Recently, the idea that Agrium Inc. (TSX:AGU)(NYSE:AGU) is becoming overvalued has made some headlines in financial media. A recent report by analyst firm Hedgeye, for example, claimed that Agrium shares are shockingly worth half of what they are today.
This thesis is based on the fact that Agrium’s retail business is due to suffer from severely contracting margins because of a cyclical downturn in the agricultural space that is currently underway. For example, corn prices have fallen from $8/bushel to around $4.30/bushel due to a few years of record crop production. The Hedgeye report suggests that similar to the historic agriculture downturn in the 1980s, the current downturn is only halfway through.
In the 1980s, retail businesses like Agrium suffered from major margin contraction due to farmer debt levels increasing and farmer incomes declining, and Hedgeye suggests this is re-occurring. At the same time, Agrium is currently trading at a forward EV/EBITDA of 9.5 times compared with its historical average of 7.1 times.
The agricultural market is not as bearish as Hedgeye suggests
Agrium is certainly expensive, and this historically expensive valuation would only be justified if the market views the current agricultural downturn as being cyclical rather than structural. If the market views the current weakness as being near a trough with a rebound imminent, the higher-than-normal valuations would be justifiable, especially given that Agrium sees growing free cash flow, growing dividends, and has a clear and demonstrated growth strategy for its retail business.
On its recent conference call, Agrium pointed out several key differences between the historic 1980s agricultural downturn and the current downturn.
Firstly, the 1980s downturn was preceded by a period of high inflation (over 15%), which resulted in the Federal Reserve needing to tighten policy by hiking interest rates (the prime lending rate rose from 6.8% in 1976 to over 20% in 1981). The result was that farmers were paying more for interest expenses at the time than their entire costs for seeds, crop protection, and fertilizers.
The situation today is different. While farmer incomes have dropped, there are several factors that are supportive to farmer incomes. Fertilizer costs, for example, have dropped substantially and are currently significantly below the 10-year average as a percentage of revenue. The 10-year average is 16.5%, and fertilizer costs are currently only 12-13% of revenue with the trend being down.
In addition to this, Agrium should benefit from how farmers choose to prioritize the spending they do have available. When farmers have limited income, they will typically put nitrogen and seed purchases ahead of potash or phosphate fertilizers, for example. Demand for nitrogen is relatively inelastic, since it is released every harvest and farmers need to continually reapply it or else crop yields will suffer.
Nitrogen is Agrium’s primary product in its wholesale division, and corn is a key product that Agrium’s retail segment is involved in (corn requires more nitrogen usage than soybeans, for example).
Agrium’s resiliency shows in the numbers
While Hedgeye suggests that Agrium’s retail margins are set to decline heavily, the evidence simply does not suggest this is happening so far. Agrium’s first-quarter crop-nutrient margins were the highest they’ve been in five years, and its crop-protection margins were the highest they’ve been in three years (despite corn prices plunging and farmer incomes declining).
In addition to this, Agrium’s return on capital employed has actually improved, climbing from 9% to 10%. From 2011 to present, despite corn prices being in a steady decline, Agrium’s overall retail gross margins have steadily risen, and EBITDA has shown steady growth as Agrium continues to pursue tuck-in acquisitions as well as build new facilities and sell higher-margin products.
The end result is that Hedgeye’s worst-case scenario for Agrium is unlikely.
