Notes:

1. This was written for a less sophisticated audience that was already familiar with the qualitative attributes of the stream finance business model (which is why we barely touch on it and why there is the redundency and other attributes that would be absent if it were written soley for VIC.

2. See link just in case the pictures, charts and graphs don't translate properly.

https://www.dropbox.com/s/fign44f9repgqce/Input%20PO%20Thesis%20(Part%201%20%26%202).docx

3. The thesis was originally released at C$1.59 or ~10% below the current quote of C$1.80 and I have yet to update it. Given this is an immaterial move in context of the longer-term opportunity, I don't think its necessary to but I did want to mention it upfront. Also, with the overallotment privilege fully excercised the share count should be adjusted upwards to 61.2m shares (similarly as it relates to the cash)...again though, not all that material. 

4. The nature of the write-up is by necessity long form, so if your like many and prefer write-ups short (or at least shorter) and sweet, you can get straight to the heart of the thesis by scrolling down and starting with part 2: If Input Builds It, Farmers Will Come...      

Part 1: Field of Streams

Input Capital is the world’s first agricultural commodity streaming company. Think of it as the Silver Wheaton (SLW) of farming. If you’ve never heard of it, don’t worry. Input’s initial public offering was only two months ago and most investors, whether professional or retail alike, don’t even know it exists. At least not yet. 

For reasons outlined throughout today's thesis, we think investors have a temporary window to purchase a great business at an absurd mid single digit multiple to '14E pre tax cash flow. In a sane world we think an owner operated emerging franchise with the ability to exponentially compound per share value in a low risk and predictable fashion like Input should trade at a multiple 2-3x that.

In other words, Input is a great business entering into what is likely to be a three to five year period of sustained super compounding and the market doesn't have a clue. With only 10 streams in place and a balance sheet that will fund an additional 20-30 streams this year, Input's cost of capital will naturally drop like a rock. Anyhow, we expect rapid compounding in cash flow along with material multple expansion to propel a 2-3x return over the medium-term.       

So what does Input do exactly? Simple: It provides both agronomic consulting and cold hard cash to farmers to help them finance their farms and become more productive. In return, Input gets a “stream” on these farmers’ future crop production. This stream allows the company to buy the canola after the harvest at a predetermined and heavily discounted price.  The company's profit is the difference between the price it pays the farmer and the price canola trades at in the market.

Critically, this is a great deal for farmers. It not only gives them much needed cash but productivity-improving expertise as well. The end result is a more productive farmer. Which is just a fancy way of saying a farmer with a lot more money than he or she would have had absent partnering with Input. Of course, Input makes out like a bandit too. Its average return on invested capital for these “streams” should clock in at 30%. 

As an example, Input provides a farmer with an upfront $1 million payment.  Input will then receive a stream of 770 tons of canola at a fixed price of $100 per ton annually for 6 years.   Assuming a mid cycle canola price of about $500 per ton (canola was trading north of $600 earlier this year), Input would generate annual cash flows of $308,000, or about a 30% yield on its invested capital. Not bad. Realize as well that the streaming contract entitles Input to receive “bonus” tons for extra upside if productivity is very good relative to history (typically 15% of the crop yield over 30 bushels/acre).  

Input’s “breakthrough” value proposition is very much at the heart of why we are so excited about this undiscovered franchise’s future. For the farmer, gaining access to critical working capital is just the beginning.  Input also provides access to bargaining power with grain handlers and input providers like fertilizer.  For example having the cash to buy fertilizer during the fall off-season saves the farmer as much as 20-40%.  Having the cash to pay also means the farmer gets a 3% discount and doesn’t have to carry interest costs.  Obviously being able to invest more into inputs also enables the farm to become materially more productive in the process.  Instead of traditionally spending $200 per acre to generate crop revenue of $150-250 per acre, the farmer can now invest $300 on inputs and generate $300-450 per acre.  Input also provides a consulting agrologist to help the farmer maximize productivity with best practices such as: soil testing, seed treatments, precision seeding, weed control, timing and application of operations, and crop residue management. All good things that in totality should result in a substantial amount of value creation for everyone involved. Think of Input then not only as a financier, but as key partner that enables farmers to dramatically improve these small farms overall productivity. This second element is absolutely critical to internalizing just how valuable their partnership is to these small farmers. The benefits extend far beyond simply providing them with capital.

For example, consider that the average canola crop yield in Canada is about 25 to 30 bushels per acre.  But the true potential of the farmland combined with best practices and proper investment in the farming inputs could produce as much 60 to 70 bushels per acre. Given this reality, clearly the “delta” or difference in overall productivity between the least productive farmers and those who have the financial and intellectual capital to implement best practices is tremendous. So, it’s the exploitation of this massive gap for the benefit of the least productive that is at the heart of how Input adds value. And trust us, given our analysis of the plight of your average Western Canadian farmer, there will be no shortage of willing takers.

The structure of the streaming contract guarantees Input Capital with a fixed number of tonnes, so it allows for substantial upside to the farmers if they can make their farm maximally productive.  Simultaneously, this also incentivizes Input Capital to help make this possible given they are entitled to a piece of the upside as well, typically 15% of the crop yield over a 30 bushel per acre hurdle.

One Streamer to Rule Them All

Let’s take a moment to savor how beautiful of a business this is. And not just because the company is a streamer either.  Input retains most of the great qualitative attributes that we love about the streaming business and practically none of the negatives. Indeed, we think Input possesses the best iteration of what is an already superior business model by leaps and bounds.

Bold words, but before you rush to judgment, consider a few distinguishing characteristics that are singularly unique in the stream finance world.

1. No production delays.

With Input, there is no extended period of time waiting for a mine to be developed.  Crops are planted year after year generating production immediately.  Every one of Input Capital’s existing crop streams will generate high margin revenue and cash flows in 2013.

