Archer Daniels Midland (ADM): A Dividend Aristocrat Trading at Some of the Best Valuations in 20 Years

Historically, dividend growth investing has been one of the best ways for regular people to compound their wealth and income over time.

 

Of course, the trick is to be able to carefully select the best quality companies, those with high-quality management teams, strong balance sheets, predictable businesses, and dividend-friendly corporate cultures.

 

That’s why dividend aristocrats have become a favorite among income investors, because with their long-term (25+ years) streaks of annual dividend growth, aristocrats can be a great starting place to look for the kind of steady blue chips that have done so well in the past.

 

Investors can learn more about all of the dividend aristocrats here.

 

Let’s take a look at Archer Daniels Midland (ADM), one of the oldest and most time-tested members of this group (with 41 straight years of payout growth to its name), to see if this boring agricultural giant might be appropriate for a diversified dividend growth portfolio. Especially with shares offering a dividend yield that is near its highest level in 20 years.

 

Business Overview

Founded in 1898 in Chicago, Illinois, Archer Daniels Midland is one of the world’s largest food procurers, transporters, storage, processors, and sellers of agricultural commodities and products through its global network of processing plants, storage facilities, and transportation vehicles.

 

Or more simply put, ADM helps to feed the world, thanks to its immense business and geographic diversification. Some of the company’s end products include vegetable oil, protein meal, flour, corn sweeteners, starch, ethanol, and other food and feed ingredients.

 

 

The company has four main business segments:

• Oilseeds Processing (46% of operating profits in Q1 2017): processes soybeans and soft seeds into vegetable oils and protein meals. These products can be sold “as is” or further processed into salad oils, margarine, and more.
• Corn Processing (26% of operating profits): converts corn into sweeteners, starches, and bioproducts. Sweeteners include high-fructose corn syrup (HFCS), which is used in products such as soft drinks, cereals, bread, and other products because it is more affordable than sugar. Starches are also used in food production and as feedstocks for ADM’s bioproducts operations (ethanol).
• Agricultural Services (12% of operating profits): utilizes its U.S. grain elevator, global transportation network, and port operations to buy, store, clean, and transport agricultural commodities, such as oilseeds, corn, wheat, milo, oats, rice, and barley, and resells these commodities primarily as food and feed ingredients and as raw materials for the agricultural processing industry.
• Wild Flavors & Specialty Ingredients (11% of operating profits): one of the world’s leading flavors and specialty ingredients companies thanks to its Wild Flavors for $3 billion in 2014. Wild Flavors’ products include flavors, colors, sweeteners and health ingredients as well as ready-to-market concepts and complete solutions. SCI is a leading originator, processor and distributor of healthy ingredients, including nuts, fruits, seeds, legumes and ancient grains.
• Other (4% of operating profits): financial services.

 

Business Analysis

Archer Daniels Midland has been in business for more than 100 years and isn’t going away anytime soon thanks to several competitive advantages.

 

Most notably, Archer Daniels Midland’s core operations – procuring, storing, processing, and selling various agricultural commodities – are extremely capital intensive. The company has the largest grain terminal and shipping network in the country and maintains hundreds of processing plants and storage facilities around the world, for example.

 

These capabilities allow Archer Daniels Midland to be the lowest cost and fastest provider of its commodities and processed products to many customers’ facilities, where it delivers directly.

 

Replicating the company’s physical footprint; fleet of trucks, trailers, tank cars, river barges, towboats, and vessels used to transport its products; and its logistical expertise would be nearly impossible. With razor-thin operating margins in this commodity industry, there is no room for inefficiencies.

 

At the end of the day, the basic investment thesis for food companies such as Archer Daniels Midland is simple: everyone has to eat. That’s especially true with a growing global population and with faster-growing emerging markets (such as China) whose middle classes are increasingly consuming more western style diets.

 

Specifically, that means more corn-based products and meat, which is highly grain intensive (that’s what livestock is fed).

 

 

However, while these underlying mega-trends may be true, that doesn’t necessarily translate to steady growth in sales, earnings, or free cash flow (FCF) for companies such as Archers Daniel Midland.

 

That’s because, thanks to the highly commoditized nature of this industry, as well as the cyclical nature of agricultural products, Archer’s margins and return on shareholder capital can be highly volatile.

