The Agriculture value chain is an interesting space (Figure 1). While much of it, like the natural resources space, is highly consolidated and controlled by large corporations or governments, billions of farmers around the world still form one key part of the chain. These farmers are individuals or families that are dependent on production improvements and increases in crop yields for their success and, in some cases, survival. As a result, they are extremely reliant on the firms from which they buy
seeds, agrochemicals[i], fertilizers, agricultural machinery and farmland (agricultural input companies). These firms are generally extremely large and powerful, often with oligopolies in their respective space, and this gives them huge market power. Their dominance is best illustrated by the fact that these firms have historically had the highest margins in the entire value chain and agriculture industry[ii].
The concentration in the agricultural input segment provides incumbents with strong market power in this strategic sector. The top 6 players in the agrochemical industry currently control 63% of the global commercial seed market and 75% of the global pesticide market[iii], both of which are R&D-intensive industries. For example, the development of new genetic traits in seeds requires, on average, R&D investment of $150 million and 10 years of development[iv]. With these top 6 companies currently contributing nearly 75% of total private sector spending in global seeds and agrochemical R&D[v], their dominance is driven by the long-term success of their investments. Even more surprising are the global oligopolies in relatively low-R&D businesses such in the agricultural input segment such as farm machinery and fertilizers. The top 3 players in farm machinery currently have a market share of 49%, while the top 5 players in the potassium market (a key ingredient in fertilizers) account for nearly 70% of global market share[vi].
Despite this consolidation and the market power it provides, the operating environment for the agricultural input segment has been difficult over the last few years. Over the last 2 years, the US has experienced a farm income recession which is expected to continue in 2016. After reaching recent highs in 2013, net cash incomes are expected to decline for the third consecutive year in 2016 (by 2.5%), while net farm incomes are forecast to decline for the fourth consecutive year from their 2012 highs (by 3%). However, income seems to be beginning to stabilize, indicated by the fact that these declines are moderate compared to the 27% and 38% reductions in net cash and net farm income, respectively, that occurred in 2015[vii]. Moreover, the US dollar has depreciated by 3.45% YTD after a nearly 20% appreciation from 2013-2015 (which negatively impacted farm exports) [viii]. On a global basis, farm incomes are also expected to improve in 2016. India, which suffered two consecutive years of drought in 2014 and 2015 which resulted in a crippling agrarian crisis, is expected to see above-average rainfall in 2016[ix].
With farmers, the primary customer base for the agriculture input segment, experiencing these headwinds, the firms that operate in the space have also had difficulties. That said, the long-term story for the segment's success and growth remains intact, and the relatively low valuations at the moment seem to have created an opportunity for companies to go through one more round of consolidation and restructuring. This should not only lead to increased valuations in the short-term, but also create sustainable long-term value for investors.
Seeds & Agrochemical Sector Consolidation
The latest round of consolidation began with M&A activities in the seeds and agrochemical sector. In December 2015, Dow Chemicals (DOW) and DuPont (DD) announced a merger of equals in a deal worth $130 billion. According to the plan provided in an investor presentation, the merged entity would be unbundled into three entities including one with a pure-play agriculture focus with revenues of $19 billion[x]. This entity would have a nearly 16% share in the global agrochemical and a 25% share in the global seeds market[xi] and should lead to it having significant market power over buyers. According to a different estimate, the merger would create the first integrated seeds and agrochemical leader in the industry, displacing Monsanto and Syngenta as the top two players in the industry, and also create strong value for investors. A study showed that over 12, 24, and 36-month periods, investors should generate excess returns of 19.4%, 24.4%, and 26.3%, respectively, by investing in the new subsidiaries of the parent company[xii].
Deal volume has remained strong in 2016, with two large acquisition deals announced recently involving Syngenta (SYNEF), Monsanto (NYSE:MON) and Bayer AG (OTCPK:BAYRY). Syngenta has accepted an acquisition offer from ChemChina in a deal valued at $43.80 billion, which amounts to a nearly 22% premium on the day of the announcement (February 2nd) and a deal multiple of 17x to trailing 12-month income[xiii]. This offer followed the rejection of $47 billion offer from Monsanto in January 2016. In what can be termed as reaction to deals in the space, Bayer made a $62 billion offer for Monsanto in May. The all-cash deal, which values Monsanto's outstanding shares -- without accounting for debt -- at about $53 billion, represents a 44% premium to the May 9th closing price. The deal has already been rejected by the management of Monsanto and, according to analysts, an EBITDA multiple similar to the Syngenta-ChemChina deal would translate into an additional 20% over the offer price for Monsanto shareholders[xiv].
