What makes a great long-term buy and hold opportunity? Is it an opportunity with extreme growth potential? Is it one that is defensive in all markets but can still capture a bit of the upside during a bull run? Is it one with steady growth and low volatility? It really depends on the buyer I guess. For me, when I'm looking for a long-term, I'm talking perpetual, buy and hold position, I look for all of the above, but I also keep an eye out for what I like to call wiggle room. Wiggle room is the ability for the company to not execute perfectly but still be able to provide shareholder value because they have some sort of outside factors acting as a safety net underneath them. I get really excited when I run into an opportunity that requires management to simply get out of the way of the natural process of things, an opportunity that can allow the simple forces of physics to move it higher. I think there is that type of opportunity in Farmland Partners, Inc.
Farmland Partners, Inc. (NYSE:FPI) recently held an IPO on 4/11/2014 and sold 3.8 million shares at $14/share, raising $49.5 million. This was much lower than the 4,666,667 shares the company had expected to sell at between $14 and $16/share. The company's IPO was taking place during considerable macro volatility and had also taken place shortly after the not well received IPOs of several other companies. Baird and BMO Capital Markets were the main underwriters.
This article will discuss: the growing business of FPI, the truly global forces that I believe will propel them to years of consistent returns on investments, the incredible odds of those forces remaining in place, the growth strategy of FPI, and finally the trade. I will try to make the case that FPI is one of the first in what I believe will be a new sector of REITs looking to become players in the same space and that FPI is in a unique position to be one of the best buy and hold opportunities currently available.
FPI: A Brief Overview
FPI is an internally managed real estate company that owns and seeks to acquire high-quality primary row crop farmland located in agricultural markets throughout North America. They will initially have a focus on row crop farms because they feel that row crops can provide stable rental income and value appreciation in a more attractive risk to return profile than other farmland, currently. Their initial portfolio consists of 38 farms with approximately 7,300 total acres, including 33 farms in Illinois, four farms in Nebraska and one farm in Colorado. In addition, the company's portfolio is long three grain storage facilities.
The company intends to diversify and achieve scale in their portfolio with further purchases of additional farmland that vary by geography, row type, and tenant. Their initial focus will be on diversifying the composition of their assets between row crops and annual crops and the company intends to opportunistically acquire infrastructural properties such as grain storage facilities, grain elevators, feedlots, processing plants and distribution centers. Finally, they will look for positions that include livestock farms or ranches in an effort to widen the spectrum of reach within their assets.
FPI's primary source of revenue will be rent from tenants. As of 05/13/2014, substantially all of FPI's farmland is leased via triple-net leases (lease agreement on a property where the tenant or lessee agrees to pay all real estate taxes, building insurance, and maintenance (the three "nets") on the property in addition to any normal fees that are expected under the agreement) to either Astoria Farms, which is controlled by Paul A. Pittman, FPI's Executive Chairman, President and Chief Executive Officer, or Hough Farms, in which Mr. Pittman and Jesse J. Hough, who will provide consulting services to FPI, have an interest.
The leases have terms ranging from one to three years and have fixed annual rent payments that require 100% of the annual rent be paid prior to the annual spring planting season. The annual rent payments in aggregate have an average value that represents approximately 35-45% of the revenue expected to be produced by the underlying properties.
In the future, FPI anticipates that all properties will be leased to parties unrelated to the officers of the company, which will further diversify FPI's net farming operations risk and tenant credit risk. The leases themselves have been structured to comply with normal leasing activities currently taking place and help provide significant hedging against risks related to the business taking place on the properties. FPI also found value in leasing the initial book of assets to the officers within the company based on risk assessments of the officers as tenants (from the FPI S-11):
"Mr. Hough was previously a partner of Kennedy and Coe, a top 100 accounting firm that focuses on agribusiness accounting, and has worked with Mr. Pittman since late 2011. Pittman, Fabbri and Hough have more than ten, three and ten years of experience, respectively, as owners of agricultural real estate and operators of farming businesses and collectively have consummated over 70 transactions to acquire and consolidate various farmland parcels. As a result, we believe Messrs. Pittman, Fabbri and Hough have a deeper understanding of agribusiness fundamentals and greater insight into factors affecting the value of farmland than many of our competitors. Upon completion of this offering and the formation transactions, Mr. Pittman and Mr. Hough will own approximately 22.9% and 4.5%, respectively, of the fully diluted equity interests in our company, which we believe aligns their interests with those of our stockholders."