2. No exposure to capex overruns or to the fragility of the capital markets.

As we saw with Sandstorm Metals, streaming companies are still indirectly exposed to the mining sector’s perpetual bonfire of other peoples money.  But this will not happen on farms – i.e. there will not be any crop input overruns (pun intended). Additionally, with Input one doesn’t need to worry about external factors such as the health of the capital markets or the negative reflexivity that turmoil there can wreak on a metal streaming companies value and future prospects. So again, unlike with precious and base metal streamers, Input isn’t dependent on mines getting up and running and hence they don’t have to worry about capital overruns, dreaded “death spirals,” the state of the capital markets (can the operator of the asset underlying the stream that just ran out of money get funding?), or any of the other issues that can end the life of a your average mining company in what seems like six seconds flat.

3. Fortress-Like Downside Protection.

Another critical difference separating Input’s model is the presence of Canadian government backed crop insurance. This is absolutely critical to understand because it makes the odds of a bad crop bankrupting Input’s streaming partner(s) essentially nil, as this insurance covers ~70% of the farmers historical total crop production. In other words, Input's farmers own government backed insurance that provides coverage that is substantially in excess of the tonnage owed to Input.

In other words, for every stream Input purchases they receive not only an asymmetric call option on canola pricing along with a hedge fund like performance fee, but what amounts to a government funded put option that protects the downside.  And did we mention that this crop insurance is paid for by the farmer and the Canadian government?  Yes, read that twice.

Taken together we think these idiosyncratic nuances make the odd’s that the company ever experiences a severe/permanent loss of capital extremely unlikely. 

As a quick aside, a big reason the market seems to be missing all of this is because the nature of these seemingly small differences is just not well understood. The fact that Inputs ag model is dramatically less risky escapes the market because most participants are not yet familiar with the unique differences at play here. Again, the market is hardly aware the company even exists (more on this in part 2).

Eventually this won't be the case, as the market will realize it’s mistake and come to appreciate the virtues of these idiosyncratic differences. Our guess is sooner rather than later given the data from this year's harvest is almost in...which should help drive a re-rating in the stock price as well as give management all the data they need to aggressively attract new capital (proof of their ability to roughly double their partners canola yields is a BIG data point).  Anyhow, early reports are indicating that 2013 is going to be a very productive year. In fact, at an expected 14m tonnes, 2013 year stands to be the best crop year on record.

Canada + Oil = ?

Let’s take a step back and ask what kind of crop these farmers are growing for Input?  Why, rapeseed plants, of course!  Never heard of it? Yeah, neither had we. Safe to say selling an agricultural commodity with a name like rapeseed is a non-starter but we digress.

Here’s an interesting story.  In the 1960’s, Canadian scientists were looking for a way to grow and process cooking oil.  They succeeded with the rapeseed plant, but quickly realized that no one was going to buy something called rape oil.  So instead, their marketing department took Canada + oil, and came up with Canola! (which explains why you’ve never seen nor heard of a canola plant.)

Now, you are probably scratching your heads like we were when we first heard about this.  Canola?  Seriously?  But did you know that canola is the most profitable crop for Canadian farmers, constituting 25% of all farm revenues?  In fact over 25% of all the world’s canola is produced in Canada, and 72% of the world’s canola exports are from Canada. Better yet, consumption of canola oil both in the U.S. and globally should continue to grow for many years to come. To give you an idea of what we're talking about, note that Canadian exports to China have compounded at ~36% annually for a decade. Over the last six years, US consumption has increased by over 80%, which is a mere 13% of total US vegetable oil consumption. Compare that to Canada, where canola represents roughly 70% of all consumption if you want to get a somewhat comparable frame of reference for the potential here. Our point is simply that export demand from the rest of the world should remain robust for canola as the size of the pie grows and it's % share of that pie grows as well.    

Regardless, canola is processed into oil and meal, which is used for cooking oil, animal feed, biofuels, and lubricants.  More importantly, canola is required for long-term food production. It also happens to be healthy for you, which is actually why it sits at the center of two secular mega-trends. In an age where the world’s population is quickly approaching 8 billion and citizens all over the 1) western world are looking for inputs (pun intended) that aid in healthier living and 2) emerging world (particularly Asia) are introducing more protein into their diets, the fundamental secular tailwinds for canola are substantial.

For more color on the primary drivers of consumption we've gone ahead and pasted below the following excerpt from a report put out by GMP securities a couple weeks back. Nothing earth shattering but we thought it offered a good high level template for thinking about the fundamental tailwinds driving demand. We think continued GDP + growth in demand for both canola oil in the west and canola meal in the east is all but certain but we digress.  

"Canola is predominantly consumed in four ways:

1. Canola Seeds – can be consumed as a food source although seeds are mostly used for processing into canola oil and canola meal.

2. Canola Oil – Relative to other oils and cooking mediums, canola oil is cholesterol free and contains the lowest percent of saturated fat. Additionally, Canola is trans-fat free, an important attribute considering that some governments, including those in Calgary, New York City, Philadelphia, Seattle and California, are restricting or outright banning its use in school meals, restaurant cooking and consumer products. As such, major food companies, including McDonald’s and PepsiCo, are switching to canola. Relative to other cooking oils, canola oil has the most omega-3 fat content, a fatty acid that helps reduce inflammation, lower blood pressure and possibly helps with other conditions including arthritis and depression.

