May 13, 2015

As a microcosm of the industry, Iowa offers the perfect example of the unpredictable nature of agriculture. Year after year, this state leads the world in corn production (it produced 2.4 billion bushels, or 17% of the entire U.S. crop, in 2014). Despite its abundant harvests, however, in some years it is still a net importer of corn. Any hiccup in production and the processors (primarily ethanol) must source supplies elsewhere to meet their needs and often at a premium price.

On the other end of the supply chain are the farms. With some of the richest topsoil in the world, farmland here is always in demand. But even this black gold is not immune to declines in commodity prices, and the recent downturn in corn prices led to an 11% year-over-year drop in land prices in Iowa, according to an April 2015 report by the Iowa Realtors Land Institute.

While production shortfalls and commodity price swings create abundant risk for both the upstream producers and downstream consumers, the flow of trade between these two is a constant that is as predictable as spring planting and fall harvest in North America. For investors in agriculture, this steady part of the supply stream – the midstream – offers opportunity for long-term returns in a relatively low-risk environment.

Investable, Scalable, Predictable

Midstream agricultural infrastructure is appealing from an investment perspective for a number of reasons. The opportunity factor is high, the level of risk-to-reward is low, and, unlike land, investments are scalable, allowing large amounts of investment capital to be put to work in short order.

1) The market remains highly fragmented, and even the largest players in this market control only a small percentage of the assets. This allows a holding company to assemble a portfolio of midstream agricultural infrastructure assets that contain the elements needed for a successful investment opportunity. It does so through a management team that has an in-depth understanding of this segment of the agricultural stream. Its thesis is to strategically acquire assets that are highly fragmented and create an origination network that can efficiently utilize established trade flow channels. Ideally, it will reach a relevant position in these channels so that it has the ability to effectively source freight, negotiate price, etc.

2) Midstream agricultural businesses are at a distinct advantage when it comes to managing risk. They have the ability to set price and they can use risk management tools to take commodity prices out of the profit equation.

If they have enough scale, they gain a number of advantages. For example, they can take advantage of market opportunities to direct grain movement to areas of highest demand, capturing premiums by hedging the futures market component of the price and instead trading the “basis” market. This much less volatile component of a commodity’s price is a key component in boosting returns for midstream companies with little added risk.

Midstream companies that have the ability to source and move product from areas of strong supply to strong demand can capture differences in basis levels that provide added value for investors.

Geographic diversity is another risk management tool, as well as a key to success for midstream operations. By spreading out locations and operating in multiple trade areas, potential risks can be minimized that are brought on by weather, crop disease and even trade-impacting political situations worldwide.

3) The limiting factor for many midstream businesses is investment capital. These businesses are typically well-known in their market, well-established and enjoy a loyal customer base. However, they are often cash poor. Midstream assets such as grain elevators and barge load-out facilities require significant amounts of capital to operate most efficiently. Often, these operations have been under the same management structure for years and even decades, so they are likely to be in need of upgraded infrastructure and technology to meet market demands and to maximize returns. As a result, immediate improvements in cash flow and the bottom line can be realized when these businesses have access to adequate capital, technology and a business model that more effectively utilizes trade flows.

Improve the Body, Preserve the Heart

Big River Rice and Grain is one example of how midstream businesses were assembled and recapitalized with an extremely successful result.

This newly formed company is made up of three former businesses in Louisiana and Arkansas. Unlike an acquisition strategy that purchases businesses to combine them and cut expenses, the goal with Big River was to create a new entity that’s truly greater as a whole than the sum of its parts.

With access to capital and a larger global partner in the holding company, Big River has already completed numerous improvements, which can result in improved cash flow and asset appreciation. What’s been created is an entity that will provide consistent cash flows for years in the future to its investors.

A key to making the entire acquisition work, however, is retaining the grower and customer base of these businesses. That takes a respect for the rural communities and the knowledge that these businesses have all been well-regarded community members for decades. Too often an acquirer will come into a small community without regard for the people, simply assessing the business on paper and making changes. In such localized markets, this approach can have disastrous consequences.

It’s true that these businesses must change their model for them to be sustainable into the future. But this can be accomplished through access to capital, technology and global markets when the right integrator is involved. And it must be done with a respect for those entrepreneurial-minded owners who built the businesses, and for the staff who are often loyal and knowledgeable with strong relationships with the customers.

The successful result can be measured when customers are retained, the business becomes more efficient and cash flows improve.

Flip the Cash, not the Assets

The temptation in a world of instant gratification is to achieve success with an asset like Big River and then quickly flip the company to capture the asset appreciation that has been gained. However, in this agriculture infrastructure investment model, the real value comes over time through generous, predictable returns at relatively low risk.

Like farmland, these valuable assets are rarely offered for sale. They are typically in locations that are ideal for their service and the barrier to entry for any competitor is high – if it’s possible at all. Purchasing land with the intent of establishing a new river terminal, for example, is a monumental task. Not only is the perfect location rarely available, the regulatory hurdles for building a new facility are extremely high.

Once an asset is added to the portfolio, the goal is to maximize the long-term value of it. It becomes a critical link in an increasingly stronger chain. Buying, improving and holding these assets creates stronger trade flows across the supply chain, which in turn strengthens the cash flow of the whole.

Should an investor need to exit a position, the last place the holding company should turn for capital is through the sale of an asset. Instead, new capital will be sourced to allow the investor to move on without weakening the chain that has been built. This establishes a long-term investment vehicle where cash can be parked safely and profitably for years.

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Brad Clark, Agspring

The opinions expressed in this editorial are the author’s own and do not reflect the views of GAI News.