Why Warren Buffett Is Loading Up On This Agricultural Giant

| About: Archer Daniels (ADM)

By David Sterman

During the course of 2012, investing in agricultural stocks proved to be tricky. One of the nation's worst droughts on record upended the business model of so many companies as crops wilted and cattle were brought to premature slaughter.

Yet there were a few beneficiaries of the drought.

Back in July, I suggested that Bunge (NYSE: BG) and Ingredion (NASDAQ: INGR) would prosper, and in that time, they've scored gains of 22% and 42%, respectively.

Back then, I looked at another major agricultural play, but sensed that it was too soon -- perhaps the back half of 2013 and into 2014 was the time to really focus on this company, I thought.

Warren Buffett has other ideas. He's already loading up on shares of Archer Daniels Midland (NYSE: ADM), acquiring 6 million shares in the fourth quarter of 2012 at an average price of $27. Shares have risen a bit further since, and show signs of breaking out of a longstanding trading range.

Though the turnaround for Archer Daniels is several quarters away, Buffett and others have begun buying now.

Here's why...

For starters, Buffett likely took note of the fact that tangible book value stands at $29 a share. Even after an impressive recent spurt, shares trade just above book value. Also, Archer Daniels is copying the moves made so successfully by rival Bunge --opening a series of grain- and soybean-processing facilities around South America to capitalize on a region that is less likely to experience drought.

In addition, Archer Daniels is slowly de-emphasizing ethanol production, which had consumed a huge amount of capital with only modest returns. The company is the industry's biggest ethanol producer, and if rivals also curtail production, then ethanol pricing will likely firm up. If the U.S. government moves ahead with plans to adopt "E15" (gasoline that uses 15% ethanol), then demand and pricing should also boost Archer Daniels' results. (Gasoline prices have also been rising this winter, which makes ethanol comparatively more attractive, even if E15 doesn't come to pass and just remains E10.)

As it stands, the national quota for ethanol will rise 4.5% this year to 13.8 billion gallons, though that remains below the industry's structural capacity of 14.7 billion gallons.

Of course, the near- and mid-term future for Archer Daniels will hinge on U.S. growing conditions during coming quarters. The company is very volume-sensitive, so if our nation's corn output rebounds, then Archer Daniels' processing facilities will be closer to full utilization. And a firm corn crop reopens the door to U.S. exports. "ADM has greater exposure to U.S. corn exports than Bunge, and would likely be the bigger beneficiary of the increase in U.S. corn exports we expect starting in February," noted analysts at Morgan Stanley.

To be sure, Buffett never takes a big position in a big company on a whim that climate conditions will produce favorable results in coming quarters. Instead, he likes businesses that have wide moats and generate considerable free cash flow. Archer Daniels sure has a wide moat, but the cash flow generation has been erratic. The company alternates years of positive free cash flow with negative ones. On a cumulative basis, it has generated a $5.6 billion free cash flow loss during the past six years.

Yet in the past few quarters, management has begun speaking of a much greater emphasis on capital allocation, returns on investment, and importantly, free cash flow. Indeed, during the past three years, Archer Daniels has invested roughly $6 billion in capital expenditures (capex) to boost the profitability of its divisions. Those gains aren't yet in evidence, due in large part to the drought of 2012, but should bear fruit as crop conditions return to normal. That's surely what Buffett is anticipating.

The stars were last aligned for this company in fiscal (June) 2009, when Archer Daniels generated $3.1 billion in positive free cash flow. Compared to the current $21 billion market value, this ratio apparently impresses Buffett.

The key question: Will Archer Daniels return to that financial strength soon? Analysts at BMO Securities believe so. "ADM's earnings power likely has increased with recent capex projects that have expanded the company's capacity and reduced its cost structure." Although per-share profits have been stuck around $2.50 in fiscal (June) 2012 and likely again in fiscal 2013, earnings per share should approach $3 in fiscal 2014, according to BMO.

Risks to Consider: Precipitation remains below average across much of the United States this winter, so a drought in 2013 as well can't be ruled out.

Archer Daniels' turnaround story has kind of slipped under the radar. The company hasn't made bold headlines with its $6 billion business revamp, preferring to let actions (and cash flow) speak for themselves. Although shares have moved up off of their lows, they remain well below the mid-$40s range seen in the past major agricultural cycle.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.