Should we try to play ethanol?
Yes. But be careful. Once it becomes widely known how easily this nation can switch away from gasoline and toward ethanol, plenty of traders will be eager to snatch up every small supplier or research firm with any connection to the fuel. This approach is a crap shoot and very unwise. The best approach, I feel, is to invest in an established, profitable company that is currently trading at a reasonable price. And I’ll be darned if there isn’t one sitting right in front of us. It’s called Archer Daniels Midland.
What prompted this post of mine is an article a friend of mine told me about by know-it-all trend maven Jim Cramer. Apparently Cramer’s rant of choice this morning was how foolish buying anything and everything ethanol can be. Seems like a legitimate take, but then he goes on to dismiss ADM as becoming “such a momentum play it makes a mockery of the fundamentals.” Mockery of fundamentals? Seems like a little bit of a stretch for a company selling at 23 times ttm earnings and less than three times book value. So, as if you need any convincing that Cramer hasn’t fully thought an idea through, let me explain why this is not true.
Ethanol is, admittedly, not what ADM has traditionally produced. It would be a huge overhaul of the current business model were the company to rely solely on ethanol sales. But at present, this is not the case and this makes the company stable and reliable. ADM has grown in to the premier food supplier in the country and consistently grown for many years. But ethanol is enormously more profitable to the company than its food products - whereby it contributes only 5% to the company’s total sales, according to Fortune magazine, ethanol contributes nearly 23% of total income.
The reason I think ADM is a reasonable investment is because even in the absence of any growth as the result of ethanol the company is selling at a reasonable price. The type of basic discounted cash flow valuations I have run on ADM’s numbers using assumptions based on no increased benefit from new ethanol sales, produce values roughly equal to the current price. To be specific, I assume free cash flow grows at 5% indefinitely and I assume a discount rate of 10% (approximately ADM’s cost of capital). Therefore what I am assuming is that current government ethanol subsidies will persist and that sales and capital expenditures will continue to grow at historic rates. This will not prove to be the case, however, as the company has announced plans to nearly double its rate of capital expenditures by 2008 in an effort to expand ethanol capacity.
What we are left with is a company that is appropriately priced given its current operations but with a speculative component that seems to have been given little added value. So long as the ethanol expansion produces a positive return on investment, the stock is a good buy at the current price of $35. However, if ethanol proves to produce nothing or negative returns, the stock is not a good buy, although no one stands to lose his shirt on it either because of the strength of the company’s traditional operations. Is this a good roll of the dice? I would say so. Moreover, ADM is the only prudent attempt to play the ethanol phenomenon, which I have been convinced is real, occurring and will continue to occur. Most other investment alternatives are entirely speculative.
What prompted this post of mine is an article a friend of mine told me about by know-it-all trend maven Jim Cramer. Apparently Cramer’s rant of choice this morning was how foolish buying anything and everything ethanol can be. Seems like a legitimate take, but then he goes on to dismiss ADM as becoming “such a momentum play it makes a mockery of the fundamentals.” Mockery of fundamentals? Seems like a little bit of a stretch for a company selling at 23 times ttm earnings and less than three times book value. So, as if you need any convincing that Cramer hasn’t fully thought an idea through, let me explain why this is not true.
Ethanol is, admittedly, not what ADM has traditionally produced. It would be a huge overhaul of the current business model were the company to rely solely on ethanol sales. But at present, this is not the case and this makes the company stable and reliable. ADM has grown in to the premier food supplier in the country and consistently grown for many years. But ethanol is enormously more profitable to the company than its food products - whereby it contributes only 5% to the company’s total sales, according to Fortune magazine, ethanol contributes nearly 23% of total income.
The reason I think ADM is a reasonable investment is because even in the absence of any growth as the result of ethanol the company is selling at a reasonable price. The type of basic discounted cash flow valuations I have run on ADM’s numbers using assumptions based on no increased benefit from new ethanol sales, produce values roughly equal to the current price. To be specific, I assume free cash flow grows at 5% indefinitely and I assume a discount rate of 10% (approximately ADM’s cost of capital). Therefore what I am assuming is that current government ethanol subsidies will persist and that sales and capital expenditures will continue to grow at historic rates. This will not prove to be the case, however, as the company has announced plans to nearly double its rate of capital expenditures by 2008 in an effort to expand ethanol capacity.
What we are left with is a company that is appropriately priced given its current operations but with a speculative component that seems to have been given little added value. So long as the ethanol expansion produces a positive return on investment, the stock is a good buy at the current price of $35. However, if ethanol proves to produce nothing or negative returns, the stock is not a good buy, although no one stands to lose his shirt on it either because of the strength of the company’s traditional operations. Is this a good roll of the dice? I would say so. Moreover, ADM is the only prudent attempt to play the ethanol phenomenon, which I have been convinced is real, occurring and will continue to occur. Most other investment alternatives are entirely speculative.
posted by Andy Kern at
1:19 PM
1 Comments:
Hi Andy - It is quite true that Archer Daniels is a good stock to buy considering its diversification across agrictulture and food. I do believe though that there is another company which stands not only to benefit more from Ethanol, but also leverage its small cap status as am agricultural services company to grow very fast. That company is Andersons, Inc (ANDE). It does most of the things ADM does, but its stock will probably outgun ADM in next 3-6 months.
-- Faisal Laljee
By
Faisal Laljee, at 01 May, 2006 17:55
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