First Days And ADM

| About: Archer Daniels (ADM)

Well the first days of my break from work are going well so far. We've been hanging out at the beach, which has been a nice break from our normal life. Removed from my home repairs and trip planning... I've been able to spend time reading, writing and researching potential investments. My hope is to spend a few hours each morning, both now and on our upcoming road trip, reading/writing/researching. While this intentional time doesn't bring the immediate financial rewards, like clocking in at my former day job, I find it immensely satisfying. We (my wife and I) still spend a lot of "busy time" with our son, but we try to schedule breaks for each other to relax and think.

One of the things I've been meaning to do is dig into Archer Daniel Midland's (NYSE:ADM) financials and business model. Now that I'm unemployed, I have time to do just that. I acquired several hundred shares of ADM stock back in 2008 and held it for several years, before selling the shares for a tidy profit. In the summer of 2012, I again bought a few hundred shares of ADM stock, when the share price dropped from the $30s to about $26. My wife and I were actually on our honeymoon at the time... and I know she was wondering what she was getting herself into. A few months later, the price recovered and we again sold at a tidy profit. We did so another time, this time for a smaller profit. (The short-term swing trades we purchased through my Roth IRA brokerage account for the tax advantages.)

You may wonder why I have traded in and out of ADM stock when we otherwise do very little trading. There are a few reasons, but one of the biggest is that until 2015, the share price traded in a fairly consistent range. (Take a look at the stock chart over the last 5 or 6 years.) That range was useful to me, as I was trying to slant the risk/reward ratio in my favor. I was, and am, also bullish on the industry that ADM participates in. While the net margins aren't great (single digits) and the capital costs are high, ADM has positioned itself well within the food/sweetner/animal feed space. That being said, you may wonder why I didn't just plan to buy and hold the stock for the next several decades. After all, many investment greats suggest not buying the stock of an individual company unless you intend to hold that stock for a very long time. I clearly had no intention of long-term ownership. The next two sections address what were/are my chief two issues historically, but I thought with so many of my investing friends snapping up shares of ADM, and the share price dropping into the lower $30s, it might be worth a look.

Ethanol

Ethanol is essentially an alcohol which can be made from various plants. The process requires sugar, so most ethanol in the United States is made from modified corn, sugar beets, or sugar cane. About 10 years ago, ADM got into this business in a huge way. American politicians foolishly, in my opinion, encouraged the production of ethanol through tax incentives and subsidies. At the time, oil prices were very high, and these programs were set up under the guise of "reducing our dependence on foreign oil". Therefore, ethanol was mixed with gasoline as a fuel additive, because subsidized ethanol cost less per gallon than refined gasoline did. What's not to like?!

Well, I've never been a fan of political interference in the business world, particularly as politicians have a horrible record of capital allocation, but my political grandstanding aside, it was a risky bet for ADM. The company spent billions to purchase (or build) the various processing facilities in the appropriate farming regions. While ethanol had legislative support for a few years, the useful life of a processing facility could be expected to far outlast the average politician's ethanol attention span. Fast-forward a few years, and you can see that the price of oil has fallen tremendously, and with it the margins on ethanol production. ADM's management has talked about the collapsing, and about the volatility of ethanol margins for a few years now. They have also spoken extensively of the excess capacity of ethanol processing facilities as a result of the federal government subsidizing the building boom of such facilities over the past 10 years. Ethanol margins have actually been negative for nearly 2 years now.

Management must know that they made a mistake investing so heavily in ethanol production, because they don't even break out that part of the business in reports anymore. Instead, it's lumped in with processing food sweeteners and additives. Unfortunately for the company, the genetically modified corn it purchases to make ethanol isn't actually useful for anything else. It has been developed for its high sugar content and doesn't lend itself to human or animal consumption. I guess it can have cattle graze the corn stubble once the ears of corn are harvested. (Makes me glad we grow wheat for human consumption and sorghum for animal grain on our farm.) Anyway, despite the miserable business line, the company has remained profitable and been paid down some debt. Speaking of debt...

Debt

The companies that make up the long-term holdings in our portfolio tend to have little, or at least reasonable, levels of debt. The reason is obvious. While the profitability of a given business can suffer, it's really hard to go "bankrupt" if you're not in debt. ADM's debt load was my other chief concern a few years ago. The business requires large capital expenditures, which reduces the amount of free cash flow. A few years ago, debt exceeded the cash on hand by a tremendous amount. That, coupled with such a huge push into the ethanol space was enough to make me a trader, or rather than an investor, in the company's common stock.

Fast-forward a few years, and the total outstanding debt per share has fallen by almost 30%. Additionally, the Return on Equity and Net Margins have improved over the last 4 years (to 9.8% and 2.7%, respectively). While not great metrics, they aren't horrible for such a volatile (and capital-intensive) business. Most importantly, as you can see from the table below, the amount of debt coming due in the next few years is fairly small as a percentage of the total. See the due dates in the table below. You'll also notice that the bonds due in the next few years have interests rates far above the prevailing rates. These factors, along with the reduction of debt over the last few years should continue to give the company flexibility for the next few years.

Click to enlarge

ADM's 2014 Annual Report

So, will we invest in Archer Daniel Midland's common stock over the next few months? We just might. I feel like the company's financial position has improved over the past few years, though I still don't love ADM. It has been reporting somewhat poor results for the last couple of years, which, I largely believe, is based on industry headwinds. I think it's a good sign that against such a tough backdrop, the company has remained profitable and paid down debt. It should gain market share. The common shares currently have a Price-to-Earnings multiple around 11 and sport a dividend yield near 3%. Most interestingly, company insiders have made several stock purchases over the last 3 months. Those purchases have far outpaced the few stock sales and were made at higher prices. I don't like the business prospects enough to be a long-term investor in ADM, but I like it enough to buy a slug of shares if the price approaches $30 in the near term. Ugh, I know, I'm a hypocrite.

What are your thoughts on ADM common stock?

Disclosure: I do not currently own shares in ADM, but may buy in the near term. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional. The information above is provided by GuruFocus.com and Yahoo Finance.