Description

Executive Summary

Archer-Daniels-Midland Company’s (ADM) stock has declined ~22% since 1/21/24 when the Company announced it had placed its CFO on administrative leave and launched an investigation into the Company’s accounting practices.  Although details regarding the accounting investigation are limited, it appears that it involves only the Company’s Nutrition segment, which in 2022 generated ~8% of ADM’s revenues and ~13% of pre-corporate EBITDA.  The magnitude of the stock’s selloff in comparison to situation at hand appears excessive, thus creating an attractive buying opportunity.

Without question, this may turn out to be quite a scandal.  Press reports, detailed below, indicate that ADM executives would have had significant financial incentive to artificially inflate the profitability of the Nutrition business given how their compensation was structured.  It is highly possible that some accounting shenanigans were taking place to the Nutrition segment’s benefit.  However, this does not appear to be a situation akin to Enron where fraud was pervasive across the entire company.  Some current and former executives at ADM might be “walked out in handcuffs”, but the underlying business should survive.  It’s important to keep in mind that ADM has a strong balance sheet and an “A” credit rating.

Financial analysis indicates that even in a significant downside scenario which takes into account any “financial games” ADM was playing with the Nutrition business, ADM will still be able to fund the growth in its dividend.  The stock is currently trading at a very high dividend yield (3.8%) relative to its mean yield over the past 24 years (2.2%).  Even the return to a 3.0% dividend yield would equate to a share price of ~$67, or >25% higher than current levels.

The resolution of the accounting situation should serve as a near-term catalyst for the stock.  This will likely take place sometime in the next few months, assuming the accounting issues are contained within the Nutrition segment as the Company’s press release suggests.

Company Description

ADM procures, transports, stores and merchandises agricultural commodities and products.  The Company processes oilseeds, corn, mil, oats, barley, peanuts and wheat.  ADM also processes products which have two primary end uses, food and feed ingredients.  The Company is organized into three main reporting business segments:

• Ag Services and Oilseeds (78% of Revenues and 62% of pre-corporate EBITDA in 2022) – This segment includes global activities related to the origination, merchandising, transportation, and storage of agricultural raw materials, and the crushing and further processing of oilseeds such as soybeans and soft seeds (cottonseed, sunflower seed, canola, rapeseed, and flaxseed) into vegetable oils and protein meals. Oilseeds products produced and marketed by the segment include ingredients for food, feed, energy, and industrial customers.
• Carbohydrate Solutions (14% of Revenues and 22% of pre-corporate EBITDA in 2022) – This segment is engaged in corn and wheat wet and dry milling and other activities. The Carbohydrate Solutions segment converts corn and wheat into products and ingredients used in the food and beverage industry including sweeteners, corn and wheat starches, syrup, glucose, wheat flour, and dextrose. Dextrose and starch are used by the Carbohydrate Solutions segment as feedstocks in other downstream processes. By fermentation of dextrose, the Carbohydrate Solutions segment produces alcohol and other food and animal feed ingredients. Ethyl alcohol is produced by the Company for industrial use in products such as hand sanitizers and ethanol for use in gasoline due to its ability to increase octane as an extender and oxygenate. Corn gluten feed and meal, as well as distillers’ grains, are produced for use as animal feed ingredients. Corn germ, a by-product of the wet milling process, is further processed into vegetable oil and protein meal. Other Carbohydrate Solutions products include citric acids, which are used in various food and industrial products.
• Nutrition (8% of Revenues and 13% of pre-corporate EBITDA in 2022) – This segment serves various end markets including food, beverages, nutritional supplements, and feed premix and additives for livestock, aquaculture, and pet food. The segment engages in the manufacturing, sale, and distribution of a wide array of ingredients and solutions including plant-based proteins, natural flavors, flavor systems, natural colors, emulsifiers, soluble fiber, polyols, hydrocolloids, probiotics, prebiotics, enzymes, botanical extracts, and other specialty food and feed ingredients. The Nutrition segment includes the activities related to the procurement, processing, and distribution of edible beans. The segment also includes activities related to the processing and distribution of formula feeds and animal health and nutrition products and the manufacture of contract and private label pet treats and foods.

Accounting Issue

On 1/21/24 ADM issued a press release announcing that its Board decided to place Vikram Luthar, the Company’s CFO, on administrative leave, effective immediately.  The press release noted that Mr. Luthar’s leave is pending an ongoing investigation being conducted by outside counsel for ADM and the Board’s Audit Committee regarding certain accounting practices and procedures with respect to ADM’s Nutrition segment, including certain intersegment transactions.  ADM’s investigation was initiated in response to its receipt of a voluntary document request by the SEC.  ADM noted that it, with the Audit Committee’s oversight, was working with its advisors to complete the investigation expeditiously and that the Company would make further announcements regarding the matter when the Board feels it appropriate.

ADM also announced that it was delaying its earnings release and conference call relating to 4Q23 (originally scheduled for 1/26/24) as well as filing its 10-K.  The Company then went on to say that it expects full year 2023 EPS to be >$6.90 and that 2023 operating profit for both its Ag Services and Oilseeds segment as well as its Carbohydrate Solutions segment would be in-line with the guidance the Company provided when it reported 3Q23 earnings on 10/24/23.  For reference, during the 3Q24 earnings call, management noted that they expected 2023E EPS to be >$7.00, so the new guidance of >$6.90 is a slight guide down.