3. Canola Meal - Canola Meal is currently the 2nd largest protein meal produced worldwide with 35.1 mm tonnes in 2012 (vs. 181 mm for soybean meal)10. As canola meal has a lower protein content than soybean meal and fewer amino acids, it is more suitable for animals with lower energy and lysine (an amino acid) requirements such as cattle and hogs. However, canola meal’s high fat content has made it an important component of dairy cow’s feed as it enhances milk production. Canola meal is also fed to poultry, aquaculture, and specialty animals (including racehorses)

4. Biofuel – Biodiesel producers can realize greater efficiencies from canola than from other oilseeds due to its ~40% oil content (vs. soybean at ~20%). Canola oil is also more stable and less prone to oxidation than other oils which leads to a decrease in corrosive acids and deposits that can increase wear on engines. In 2012, Canada adopted a renewable biodiesel mandate and by law, 2% of diesel must be produced from renewable content (such as canola, corn and soybean). In the US, canola oil was the second most-used feedstock for biodiesel after soybean oil. In Europe, EU biodiesel policies helped increase industrial use of canola oil from 1.3 mm tonnes in 2002/03 to 6.7 mm tonnes in 2012/13. Additionally, the 2009 EU Renewable Energy Directive gave the biofuel market a boost by requiring 10% of the EU's energy for transport come from renewable sources – including biofuels. In 2011, the EU spent €9.3-€10.7 bln subsidizing biofuels (includes excise tax exemptions)." 

What makes this story even more fascinating is that there are over 50,000 canola farmers in Western Canada alone.  Talk about a borderline absurdly long runway of growth potential (remember we are starting from a base of 10 streams/farmers, not 100 or 1000, but 10).  Furthermore, this streaming model could easily be translated to farmers in the upper United States, and farmers of other crops such as grains and pulses (lentils, beans).

Even more compelling is the demographics of Canadian farmers who will soon be undergoing a massive generational transfer of farm assets (over $30 billion) in the next several years.  This is one of the reasons why so many of Canada’s skilled farmers will soon be faced with the expansion opportunities of a lifetime. The rub is that these farmers cannot afford to take advantage of it on their own. Which leads us to the fact that there is a critical shortage of flexible financing solutions for Canadian Canola farmers.  This is especially true with financing farmers with the requisite working capital to operate and grow their farming assets in the most productive manner possible.  The key to Input’s value proposition to the farmer is that it offers them flexibility and control.  This cannot be overstated enough.  Sure, the traditional bank’s loan may come with what appears to be a lower fixed interest rate, but if the farmer is starting to run low on cash, the bank is going to come in and force the him to liquidate one of his tractors – at the very worst possible time.  Input generates a lot of goodwill with its farmer partners because they will not force the farmer into a corner like this. 

In addition, as we stated before, Input will not only give them this flexible capital, but is also committed to help them potentially double their crop yields!  It’s safe to say that no bank loan officer will help the farmer achieve the yields of his dreams.  And this is one of the reasons why farmers are so enthusiastic to partner with Input.  When Input can demonstrate to them how their farm can generate double the amount of crops, it almost does not matter what the cost of this capital is to the farmer.

The ideal farmer partner for Input Capital are young farmers with the skills but who need capital after purchasing the intergenerational transfer of a farm, or older farmers who foresee a large expansion opportunity, or good farmers who simply need more working capital.  The farms typically range in size from 3,000 to 12,000 acres and are located in the black/dark brown soil zones of Western Canada.

Before we move on then, a couple of things seem clear. One being that canola is a major player in the Canadian economy. And two, despite this fact, canola inexplicably remains largely overlooked by the investment community.

Especially when we juxtapose it with Potash, one of the investment community’s perennial favorites. The point here is to use Potash merely to illustrate the multitude of meaningful similarities between these two unique commodities and the bevy of structural similarities that make the comparison far from specious.

Consider some of the data points below:

• Canola is a bigger global market than potash
• Canola is a bigger export business for Canada than potash
• Canadian canola exports have been growing at a CAGR of 18.3% over the last 10 years (compared to 13.6% for potash)
• Canola is Canada’s #7 export to the world (potash is #10)
• Canadian canola exports have double the market share in global export markets than potash
• Canadian canola exports to China are 8.5x the value of Canadian potash exports to China
• As already noted, Canadian canola exports to China have been growing at a CAGR of 36.4% over the last 10 years (compared to only 4.1% with potash)
• Canola currently represents 16.0% of all Canadian exports to China (compared to only 1.9% for potash)
• Canola is Canada’s #1 export to China (potash is #12)
• Canola employs 228,000 Canadians.  Potash employs 5,000 Canadians.

Once all that is internalized, consider for a moment that there is only one publicly company providing investment exposure to Canadian canola production: and that’s Input Capital Corp. (TSX.V: INP).  It has a market cap of only about $100 million. Yet (remarkably) there are three companies providing investment exposure to Canadian potash production: POT, AGU, MOS. Now these are indisputably inferior businesses on pretty much every meaningful level and yet bafflingly, these companies have a combined market cap of essentially $60 billion.

Think about that…

Input’s Owner-Operators

The management team behind Input Capital has a long history of value creation.  They previously founded Assiniboia Farmland Partnerships in 2005, which was one of the very first private equity farmland partnerships in Canada.,  Starting with $53 million in equity capital, they eventually amassed over 117,000 acres of farmland in Saskatchewan worth over $125 million with over 136 farmer tenants.  The Partnerships produced 20% IRR net of all fees since 2005, returning over 200% to its shareholders.

Through Assiniboia, management was able to form strong farming relationships with their tenants, over 75 of who are canola farmers.  Unsurprisingly it was the trust built through these relationships that helped Input Capital create what your editors view as an amazingly innovative streaming contract on an already innovative business model. Nonetheless, it was this goodwill that provided Input with the customer beachhead necessary to prove out the concept in all its cash generating glory.

Turning to the question of incentive alignment, note that Input’s directors and executives own ~20% of the common stock and are therefore strong aligned with shareholders to create long-term value. As one of Inputs key executives put it, “make no mistake, we’ve got it all on the line.” 