Finally, the equity ownership by the officers (I'm including Mr. Hough as an officer based on his consulting contract) as indicated above helps align shareholder-management interest. I have no issues with the initial leases, structuring of the leases, or parties involved. I find this to be attractive as a future holder of the equity based on all the above factors.
FPI plans to diversify their lease structuring, not entirely by choice, in the future to include leases that not require 100% upfront, pre-planting payments and leases that rent is based on a set percentage of the properties revenues generated, which will decrease future revenue visibility - something to be aware of in the future.
The Market Opportunity: Several Established Global Forces Will Act As A Constant Catalysts For Growth
All or substantially all of the information in this portion of the article was derived from one of six sources: United States Department of Agriculture - National Agriculture Statistics Service, Food Security and Population Growth in the 21st Century, One-Quarter of World's Agriculture Grows in Highly Water-Stressed Areas, The Great Balancing Act, the team of professors at the University of Texas at Austin who were kind enough to entertain my questions (who wish not to be mentioned individually), and my own analysis. You are welcome to read any of the above sources in their entirety, and I would recommend doing so as they are interesting and well put together.
The fate of FPI as a company will rest entirely on the value of food, which will drive the value for the underlying assets within their portfolio. Understanding what determines the value of food, the moving pieces on a global scale that create the baseline demand for food, and the potential for food creation is key to risk managing a position in FPI.
We'll start by addressing the constant growth in demand for food which is primarily driven by population growth - there are several other factors that we will discuss that also create demand but the primary catalyst is population growth. The United Nations projects that global population will grow by 11.6% from 6.9 billion people in 2010 to 7.7 billion people in 2020 with population growth further projected to hit 9.3 billion by 2050. These projections have grown less and less accurate with a significant bias to the upside over the last 20 years as globalization of trade and the advancement of medicines has created environments conducive to growth. In any case, an overwhelming amount of historic data suggest that population growth will achieve a growth rate of at least 1.3% as has been the norm since the industrial revolution.
For most countries, population growth rate is approximately 2-3% a year, which should translate to an annual increase of 3-5% in agriculture production levels. To feed today's population with a basic 2900 kcal diet, the average annual rate of cereal production per capita needs to be around 420 kg per year. The expected cereal production for 2050 is 360 kg. The Food and Agriculture Organization projects a 55 percent increase in total direct human calorie consumption from 2006 to 2050. All of these figures have been prepared with the assumptions that China and India, the two largest country populations in the world, grow at historic rates - which haven't fully been adjusted for the most recent uptick in growth over the last several years, meaning that the gross production and consumption numbers are almost certainly wrong to the downside. Again, even without up to date averages and the most accurate figures it becomes clear that population growth should continue and should begin accelerating to historic levels over the next twenty years, creating a larger baseline demand for food than at any point in history.
One final point to consider when discussing population growth, this hasn't been factored into projections because it is highly speculative and variable, is that as global GDP rises (especially in the largest countries) so does the demand for higher quality sources of nutrition. This becomes especially true when speaking in terms of protein consumption, which history has shown us tends to shift toward the consumption of livestock and other animal sources once GDP hits a certain level in developed countries. At least 3 billion more people are likely to enter the global middle class by 2030, and they will almost certainly demand more resource-intensive foods like meat and vegetable oils. Primary row crops (the initial portfolio of FPI properties and their short and medium term focus for acquisition) constitute a significant portion of livestock feed, with seven pounds of feed required to produce one pound of beef, according to the United States Department of Agriculture. These changing diet trends, coupled with global population growth, are expected to require additional annual production of over one billion tons of grains by 2050, an increase of 45.5% from 2005-2007 levels, according to the UN FAO.
