|Shares Out. (in M):||0||P/E|
|Market Cap (in M):||3,351||P/FCF|
|Net Debt (in M):||0||EBIT||0||0|
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.
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
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
|Entry||09/07/2007 02:48 PM|
|1) the $.24 cent number is the number from Milling & Baking news, which, since there is no spot markt for HFCS, my best guess at the contracted number. . and it need not be the same number for everyone. They are seperate contracts with no transparency. Recall in the early 1990's these companies were brougth up on price fixing of HFCS charges I may be wrong but i have in my notes from a meeting with CPO that they confirmed the $.24 number. With your question i went back through conference calls and could not find a specifically spoken of number at either cpo or adm. I will check coke and pepsi later and get back to you. |
Also, I don't believe sugar per lb and hfcs per lb are exactly comparable on a per lb basis. i think you need less weight of hfcs to get the same "sweet" impact as suger. Not sure of how much less but i think around 20% . . which would make current prices comparable. CPO claims Sugar is still 20% more expensive but i don't think thats the case.
2)every one cent move in hfcs = $.23 in eps very approximately (i.e. many assumptions in this number)
3)Mexico bottlers want HFCS because they have subsidized high price sugar also . . thus hfcs is cheaper for them vs. sugar . . at least i think. CPO was at a conference this week saying they now expect no additional hfcs going to mexico next year, i'm told
4)don't think co-products are impacted much by gmo issue. not traded much internationally as far as i know. Interestingly, this is the part of the thesis i have the most confidance in but it is not working in pricing at all yet. This is likely because flood of ddg is yet to come
5) couldn't care less about cpo's cost of capital. Peak earnings are dependent on industry prices which are dependent on industry supply and demand, which of course are dependent on marginal costs. The issue is return on replacement cost of new productive capacity. Tate & Lyle is building a new Wet Mill in Fort Dodge, IA, so that is prima facia evidence that we are at replacement cost economics (and we were in early 2006 when the plant was contemplated . . economics may be similar because cap cost went up as did prices). On current estimates of costs and prices,using only corn starch (not further conversion to hfcs or ethanol, which presumably is more profitable) one gets a 35% irr.
Also, building of all the dry mills is prima facia evidence of reaching replacement cost economics on part of the output stream
Also, remember, its not just the Wet mill replacement economics that matter, its the cost versus sugar and the csd makers cost to swith back to that input. So if HFCS prices go higher w/o sugar prices also going higher, they will kill demand.
6) there is much talk of delays and cancellations. But the big wave that is coming on later this fall and early next year is almost finished . . . and will get done. Even the mcmansions in my town are being finished despite a free fall in prices
7)I'm way too tired on a friday to go into the details of dry mill ethanol economics, but suffice it to say, with a $.51 subsidy over gasoline @ current capital costs, it very hard to make ethanol production uneconomic, however, wall street some how did by building so much of the these plants with no plan to be able to physically sell it. That will take capital and will get solved in (one or two seasons assuming the ethanol buildout slows down). Not nearly in time to save CPO's $2.80 expected number for next year.
8) Both ethanol prices and sugar prices are in the toilet in brazil, so i'm not sure what you mean by booming demand for sugar cane in Brazil? I suppose capacity for cane refining for sugar and ethanol have been built out too much . . which is causing cane demand to be high but profitability to be low. Anyone who can arrange a trip to brazil and argentina to explore these issues, please let me know.
|Subject||yada yada yada . . . look at t|
|Entry||09/07/2007 05:16 PM|
|yada yada yada . . . look at the facts, not what management says. That is how to make money in shorts, particularly shorts in this industry, where obfuscation is commonplace. @ 17x for a commodity company, what management says is going to happen is priced in, imo. |
I've heard that this company has a lot of metrics that makes it interesting to quant strategies . . which has been driving buying . . but i have no opinion on that.
|Entry||09/08/2007 02:42 PM|
|Thanks for the excellent idea. I like the near term catalysts as well as the longer term health pressures. A few questions:|
1) I'm having difficulty believing that the sell side analysts are completely missing some issues you mention here. What are the bull arguments for rising HFCS prices? What do the bulls/management have to say about higher negotiated corn prices? At a $.70 EPS hit, that alone looks like it would sink next years earnings, save for large increases in HFCS pricing.
2) Do you have a perspective on what normalized earnings are here, and where next year will fall in the cycle?
3) Have Pepsi/Coke alluded to expecting better HFCS pricing this year? Have other HFCS producers warned of pricing pressure, or have they all cited expected increases?
4) What percent of the HFCS market is Coke/Pepsi?
5) Do you have any thoughts on the Jan 08' options? Seems like they may be a good way to play this, giving the timing you cite.
|Entry||09/10/2007 01:14 PM|
|Thanks for the interesting write-up|
1. Are you aware of any instance in which a plant/company has meaningfully switch its wet milling ethanol capacity to HFCS?