Alas, the above factors point to the fact that we have something special in Input’s executive suite – and by special, we mean visionary owner operators that appear to possess the requisite skill sets and character to build a multi-billion dollar business. In other words, these guys are flat out good and their presence at the helm of this undiscovered emerging franchise should put the discerning investor at ease. 

Our calls with CFO Brad Farquhar illustrate this point nicely. For example, Brad has exhibited contrarian, second order thinking on a level that is rare in our experience. Case in point was the borderline glee in his voice while he explained to us that in his estimation Canola prices were poised to come down in the near term off the back of what has been a record breaking year for Canola farming across Canada. Like a value investor happy to giddily average down on a position in the name of long-term profit, Brad was palpably excited about the opportunity for Inputs terms of trade with farmers to widen in their favor, especially given the ~$45m in dry powder the company is looking to deploy this year.  This might not sound like much, but let’s just say that in our experience, its incredibly rare for an executive to openly root for price declines in way that simply screamed “long-term greedy”. We’d be lying if we said we didn’t love it.

Another illustrative example was when Brad was responding to a myriad of our questions on capital allocation and the paramount importance of preserving/growing per share value. Consider that while discussing his thoughts on utilizing equity for growth (we were careful not to lead him), Brad was emphatic that any future raise would only be considered if it was done at favorable prices, read in a manner that materially augmented per share value. He pointed out that Input had attempted to go public earlier this year.  When their bankers informed them that they had the money but that the pricing would come in lower than what they wanted, they turned it down without blinking an eye. He told us essentially that the decision to walk away wasn’t much of a decision at all and that they would have held out for better terms indefinitely rather than go public merely for going public’s sake. The equity represented most of their own money/nest eggs after all. Which brings us to a related point, namely that throughout all of our conversations he was always quick to emphasize historical examples wherever possible whenever a matter of principle was involved. We could tell it was important to him that we understand that this was much more than mere talk. 

Another little gem concerning our conversation with was our discussion of his thoughts on share repurchases. Given the model is one that typically uses serial equity raises (ideally at elevated valuations) in the service of rapidly compounding per share value – and hence is uniquely vulnerable to the empire building CEO – naturally we wanted to know whether he plans on buying back stock in the event of a significant selloff and if so, why.

This was important in our mind because we wanted to know that whether we find ourselves in a recession – or really any environment that is marked by a steep drop in equity prices – we can count on them to shrink the share count aggressively. Remember that the idiosyncratic differences that define Inputs unique model put the company in a great position to prudently buy back stock in a way that other early stage streamers like SND cannot, a fact that Brad was quick to point out. You see with Input, cash flows are not only highly certain, they are received relatively immediately and therefore can be reinvested immediately. Also given the present valuation, by our math a buyback at half today’s price would allow Input to put that capital to work at higher returns with a fraction of the risk – at least relative to the alternatives uses of that capital (i.e. investing in additional streams).  Clearly buying back stock at a low single digit multiple to pre tax earnings when the equity is worth 10x or more (conservatively) is a very good use of Input's internally generated cash flow. In fact, hearing him make the case for doing so (as if we weren't secretly pumping our fists while he did it) amused us to say the least.

And while he did preface his response by saying that Input was still an early stage (newly public) company, and hence had not “officially” had board level discussions on share repurchases, he did say that he personally “would be a huge buyer” if the stock were to decline.  And better yet, that as CFO and co-founder of the world’s first agricultural streaming company, he understands the “cash-generating power of the business better than anyone else alive.”  He emphasized that in this scenario “buying back our own stock is the best thing we could do”.

So while it's always possible he could have been insincere, judging from his tone and other factors our internal bs meter told us he meant every word.  At any rate, call him, we encourage members to see and judge for themselves.

Input’s Breakthrough Value Proposition Quantified

Editors note: At Portfolio Ops, part of our due diligence process consists of designating various members of the team and trusted colleagues with the task of devil's advocacy with every idea under consideration. Below is a few questions that we felt were particularly thoughtful in this regard. Our hope here is that by answering these questions they will provide members with not only some hard won insights, but also a springboard of sorts for members to write us with their own questions and concerns. 

Q: If these deals are so lucrative, why then doesn’t everyone do it? What’s behind this, is the issue capital constraints, awareness, or belief in the efficacy of methods / fertilizer etc.?

A: Everybody isn’t doing it because the more you dig into the details of Input's model the more you realize that it would take a substantial sum of money and many years to ramp the learning curve here even if you could somehow replicate the relationships and the myriad of other intangibles that we feel creates meaningful barriers to entry. After all, Input is a trust based business that was created and fine tuned through continuous effort over many years. It is not something that can be replicated easily with a big pile of cash.  The company was able to slowly build out it's circle of competence in both stream finance and agronomic consulting only because they could rely heavily on their pre-existing relationships with the farmers that lease out their farmland from the farmland partnerships they ran. 

Sometimes a great idea can be staring at you in the face, but if it’s difficult to implement, then it won’t get done.  For example, a lot of investors in the last decade believed that farmland prices were going to skyrocket.  We even thought so too.  But did we buy any farmland?  No . . . because it’s really hard!  There’s no farmland equities traded on a liquid financial exchange.  There’s no futures on farmland.  Even if we went out and bought some land personally, we’d then have to grow the crops ourselves or lease it to some farmers and manage it.  Farmland had not been “financialized,” and therefore very little institutional money went into it.

But Brad and the Input Capital management team did.  They had the thesis right, and then walked the walk by creating a series of private equity farmland investments.  And that’s what they are doing here with Input Capital.  It’s not just a matter of coming up with the capital.  They had to have the right relationships – with the farmers, with the agrologists, with the grain elevators, etc.  And these relationships were earned through trust developed over many years.

