by the following factors:
Animal Nutrition results were much lower compared to the same quarter last year due to significantly lower contribution from amino acids, pockets of softer global feed demand affecting volumes, and continued demand fulfillment challenges and inventory losses in Pet Solutions. [...] Human Nutrition results were in-line with the second quarter of 2022, as the team effectively managed a challenging demand environment. Flavors results were significantly higher than the prior year due to improved mix and pricing in EMEA and improving demand in North America . Specialty Ingredients results were lower year-over-year due to softer demand for plant-based proteins, particularly in the meat alternatives category in North America and Europe , partially offset by strong performance in texturants.
Now that we have a broader picture of what has been driving the changes in the past quarter, we have to understand how to use these results for our evaluations.
Impacts on dividend sustainability
Previously, we have been saying that ADM could be an ideal candidate for a dividend- or dividend growth portfolio. Now in order for this statement to remain true, we have to make sure that the dividends are still safe and sustainable, despite the deteriorating financial performance. The following chart shows how ADM's payout ratio has been developing over the past five years. We can see that despite the decline in EPS, the payout ratio has not jumped significantly, and remains quite low.
Also, when we compare ADM's payout ratio to those of its peers in the agricultural products and services industry, we can see that ADM has relatively low payout ratios and a much strong track record of dividend payments than its peers.
As a result, we believe that ADM still remains an attractive candidate for dividend investors, despite the lower quarterly earnings than a year ago.
Further, the free cash flow of the firm in Q2 has been more than enough to cover both its dividend payments and share repurchases.
The main question that needs to be answered now is how the recent developments, including macroeconomic changes, dividend increases etc. have impacted to firm's valuation. To answer this, we will once again be using dividend discount models, but we will give an updated view on the input parameters, namely the required rate of return and the perpetual dividend growth rate.
Valuation
When coming up with a valuation for a stock, our aim is to be as realistic and as up-to-date as possible. Both input parameters can have significant impacts on the valuation, therefore it is crucial to always have the latest information incorporated.
1.) Required rate of return
In our previous writing, we have been using a required rate of return of 7%, based on the firm's weighted average cost of capital. This needs to be updated now, however. Since then, the macroeconomic environment, especially the interest rate environment, has changed significantly. Higher interest rates normally lead to higher cost of capital. For this reason, we will be using a required rate of return of 9% for our calculations today.
2.) Perpetual dividend growth rate
To gauge what dividend growth rate could be realistic in the near term and in perpetuity, we need to look at ADM's historic dividend growth rates. Depending on the time frame that we are looking at, the growth rate is between 3.4% and 10.4%.
Dividend growth (Seeking Alpha)
Now that we have the updated input figures, we will create two scenarios to come up with a reasonable range of fair values.
Scenario 1. - Low case
In this case we assume that ADM will be growing its dividends at a 3.4% rate in perpetuity. This calculation gives us, however, an unrealistically low fair value of $35 per share.
As we believe that this approach is too conservative because it does not take into account near term high growth rates and the positive benefits of share repurchases.
For this reason, we have decided to create a second scenario, which accounts for the potential near term rapid growth.
Scenario 2. - High case
In this case we assume that for the next 5 years, ADM will be able to increase its dividends at the same rate as they do today - by 10.4%. In order not to be overly optimistic, after the 5 year period, the dividend growth rate would revert to ADM's 5YR historic average of 5.8%.
This calculation gives us a fair value of $75 per share, still about 12% below the current market price.
As both of these calculations suggest overvaluation, we wanted to make sure that we take a look at the stock price from a different perspective as well.
The following table shows a set of traditional price multiples, which are all indicating that the firm is relatively undervalued compared to both the sector median and its 5YR historic averages.
Price multiples (Seeking Alpha)
If we narrow the peer group to firm's in the agricultural products and services industry, the price multiples are no longer indicating that much of a discount, but they are definitely not showing a significant overvaluation.
Conclusions
ADM's financial results have been significantly worse than in the second quarter of 2022. Revenue, EBIT and EPS have all declined. Important to note that Q2 2022 has been a record quarter for ADM in many senses, therefore the compares have been difficult to match.
Despite the lower earnings, ADM's dividends remain safe and sustainable. The firm's free cash flow generation as wells as its healthy levels of payout confirm this thesis.
Due to the macroeconomic changes, we have decided to update our required rate of return from 7% to 9%, in order to match the firm's latest weighted average cost of capital estimate.
The dividend discount models that we have been using are indicating an overvaluation, while the price multiples are showing that ADM is trading at a significant discount compared to both the consumer staples sector median and its own 5YR averages.
For these reasons, we maintain our "hold" rating.
For further details see:
Archer-Daniels-Midland: Overvalued, Reiterate Hold For Sustainable Dividends