On 1/26/24 ADM’s CEO Juan Luciano sent a letter to employees (disclosed in an 8-K) in which he commented, “ADM is an organization of high integrity with extremely competent and dedicated colleagues that I am proud to lead, and as much as we strive for excellence, we are not perfect.  When we become aware of potential issues, we take the time to analyze, to understand and to fix them if needed, with transparency.  So, we are conducting an investigation about intersegment sales, which involves the transfer of goods and the related financial accounting between business segments. For this reason, it is taking longer to close our financial results, but these sales do not materially affect our overall results.”

On 1/29/24 Reuters reported that ADM was delaying paying performance bonuses to some executives until its financial statements are completed and audited, according to a staff memo.  Reuters noted that while the Nutrition segment is a relatively small unit of ADM’s overall business, it played an outsized role in executive compensation.  A change by ADM’s compensation and succession committee in 2020 tied half of long-term executive compensation to operating profit growth of the Nutrition segment, according to ADM proxy statements.  According to Reuters, ADM reported average Nutrition operating profit growth from 2020 to 2022 of a larger-than-forecast 21.4%, which topped the Company’s average adjusted return on invested capital target.  As a result, seven ADM executives were awarded more than 841,000 performance share units (PSUs), twice the targeted payout.  Those PSUs were valued at nearly $69mm when they vested in February 2023.

Importantly, on 2/2/24 Ray Young, who was formerly ADM’s CFO from 2010 to April 2022, abruptly resigned from the Board of Hormel Foods (HRL), which he had joined in March 2023.  Then, on 2/9/24 Ray Young informed Marsh & McLennan (MMC) that he wouldn’t seek reelection to the company’s board at its 5/16/24 annual meeting.  Ray Young had joined the Board of MMC in March 2023.  Mr. Young’s behavior suggests that he was party to “what’s going on” and is now most likely devoting all of his energies toward establishing a legal defense for himself.

Downside Scenario

While information about the accounting situation is limited, it does appear that ADM’s Board is acting responsibly and in good faith, taking appropriate steps to investigate the matter in a timely fashion.  It also appears that the situation is limited to ADM’s Nutrition segment, given that the Board would have needed to disclose in the press release if the situation did involve ADM’s other segments.  This is supported by the fact that the press release indicated that 2023 operating profit for both Ag Services and Oilseeds as well as the Carbohydrate Solutions segment would be in line with prior guidance.  With this as a backdrop and taking into account industry fundamentals, one can build a reasonable downside scenario for ADM.

The analysis below uses the following assumptions for its projections:

• Ag Services and Oilseeds
  • Flat oilseeds volume from 2023E levels
  • Crushing spreads down >50% from 2023E levels, taking into account considerable new industry capacity coming on-line which should place downward pressure on profitability
  • Refined Products and Other spreads down >50% from 2023E levels, taking into account current pressure on ethanol margins
• Carbohydrate Solutions
  • Flat corn volume from 2023E levels
  • Reduced margin/MT for Starches and Sweeteners
  • No margin for Vantage Corn products
• Nutrition
  • Operating Income dropping from ~$600mm in 2023E to $100mm.  This is a very sharp decline to take into account any “funny business” going on in Nutrition’s numbers (hence the accounting investigation).  This may seem draconian, but it’s better to be conservative than not.
• Capex
  • $1.5bn in annual spend, even with 2023 levels
• Dividends
  • $2.00 in 2024, as declared by the Board, and then increasing to $2.04 and $2.08 in 2025 and 2026, respectively.

As can be seen in the Downside Scenario, the assumptions used equate to ADM generating annual EBITDA of $3.8bn.  This is well below the current consensus estimates of $5.1bn, $5.2bn and $5.1bn for 2024, 2025 and 2026, respectively.

Even with this level of EBITDA and without shrinking its capex budget, ADM will have a dividend coverage ratio (FCF / dividends) of ~1.4x.  Accordingly, ADM will still be able to not only pay its currently declared dividend rate of $2.00/share annually but also to continue to grow its dividend from there.

Valuation

ADM is really a “dividend aristocrat” stock.  In his 1/26/24 letter to employees (referenced above), ADM CEO Juan Luciano noted that ADM has grown its dividend for more than 92 years.  Obviously, there are many metrics by which one can value a business, but for a Company like ADM, the dividend yield is particularly relevant and “reversion to the mean” is a powerful force.  As can be seen in the chart below, for the past 24 years ADM has traded with a mean dividend yield of 2.16% (it’s hard to see, but the mean dividend yield is shown in text box in the center of the graph.  Also, see the histogram on the right for the normal curve distribution of dividend yields).

As shown in the “valuation analysis” in the tables above, if ADM stock “moves past” this accounting issue and returns to its historical mean dividend yield of 2.16%, the stock would trade up to ~$94, or >75% upside from current levels.  It the stock merely returned to a 3.0% dividend yield, down from 3.8% currently, the stock would trade to a price of ~$67, or >25% higher than current levels.

Catalyst

Resolution of the accounting issue, which will likely take place within the next few months.