What Input does is so powerful because they give a farmer the financial tools he needs, the agrologists give him the information, the science and the coaching he needs – so that the farmer just needs to go out and execute. And assuming average weather, he’ll do better than he has before. All because the marginal crop yield return on the next dollar of inputs is astronomical, and he’s not “going at it alone” – and hence likely to make a fatal mistake in an area where he may be a little out of his depth.

That, and it takes money to make money. If you don’t have money (are working capital poor) you might succeed by pulling yourself up by your own bootstraps over time. But wouldn’t it be easier to take on a financial partner who will put in equity-like capital and take it out on a predictable schedule over six years? Of course it would be, and that is what Input does. It brings the best of everything together.

Q: From a secular perspective, the AG industry in the U.S. has gone industrial with a sophistication and scale that is dramatically higher than just 10 years ago.  Is this not the case in Canada? In other words, why isn’t the canola market as sophisticated as say corn in the U.S? The reason we ask this is that one would imagine a large, sophisticated farmer would figure this out and keep all the incremental margin for himself. What’s the deal here?

A: Our understanding is that things have gotten way more sophisticated. A typical grain farm needs 5,000 acres to get scale. Some of Inputs clients are much larger than that. But these new technologies – variable rate tech, GPS, precision agriculture, etc. etc. – are just coming into maturity for what Canadian’s grow and how they grow it across Western Canada.

For these reasons, we believe the next 10 years should be an unbelievable time for Canadian farmers as tech and soil and seed science converge, but it is indisputably  more capital intensive than it’s been in the past. Those with the capital will succeed, and those who don’t will be hobby farmers.

Even large, sophisticated farmers are struggling with the capital requirements of farming today. Land is way more expensive than 10 years ago, equipment is bigger and more expensive, labor is more expensive, inputs are more expensive, and the scale is way more massive. The improvements in potential results outweigh all of this, that is if you have the capital to unlock the productivity potential.

As we understand it then, everyone would love to do it if they could, but again, the tools available to the vast majority of farmers today in Western Canada are limited and inflexible. What Input Capital offers is much more material to a farmer than what their banker has to offer, and much more flexible than what their trade credit supplier has to offer.

So again, Input’s main benefit is that their financing of working capital is non-constraining, flexible, and therefore gives farmers control which allows them to be very opportunistic and provides them with the requisite freedom to make the right decisions economically long-term.

Sadly, often times farmers make decisions not based on best economic long-term outcome, but according to their opportunities as they become available, which is often when they are most starved for capital and hence maximally vulnerable. And even in flush times when they do have money they will invest, but then in an ironic twist of fate, that will only leave them tightly constrained and in a poor position the following year, especially if things get worse. For example, if it’s a great year this year, a farmer may take the cash and purchase the farm next door to expand, but then this leaves them tightly constrained with a lot more land but essentially no working capital to make that land productive in a maximally efficiently manner.

Remember that these are farmers, otherwise known as are real live human beings that aren't all perfectly rational economic actors. Better yet, even on the rare occasion when these farmers do act like homoeconomicus - say by buying a neighbors old farm when it comes up for sale for the first time in 20 years - even then, they tend to get excited and overpay (shocking!). And even if they get fair deal there, the truth is that the odds are as good, if not higher, that the farmer in question will be working capital poor and hence need Input just the same. (Who cares anyway. The point is simply that with people being people, an addressable market of 50k farms, a true "no brainer" value prop from the farmers point of view, clearly the true demand for Input's streams could be in the many billions of dollars)  

Another example of how truly priceless a relationship with Input can be gleamed by looking at what happens to a farmer if sometime in the future he has a horrendous year for whatever reason. In this case, Input can allow the farmer to roll over the promised base tonnage into the next year, so that the farmer isn’t put out of business. Obviously Input’s flexibility generates a lot of goodwill compared to other kinds of bank financing.

In sum, Input helps farmers drive down their cost of capital through productivity improvements and various cost savings, all of which is quantified below:

1. Buying inputs off season (~20-40%)

2. Discount for Paying Cash (~3%)

3. Interest Costs (~10%)

4. Flexible Crop Marketing Program (~6-12%)

in sum, through the above (and other) ways, they help farmers unlock their productive potential. The fact is, this isn’t just some clever slogan, as Input is able to reduce a farmer’s inherent cost of capital on average by a whopping ~39 – 65%!!

What’s Input Capital Worth?

Current Price: $1.60

Shares Outstanding: 59m

Market Cap: $94.4m

Fully Diluted Shares: 62.6m

Cash: ~$37m

To get an idea of what Input is worth, let’s crunch some numbers to get a feel for the cash generating power of the business assuming the company deploys its existing war chest at similar returns of some of the company’s more recent deals. Lets also assume no further equity financing between now and year-end 2014.

We use YE 2014 only because the company should begin to receive the high margin cash flows derived by putting to work the tens of millions presently sitting in cash on Input’s balance sheet.

At any rate, a great way to accomplish this (we think) is to use the last deal Input inked in Alberta for guidance. With that deal we saw Input pay $1mm upfront for a 6 year deal in which the farmer will sell the company 888 tonnes of canola per year, for six years, at a predetermined and heavily discounted price of $100 per tonne.

So, if we take the $35m from Input’s most recent capital raise plus the $5 to $6 million in FCF the company should generate both this year and next, that gives us a range of something between $45 & $50m in available capital for reinvestment before we account for any bonus tonnage.

So 45 x 888 equals 39,960 tonnes on the low end. If we user the higher end of the above range, we get 50 x 888 or 44,400 tonnes. Add the mid point or ~41,880 to the tonnage Input is already set to receive this year from its streams already in place – which is another 17,152 tonnes (give or take), and we are looking at a total of approximately 56,032 base tonnes as a reasonable basis for projecting the company’s earnings capacity come year end 2014.

