As a long-term investor, I am always on the lookout for megatrends that will drive a sector or industry over the next 10 or 20 years. Few of these possible trends are as strong as the effect of a surging global population and a rising emerging-market middle class on food demand.
Malthus: Correct -- But 250 Years Off Target
"The power of population is so superior to the power of the earth to produce subsistence for man, that premature death must in some shape or other visit the human race."
So wrote economist Thomas Malthus as he predicted a catastrophic famine in the near future on the lack of agriculture to feed the world's growing masses. Unfortunately for Malthus, he wrote this in 1798 and is best remembered for being wrong.
Turns out, he might have just been early.
The United Nations projects that food production will need to double by 2050 or the world will face heightened scarcity and food security problems. Since the increase in arable land every year is marginal, crop yields need to increase at a rate of 2.4% each year over the next four decades.
An annual increase of 2.4% in yields doesn't sound too tough until you consider that yields for the four staple crops (corn, rice, wheat and soybeans) have only increased at an annual average of 1.2% over the 47 years leading up to 2008. If that were not bad enough, researchers at the University of Reading estimate that crop yields could fall by as much as 12% by the middle of the next decade on climate change and volatile weather patterns.
There is really only one way that the world is going to be able to produce enough food to avoid a Malthusian catastrophe.
The graphic below shows the effect of nutrient application on crop yields -- and the correlation is undeniable. Producers in other countries are not yet using the level of nutrients in the production process as used in the United States but will need to increase usage in the future.
The only way crop yields are going to be increased to levels high enough for production to meet demand is going to be through a huge increase in the use of nutrients.
And one nutrient producer is offering a hat trick to investors.
Agrium (NYSE: AGU) is the largest nutrient retailer in North America and has 1,400 facilities in seven countries.
Beyond its retailing strength, the company is also a major international wholesaler within sales in North and South America and in Europe. Agrium is the fourth largest producer of nitrogen in the world and the third largest producer of potash in North America.
Management has been focused on diversifying operational earnings over the last decade. In 2005, the nitrogen and potash wholesale segments accounted for a combined 77% of earnings before interest, taxes, depreciation, and amortization (EBITDA). By 2013, the two segments account for just under half (48%) of operational earnings with the retail and crop protection segments accounting for another 43% of EBITDA.
The company has a strong competitive advantage on its Western Canada nitrogen production where natural gas prices are lower than even the U.S. Gulf Coast. Used in ammonia production, the key feedstock in nitrogen fertilizers, the cost of natural gas makes up 70% to 90% of the total production costs for nitrogen-based nutrients. Lower gas prices in Western Canada resulted in a margin of $243 per ton above costs, 15% above the average margin across the peer group.
Beyond the long-term growth story behind nutrient producers, historic droughts in key markets may drive sales in the near term.
The National Climatic Data Center reported in March that more than 37% of the United States is in moderate to severe drought, with the most extreme areas in California and throughout the Midwest.
Brazil is experiencing its worst drought in more than four decades with lower forecasts for sugar, coffee and soybeans all pushing commodity prices higher. Coffee prices have surged 67% on poor growing conditions while sugar and soybean prices are both up 8% since the beginning of the year.
Australia is also experiencing a drought of its own across key agricultural regions in the central and northern parts of the country. Temperatures have set record highs with the average temperature the highest since 2005.
Among six companies in the peer group, shown in the table below, Agrium has the lowest enterprise value-to-sales (EV/sales) ratio of 1.1 times versus the group median of 3.4 times and the second lowest price-to-earnings (P/E) ratio at 13.1 times versus a median of 17 times trailing earnings.
On the median multiple for the group, Agrium would be worth almost 30% more on a P/E basis and 300% more on a EV/sales basis. With the company's advantage in retail and margins, shares should command a premium to peers instead of a discount.
Not only is the company in a long-term secular growth story and a terrific value relative to peers, but management has made the commitment to return cash to shareholders. The company has tripled its dividend over the past two years to $3 per share and pays one of the higher yields in the group at 3.2%. Almost $1.4 billion in shares were bought back over the last two years and management intends to return 25% to 35% of free cash flow to shareholders.
Debt has increased significantly from $783 million in 2007 to $3.1 billion last year but should not be a problem. The company has used debt to finance long-term assets which have increased 179% over the last six years to $4.9 billion in 2013. The capital structure allows the company to leverage its 5.9% return on assets to a 15.7% return on equity.
The company's net income of $1.06 billion more than covered the $145 million in interest on debt and current assets cover current liabilities by more than 1.5 times. It would be nice to see management continue to pay down debt but the high level of financing isn't really a concern.
On consensus estimates of $7.77 for 2014 earnings and $17.2 billion in sales, the shares could be worth $132.09 on a price-earnings multiple of 17.0 times. I added to my own position in December of last year and am looking past the 7% gain to a strong long-term holding. Investors can set a buy-under price of $105 per share and enjoy the 3.2% dividend yield until long-term drivers push shares significantly higher.
Risks to Consider: Volatile weather patterns may translate to more volatility in all stocks tied to the agricultural sector. Record crop production and a breakdown in the pricing structure for potash drove shares lower last year. Investors need to stay focused on the long-term drivers rather than short-term fluctuations.
Action to Take --> The nutrient industry is looking at some huge growth drivers over the next several decades. Global demand for increased crop production with nowhere to turn but higher nutrient usage could make these companies the safest bet on higher sales and higher shareholder returns. Agrium is not only a best of breed in the space but is also significantly undervalued.