Description

Investment Summary Of Adecoagro (AGRO)

Direction: Long

Price: $9.66

Market Cap: $1.2bn

Target: $27.00 (179% upside)

Thesis Summary:

Adecoagro, one of the largest agricultural operators in Latin America, is currently trading at a large discount to normalized free cash flow and net asset value due to the political and economic risks associated with Argentina and a large capex cycle in Brazil. Under a normalized environment, AGRO is expected to generate around $160mm of free cash flow against a current market cap of $1.17bn. This does not include any assumptions for a backlog of projects in Argentina with 50%IRRs that won’t be initiated until Argentine capital controls are lifted and export taxes are reduced.

Each of the Argentine presidential candidates are campaigning on more economically moderate platforms than their predecessor, Cristina Kirchner. Argentina needs to attract US Dollar in order to avoid a balance of payments crisis, which will require an elimination of capital controls and a convergence of the dual exchange rate. These changes would greatly benefit AGRO’s land valuation as well are their ability to produce free cash flow. This can be summarized as follows:

• All candidates plan to reduce export taxes, primarily on non-soy products. AGRO estimates that these reductions in export taxes would add roughly $50mm of free cash flow

• 90% of AGRO’s revenues are in USD while 40-45% of their costs are in Argentine pesos. A 20% devaluation of the official exchange is estimated to add $40-$60mm of free cash flow. Moreover, meetings with management revealed a backlog of projects with 50%IRRs in an environment with no capital controls and lower export taxes (these projects are a source of upside; they have not been incorporated into our estimates)

• AGRO’s capex cycle for their Brazilian sugar and ethanol plants has ended and it is expected this should stabilize free cash flow to around $63mm/year starting in 2017

• On a 2017 pro forma basis, this could increase Free Cash Flow to around $163mm. Relative to today’s market cap of $1.17bn gives us a 13.9% FCF yield. Applying a 5% FCF yield produces a 2017 market cap of roughly 3.26bn or about $27/share.

Argentine Equities:

Argentina’s economic turmoil and Kirchner’s regime have diminished investor confidence and discouraged foreign investment, which has depressed Argentine equity prices. However, 2013 elections and Kirchner’s unsuccessful attempt to amend the Constitution to allow for a third presidential term have eliminated any chance for the Kirchner regime to continue. Argentina currently has a very low market cap-to-GDP ratio in comparison to its Latin-American peers. Historically, when a Latin American country’s market cap-to-GDP ratio falls below 10.0% prior to a major political transition into orthodoxy, equity returns in subsequent years are incredibly high. The reforms suggested by the presidential front-runners, along with the favorable investor sentiment associated with these candidates, supports a further continuation of this historical trend.

Company Overview:

Adecoagro is a multinational company with major operations in Argentina, Brazil, and Uruguay. Adeco focuses on farming, sugar/ethanol/energy, and land transformation. The company produces agricultural products such as soybeans, wheat, corn, sunflowers, dairy, and rice primarily in Argentina and Uruguay. Adeco produces sugar, ethanol, and energy in Brazil.

The shareholding structure of Adeco is 52% free float, 21.3% Soros, 12.7% Dutch pension fund PGGM, 11.7% Qatar Investment Authority, 10.7% Ospraie, 5.7% Wellington, with the rest owned by managers and directors.

Daniel Gonzalez, the current CFO of state-owned YPF (Argentina’s largest integrated oil & gas producer) recently joined AGRO’s board. Management has indicated this is already helping immensely with government approvals and AGRO’s overall ability to conduct business inside of Argentina. The company has 20-30 projects with 50% IRRs it will initiate once the Argentine political regime change takes place.

The company is currently buying back up to 5% of its shares and plans to issue a dividend in the coming years (once Argentine capital controls go away), adding to the total return story.

The revenue streams between Argentina’s agriculture and Brazil’s sugar & ethanol operations have been approximately 50/50. However, given sugar & ethanol’s higher EBITDA margins (~40% versus farming EBITDA ~20%), the completion of Adeco’s last sugar mill, and Argentina’s restrictive agricultural policies, Adeco is likely to see a greater proportion of its revenues in its sugar & ethanol segment in the future.

