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Archer Daniels Midland Enjoys Tailwinds, but Risks Remain
Stock Analysis & Ideas

Archer Daniels Midland Enjoys Tailwinds, but Risks Remain

Archer Daniels Midland (ADM) is one of the most prominent producers of ingredients and natural products for human and animal nutrition worldwide.

The company utilizes natural crops to produce staple foods, sustainable industrial products, renewable fuels, and a vast pantry of food and beverage ingredients. It also produces nutrition for pets and livestock. I am neutral on the stock.

The War’s Effect on Crop Prices

These days, ADM is in a unique position. Being a major player in the industry, the company has recently attracted investors’ attention as the ongoing war in Ukraine has a notable impact on global agriculture production.

Ukraine is a major net exporter of many leading cereal crops, including wheat, maize (corn), and barley. The country is also a dominant exporter of sunflower oil, one of the world’s dominant vegetable oils.

With the West sanctioning Russia as well, which is also a major agriculture exporter, worries regarding food shortages have risen. For context, in the wheat and meslin space, the Russian Federation stands out as the top wheat exporter globally, shipping a total of 32.9 million tonnes of wheat and meslin, which equals around 18% of global exports.

As a result, grain commodities have skyrocketed over the past couple of months. Wheat futures trade 50% higher compared to last year. Oat, rice, and canola futures are also up by around 70%, 28%, and 33% year-over-year. Again, the second-largest exporter of canola seeds and rapeseed in the world, for illustration, is Ukraine.

ADM has three primary segments, which are all bonded to the ongoing rising prices environment. The company’s Ag Services and Oilseeds segment’s activities include crushing and processing oilseeds such as soybeans and soft seeds (cottonseed, canola, sunflower seed, rapeseed, and flaxseed) into vegetable oilsand protein meals.

The Carbohydrate Solutions segment is involved in corn and wheat’s wet and dry milling activities. Finally, the Nutrition segment serves several end markets, including food, nutritional supplements, and feed and premix for livestock, aquaculture, and pet food, which require the underlying basic crops during production.

Impact On ADM’s Financials

With the market turning to producers such as ADM to make up for the reduced supply of ingredients and natural products, the company has been benefiting from growing sales.

The company has also been able to pass on the increased energy and produce costs to customers through its pricing power. Since everyone needs to be fed, demand for agricultural products is extremely inelastic, as consumers are willing (or forced in that regard) to (over)pay for these basic foods.

ADM’s latest results illustrated that. Revenues increased 25.2% to $23.65 billion, with the company operating in a constrained supply environment for crops, and for other products, as a result of continued supply chain and labor availability issues.

We can see the ongoing situation reflected in ADM’s net margins. Net income margins came in at 4.46%, significantly higher than 3.65% in the comparable period last year.

The agriculture industry is infamous for its razor-thin margins. This increase may seem trivial at first, but precisely because margins are that thin, a small expansion can have a material impact on earnings. Specifically, adjusted earnings per share increased by 36.6% to $1.90, substantially more than revenues amid the expansion in margins.

Valuation Justified?

With ADM’s earnings on the rise, investors’ interest in the stock has grown substantially. The stock is currently trading nearly 42% higher year-over-year, as the company appears positioned to deliver record earnings in Fiscal 2022.

Wall Street expects the company to achieve EPS of $6.17 for the year, implying an increase of 18.8% year-over-year. It will be the most profitable year in the company’s history by far. At the stock’s current price, it implies a P/E of 14.4.

While this may sound like a reasonable multiple, investors should be rather wary of the possibility of the company’s earnings declining going forward.

If commodity prices remain elevated, the current multiple could be somewhat justified. On the other hand, if commodity prices were to normalize going forward, investors would find themselves exposed.

The stock’s valuation could easily compress to a P/E in the high-single to low-double digits, which, along with a weaker net income, could result in heavy losses.

Wall Street’s Take

Turning to Wall Street, Archer Daniels Midland has a Moderate Buy consensus rating based on four Buys and five Holds assigned in the past three months.

At $99.29, the average Archer Daniels Midland price target implies 11.7% upside potential.

Takeaway

Archer Daniels Midland is a reliable company with incredibly mature operations. After all, it boasts 47 years of consecutive annual dividend increases, which classifies it as a Dividend Aristocrat.

While the ongoing trading environment has been very favorable for the company’s results, risks are attached to its elevated valuation multiple.

Archer Daniels Midland will be in big trouble if commodity prices return to their historical averages. Its costs will have remained elevated amid the ongoing inflation levels, which will lead to a substantial compression in margins.

Accordingly, the valuation multiple will be compressed as well, causing tremendous investor losses. Thus, investors should not just focus on the current, fortunate climate but also pay attention to the bigger picture.

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