Also, according to management, it’s reasonable to assume that these new tonnes will have a $100 delivery payment just like the 888 tonne deal noted above. Given that, we should be able to forecast Input’s “normalized” earnings power in future years in a manner that is at least approximately correct. In other words, we have all the secret ingredients necessary to derive our estimate.

So, assuming a net profit of $400 per ton (a number we derived simply by taking our $500 “mid-cycle” or “normalized” estimate for the price of canola minus Inputs $100 purchase price/bushel), the company would generate ~$22.4m in net revenue by year end 2014.

Being a small company, Input’s expenses are very low – currently only about $1.2m per year.  Let’s assume that this will double to ~$2.4m (they will likely be hiring a couple of sales/marketing people and be spreading the word about Input to more farmers).  Input Capital’s pre-tax earnings will be ~$20m.

In other words, investors are getting a chance to purchase Input today at a mere 5x pre-tax earnings.

Remember as well that this is BEFORE we’ve taken into account the value that will likely accrue to Input based on the value of its bonus tonnes related to it’s own forecasted yield improvements. The funny thing is, based on early indications this number is looking to be very significant but of course we will have to see.

Ok, well, what about if we include “performance fees” bonus tons in our assessment? What’s our implied YE ’14 multiple to pre tax cash flow?

Great question! If we want to try and back into what we’re paying if Input delivers on its claims as it relates to its ability to dramatically improve the productivity of its partner’s farms, shareholders will be very happy campers. The thing is, to do that investors need to realize that for every 10 bushel per acre yield increase over the 30 bushels per acre hurdle, Input stands to benefit to the tune of about an 8% increase in total tonnage received.

What’s interesting is that our understanding is that Input’s farmers could quite possibly hit 50 to 60 bushels/acre, or at least something close to it without too much trouble. Indeed, one can look at a variety of examples from this years harvest (according to management) and conclude that is a number that is very possible. Of course until the imminent release of the data from this years harvest we can’t say for sure, but all indications lead us to believe that such an estimate isn’t aggressive.

Regardless, according to the anecdotal evidence from this years harvest it appears shareholders have multiple reasons to believe Inputs average streaming partner will manage to improve his bushels per acre metric to something close to the 60 mark hypothesized above. If that proves true, Input would earn additional bonus tonnes of ~13k tonnes or approximately $5.3m for the year. And again, if the data proves this out, it’s not unreasonable to assume these performance fees will repeat over the life of the streaming contract. Sure, 2013 was the best year on record but these yield improvements have presumably been driven by Input specific initiatives and hence, are more likely than not to be sustainable.

If that’ the case, an upside estimate of Input’s “true” annual pre-tax earnings come year end 2014 should clock in at ~$25m. This would obviously make the base case owner earnings multiple we derived above even lower. By our math investors who get in at the current trading price would be paying an implied 4x YE ’14 pre tax cash flow. 

Now that’s the type of valuation on an undiscovered emerging franchise that gets your editors at Portfolio Ops out of bed every morning!!!

And with that, we’ll leave the rest for part 2 coming later this month.

Until then, feel free to email us with any questions and rest assured we are just scratching the surface of this remarkable opportunity. Until then!

- The Portfolio Ops Team

We then arrive at music, the knowledge of harmony. Are the parts concordant with the whole, and is the whole concordant with the world at large? How does the business harmonize with its community, employees, competitors, shareholders and the environment?

                              – Chris Begg, East Coast Asset Management

In part one of our Input Capital recommendation, your Editors laid out the high-level case for Input in our usual qualitative focused manner.  Input currently has all the pieces they need to become a billion dollar company over the next five years (with equity raises at higher and higher prices).

To become a billion dollar company, Input will have to raise ~$250 million dollars and deploy $300 to $400 million with the difference being a redeployment of earned capital. As an average stream is ~$1 to $2 million we can reasonably figure there will be ~~150 to 200 individual streams in place at that time.  Yet, each of these streams represents a decision by both the farmer and Input.  As such, part two of the Input Capital thesis will focus on the fabulous economics for both the farmer and Input as well as reiterate the multi-layered downside protection embedded in Input’s business model.

At any rate, the thesis with Input remains the same, as it is very much a business that “deserves to win” (as the guys over at East Coast Asset Management recently put it). And why wouldn’t they! Given the company has created the proverbial key that fits mom and pop canola farmers “productivity unleashing lock”, we envision an environment where everyone involved should thrive. Indeed, we expect the company’s breakthrough value proposition will create tremendous amounts of wealth for all involved for many years to come.    

Farm Level Economics: Why the Heck would a Farmer give up 40% to 50% of his most profitable crop?

With over 50,000 canola farmers in Western Canada, the market is not institutionalized with the average farm in the range of 3,000 acres. Modern farming requires a significant amount of capital (land, labor, equipment, seed, fertilizer, water, etc.) which is by no means cheap. Additionally, in a farming family the working capital of a farm is stripped out every generation for Mom & Dad’s retirement.

And while the truck commercials we watch every Sunday during NFL games (Shout out to your Editor’s undefeated hometown KC Chiefs!) romanticize farming, the capital intensity of the business often means a farmer is attempting to keep all the proverbial plates spinning by “robbing Peter to pay Paul”. Perhaps it’s a bank line that is able to be drawn to pay for some new equipment, or taking a new tractor with a note instead of scrimping on high quality seed this year, and so it goes. And so the vast majority of farmers are not properly capitalized and typically find themselves busting their tails simply to make ends meet. As management describes the change that comes with proper working capital management, Input’s capital changes a farmer’s perspective from: “Git ‘er done” to “Git ‘er done well.”