2. Can you detail how you arrive at your estimate for switch back capacity contribution to overall capacity .. i.e. "5% and 10% [level] of HFCS capacity"? 10% seems like a very high number.
|Entry||09/10/2007 02:19 PM|
|Thanks for the idea. We have a couple questions were we are trying to get more comfort |
1. Based on our estimates (similar to yours) US sugar should be trading at 22-23 cent per lbs. HFCS 55 according to street models, ADM, and Tate’s management was locked in at 17 to 18 cents in 2007. How do you get comfort in the fact that they won’t get an increase over the next two years and trade at a slight discount to sugar? Maybe at 20 cents per lbs? Obviously given the high degree of operating leverage every incremental percentage increase in HFCS pricing will effectively drop through to operating profit holding net corn cost constant (which will likely be up this year)
2. It is our understanding that ADM and Cargill control the majority of the “flexible” wet mills and may be willing to make lower margins on ethanol to see increased pricing in HFCS. Are these the mills your consultants feel will switch capacity?
3. We have seen that Tate is adding new wet mill capacity this year but is not bringing on HFCS production. Instead they are producing value added starch products as management claims these produce high teens to low 20’s operating margins. Do you know if any of the restart or flex capacity may look into producing more of these niche products?
4. Have you been able to quantify the cross markets between DDGS and corn gluten? It is our understanding that DDGS are only used to feed larger animals (cattle etc) while corn gluten focuses more on poultry. Also have you been able to quantify what portion of the byproduct is corn oil and how corn oil prices have trended?
5. In your last segment on demand you state that the net affect of open borders will be near zero additional demand to the US market for HFCS. Some industry analysts seem to believe that the open border could add 3 to 4% in HFCS demand. How do you get comfortable with this fact as it would eat away all of the restart capacity?
Once again great idea and thanks in advance
|Entry||09/11/2007 06:04 PM|
|oligopoly pricing power? why did they not exert it the past in 2002-2006? The evidence of returns being higher in commodity businesses with oligopolistic structures is very murky. Certainly has not been tested in structure where there are only two large buyers with an alternative that is far cheaper, healthier and the consumer's like more than the product whose price is being jacked up. If the sugar tarrif goes away HFCS capacity is worth scrap value. |
Also, HFCS is not major business for ADM or Cargill. For ADM, certainly Ethanol is just as, if not more important. Similar for Tate & Lyle. If you really think ADM will not switch production back, then short it as ethanol will get silly in the midwest. Way too much of it.
I don't really think actual switching is the critical issue, its really leverage in the negotiations . . and the producers have lost it with low ethanol margins and low sugar prices.
In CPO management's lucid moments they admit investors shouldn't expect much improvement in HFCS pricing in 2008. If prices stay flat this story likely works.
As to my sensitivity to corn and hfcs price changes i will go over the math again and let you know if i come up with a different answer. i'm pretty sure i did the math correct but i'll check again.
Cadbury says HFCS prices will be coming down. Can't find anyone else who says so but i'm looking.
rii136 . . if you have a hard time believing the sell side is missing something like this, i can't offer you any help.
the Mexico situation is complex and explaining all my reasons for being unconcerned is too much for now, however, as mentioned, CPO publicaly stated last week they expect no additional HFCS to go to Mexico next year (i am told).
All the livestock companies are working on formulations to use DDGs for all animals. Talk to the head of nutrition at SAFM and SFD, if you can get them on the phone. Haven't checked on oil lately but oils continue to be strong. Won't offset the weakness in meal though.
|Subject||reply to cargill letter|
|Entry||09/20/2007 02:10 PM|
|anyone who pays attention to anything anyone is saying in public about these negotiatons is likely not a very accomplished poker player. The letter from Cargill is obviously intended as a signal to the other sellers, nothing more. Why else make it public? Interesting, this is the first year that such a letter was made public, why? |
i would ignore anything that is being said and look at the facts. perhaps someone who does game theory analysis should tell us the answer. 2 buyers, 4 sellers, 2 of whom have substantially more capacity available this year than last due to collaps in margins on a switchable product. Negotiations are watched closely for no collusion due to settlement of collusion acusations 12 years ago. buyers are the same buyers who would save money by shipping down to mexico so the whole mexico argument does not really work.
there is a rational game theory answer and it seems pretty obvious to me . . .
|Entry||09/20/2007 02:59 PM|
|How easy would it be for Coca Cola and Pepsi to replace HFCS with sugar? Is this as simple as flipping a switch, or would it require infrastructure changes, etc? Also, if they were to do this, do you have a sense of how much sugar they would need to use per unit of HFCS to achieve the same effect? Have they ever done this in the past when HFCS prices rose?|
I'm trying to get a sense of to what degree this is just an empty threat or if this is a real bargaining chip. If its an empty threat, they would seem to be in a tough spot negotiation-wise. Is there some sort of middle ground tactic where they reduce the amount of HFCS they use, while doing a partial replacement with sugar?