Now that we've established the demand-side for the need and value of food rising and at least the primary driver of that, what about production? It would be a normal assumption to make that the same factors that helped drive population growth, namely expansion of global trade and technology, would contribute to an increased ability for production of food - which would then help balance out at least the price of food. That assumption would be wrong.
Global food production has risen; yes this is true, but the global food production per person and the yields of major crops have fallen over the last 30 years. In fact, world cereal yields and agriculture production have declined since 1961. In addition, the amount of farmland in use and the productivity of that farmland over the past 20 years have slowed. According to the UN FAO, global cropland area grew by 78 million acres from 1991 to 2011, compared to 238 million acres added from 1971 to 1991. Moreover, according to the USDA, U.S. cropland area declined from 464 million acres in 1987 to 408 million acres in 2007. Global crop yield gains, as reported by the USDA, also decreased to approximately 1.4% annually from 1993 to 2012 after averaging 2.0% annual growth from 1973 to 1992.
This concerning trend has been caused by several factors, the most important being water depletion and stress (which we'll go over shortly), and has had the effect of both increasing the price of food, the land that the food is being derived from, and consolidating the production of such foods to just a few areas in particular. For instance, currently, six countries - United States, Argentina and France - supply 90% of global grain exports. This places a significant amount of pricing dependence on the well-being of these producers and their willingness to contribute to the demand side. Should those producers have a drop in yield, a wide spread crop infection, or a desire to contribute more of their food mass to other sources (biofuels, etc.) that would materially impact the price of food globally. What does that mean to FPI? Well, FPI is located in one of those major producers and is acquiring assets across the major monopolized classes, driving the visibility of their revenue and helping secure a "put" against massive losses. There is an underlying buyer at every sell for their tenant's product and that doesn't appear to be in a position to change anytime soon. There simply isn't enough supply in the pipeline to meet future demand, which is what you look for when dealing in terms of commodities. What FPI is buying is in fact a commodity and the commodity they will partially own (the food being produced) will continue to increase in value with time.
Finally, do the above problems have the ability to be corrected? Can we change our habits and begin to sustainably create more food or have less demand? Is there major risk to the bull thesis based on this supply/demand dynamic? The short answer is no. Outside of a miracle GMO helping increase crop yields on an exponential basis or disease wiping out large portions of the population or significant changes in the rate of human reproduction, there is not a serious visible threat to the dynamic.
The primary factor above that was helping drive down crop yields, furthering the power of the supply/demand dynamic, that will also almost guarantee the dynamic stay in place even should one or two of the above listed variables be introduced, is water depletion and water stress.
I should start by saying that only a third of the Earth's soil is suitable for agriculture - 30% of this arable soil is expected to experience erosion by 2050 due to unsustainable agricultural practices. That fact alone is jaw-dropping when considering our bull thesis dynamic. Moving forward from that, a new study from WRI's (World Resources Institute) Aqueduct project reveals that more than 25 percent of the world's agriculture is grown in areas of high water stress. Water stress is the ratio of total water withdrawals to available renewable supply in an area. In high-risk areas, 40% or more of the available supply is withdrawn each year. A higher percentage means more water users are competing for a limited supply. This figure doubles when looking at irrigated cropland, which produces 40 percent of global food supply.
More than 40 percent of wheat is grown in areas facing high or extremely high levels of water stress. Remember, wheat plays an ever growing role in helping meet demand in other food categories, especially those that should come into play in countries increasing their GDP. Water is the key ingredient to the production of food crops - something that the above charts and statistics are telling us will become more and more of a negative factor to production in the future. Irrigation alone can dramatically increase crop production. However, it is an enormous water consumer and the single-largest driver of water stress around the world. As ever-higher food demand drives more farmers to irrigate their land, the world's rivers and aquifers will be increasingly strained. The more we try to produce, the more strain the system is placed under, which will only lead us to the endpoint of dropping production and more water stress. It's the equivalent to a company not being able to produce a widget at a profit -- the more they try to produce, the closer they move to insolvency. In this case, it benefits the assets in the FPI portfolio, something that bulls should not feel bad about taking advantage of.
