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June 17, 2013

ADM

For more than a century, ADM has been converting crops into products that meet critical human needs. The more than 30,000 employees of the firm around the world have been transforming corn, wheat, cocoa, and oilseeds into products for human food, animal feed, energy and industrial uses. The firm has an impressive historical record in terms of earnings and is ranked 92nd among the Fortune 500 companies.

ADM’s unique risk results mainly from environmental concerns and management factors. Processing of agricultural products especially for the production of energy is associated with air pollution and governments around the world have been increasing regulations to govern industrial pollution. The company has also been marred with accusations of price-fixing in the past and investors are wary of the economic and financial costs resulting from lawsuits associated with this conduct. ADM is a very large player in the global food processing industry. Some of its executives have taken advantage of this status in the past to collude with product distributers in order to fix prices, resulting in antitrust lawsuits against the firm.

The other major risk facing the company relates to social sustainability. ADM sources its raw materials from around the world, from Brazil, to Indonesia, to countries in West Africa. Some of these markets, especially Indonesia and West Africa, have been notorious for irresponsible social practices like child labor, indecent wages, and poor working conditions. As a result of these factors, the company’s specific risk is very high totaling to about 93.94 percent of total risk while the market risk accounts for only 6.06 percent of the company’s total risk.

I selected the bottom-up beta as the measure for ADM’s market risk because it is more detailed. The firm operates in three main industries namely oilseeds processing, corn processing, and agricultural services. These industries have different betas according to the country of operation and the nature of the industry itself. The bottom-up beta was preferred to the top-down beta because the former takes into account the country risk and the risk of the specific industries.

ADM has a very high potential for earnings growth in the near future. The firm has been reinvesting most of its earnings mainly in research and development and extending its market share. As a result, the firm has not been paying dividends in the recent financial years. The company registered a return on equity of 11 percent on average over the last three financial years and an average return on capital of 9.7 percent over the same period. The cost of equity, on the other hand, was 8.53 percent while the cost of capital (WACC) was 8.07 percent. This suggests that the firm has been adding economic value to equity as well as to total capital invested.

ADM debt-to-equity ratio was quite unstable over the past three years with the debt ranging from 23.384 million in 2009 to 17.177 million in 2011. This trend is expected to continue in the foreseeable future. Moreover, it was noted that the firm has not been paying dividends in the recent financial years. Moreover, according to analysts’ projections, the firm’s future dividend payouts will be less that the cash flows attributable to equity shareholders. For instance, it is projected that the firm will make a dividend payout of $1 for the financial year 2012, out of $4 earnings per share for the same year. Therefore, it was inappropriate to use dividends as the free cash flows for establishing the true value of ADM. Consequently, the cash flows used in determining the intrinsic value of the firm are free cash flows to the firm (FCFF). Free cash flows to the firm are more suitable for corporate valuations involving fluctuating debt to equity ratio. In line with the choice of cash flows, the cost of capital of the firm was used as the discount rate as opposed to the cost of equity. The cost of equity is suitable for discounting purposes when the cash flows attributable to equity shareholders are quite stable, but that was not the case in this valuation.

Inflation in the US which is the local currency of ADM is quite stable and has been running below 2 percent in recent years. Thus, it is not important to value the company on the basis of inflation-adjusted cash flows. The US Federal reserve is also keen on keeping inflation at bay (mostly below or about 2 percent). Hence, inflation is not expected to rise in the future.

The company’s earnings before interest and taxes (EBIT) have been growing over the past four financial periods. This growth rate is expected to continue at least in the next three years after which it will decline and finally stabilize in the fifth year. Thus, the firm is expected to have a three-phase growth pattern. Stabilization of the firm’s earnings is expected to result form increased competition in the industries in which the company operates. The agricultural processing industry is characterized by moderate barriers to entry with the main barriers being research and development and capital requirements. In respect to capital, large scale investment is necessary to achieve economies of scale. These economies of scale include those resulting from covering a wider market than competition. These barriers are, however, unsustainable in the medium term to long-term as big players are likely to enter the market and eliminate the economic profits.

The company is expected to continue reinvesting its returns at the rate of 36.25 percent in the next two years at 25 percent thereafter. These estimates are in line with the expected growth and subsequent stabilization of the firm’s operating income.

The value of equity as determined through the cash flow discounting model amounted to $78,718.01 million. The market value of equity, on the other hand, stands at 11812.8 million. This indicates that the firm is overvalued by the market. The value of equity associated with the high growth phase amounts to $17,418.98 million. This is about 22 percent of the estimated intrinsic value of the firm with the rest being accounted for by the stable growth phase. Given that the high growth period covers only two years and it starts declining immediately after one year, the intrinsic value associated with this period is not very sensitive to changes in the various assumptions upon which the valuation model is based such as growth rate of cash flows and the cost of capital for the firm. The expected long-term growth rate of the firm is quite realistic especially considering the fact that the firm operates in the agricultural sector where the threat of obsolescence is rather low. Provided the firm keeps investing in research and development and maintains its market share, it will not be difficult to achieve the expected growth rate in the stable growth phase.

ADM’s return on equity has been higher than its cost of capital, indicating that the firm has been earning higher than expected returns on invested capital. It is perhaps as a result of this factor that the company’s management has withheld payment of cash dividends in the recent financial years. If I was higher to enhance the value of the firm I would focus on the firm’s dividend policy. Given that the company has been earning returns on investment that are above its hurdle rate, it is more appropriate to reserve most of the firms earnings for reinvestment in the next two years when the firm is expected to experience a high growth rate. After the two years the company should then adopt a fixed rate dividend payout policy that is in line with the forecasted long-term rate of growth. With regard to the choice of financing, it is important that the firm does not increase its current debt level very much so as to avoid increasing its financial risk. However, the company can take up additional debt to finance its new investments given that its current cost of debt is significantly below its cost of capital. The firm can increase its value by increasing its debt up to the point where it’s cost of capital stops decreasing. The firm’s low cost of debt results from its large size and excellent historical performance. At this point, the company will have achieved its optimal capital structure.

From my analysis, I can conclude that the ADM’s stock is likely to be a growth stock over the next two years after which it will be suitable as a dividend stock. Therefore, investors seeking capital gains should purchase the stock at present before its earnings become stable. The company has started signaled to investors that its reinvestment opportunities are declining by declaring a $1 per share for the financial year 2012.

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