|Subject||it appears with hfcs 55 it req|
|Entry||09/20/2007 03:48 PM|
|it appears with hfcs 55 it requires a bit less than one lb of sugar to replace 1lb of hfcs. it does cost capital and time to switch . . . not a flip of a switch. however your lst point is most relevant . . . partial replacement. some industry consultants are convinced coke is about to come out with a premium brank "real coke classic" with real sugar. input costs would be ~ 20% more at 07' hfcs and coke could charge much more than 20% premium. Buyers would purchase for taste and health. taking 5% of market with products like that would be end of hfcs. remember, hfcs is already growing at 0 to -1% per year. |
i don't know why everyone is so fixated on lack of alternatives for coke and pepsi, concentration of the industry actually favors the buyers, not the sellers (2 vs. 4) . KO and PEP have no where to go but with ethanol margins in the toilet, neither do the sellers.
|Entry||09/20/2007 11:22 PM|
|. . . and also, switching for 20-25% of demand that is not carbonated soft drinks is much easier (liquification of sugar is not required), so food companies, who might seemingly have less bargaining power might actually have more. "ok, you are already only 20% cost advantage over sugar, i can easily switch and i'd be going to a healthier more desirable product that i can charge a premium for."|
Also, a consultant i spoke with today thinks easily 10% of total capacity is switchable from ethanol.
If buyers can't at the least hold pricing steady in the face of falling demand and additional capacity, they are doing something very wrong.
|Subject||listen to the tate & lyle call|
|Entry||09/28/2007 10:02 AM|
|Subject||Would you mind boiling it down|
|Entry||09/28/2007 10:29 AM|
|Unless they are obvious, I am sure that most memebers will not pick up all the nuances and implications as you will, in as much as this is your idea.|
|Subject||FINAL COMMENT TO FW51'S FINAL|
|Entry||09/28/2007 11:31 PM|
|FW51, i'm glad you are confidant in the 2c/lb price increase next year. i suppose there is no reason for the negotiations to take place since you already have the answer.|
still don't understand the logic on HFCS vs. ethanol at ADM. Are you considering ADM's new dry mill capacity coming on? And there is substantial enough switchable capacity at Cargill to tank prices. . . but once again . . does it really matter? its not whether they switch its negotiating leverage. Last year ADM could say, "pay me x or i will go make ethanol". This year the buyer will say "ok, go make ethanol then".
Price ceiling is not dependent on sugar price in the u.s. 4% of HFCS capacity is in canada which is not regulated. That HFCS comes down here if displaced. Sugar in canada is $.17, which refining included is just about exactly where the high priced HFCS is being sold on a dry equivalent basis. HFCS prices can't go up.
I appreciate your interest in the idea and i appreciate your work on Tate & Lyle. It was helpful to my understanding of the issues.
|Entry||09/28/2007 11:35 PM|
|tate & lyle, despite being in the midst of very important negotiations where showing weakness is very detrimental, was forced to disclose that HFCS volumes are weak and the supply demand balance is still tight but "not as tight as we thought before". They also acknowledge 3-5% ethanol is switchable to HFCS (industrywide) of which they have some. They acknowledged poor ethanol margins were hurting them. But for some reason they said no one would switch as the margins are adequate in both businesses to continue making equal amounts.|
|Entry||10/30/2007 12:02 PM|
|Do you have an update on their earnings and what you thinking is now?|
Thanks for the great call.
|Subject||it'll be a great call when the|
|Entry||11/01/2007 06:28 PM|
|no substantial comments. I thought the tone of the call was very very different than the previous ones. I really don't beleive anything that is said by player's in this industry because what they say may be directed at the negotiations and signalling to competitors. I think, reading between the lines they are setting up investors for lower guidance for 2008 when it comes out. |
I was pleased with south america . . i have far less confidence in that part of the thesis because i have so much less information about what is going on down there. But world sugar rules the story down there and it was confirmed.
I may have more comments after i hear more from tate & lyle and adm next week.
|Subject||Any updates on this name?|
|Entry||12/04/2007 10:57 AM|
|has there been any word on contract negotiations with Pepsi and KO, or any other incremental information?|
|Subject||not really but some very impor|
|Entry||12/13/2007 05:05 PM|
|i met with the company as did many investors. i also met with ADM and Tate & Lyle. I am convinced there is not ascertaining from any of them what is actually going on with pricing. I suggest we wait until they give 2008 guidance. However, the corn price movements are not good for them, obviously.|
CPO is much less sure of itself than it used to be. They claim HFCS is still tight but that pricing is maxed. This will be a cash cow business that will fund future growth in specialty starches, polystarches and a whole bunch of stuff i've never heard of before.
