Description

I know, if you wanted to supply capital to farmers, you’d just pay more taxes.


Company Overview

AG services, though more than a mere bank, is at its a core a lender to large farms. Along with raw capital, it also resells (either on credit or through a raw sale) farm inputs, such as seed, fertilizer and pesticides. Its consistent goal since inception has been to become a one-stop shop for farm input purchasing and financing for customers who want flexibility and specialization that large cooperatives and banks can’t offer. AG offers the purchasing power of a cooperative and the capital strength of a small bank, and also the added advantage of flexible, targeted packages along with value added agricultural services. Those value added services include agricultural consulting, financial organization and monthly reports, and even multi-peril crop insurance brokers, which also provides some revenue.

Founded by current management in 1985, AG has profitably expanded its credit base during a volatile seventeen years for the farm industry. While planting conditions, government subsidies and commodity prices have been all over the map, AG’s book value per share has made a steady climb from $0.02 in 1987 to $12.55 in 2001. The CAGR of book value per share over the last 5 and 10 years is 16.82% and 19.61% respectively. ROE (on average equity) averaged 14.01% and 16.71% over the last 5 and 10 years. Earnings per share have been positive every year since inception and have grown from $0.04 a share to $1.36 in 2001.

Although over 90% of AG’s $350 million in annual revenue comes from selling farm inputs, the financing leg of its business generates almost 40% (and growing) of pre-tax income, and in truth is intractable from the input resale business.

The Industry

Although AG is the only public company of its kind, there of course is significant competition in the farm input and capital business. In most cases, farmers get their capital through the Farm Credit System, a nationwide network of cooperatives that, like ASV, use their advantaged purchasing power to provide inputs to members. Also like ASV, the cooperatives act as financiers, getting capital from a small enclave of six intermediary banks (e.g. Agri-Bank, Ag First, Ag America). The two largest cooperatives in the national are Farmland Industries (#160 in the Fortune 500) and Cenex, which combine for nearly 1 million farm members. Compare that to ASV, with approximately 1,500 total customers, and you can get a good picture of the industry pie chart. Besides the coops, ASV’s competition is basically local banks, which of course only compete on the capital side of the business, and the occasional manufacturer with a side underwriting program, though those programs are often farmed out to banks (or more recently to AG itself).

There has been a clear and powerful industry trend toward farm consolidation, meaning that farms are getting larger. That consolidation creates some seemingly worrisome conditions for AG. First, larger farms have an easier time getting capital, and thus may not be motivated to seek out any solution outside of a traditional bank (whether inside or outside the Farm Credit System), where AG stands out as a relatively unique provider. Second, larger farms have increased purchasing power, which in turn puts pressure on the gross margins of the input resale side of the business. AG has responded to this trend in the value chain with an explicit strategy shift, beginning around 1997.

The shift was centered on seeking out the large, consolidated farms as customers by focusing on maximizing the flexibility and depth of its input/financing offerings. The shift was marked by the introduction of its "Agri-flex" program, a modular system that allowed large customers to cherry-pick from a complete selection of combination capital/inputs/services that management claims co-ops and other competitors have had a hard time duplicating. The result has been a decrease in customer count growth, a tightening of resale gross margins, a large increase in revenues per customer, and an increase in portfolio quality. A side result has been to expand the realistic addressable market. AG has less than 1% of its market in aggregate, and for most of its constituent crops (e.g. corn, soy, wheat), and has found itself focused on a customer-type that makes up a large (and growing) piece of the market.

AG's strategy has looked strong, as not only has it attracted large farms with its Agri-Flex program, but it has also generated significant business from suppliers seeking to outsource financing for direct seed and chemical purchases.

The Capital Model

Before even considering investing in this company, it’s crucial to understand its core financing model. Prior to 1997, the company primarily raised capital through equity (1991 IPO, then a follow on offering), traditional debt, and quasi-equity (a convertible bond that was since fully converted). Because return on capital was consistently greater than the cost of its capital, including equity capital, this strategy was largely successful, though it tended to leave ASV overcapitalized. Then ASV changed its capital raising approach, and started to securitize its customer receivables. The receivables are pledged to a conduit at variable commercial paper rates. In turn, customers are charged rates ranging from prime to prime + 4%. The spread between these rates comes back to equity holders, with the floating rate risk being passed on to customers, whose debts to ASV also have variable rates.

In addition to the securitizations, which accounts for the bulk of its financing, ASV will also use straight debt (for example, it has a $30m term loan) to finance its portfolio. Unfortunately, it decided to lock in its most recent $30m term in Aug. 2000 with a rate swap, leaving it with interest rate risk that obviously went against it over the past year or so.

What this means is that AG is not generating cash flow. It is plowing all of its cash flow back into the business in the form of increased receivable exposure. The bright side to this is that it provides very clear accounting treatment -- it takes full ownership of the risk and interest from the receivables on its financial statement without any of the notorious gain on sale problems you might see in somewhat similar entities.


Credit Risk

As with any lender, underwriting efficacy is critical. More so because every customer is inherently in a difficult, volatile business. Since inception, AG has taken great pains to manage its credit risks well, and thus far has been quite successful. It has several advantages in the regard. One is its concentrated customer base. With only 1,500 or so borrowers, more granular tabs can be kept, including regular farm visits, which is the norm. Another is Federal multi-peril crop insurance (covers drought, wind, hail, flood, etc.), which its customer are required to purchase and assign to AG as collateral. The company generally cap credit at 80% to 95% of the Farm’s multi-peril coverage. Third, AG gets a senior lien on the actual crop and an assignment on any government subsidies due the Farm. When a Farm goes to sell its crop, the check actually goes to AG, and AG returns any overage to the Farm rather than the other way around, a nice proposition from a lender’s perspective. Fourth, in providing value added services, AG is able to both understand and help support its customers. AG will both require and help create monthly financial reports, crop yield information, marketing strategy, etc. for customer farms. Fifth, despite its concentrated customer base, no Farm does or will account for 5% of outstanding receivables.