Farm Machinery and Fertilizer Opportunities
Based on the M&A activity in the space in recent months, the seeds and agrochemical sector may go from 6 major players to just 3 in a short time. Although other sectors in the agriculture input segment have not seen similar consolidation, declining valuations here may be creating M&A opportunities for incumbents. For example, the fertilizer sector had some deal volume in 2015, with an offer of nearly $8 billion by Potash Corp (NYSE:POT) for K+S (NYSE:ETR), reflecting a 41% premium on the last traded price and a 43% premium over the six-month average on the day of the offer (June 25, 2015)[xv]. Similarly, CF Industries (NYSE:CF) offered to buy the North American and European assets of OCI (OTCQX:OCINY) for $8 billion in 2015 with the aim of creating the world's largest nitrogen fertilizer company[xvi].
As can be observed from Figure 2, most of the major fertilizer companies are trading at significant discounts (20%-30%) from the end of 2014. Despite these lower valuations and an adverse business climate, these companies have maintained a strong ROIC in the range of 7%-12%. There are a few exceptions in the industry, such as CF Industries, which has different dynamics due to its ambitious expansion plan over the last 12 months including a failed acquisition attempt with OCI. According to FactSet, the largest four firms in the industry have net debt to equity in the range of 20%-80% while net debt to EBITDA ranges from 0.25x to 2.30x. These numbers suggest that, overall, the balance sheets for the industry are not overleveraged and there is a scope for industry consolidation via M&A.
In contrast, instead of consolidation, farm machinery companies are looking at M&A to help them gain insights into software, robotics, GPS, satellite monitoring, climate data, and even drones. While this might seem strange, it is meant to give them the skills and insights they need in order to move into precision farming[xvii]. For example, Deere & Co (NYSE:DE), the market leader in the farm equipment industry, has entered into a definitive agreement with Monsanto to acquire its Precision Planting equipment business and enable exclusive near real-time data connectivity between certain John Deere farm equipment and the Climate FieldView platform. The agreement represents the industry's first and only near real-time in-cab wireless connection to John Deere equipment by a third party, and could be the start of a trend of similar deals.
Accessing the Opportunity
With the world's population projected to increase from 7.3 billion people in 2015 to 9.8 billion in 2050 (UN Projections, 2015) and rising standards of living, feeding the human race over the next few decades, and beyond, is expected to be a significant challenge. From 2005-2050, global demand for calories and proteins derived from crops is expected to increase by 100% and 110%[xviii], respectively. Considering the fact that technologies and resources indispensable to global food security are controlled by just 15-20 corporations and, based on the trends mentioned above, an investment in the agricultural input segment could generate strong returns for investors.
The First Trust Indxx Global Agriculture Index ETF (NASDAQ:FTAG) is the only fund in the market that provides exposure to the agricultural input segment. The ETF seeks to track the Indxx Global Agriculture Index, a market capitalization weighted index designed to measure the performance of companies which are directly or indirectly engaged in improving agricultural yields and production. The index is comprised of farmland companies and firms involved in chemicals & fertilizers, seeds, irrigation equipment, and farm machinery. As of June 30, 2016, the index consists of 46 constituents, with a weighted average market cap of $35.67 billion.
For more information on the index, please visit here.
[i] Agrochemical refers to chemicals used for crop protection practices. Agrochemicals cover the all ranges of herbicide, fungicide, pesticides and insecticides.
[xvii] Precision farming is a concept that allows the user a way to deal with every field and field section variations. Soil texture, composition, organic matter and pH levels all effect how soil uses and retains nutrients. Nutrient levels fluctuate because of factors like drainage, field work practices, cover crops, weeds and previous year's yields.
[xviii] "Global food demand and the sustainable intensification of agriculture" by Tilman, Balzer, Hill and Befort (October 12, 2011)
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Indxx LLC is the index provider