You may ask: isn’t there alternative financing available to farmers that doesn’t give a 30% IRR to the financier?  The answer is yes but only for certain types of assets.  Acreage can be mortgaged, equipment financing is available through the manufacturers, and there is seed & fertilizer credit available from the crushers and grain elevators on undesirable terms. For example, there is only traditional fertilizer credit available two weeks before planting season so the farmers don’t blow the capital on something else… Guess who knows that?  Fertilizer companies.  So the price of fertilizer rises dramatically when the credit is available thus dis-incentivizing the farmer from purchasing the optimal amount.

So what can a farmer really cut back on?  They need land, large farm equipment to harvest the crop at the optimal time, obviously they need labor and water to grow the crop. So what are the only variables that farmers can cut back on?  That’s right – fertilizer and seeds (of the less productive and reliable variety).

So in this scenario the farmer is leveraged to the proverbial hilt and they cut back on the very part of the equation (fertilizer) which would maximize their crop yields in both bushel and dollar terms.  To you Editors – that is the definition of suboptimal!

Working Capital for the Whole Farm?

Input Capital’s agreements not only support the farmer’s canola crop but also the other 2/3^rdof his crop.  How does this work?  Input’s stream to the farmer will provide up to $300 per acre of the farmer’s total farm (even though the contracted payback stream is only on canola).  To that farmer, this is an exceptional trade-off as it allows the farmer to maximize his whole farm while keeping roughly half his previous canola crop.

A standard farming rotation for a Canadian canola farmer is 1/3^rd canola, 1/3 wheat/durum/barley, and 1/3^rd peas/lentils. The farmer must rotate his crop every year to (1) maintain proper soil chemistry as the different crops extract and provide complimentary nutrients to the soil and well as (2) minimize disease that can spread if farmers fail to rotate their crops.  As Input management says “canola then snow then canola is not a crop rotation!”  So when a farmer considers Input’s offer and recognized his ability to optimize his entire farm by lowering his cost of capital by buying fertilizer off peak and delivering his crop at an optimal time he jumps at the chance. In other words, the farmer understands his economics and the overall value proposition Input offers immediately.

Yield Enhancement

Input has a view that the amount of working capital required to run an optimal agronomic program is about $300 per acre each year. Assuming a farm of 3,000 acres that’s a working capital need of $900,000 which is no small task.  So farmers typically underutilize fertilizer and thus spend about $200 per acre.  When applied to canola a typical haul for a $200 working capital acre is in the neighborhood of 25-30 bushels per acre.  Yet with the $300 per acre and the requirement to have a soil agrologist, the farmer stands to achieve crop yields much closer to the land’s inherent productive capacity of 60 to 65 bushels per acre. Suffice to say that if a farmer can double his output on a per acre basis which requires no extra land or labor he will do so… To make the math simple, if the farmer was doing 25 bushels per acre and doubles his output yet pays only half his crop he is flat economically with respect to canola.  So when considered in the context of his yield maximization of the other 2/3rds of his acreage the deal is a “no brainier” for the farmer. After all, the return on that incremental capital deployed is astronomical. Which is just another way of saying that by investing a little more he can make his farm A LOT more money.

In summation, if a farmer can lower his cost of capital, increase his crop yields on all of his farm, and retain upside to half his historical crop all for no capital outlay (read having to pony up any money of his own) he is going to jump at the chance.

Input Economics: With 20% IRR’s on base tonnes & 30% pre-tax IRR’s inclusive of bonus tonnes, can it be that these returns are simply matter of funding off season fertilizer purchases?

As shown above, a farmer is able to post material gains by utilizing excess working capital efficiently. Yet how can Input expect to earn a reasonable return on investor capital when the farmer is reaping these types of rewards? Therein lies the magic of canola streaming and the whole reason Input is focused on the crop in the first place.

As described in detail in part 1, canola has many attributes as a cash export crop yet we saved one pertinent detail for this part.  The key component is as follows: Canola has properties such that proper fertilizer and agricultural techniques can double the crop yield (as opposed to a 20% yield enhancement in wheat and peas).  Yes.  Double – as in 100% increase.  Yet many farmers aren’t doing it themselves…

Here is how Input models their contracts: they target a 20% IRR by contracting a fixed number of base tonnes assuming future prices utilizing the canola and soybean forward rates.  Now, 20% is a real figure especially when Input begins receiving cash during the first 12 months of the contract (note that the company wrote its first contract on Feb 1, 2013 and got all their first year revenue from that farm before October 15,2013 but we digress).  Since the contract is for tonnes as opposed to dollars, Input can earn vastly in excess of their targeted 20% return if/when canola prices rise.  Conversely, if canola prices fall, Input makes a lower IRR yet in the vast majority of scenarios Input still has a positive IRR.  So assuming some contracts will earn less than 20% from price declines and some will earn more it’s reasonable to assume 20% IRRs on base tonnes going forward with reasonable confidence.  Not bad at all!

However, we have neglected one key return stream for Input – the bonus tonnes.  To describe bonus tonnes in financial parlance – they are akin to performance fees for hedge funds.  If/when the capital allocator performs above and beyond they are entitled to extra compensation.

For Input, this compensation is 15% of all tonnes over 30 bushels per acre. Ok so that might be nice but how valuable could this really be? Take a look at the below – the bonus tonnage opportunity adds nearly 10% in very reasonable scenarios and up to 20% in most scenarios.  Recall this bonus tonnage IRR must be added to the base tonnage IRR such that a 30% IRR is a very reasonable scenario.  How many businesses do you know with this type of yearly IRR potential?

Current metrics put the crop productivity for the year in the ~36 bu/ac range.  As illustrated in the above chart, with canola at $500 per bushel and ~35 bu/acre Input can expect an IRR of ~31% before overhead and taxes this year.

