Drought Got You Down? Don't Jump Into Food Producers Now

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If you are tempted to buy into food producers to capitalize off the "overblown" market reaction to the US drought, think again. From challenged operations to uncertain contracts and weak free cash flow generation, there are several reasons to be pessimistic about the major producers. Some analysts are even urging their clients to have a tepid, possibly bearish, outlook on food prices. Why? Below, I answer this question through analyzing 3 stocks.

The Pros & Cons Of Buying Archer Daniels Midland (NYSE: ADM)

ADM trades at 12.9x forward earnings and is forecasted for 10% annual EPS growth over the next 5 years. The company has gotten aggressive with takeovers, but GrainCorp recently rejected the $2.8 billion buyout. The bid came at a 33% premium to the previous trading value. In late October, the farm product producer reached a tentative agreement with a Mexican business to sell its quarter stake in Gruma SAB--a move that many view as a way to hold up the credit rating and still allow for M&A. In addition to creating value through inorganic growth, management has also amended its qualified pension plan to make out lump sum payments to some employees, which is estimated to reduce obligations somewhere between $140 and $210 million.

It is particularly odd that, despite record farm incomes, product sellers have underperformed. On the other hand, investors exaggerated the benefits of a domestic drought. With prices for a variety of goods falling and food accounting for just 14% of average consumer budgets, food inflation should be relatively muted. Moreover, vegetables and fruits are quite stable as a result of irrigation. In mind-June, ADM acquired a port terminal in Brazil to handle agricultural inputs and increase storage capacity by 3 million metric tons per year.

ADM has a return on capital of 5.2%, which is 890 bps below the industry average and also what is necessary to create value. Operating margin of 2.2% is also substantially below the 4.9% industry average, and long-term debt to equity is very weak at 36.4 versus an average of 25x for the industry. ADM may generate substantial operating cash flow relative to its price, free cash flow - the value behind all companies - has hovered in and out of negative territory.

Why Potash (NYSE: POT), Mosaic (NYSE: MOS) Are Both "Holds"

Potash trades at a respective 14.4x and 11.4x past and forward earnings versus corresponding figures of 12.8x and 10.7x for Mosaic. Both companies are extremely liquid, but Mosaic is particularly strong with a current ratio of 3.9x and virtually no debt. 2 weeks ago, Standpoint Research upgraded their price target on the specialty chemical producer from a "hold" to a "buy". It is forecasted for 7.4% annual EPS growth over the next 5 years versus 4.5% for Potash.

But does this mean that Potash, which trades at higher multiples despite weaker liquidity and lower growth, is to be avoided. While I recommend preferential buying of Mosaic, Potash is still creating value with a return on invested capital of 25.3%, which is well above the 21.5% industry average. The stock is down 18.8% from its 52-week high and just 5.8% above its 52-week high. What will the future hold?

Management has cited "lots of hurdles" to its attempted takeover of Israel Chemicals. Yet the core business looks strong with an expected rebound of ~58 million metric tons is predicted for 2013. This sharp growth will be driven by soaring demand from emerging markets China and India. Unfortunately, Potash will have to shut down 2 Canadian potash mines over eight weeks to prevent inventory stockpiling. Mosaic, on the other hand, potentially has it worst with management lowering guidance for potash and phosphate as a result of uncertain Chinese contracts. This has caused some, like Canaccord Genuity, to lower the recommendation to a "hold".

Potash and Mosaic also generate very weak free cash. For the last three years, Potash has seen FCF hover around its current $1.1 billion, which is a 3.2% yield. Mosaic yields 3.4% and has a smaller economic moat. So, all things considered, both producers are a mixed bag - neither a "buy" nor a "sell", but a "hold."

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