Description

Corn Products is a classic example of a commodity company receiving a growth company multiple at top-of-the-cycle commodity earnings.  The stock is trading at over 18 times 2007 earnings estimates of $2.40.  2007 is likely to represent peak earnings as over the next 2 years, earnings will decline to about $1.50 or lower.  CPO’s primary product is High Fructose Corn Syrup (HFCS) and related by-products.  Earnings will decline because HFCS and by product margins will come under pressure from excess ethanol supply and declining worldwide sugar prices.

The peak earnings argument is not very difficult to make.  CPO owns “wet” corn mills that produce HFCS, some other starches and sweeteners as well as three by products: corn oil, corn gluten feed and corn gluten meal.  Massive amounts of new corn milling capacity are about to come on line in the form of “dry” corn mills that have been built to produce ethanol.  Ethanol capacity and the related milling capacity will rise 25% over the next 4 months and up 50% versus 2 years ago.

The bulls on CPO argue that these are “dry” mills that are going to produce ethanol and CPO has “wet” mills that produce no ethanol,.  However, many “wet” mills can produce both ethanol and HFCS, and can switch a certain portion of their capacity between the two.  Also, the “dry” mills produce a by-product called Dry Distillers Grains (DDGs) which can and does compete with CPO’s by-products; Corn Gluten meal and feed.

Digging a bit deeper into the story – 

HFCS Margins at a Peak; Likely to Fall

Domestic HFCS prices are negotiated once per year between the large beverage companies (Coke and Pepsi) and the HFCS producers (ADM, CPO, Cargill, Tate & Lyle and a few others).   Negotiations usually begin in late summer and are finalized with all producers by mid-November.  Last year was a great year for the HFCS producers.  Ethanol margins were very high – they averaged 115 cents per gallon the first 9 months of 2006 versus a long term average of about 43 cents and about zero today (according to Bloomberg’s calculation) - so producers switched maximum production from HFCS to ethanol.  In addition, due to low utilization in prior years, Cargill and Tate & Lyle had taken down roughly 4% of industry productive capacity.  Supply was very tight and Coke and Pepsi could not use the threat that they would switch back to sugar since world sugar prices were near peak at $.16 per lb. (domestic sugar prices are impacted by a government quota and tarrif regime that cuases prices to average 12 cents per lb higher than world sugar prices).  Thus, the producers contracted for an HFCS price of greater than 24 cents per lb, the highest price in more than a decade. 

In addition, at the time of the 2006/2007 contract negotiations, corn prices were just beginning to move higher.  CPO has a policy of locking in all its expected HFCS corn needs immediately upon contracting.  CPO likely locked in corn at ~ $3.25, ensuring a very nice margin relative to what it would have paid on actual average corn for 2007 of ~ $3.75.

Unfortunately for CPO, the world changed dramatically between last year and now.  Dry mill ethanol cash margins have collapsed to near 0 now.  This drop in ethanol margins now makes the  incremental margin at a wet HFCS mill on crushing a swing bushel of corn to produce HFCS much higher than crushing that bushel to produce ethanol ($6.60 per bushel vs. $ 4.08 per bushel).  Thus, all switchable capacity is likely to go back to producing HFCS.  The companies that have switchable capacity (of which ADM is by far the largest) will not disclose how much capacity is switchable and to what extent they are doing it.  However, even ADM admitted switching capacity to ethanol last year and consultants and others we have spoken with are sure capacity is being switched back to HFCS.  I estimate the portion of HFCS capacity being used to make ethanol last year that will switch back to HFCS production this year to be between 5 and 10% of HFCS capacity.

In addition, the 4% of industry capacity that was off-line last year is back up and running just as world sugar prices are back down to a very depressed $.09 per lb.  This makes the domestic cost of sugar 21cents per pound.    Although the threat to return to real sugar as an input in soda has historically been more of a negotiating tactic than a real threat, both Coke and Pepsi are now introducing “real sugar” drinks (because there is somewhat of a health food backlash against HFCS) making the threat to switch much more credible. All this puts the HFCS buyers in the better bargaining position.

Also, given the current corn futures curve, CPO is going to be locking in a materially higher corn price this year than last ( I estimate $3.85 per bushel vs the estimated $3.25 last year), so even if HFCS pricing is the same as last year, margins are going to go down. An increase in corn costs of 50 cents per bushel – all other things being equal – would reduce CPO’s earnings by ~ 70 cents per share off a $2.40 base. However, it is unlikely, given the discussion above, that pricing will be stable. It is likely to decline. 

BY PRODUCT PRICES TO GET SLAMMED

CPO receives between 12% and 20% of its revenues per domestic bushel from by-products that compete with the by-products of the expanding dry mills that produce ethanol. The main by-product of ethanol production from dry mills is DDG’s.  DDG’s can be substituted in certain animal feed for corn meal and feed.  There is going to be so much DDG’s around the price will likely fall to 0 after freight as the material cannot be stockpiled due to EPA regulations.  Since this low-cost feed can be substituted for corn meal, feed, and soy meal, the prices of these by-products are likely to suffer materially.  Our estimate is that nearly 10mm short tons of incremental DDG are going to be produced by mid 2008 vs. mid 2006.  This amount equals 800% of total corn gluten meal produced and 200% of gluten feed produced annually . . . a staggering quantity. Every 1% decline in the price of Gluten Feed and Meal equals roughly a decline of 1 cent in CPO eps, everything else being equal.

SOUTH AMERICA “NOT TO THE RESCUE”

The company and the bulls claim that CPO’s South American margins are going to return to the 15 – 17% that they were in the early 2000’s, up from about 12% today .  The South American sweetener market is driven by Brazilian sugar, so unless international sugar prices recover from multiyear lows, there is not much hope for a material improvement in CPO’s South American operations.  Additionally, the low South American sugar price is impacting Brazilian ethanol prices negatively.  This is making the price of ethanol low enough to economically transport to the east coast of the United States, even after the $.54 /gallon tariff.  Obviously, this is further bad news for the ethanol complex and Corn Products for the reasons explained above in the HFCS section.

DEMAND

Domestic demand for HFCS is at best showing 0 demand growth now.  Due to the health issues, preference of consumer for real sugar drinks, and beverage manufacturers' desire to cater to that demand, it is reasonable to forecast a drop in domestic HFCS demand.

Although it appears that the United States and Mexico agreed to end their long standing dispute on restricting HFCS access to Mexico (and Mexican Sugar access to the U.S.) on January 1, 2008, it is not likely that this will materially increase demand for domestic HFCS.  Most experts think that the Sugar industry is so powerful in Mexico, that the lifting of the legal restrictions will be replaced by subtle actions (such as sugar requirements in carbonated soft drinks) that will effectively severely limit HFCS going into Mexico.  In any event, it appears that Mexicans are very committed to real sugar in their Coke and Pepsi.  Mexican Coke, where available in the United States southwest is quickly sold out at premium prices.  Thus, Coke and Pepsi are talking about rolling out new real sugar products to satisfy that and the “health conscious” market.

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