The company had an EBITDA of US$216mm in 2014 and projects EBITDA to be $240mm and $300-340mm in 2015 and 2016 respectively. These projections do not include export tax reductions, which is quite possible given the presidential front-runners’ relatively favorable stances towards agriculture.

The company owns land that was recently valued at US$884.0mm (Cushman & Wakefield) against a book value of $185mm, and owns additional assets and machinery valued upwards of US$1bn. Based on comparables, the Argentine land intrinsic value is at least 50% higher, adding about $450mm of asset value to the already large discount to liquidation value.

Catalysts:

Argentina:

The three presidential front-runners, Scioli, Macri, and the close third Massa, all plan for economic reform:

• Macri has already proposed a clear plan, which eliminates wheat, and corn export restrictions/taxes, reduces the soybean export tax by 5% each year, and eliminates the export tax on meat. Plans to eliminate capital controls.

• Massa has proposed to eliminate the export restrictions on wheat and corn along with the export tax on wheat. He also proposed reducing the export tax on corn by 50%. Plans to eliminate capital controls.

• While Scioli has not made a public statement, his advisor has stated that wheat and corn export restrictions/taxes would be cut. Plans to eliminate capital controls.

If these reforms are put into action after the election, the additional revenue generated would directly boost Adeco’s earnings. It could also lead Adeco to shift more of its farming production towards the more profitable wheat and corn.

The presidential candidates also plan on removing capital controls and FX restrictions, which would benefit Adeco. Due to Kirchner’s capital controls, the Argentine peso has stayed artificially strong throughout the years. If these capital controls and restrictions are removed, there should be a convergence between the official exchange rate and the black market rate, or ‘blue rate’, which will cause a devaluation of the peso. This will have a positive effect on Adeco’s financials as 90% of its assets are in US dollars while 40-45% of its costs are in Argentine pesos.

The land value should appreciate after the elections. Kirchner’s policies and Argentina’s economic turmoil have led to a devaluation of the farmland. A recent assessment by Cushman and Wakefield valued Adeco’s Argentine land holdings at less than US$4,000 per hectare, a relatively low price in comparison to the land prices of its Latin American peers (estimates suggest $6,000-$8,000). C&W valued AGRO’s farming assets at $884mm versus a book value of $185mm. If the new administration fosters a friendly economic environment for both investors and agricultural companies, which is highly probable, Adeco’s Argentine farmland should appreciate greatly in value. Despite Argentina holding the most fertile farmland in the world, where average cost of production is roughly 1/3 lower than Brazil and half of the U.S., capital controls and an unfriendly business environment over the last 15 years have prevented much foreign direct investment.

El Niño, a recurring meteorological phenomenon, is predicted to continue this year into early 2016. This bodes well for Adeco as this weather pattern increases soybean yields by up to 15%, which would increase total soybean production and revenue.

Brazil:

A Brazilian law was recently passed that increased the required ethanol blend in gasoline from 25% to 27%. This will generate greater demand for ethanol in Brazil, which will increase Adeco’s revenues. Adeco is also positioned to take advantage of this greater demand as it recently completed the expansion of its third sugarcane mill Ivinhema, which gives the company a total sugarcane crushing capacity of 10.2mm tons.

Ethanol prices also show increasing correlation with gas and oil prices. While oil and gas prices have declined drastically from late 2014 to early 2015, the commodities show signs of recovery and current research supports continuation of this trend. This should boost ethanol prices and generate greater revenues for Adeco.

Monetary policy divergence and other factors could lead to a decline in the value of the Brazilian real relative to the US dollar. This should benefit Adeco’s financials as many of their costs are denominated in the Brazilian real.

The sugar business has not done well recently due to lower sugar prices and high inventories. Once the sugar business returns to its historical margins of 30%, as opposed to its current 8% margin, profitability will increase.

Risks:

A new Argentine president could fail to eliminate capital controls and export taxes.

Adeco could face further operational issues in its sugar business, which would impair the profitability of the company.

Adeco could face a continued widening of the official exchange and blue rates, which would pressure Argentine margins. Similarly, if the Brazilian real appreciates, Adeco’s Brazilian margins would decrease.

USDA forecast lower prices this year for many of the crops that Adeco produces. This could pressure revenues stemming from their agricultural segment.

Appendix:

Catalyst

Presidential elections, economic reform and macro events discussed above