More interesting though is what i discovered with respect to the Canadian situation. The industry makes a lot of noise about the umbrella it gets from high priced sugar in the u.s. However, it appears ~ 8% of non-Mexico production is consumed in Canada. Canadian bottlers are set up to readily switch between hfcs and sugar based on price. Canadian sugar is priced at brazil level + refining + transport. Guess what . . . at current prices in Canada they should be switching. That means 8% less cap utilization. That may be an even more important factor than ethanol switching and no one realizes it (except i'm sure ko, pepsi and the rest of the users who no longer need volumes in Canada). If the sellers got pricing i'm a monkey's uncle.
|Subject||bobby, any updates?|
|Entry||03/28/2008 01:22 PM|
|Do you remain short and do you have an updated price target? Thanks.|
|Entry||04/16/2008 06:38 PM|
|i remain short. actually just added to the position. it appears thesis on by-products is playing out somewhat as ddg, meal and feed are flat in the face of corn exploding . . this is hurting net corn cost (although oil is helping a bit). Sugar has weakened a bit again although starch remains strong. i think south america remains the biggest risk to this story . . . and the desire by investors to own anything ag related.|
|Entry||04/21/2008 10:35 AM|
|Are you expecting anything earth shattering to come out of the earnings call? a ton of downside puts were purchased today.|
|Subject||Any thoughts after conference|
|Entry||04/22/2008 07:54 AM|
|would be appreciated.|
|Subject||RE: Any thoughts after confere|
|Entry||04/23/2008 01:41 PM|
|Ok, so I gave the procurement departments at KO and PEP way too much credit. Obviously, they had no understanding of how to negotiate against ADM, CPO, TATE, etc. If they did, they would have figured out that they could have forced much lower prices. They didn’t. Pricing kept up and perhaps exceeded increases in net corn costs. |
However, the good news relative to expectations appears to be being driven by the same primary factor as last year: CPO buys corn forward for their projected volume requirements for the full year. By-products don’t trade so can’t be hedged. Since Corn prices have rocketed up since buying forward and by-products have followed (albeit at a slower rate . . . so spot net corn costs have actually gone up), CPO’s net corn costs have declined materially. Since this happened last year, I can’t believe I didn’t see it coming again this year. I think the reason is that I thought they were lying about pricing and would have that benefit eaten away by less than expected prices.
Regardless, the short story is stronger than ever . . . albeit put off until the 2nd half and 09’ for the following reason:
1. Volumes are awful. They reported north America volume down 4% this quarter. That follows down 3.7% last quarter. They attributed it “mostly to weather”. Yeh right. The reason is that ethanol switching is taking place (cpo has no switchable capacity so they lose some market share) and/or Canada is switching to sugar (canada is 8% of non-mexico NA demand and its bottlers pay world sugar prices and have easily switchable capacity). Also, there may be some food producer switching and base HFCS demand is going down due to obesity/health issues. With another year of crappy ethanol margins (which is virtually gauaranteed) and bad volumes, KO and PEP’s buyers are going to have to be comatose to not realize that capacity utilization is no longer tight. To help them in their calculations, they might realize that the HFCS price necessary to maintain CPO’s margins would make HFCS unequivocally more expensive than world sugar @ current spot prices and even more expensive than domestic sugar prices for all but the best volume discount customers. It may require a 2x4 upside the head of the buyers, but I think they will catch on.
2. Corn is not likely to go up for a 3rd year in a row at the current rate and thus, we will, at some point, get a flattening out or even reversal of the above-mentioned by-product benefit. What a shock that will be. The by-products have been an awesome tail wind that will become a headwind. Most likely next year but possibly sooner if Corn falls, as it should.
3. South American margins are not improving as promised. They were down to 11.3% this quarter from 11.8% last quarter and 12.5% yoy. This is despite very good tapiaco starch prices. Low sugar prices are taking their toll and volumes are declining similar to in North America . . . but for now the absolute price increases are carrying the day in terms of higher overall operating income. The delta on these price increases will not persist forever and then the pressure on margins should begin to come through.
4. The company appears to understand the unsustainable nature of the profitability of its commodity businesses so it is deploying material capital to non-commodity starch and sweetener strategies. Such strategies may work . . . but there is no evidence the company is good at that sort of thing, particularly not the specialty sweetener business. Tate fell flat on its face in that business and there are plenty of other players trying to go after that market.
Patience is justified, despite my partial incorrect predictions of the future on this one. How many commodity company’s can you buy trading at 200 + % of replacement cost, 14x eps on prices and margins that make its product uncompetitive against a substitute and where demand is shrinking 3-4% per year? Oh, and I didn’t even mention the ethanol switching issue.