 

 

Then again, this has always been the case, so how exactly has Archer Daniels been able to deliver an impressive 41 straight years of dividend growth in this boom/bust industry? The answer lies in management’s long-term focus and adaptability to rapidly-changing market conditions.

 

While Archer Daniels’ existing businesses will continue generating cash flow for many years to come, it seems that the company’s management team recognizes that the company’s high sensitivity to commodity prices isn’t ideal. The 2012 drought, regulatory-driven ethanol business, strong U.S. dollar, volatile crop prices, and recent plunge in oil prices highlight some of the uncontrollabe struggles that Archer Daniels’ current business can face.

 

Perhaps unsurprisingly, Archer Daniels is gradually shedding low-return operations and moving into areas of higher value in an attempt to structurally improve its return on capital and remove some of the price sensitivity of the business.

 

 

Starting in 2012, management initiated a long-term turnaround plan that involved two main strategies. First, ADM would sell off non-core businesses (i.e. those with the lowest margins) and reallocate the capital into acquiring a number of higher margin businesses, specifically those in specialty foods products (such as the 2014 $3 billion purchase of Wild Flavors).

 

 

 

The next step would be to leverage the company’s world-spanning supply chain and large capital resources to launch numerous specialty products, which management believes can achieve at least $1 billion in new annual sales.

 

 

Finally, and most importantly in a commodity industry such as this, management is laser focused on achieving large scale cost reductions through numerous avenues, including synergies with the large number of recent acquisitions.

 

In fact, between 2013 and 2019 ADM hopes to cut over $1 billion in annual costs, including $275 million it achieved last year and another $250 million it’s on track to cut in 2017.

 

 

Of course this long-term turnaround still has a few years to go, and in the meantime the crash in commodity prices, combined with a plethora of divestiture and acquisition-related expenses has resulted in Archer’s profitability falling to very low levels, even compared to its industry peers.

 

 

That being said, while Archer certainly faces numerous challenges in the years ahead, dividend investors should take heart in management’s well planned turnaround for a higher margin future.

 

In addition, the company’s large scale and strong financial position continues to bode well for its long-term dividend growth outlook, thanks to management factoring in consistent payout growth into its long-term capital allocation plans.

 

 

Overall, it’s hard not to like the transition Archer Daniels Midland is making, and its set of hard assets is very difficult to replicate. However, the number of uncontrollable macro factors the company depends on for pricing many of its products and generating an acceptable return is still a major risk.

 

Key Risks

While Archer Daniels Midland is generally a low-risk dividend growth stock, that doesn’t mean that investors don’t have several concerns to consider.

 

First and foremost is that Archer operates in a highly competitive field. In fact, while its scale is large, it has three sizable rivals, including Bunge Limited (BG). And since Archer Daniels is essentially a middleman between farms and consumers, it is unable to achieve any kind of moat, meaning significant pricing power.

 

That means that its sales, earnings, and cash flow are driven by factors largely out of its control, including the weather, commodity prices (especially the prices of soybeans, corn, and oilseeds), and government agricultural policies.

 

For example, in 2011 and 2012 the severe drought in the U.S. resulted in far less demand for food processing (due to crop failures), which had a large negative impact on its operating profits.

 

 

Another risk is U.S. agricultural policy, specifically corn subsidies and ethanol mandates, which have resulted in corn becoming Archer’s largest and most important product over the past few decades. In fact, about 43% of ADM’s sales are from heavily subsidized agricultural products.

 

Any future reversal of these subsidies or decreased ethanol mandates (which cost U.S. consumers $6 billion a year in higher gas costs) could leave Archer in a very uncomfortable position, having to once again restructure its fundamental business model.

 

And it’s not just U.S. government policy that is a risk. Remember that Archer operates globally, which means that its long-term plans to diversify internationally need to be approved by foreign regulators, something that is far from certain.

 

For example, back in 2013 Australian regulators blocked the company’s attempted $3.1 billion acquisition of GrainCorp stating that it was “not in the national interest”.

 

That decision came as a huge surprise to industry analysts, especially given the favorable economic relationships between the U.S. and Australia, as well as ADM’s various promises to help win support for the deal. That included investing $200 million into expanding Australia’s grain export infrastructure (Australia is the world’s 3rd largest grain exporter behind the US and Canada) and limiting annual increases in silo fees.

 

Archer Daniels’ Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Archer Daniels’ has a Dividend Safety Score of 88, indicating that its payout is not just very safe, but among the most dependable on Wall Street.

