Adecoagro: A Solid Operator With Argentina And Ethanol Risks

| About: Adecoagro S.A. (AGRO)
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When I wrote on SLC Agricola (OTCPK:SLCJY) a couple of weeks ago, it was just the first of a handful of Latin American farming names leveraged both to growing international food demand and rising farmland values in Brazil. SLC Agricola is not the only one that looks undervalued, though, as Adecoagro (NYSE:AGRO) looks even more undervalued than SLC Agricola.

There are reasons for this undervaluation, though. For starters, a substantial percentage of the farmland that Adecoagro owns is located in Argentina - a country undergoing significant economic turbulence and a lot of uncertainty regarding financial/tax rules and regulations. What's more, while about 70% of Adecoagro's 2013 EBITDA is likely to be generated in the more stable country of Brazil, the nature of the business there (sugarcane and ethanol) is volatile in completely different ways.

All told, I believe Adecoagro is significantly cheaper than SLC Agricola, but that at least a portion of that difference has to be viewed as compensation for the significantly different risk profile. Even with some sizable haircuts to valuation, though, I believe Adecoagro shares are worth about $10, or 60% more than today's price. Investors considering Adecoagro need to be aware of the risk that flagging crop prices and rising global rates could significantly slow land value appreciation and/or that ethanol prices could reverse, but risk-tolerant investors may find the balance here still very favorable.

Busy Across Multiple Borders And Markets

Through a fairly complicated legal business structure, Adecoagro is basically a Luxembourg company that owns a Delaware company that owns another Delaware company that owns companies that operate locally in Brazil, Argentina, and Uruguay. This convoluted structure creates some particular risks for the company, but we'll get to that in a moment.

Like SLC Agricola, Adecoagro buys, develops, farms/operates, and occasionally sells farmland. Adecoagro owns a little under 300K hectares (HA) and controls an additional 145K ha. This land is spread across multiple farms in Argentina, Brazil, and Uruguay, where the company grows corn, soybeans, rice, wheat, sunflowers, and sugarcane, while also raising cattle for meat and dairy. The company's Brazilian acreage is used almost exclusively for sugarcane, while the most recent crop breakdown for Argentina and Uruguay was 42% soy, 21% corn, 16% rice, and 13% wheat. About 70% of the company's land is actively used, with the remainder held over for development and appreciation potential.

Sugarcane And Ethanol Driving More And More Of The Business

As of the last quarter, farming is still the primary business activity of Adecoagro at nearly 60% of reported revenue and more than half of adjusted segment EBITDA (which includes mark-to-market hedging gains). That said, the company's management has made it clear that sugarcane and ethanol is a major part of its future - and not just due to the fact that planted acres in the farming business are going to decline about 6%, while the sugarcane plantation acreage is to increase almost one-quarter.

Adecoagro recently opened its third mill in Brazil (Ivinhema), adding about 40% to its annual crush capacity (7.2M tons). Even more construction could be on the way, though, as management has previously discussed having as much as 11.5 million tons of capacity in operation by 2017. It's important to note that this crush capacity is dual purpose, giving the company flexibility between sugar and ethanol as markets dictate.

Ethanol continues to be big business in Brazil. Ethanol has 41% share of the Brazilian fuel market, and relative to what the Brazilian government does to Petrobras (NYSE:PBR) with gasoline and diesel pricing, it's a business that's treated well by the government. Not only has the Brazilian government recently increased gasoline prices and the ethanol mix (from 20% to 25%), but also put a number of financial incentives into place. Companies like Adecoagro are going to see lower taxes in their ethanol operations, as well as cost-advantaged access to funding for sugarcane planting and ethanol inventory financing.

All of this support aside, this is still a refining business with all of the attendant volatility and risks. Not only is Adecoagro tiny when compared to Cosan's (NYSE:CZZ) crush capacity, but there are uncertainties and risks at every level - the quality of the cane harvest, the cost of crushing/processing the cane, the final realized price of sugar and ethanol, and so on. Even so, about 70% of 2013's estimated EBITDA is expected to come from the company's Brazilian cane and ethanol operations.

A Good Land Book, But How Much Can The Company Do?

Relative to SLC Agricola, Adecoagro doesn't make land development and investment quite as much of priority. But that's not to say that they don't do it or that it hasn't generated good results. The appraised value of Adecoagro's land has increased about 17% over the past two and a half years, and sales are continuing to go off at prices above appraised values.

That said, I'm not sure how much Adecoagro can do here. Brazilian law is little convoluted and murky with respect to foreign ownership, and while there is still discussion of changing (and clarifying) those laws, the general rule of thumb is that foreigners can't do much on their own with respect to farmland ownership in Brazil. Add in Adecoagro's convoluted ownership structure and it's a setup ideally suited to long legal battles.

Adecoagro may be limited in its efforts to develop additional acreage in Brazil (and/or may have to join Brazilian companies in joint ventures) and may instead have to turn to areas like Paraguay and Colombia. At the same time, though, that may not bother management as it still leaves the company ample opportunity to lease sugarcane farmland in Brazil and set up additional crush capacity to expand the ethanol business.

Valuation Suggests A Lot Of Fear

Apparently there's an unwritten rule that financial writers must mention it when famous investors own stakes in certain companies, so in the interests of compliance I'll point out that George Soros's Soros Fund Management still owns more than 20% of the shares of this company. In any case, I do not believe Soros's stake adds value to the company.

Speaking of value, I look at this company from the perspective of both EV/EBITDA, which values the company's near-term crop and ethanol/sugar production, and NAV, which tends to reflect more of the value of the underlying land.

On an EBITDA basis, I believe a 7.5x multiple is fair. Although this is lower than the traditional range of 8x to 10x for agricultural companies, I believe it's fair given the higher proportion of sugar/ethanol in the mix, as well as the risks tied to the Argentine operations and its status as a non-Brazilian company. This results in a fair value of about $10.20.

Unfortunately, NAV valuation is more of a "black box" assessment as it involves looking at the farmland that the company owns and then valuing it on the basis of past appraisals and recent comparable sales. Even allowing for a significant haircut to the value of the Argentine land holdings due to concerns about currency, capital controls, taxation, and so on (and ignoring that the difference in productivity between Argentine and Brazilian farmland isn't nearly so great), I would estimate that the net asset value of Adecoagro is about $9.90 per share.

The Bottom Line

SLC Agricola is trading at a steep discount to apparent fair value due to investor worries that global crop prices are due to decline and that the market for farmland has gotten overheated. That seems like rampant confidence compared to the discount at Adecoagro. Even with sharp haircuts across the business, a fair value of about $10 suggests that these shares are close to 60% undervalued. In my mind, that factors in some pretty major pessimism regarding Argentina, crops in general, and Brazil's ethanol industry.

All things considered, SLC Agricola looks like the better-run company in some respects - it has some of the highest-yielding cropland in Brazil, it makes use of the most advanced agricultural inputs, and it has demonstrated an above-average ability to take what is effectively savannah and turn it into usable land worth 50% to 100% more.

But I wouldn't sleep on Adecoagro. The company has demonstrated that it can run a profitable farm business in Argentina, while also taking advantage of Brazil's still-burgeoning ethanol industry. With serious pessimism already factored into these shares, I believe aggressive risk-tolerant investors should consider Adecoagro as an undervalued play on both Argentina's agriculture sector and Brazil's sugar/ethanol sector.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.