Agriculture currently accounts for more than 70 percent of all human water withdrawal. The 2030 Water Resources Group forecasts that under business-as-usual conditions, water demand will rise 50 percent by 2030. Water supplies, however, will not - and physically cannot - grow in parallel. Agriculture will drive nearly half of that additional demand, because global calorie production needs to increase 69 percent to feed 9.3-9.6 billion people by 2050 (as mentioned above). This is yet another instance of a problem with no realistic, visible solution in sight. This variable to me is the single largest reason to be bullish -- the FPI thesis dynamic. When talking in terms of downside protection, long term, this should act as an insurance policy against production increases, even in the case of GMOs, for a considerable duration. It's a mathematical certainty that water supplies cannot meet demand which makes water stress a mathematical certainty which makes flat line or decreasing food production per capita a mathematical certainty. All good things when these contribute to your commodity increasing in value.
The Growth Strategy And A Breakdown Of The Financials
The growth strategy at FPI is one of the most straight forward, well planned, visible strategies I have ever seen. It's easy to understand and based on the experience of management as well as a few competitive advantages it should be executable. From the S-11:
Focus on Current Rental Income Generation and Long-Term Appreciation - In the words of the CEO, "this is not a land-flipping and trading mentality; this is about building long-term value in an asset class that for all kinds of macro reasons we believe is certainly going to keep appreciating". The idea here is to generate cash flows in the short term and appreciation in the long term. They aren't in the business of land flipping but they will sell a property to increase the overall risk/reward dynamic.
Continue Our Disciplined Farmland Acquisition Strategy Based on Agriculture Fundamentals - Target farms of varying sizes, acquire farms from undercapitalized sellers, and use Operating Partnership units to entice older farming families to sell as a way to estate plan and defer current income taxes from land price appreciation (OTCQB:HUGE).
Diversify our Portfolio by Geography, Crop Type and Tenant - self-explanatory.
Utilize Our Real Estate Management Platform to Achieve Economies of Scale - FPI believes that they can expand their current portfolio of assets several multiples before a need to increase SG&A. That's a significant benefit to the shareholder in many ways but primarily because the only expenses the company should take on in the short term should be directly as a result of acquiring assets, which is to be expected and is a normal part of this type of business model. No addition of any frivolous expenses is a big plus.
The financials at FPI are unique to their business. Again, leverage in this case is something that shouldn't even be talked about. FPI's model is to take on massive loans on the front end and make a spread between loans and rent. The simplicity of this model to me is a big-time value-add for shareholders. I think buyers will understand the plan and be able to assess the progress of the company upon updates to the book of assets.
The company currently has ~$50 million in cash and a $30.0 million credit facility at its disposal. They also have an unlimited use of their OP units, which can act as currency. This to me is the second largest reason to buy. Hands down this is their most powerful financial engineering tool and provides incredible flexibility for acquisition while maintaining current debt levels. I cannot express adequately the importance of these OPs going forward. The increasing average age of farmers in the US (57) as well as the desire for many of these farm operators' immediate families to not take on the family business should lead to ample opportunities to acquire positions using OPs. The benefit is obvious to all parties involved. I'm looking at that as the major upside driver to short-term numbers from a financials perspective.
Another advantage using the OPs presents is the ability to rely more heavily on these as a "financing" vehicle during environments of rising interest rates. The OPs can be bought out at later dates when financing is more readily available or at lower interest rates, easily if FPI can structure that specific into the OP itself. FPI can use these as placeholders to ensure the most efficient aggregate debt structuring for the overall book of properties, which is something unique to companies in this space.
The financials are less relevant to this company than the aggregate acquisitions, the specifics involved in those acquisitions, and rising tide of overall economics involved in their business for the time being. I would like to see an aggressive first quarter from FPI and at least one major acquisition finalized with several acquisitions in place. I would also like to hear positive updates on efficiency at the currently owned properties and updates as to the specifics of the costs of hedging on those properties. Considering the majority of the portfolio is "owned" by officers of the company, management should be able to provide more color as to the operations on a property specific level than normal.