 

That’s not surprising given the company’s dividend aristocrat status, and the fact that Archer Daniels Midland is set to become a dividend king (50+ consecutive annual dividend increases) in just nine years.

 

Such consistent and secure dividend growth is mostly a result of two factors.

 

The first is that management has a stated long-term policy of paying out just 30% to 40% of EPS in dividends each year. While earnings volatility in any given year can occasionally push the payout ratio above this level, overall Archer’s dividend is well covered by its earnings, providing a strong safety buffer during times of industry or economic stress.

 

 

The other major safety factor is the company’s strong balance sheet, including a large cash position, high current ratio (short-term assets/short-term liabilities), and low leverage ratio.

 

 

These metrics are important because Archer operates in a highly capital intensive industry, one that’s also cyclical and characterized by razor-thin margins.

 

That’s why management has wisely chosen to take a conservative approach to debt over the decades, resulting in Archer Daniels having a below average leverage ratio (Debt/EBITDA), low debt/capital ratio, and a strong (double digit) interest coverage ratio.

 

 

As a result, Archer’s cash flow easily covers its debt and short-term obligations and explains why it has a very strong, investment-grade credit rating.

 

A strong credit rating helps ensure that Archer Daniels has cheap and plentiful access to debt with which to invest in growing its business while still rewarding dividend investors with safe and steadily growing payouts.

 

Altogether, Archer Daniels’ dividend appears to be very safe. The company’s payout ratios are healthy, the business generates dependable free cash flow, and the balance sheet is in great shape. Even if commodity prices weaken further, it’s hard to imagine a scenario that jeopardizes ADM’s dividend.

 

Archer Daniels’ Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Archer Daniels’ Dividend Growth Score of 42 indicates about average long-term dividend growth potential. That’s not surprising given the company’s strong, long-term payout growth rates over the decades.

 

 

Of course the key to strong and steady dividend growth, especially given management’s targeted 30% to 40% EPS payout ratio range, is the company’s ability to overcome its recent industry challenges and achieve the strong long-term growth that analysts think is possible.

 

Specifically, that includes increased demand for soybeans and grains (from long-term rising meat demand in emerging markets) and ADM’s move towards specialty foods, which should allow long-term sales growth in the low single digits.

 

Combined with ongoing cost cutting and higher specialty segment margins, as well as share buybacks (4.6% annually over the past five years), this should allow ADM to hopefully achieve low to mid-single-digit annual EPS growth over time, although the path almost certainly won’t be linear given all of the macro sensitivities the business has.

 

That level of earnings growth should likely translate to around mid-single-digit annual dividend increases over the long-term.

 

Valuation

Over the past year, concerns over ADM’s short-term growth has resulted in shares underperforming the S&P 500 by close to 20%.

 

As a result, ADM’s current forward P/E ratio of 15.4 is much lower than the industry average of 20.2 and below the S&P 500’s forward P/E of 17.8.

 

Meanwhile, ADM’s current dividend yield of 3.1%, in addition to being much higher than the market’s 2.0% payout, is also much greater than the industry median (1.9%), as well as the company’s own 22-year average payout of 1.9%.

 

In fact, right now Archer Daniels Midland’s dividend yield is higher than 76% of its global peers and in the top 5% of its own yield over the last two decades.

 

At today’s share price, long-term income investors can probably expect annual total returns of about 7% to 9% (3.0% yield + 4% to 6% earnings growth), assuming macro conditions do not structurally change for the worse.

 

Conclusion

Archer Daniels Midland, despite its dividend aristocrat status, ultimately depends on a number of factors outside of the company’s control – corn and soybean prices, oil prices, ethanol regulations, and government subsidies.

 

While management appears to be making the right capital allocation moves to gradually diversify the company into higher-returning areas that are less susceptible to swings in commodity prices, these actions also suggest that management might be less optimistic about some of Archer Daniel’s existing operations.

 

With that said, the company’s dividend remains very safe and offers reasonable growth prospects, but shareholders ultimately need to be optimistic about macro headwinds abating and ethanol mandates remaining favorable.

 

Trading near their 52-week low, ADM’s shares are starting to look interesting. However, for a company with such high reliance on commodity prices and government subsidies, ADM seems more like a trading stock to me rather than a core long-term investment – even despite its quality management team and strong balance sheet.

 

Investors seeking safe income from more predictable businesses should consider reviewing some of the best high dividend stocks here instead.