There was a period nearly 10 years ago when Bunge (NYSE:BG) and the investment thesis that attached to it seemed to sweep all before it. It was alleged that emerging economies were the only ones in the world with any growth potential, and their growth would be both rapid and smooth. Their middle classes would expand steadily and their demand for foodstuffs would be boundless, while commodity consumption in developed economies would be maintained despite permanent recession. Consequently, the prices of agricultural commodities, in particular, would rise indefinitely. If we did not already know how that story worked out, a quick glance at Bunge's long-term price development (shown on the left below) would be enough to make it pretty clear.
But recently there have been signs of renewed life in the shares. After a disastrous Q4 2015 report and a Q1 2016 that generated little enthusiasm, the market has greeted each subsequent report with increasing warmth. The price rise that greeted Bunge's Q4 announcement - 10.0% in a day and 20.2% over 10 trading sessions - suggests that the market may, at last, believe that the worst is over for this company.
It has certainly had a lot to contend with. The currencies of two of its principal countries of operation have nose-dived. Until 2015, one of them, Argentina, maintained punitive taxation on agricultural exports, such as 23.5% ad valorem on soybeans, severely curtailing agricultural activity in a country that had traditionally been one of the world's breadbaskets. The prices of the commodities Bunge processes, stores, trades, transports and in some cases packages for final sale have been all over the map, but all except corn are down sharply from 2012 levels, and corn had only a year's grace, peaking in 2013.
But Bunge has also suffered from investor misperceptions. Bunge does not farm: it is a consumer, not a producer of agricultural commodities. It buys and stores, buys and transports, buys and performs basic processing such as flour milling, sugar refining or crushing oilseeds. It does not own or lease cropland and it does not plant anything. It may occasionally serve as a farmer's agent, charging a fee to store or transport produce that it does not own, but generally it acts as principal: Bunge is fundamentally a trading company. It usually holds produce for less time than it was on the ground - for instance, a bulk carrier's voyage time from the Río de la Plata to the Nile. It actively hedges, not only in futures markets but through offsetting long positions in storage or arising from private purchase contracts against short positions that result from private delivery contracts. Private contracts may be one-offs (a Japanese food producer needs a cargo of sugar) or ongoing (Nigeria needs 500,000 tons of corn a year).
It sells largely to wholesale customers who are quite aware of raw material cost developments. Many of them have the purchasing power to insist that any savings are passed on to them (for example, a customer like Unilever (NYSE:UN, NYSE:UL) is in a position to demand the best deal possible). Consequently, the prices that Bunge receives at the storage facility, port terminal or processing plant rise or fall pretty closely in line with the prices it paid to farmers. Bunge's profits are made from the spread between the two. Investors get spooked by declining revenues, but if the spread remains stable, the profits of a firm like Bunge need not be affected. In the case of storage and transport, the spreads are essentially a temporal or locational arbitrage spreads; in the case of processing, they are analogous to the "crack spread" familiar to oil refiners.
As the table below suggests, the spread can vary, especially when rapid changes in the market whipsaw Bunge, as occurred in 2008-9 (including the currency market: note the behavior during this period of the Argentine Peso and especially the Brazilian Real in the chart above). Excluding those extreme circumstances, the variability of its revenue is more than four times higher than that of its gross profit, indicating that, by and large, operating spreads are more stable than commodity prices. This, after all, is in consumers' interests: Unilever and similar companies want good deals, but they do not want to drive the processors on which they rely out of business.
Ethanol production - a substantial, sugarcane-based business for Bunge in Brazil, and a smaller, corn-based business in the U.S. and Argentina - suffered from declining prices as the price of oil, for which it is substituted, also declined. However, world sugar and corn prices rallied strongly from mid-2015 and mid-2014, respectively, squeezing the processing spread at the same time that the weakening Brazilian economy saw fuel consumption of all kinds declined. The result was losses for Bunge, exacerbated by deteriorating conditions in conventional sugar trading. Although prices of both raw materials have since retreated, and I have argued elsewhere that the long-term outlook for sugar prices is less than rosy, this is likely to continue to be a difficult business until oil prices rebound. At $1.50/gallon, blending ethanol into gasoline does little to reduce costs at the pump.
Bunge's small fertilizer activities (1% of 2016 revenue) are the exception to these generalizations. But even here, Bunge no longer produces the raw materials, having sold its phosphate mining interests earlier this decade. This is a conventional manufacturing operation, formulating a range of fertilizers from purchased inputs and marketing them to end-users in Brazil and Argentina. Otherwise, all of Bunge's activities have the profile described, and their geographical spread is as follows:
The Southern Hemisphere harvest is currently in progress. When it is complete, the USDA expects world wheat production to have risen 2.3% in the 2016/7 crop year, corn 7%, rice 1.7%, soybeans 7.9% and sugar 3.0%. Argentine growers, freed from export taxes, are expected to increase their wheat and corn output by 32.7% and 25.9%, respectively, while a return to more favorable growing conditions in Brazil should boost its corn output by 29.1%, soybeans by 7.8% and raw sugar by 10.9%. All of which suggests that the demand for Bunge's storage and transport facilities, trading services and commodity processing will remain fairly strong.
From the description of Bunge's earnings model, it should be clear that throughput is about as important to its gross profit development as spread levels. While stock-building is likely to continue for most major commodities, consumption of soybeans, in particular, may improve on continued strong Chinese demand and as their use in animal feed revives. In 2016, throughput declined by 0.3%, entirely as a result of reduced sugar refining and ethanol production. It is likely to increase this year, as ethanol demand stabilizes (albeit at depressed levels) and the increase in Southern Hemisphere crop production raises demand for Bunge's services across the board.
Although throughput ticked up slightly in 2016, storage and transportation spreads contracted significantly, from $13.85/ton to $11.07. In the nature of the case, these are not nearly as rich as processing spreads, but given the massive quantities involved (134.6 million metric tons in 2016), even small declines can be painful, and a decline of 20.1% very much so. This decrease accounted for all of the decline in Bunge's gross profit last year. Essentially, it represents less successful trading than in 2015: as all SA readers can appreciate, some years work out better than others. Processing spreads, even for ethanol, are considerably richer, but the throughput involved is dwarfed by Bunge's purely trading business. Trading accounted for 61.8% of Bunge's 2016 gross profit, and would contribute even a greater portion in a year when its trading is more successful.
Based on the Yahoo Finance consensus of 12 and 11 analysts, respectively, Bunge is trading at 13.5X current year earnings and 12.3X next year's. The difference between highest and lowest estimates this year is 12.6%, suggesting a reasonable degree of certainty (no doubt reinforced by the company's provision of guidance), but it widens out to a clearly less confident 28.1% for 2018. This is fair enough: a trading business is in the nature of the case difficult to predict. The sort of trading in which Bunge is involved is more predictable than that of a Wall Street brokerage, but it has its inherent uncertainties.
This is why it trades, and should trade, at a discount to the market average. The dividends it pays - giving it a current yield of 2.1% - and its program of share repurchases ($200 million repurchased last year, after $300 million in 2015) should give it some downside protection, but can anyone seriously contemplate building a position in the immediate aftermath of a two week, 20% price rise? Probably not wisely. It is unlikely that the shares will run away from an interested investor, and there's a chance they could retrace some of the ground they have recently gained. But my suspicion is that they will move sideways from here. If they do, investors might contemplate building a position, gradually, starting 10 trading days from now.
Disclosure: I/we 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.