Also, it's worth mentioning that FPI has a realistic chance of being the beneficiary of joint ventures in the near-term and especially the long term. There's a few factors that will drive this, namely that foreign countries faced with large future food supply deficits (China, India, etc.) need to find ways to address this growth constraining issue, and that global agriculture and commodity conglomerates will want to ensure that they are at least a player in a game that could shave up to 25% of their profits (their spread) should their buyers add enough land to a proprietary portfolio (squeezing ADM, Cargill, etc. out of the picture). Again, based on the unique expertise that FPI brings to the table (management), the existing network of management, and the restrictions within some of the potential parties corporate structuring, I see FPI as an attractive option for JV.
There are other avenues the above parties could pursue, such as purchasing shares in funds that invest in farmland directly or deploying money for private placement within such a fund, but neither would give the type of ownership structuring or hand on control that an FPI option would. I think that makes FPI a front runner for these types of money flow across all durations. This is already happening in the international markets.
Speaking of those alternative channels for fund flows (mutual funds, PE firms, pension funds, endowment funds, etc.), they also become a potential option as not only a shareholder but a possible funding pathway. From a shareholder perspective, all players are in the search for yield after operating in a ZIRP environment the last 6 years. The pension funds in particular are also faced with the scary reality that they have large unfunded liabilities on their books with the uncertainty of further ZIRP ahead (even with the Fed forecasting higher rates and slowing the pace of purchases under their QE program rates recently hit a 2014 low across all durations). The possibility of an investment in FPI becomes an outlet that can provide the yield and lower levels of volatility they are looking for. The funds potentially flowing into FPI could be immediately deployed and add unpredictable increases in revenue to the financials. I don't think this should be a primary reason to own the stock and I'm not pricing any of this into my models at this point, but the potential matters.
Finally, when looking into extremely affordable capital sources (up to and including free if the right JV opportunity presents itself), I know there are several biofuel companies either actively participating or planning to participate in the "land grab" as a way to help control long-term costs of goods. Everybody with any interest in food or using food as a source of income understands the pricing pressures and inflation of the commodity. It's in the best interest of these dependent companies to hedge their exposure to pricing and the fact that they can do so while experiencing asset appreciation and income from rent makes farmland an attractive option. FPI, if they can develop relationships with the funds mentioned above, could use these funds to keep them in front of a steady stream of alternative energy buyers.
Overall, the growth strategy and financials make sense, they are what should be expected, and they provide a large amount of immediate upside potential. The bottom line at FPI is about food prices. Understanding, the dynamic of how the demand and pricing is created is the real value of this article and is what you should focus on. Everything else with FPI is a direct result of those variables and is dependent on their long-term results, which is why that was the majority focus of the bull thesis.
I think the title implies that the trade here is long. There's just so much to like about this company, their model, their flexibility in financial engineering, and the tailwinds that should continue to push the price of its "commodity" higher.
I look at FPI as an opportunity to own inflation, to own several certainties, and to own a story that will become more of a headline grabber as time goes on. I think they have a great initial portfolio, owners of the properties that have direct tied interests to the company, owners of the properties that have a unique sophistication in operating the properties that will be hard to replicate in exact going forward, and that they'll see immediate organic efficiency growth from the existing book.
I think that they are a company that is among the first of their kind and that being first will provide a marked strategic advantage. I think that FPI will be able to help consolidate the highly fragmented US farmland market and that they'll be able to soon take advantage of international opportunities.
Clearly, this is a long-term position for buyers. They won't be putting up huge growth in any category across any rolling short-term duration, but they will steadily grow revenues in the short term and slowly decrease their net debt reliance long term.
I do however think that based on the supply/demand dynamic that the overall mechanism of growth will add 6-8% yearly growth in organic revenues between the combination of land price appreciation and income derived from foods produced on those lands for the next 8-10 years before accelerating to adding 9-12% yearly growth after that duration. I use the term revenues loosely because the land appreciation won't be realized but does move the overall valuation of the company. I expect both of those figures to increase incrementally if capital is acquired at lower-than-expected costs via non-traditional financing vehicles as discussed above. I think at current market cap of approximately $50 million that the company is undervalued and should see steady price improvement for the remainder of 2014 and into the long term.
I think that FPI presents a unique, "set and forget" position that should be strongly considered. Good luck to all.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in FPI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.