The numbers bear this out. AG’s reserving has withstood 17 years of what has not been pure Farm euphoria with pretty good consistency. Since 1997, the credit reserve as a % of gross receivables has been 4.03%, 3.14%, 2.86%, 2.83% and 3.37%. AG also discloses the origination year and internal credit rating of each tranche of outstanding receivables, with the ratings being (1) Acceptable (2) Watch (3) Sub-standard (4) Doubtful (5) Loss. Generally 70-80% of receivables out are (1) and another 10% - 12% are (2). The company also regularly examines the value of its collateral and writes down impairments. The recent provision for doubtful notes has pretty consistently sat between 1.8% and 2% of revenue.

Valuation

Go ahead and close excel. Here’s my entire valuation story: Pay book value ($12.89) for an excellent, founder operated business that has consistently generated strong returns on equity and is nowhere near any reasonable saturation point. Historically, you haven’t had many chances to buy AG at book. Here’s the average Price to Book from FY 1996 to 2001: 1.86, 1.95, 2.02, 1.66, 1.81, 1.77. Since the valuation argument behind buying a 15% ROE business at book is straightforward, I’ll focus on why the slight hiccup in recent results should not result in a company valued at book.

First, results in 2001, though solid, were beset by significant extraordinary costs for the develompent of its e-commerce business (discussed below) and dropping interest rates. The spring of 2002 was terrible, weather-wise, for many farms, which caused serious planting delays which in turn hurt Farm input sales and margins. The concomitant drop in interest rate did not hurt interest margins (except insofar as the above mentioned hedged) b/c of variable on variable spreads, but of course the lower prime rate did knock down gross financing dollars. This unfortunate combination of (industry-wide) miserable weather and quickly dropping interest rates, along with the unfortunate hedge, didn’t exactly maul AG, but it hurt net income in the first two quarters of 2002. For the first 9 months of the year, net income dropped YoY from $6.855 million to $5.155 million as a result of the above factors. The third quarter results reversed trend with the horrible planting season gone and AG picking up a bit in its insurance brokerage operations.

Note that this downturn didn’t have a particularly deleterious credit affect, but rather depressed input purchases. The poor weather in the spring is anomalous but not unprecedented, and there’s no particular reason to believe that its affects should continue into the future. Management certainly doesn’t seem believe as much.

Risks

The risks here are almost too obvious to point out. Let me Summarize: The domestic Farm industry. Although I believe (and AG management believes) that AG has proven it is not particularly vulnerable to the inevitable waxing and waning of US Farms over the years, there is no doubt that a bad enough hit to the industry would cut directly into AG’s heart. If you are convinced that the US farm industry is going to implode, and I know some that are, I would not suggest this investment.

A second, typical financier risk would come from a drastic rise in interest rates, which could cause serious credit impairment for AG’s customer, particularly the longer term receivables, leaving AG in liquidity trouble with a heap of rising commercial paper and LIBOR exposure.

A third risk is embedded in the industry trend of consolidation. In my opinion, the large farm trend has symmetrically increased AG’s risk, leaving it with a great upside and a greater downside. The potential market is now quite large relative to AG’s base, especially considering AG’s proven ability to diversify by crop, but with size comes increased customer purchasing power and the potential ability to continue to squeeze input margins and claim prepayment discounts.

A fourth risk is future capital requirements. Its $345 million (max) conduit securitization deal runs through 2004, and AG has not had a problem increasing the cap nor extending the maturity. If AG is successful in continuing to grow, however, it may well need other sources of capital in addition to this securitization program to finance additional growth. That could result in future equity offerings, though I know of no imminent plans.

Finally, government regulation is always a risk. Farm subsidies are actually a naturally hedged risk, as increased subsidies help demand for inputs but hurt demand for credit. An eradication of Multi-Peril crop insurance would not be a good thing, but it has lasted six decades without much trouble. AG isn’t overly concerned with the recently debated Farm bill (not that AG is not materially exposed to peanut or tobacco farmers).

The Powerfarm Kicker

One interesting sidelight to this story is AG’s e-commerce portal, powerfarm.com. Powerfarm is interesting for two reasons. First, it has temporarily depressed net income for the last several quarters, but its losses are quickly abating. Second, it has been largely if slowly successful in increasing its reach (number of suppliers signed up and customers online) while many competitors have taken the flame and fizz route. Powerfarm cost $0.18 in EPS in FY 2001 and $0.08 thus far in FY 2002. Meanwhile, Power-farm revenue for the first 9 months of FY 02 increased from $800K prior year to $3.6 million. The company is very positive about Powerfarm’s potential, but in my view this should be downplayed as at most a possible kicker, but at least drag on earnings that will be removed in the next few quarters.

Catalyst

At heart, I see this as a strong business with upside potential that can be purchased at book, a book that includes historically adequate reserving, so any catalyst are secondary to my thesis. However, management expects Powerfarm net losses to decrease materially next year, and sees EPs increasing 15%-20% even expecting a continued very low interest rate environment. The elimination of those costs will make the ratios look superficially more attractive. Also, Ag is currently renegotiating the liability it has already accrued from its interest rate swap, and it's possible that the renegotiations provides either retroactive or at least future relief from the depressing effects that fixed rate hedge has had on result with dropping interest rates.