That is exciting to put it mildly…

And again, the above rates of return are achieved even though Input only gets paid on the canola. We should note as well that the way Input structures their contracts to make the farmer’s decision making for him is genius:

• Input maximizes the entire farm but takes only 50% to 60% of the farmer’s normalized planted canola.  So the farmer still has 40% to 50% upside on his canola crop and the canola can double in terms of bushels per acre so the farmer is incentivized to focus on canola.

• Yet, the farmer still gets the productivity enhancement on his other crops (think wheat and peas), which he certainly cares about but Input more or less does not. The simplest way to think about this is that any and all benefits from yield increases in the farmers other cash crops is all gravy from the farmers point of view.

• So essentially Input has incentivized the farmer to max his canola output, giving upside for the farmer in the process. But remember, Input’s payoff is asymmetric: 20% base case return with no bonus tonnes (and farm insurance paying off in excess of Input’s contracted tonnes covering the downside protection) AND the farmer is incentivized to maximize their canola crop per acre so Input’s true IRR is materially > 20% given normalized expected bonus tonnes.

C’mon!?! Downside Protection in a Deal with VC like Exponential IRR’s?!?

Wow, now that we understand the specific crop yield enhancement ability of canola as the driver of exceptional rates of return for both Input and the farmer, let’s return to the downside protection aspect of the risk/reward equation.  I mean a high rate of return has to be risky, right??  Professor Fama from the Chicago Booth Business School just won a Nobel Prize for proclaiming markets efficient.  So there has to be downside does there not?!?!

How about no.  Here’s why:

• Crop Insurance: 70% of each farmer’s historical volume is insured by the Canadian government and Input sets their capital advancement threshold below this level. Meaning they ensure their investment will be fully covered in the event of a disaster. Notably, this insurance is backed by the Canadian government at both the provincial and federal level. Turning back to the point, crop insurance is based off of a 10 year weighted average on volume (with recent years given more weighting than the older years). Also the price is set once per year on or around December 15th based on forward market conditions and the crop environment. December is chosen based on normalization of price versus yearly volume both in Canada and US.

Keep in mind that given the expected volume increase in each farmer’s canola crop per year and the formula for calculating yearly insurance volumes, Input’s downside protection should actually increase yearly! (And yes, you read that correctly.) This is because every year a farmer produces a solid canola crop not only does Input get paid handsomely – the next year’s insured volume rises in lockstep with the farms increased production such that most future crop failures (outside of a truly Biblical esque multi-year plague) would result in a farmer getting paid well in excess of the amount owed to Input. This is a pretty incredible data point don’t ya think?

• Crop Substitution: Recall as well that only 1/3^rd of a farm is typically planted with canola.  This is not only scientifically superior, it reduces a farmer’s – as well as Input’s – absolute risk. What this means is that if a farmers canola crop fails, not only will insurance kick in but Input can lay claim to a portion of other commodities grown that year to hit their base tonnage requirement (which remember is underwritten at a ~20% IRR). So if the first point wasn’t enough to make the “pulse quicken and pocket book open” (as a young Warren Buffett put it long ago), this second point should certainly do the trick.

• 2^nd Mortgage on the Farm & related assets: Lastly, to ensure the farmer doesn’t spend Input’s upfront streaming payment wastefully, Input takes a 2^nd lien mortgage on the farm. This is simply another layer of protection on farmer misappropriation of the proceeds. Think of it as the third “escape hatch” built into every contract in order to essentially guarantee that Input will (at minimum mind you) compound its invested capital at 20 percent plus. Incredible!

Valuation Shift

In Part one of this report, at a then-trading price of $1.59, your Editors asserted Input Capital was trading at ~4.0x 2014E pre-tax cash flow. While this figure is clearly a much lower multiple than a business of this caliber ought to trade for, let’s double back on our assertion that Input capital can be a billion dollar company in 4 to 5 years while raising just $250 million in investor capital. And again, we assume Input raises all this capital at $1.60 every time, which is very (borderline stupid) conservative. We mean if one assumes a gradually rising stock price over time (as we do), and that the company opportunistically issues shares along the way, then Input would be left with far fewer shares than what’s taken into account below. Obviously per share earnings would be far higher in a less conservative/more realistic scenario but we’re sure you get the point.

Additionally, we’ve tried to be very conservative as as far as our book value exit multiple is concerned. Most stream finance industry experts tend to use a simple rule of thumb of 3x book – indeed, streamers often trade at 3x book.  Given the ROIC and the magnitude of the value creation runway here, Input certainly should. At least assuming things play out anywhere in the ballpark of what we expect, as in that case anything less is arguably intellectually indefensible. Just for fun though we went ahead and decided to triple down on conservative inputs for conservatism’s sake.

That in mind, note that in our March 2018 scenario, 3x book gets us to $1 billion.  The key is to get there without issuing any more shares than necessary.

Conclusion

As we have laid out in a macro sense in part one of this report and at a micro-level in part two, Input Capital is an owner operated, innovative high return business that offers a value accretive win/win value prop to both farmers and investors. Never before has the power of the streaming model been unleashed in the agriculture space by a public company. Nor has a streamer ever come locked and loaded with this level of downside protection or such predictability built in. Best of all, even after the run-up over the last couple of weeks we think Input remains not only nonsensically cheap but is set to move higher in the near-term (more on this in next weeks alert).

Clearly we like the risk/reward here. After all, as a first-mover in the space with the requisite knowledge earned through their private equity ownership of Saskatchewan farmland since 2005, CEO Doug Emsley and CFO Brad Farquhar have built an exceptional business which can reasonably be expected to transition its first mover advantage into a competitive advantage as a trusted, “go to “ provider of farmland working capital.

Enjoy the ride!