Jan 25th, 2015 by aboveaverageodds
Editors Note: While I initially started cobbling together part 3 a couple of weeks ago prior to the January 6th press release (see the link below), unfortunately the stock proceeded to shoot up ~15% on something like 10x the average daily volume on the news. Yet given an inexplicable 8% selloff a few days after in the face of what I believe to be a legitimate “game changer,” not to mention a major de-risking event, I decided to go ahead and post what remains for those of you who continue to be interested in the longer-term story at Input – with promises of bringing it all together come next week for part 4.
Keep in mind that while normally I’d take the time to update part 3 prior to posting, due to an unusually busy schedule over the next week I simply don’t have the time. In fact, I haven’t edited it much at all at this point and it’s probably twice as long as it would be if I had the time to refine it the way I’d initially intended. Regardless, hopefully members will find it a worthwhile read despite these shortcomings. I think it will be worth the effort – and again, expect a fully up to date part 4 the week after next.
At any rate, the positive initial reaction was definitely warranted and largely due to Input’s ability to deploy another ~$16.9m into an additional 26 canola streams in the month of December alone, a data point that is particularly notable in a number of key respects.
For example, the announcement gets the company almost half way to their full year (2015) guidance of $40m, a mere one month into “deployment season”, a period that typically spans from January to May. This was a surprise to say the least given farmers are typically focused on their operations in the October through December period, not to mention the fact that last year the company didn’t deploy any cash until well into January. Point being, the Jan. 6th update may be the most important event in the company’s history, as it highlights the huge demand for Input’s services as well as the long-term viability of its high quality business model. It also hints at what I’ve believed for some time. Namely, that the size of Input’s total addressable market will prove to be much larger than what is currently reflected in the company’s current quote.
As always time will tell.
Also, if what follows below comes off as disjointed, keep in mind that certain sections of the original piece have been cut given they don’t reflect the latest numbers, in particular the valuation section and a few others that imo were to “early stage” to bother including. Nonetheless, what remains should be plenty sufficient to drive home why I continue to believe the stock is materially mispriced, even if certain parts are somewhat dated.
So with that, enjoy!
1 Year Later – An Annual Review
So what’s new?
At a high level, not much. INP remains the world’s first and only agricultural commodity streaming company (no natural comps) focused on providing farmers with upfront cash in lieu of a multi-year, high-return Canola royalty stream. Streams characterized as much by their ability to mitigate risk as by their ability to generate outsized IRR’s. (check out the Q&A at the end of part 2 for some color in terms of the multi layered and essentially government guaranteed downside protection)
Furthermore, armed with what is now a proven model, a hugely lucrative win/win value proposition, roughly $60m in cash to deploy at highly attractive returns, not to mention an almost stupidly large addressable market relative to its current stream count, Input’s potential to sustain a high rate of increasingly profitable growth in both the short and long-run is utterly tremendous. Yet the company remains poorly understood and substantially under-appreciated.
Granted, I suppose this shouldn’t be all that surprising in that Input, like most unique, newly public businesses with no real public or private peers, is naturally a strong mis-pricing candidate. Names like GOOG, MERC, MA and MCO come to mind, all of which looked statistically expensive through the rearview coming out of the gate but turned out to be anything but – indeed, they proved to be tremendous bargains for those willing to look 12 to 24 months out. I think a similar dynamic is playing out here.
In any case, slow canola realization from the 2013 harvest and a variety of other temporary issues – such as an abnormally harsh winter, logistical issues that affected rail availability (congestion resulted in delayed Canola shipments due to a lack of takeaway capacity) and a falling canola price – ultimately drove the stock back below last summer’s $2.30 secondary issuance. The thing is, at~$2.12 per share, I’d argue the present set up offers the single most attractive risk/adjusted reward since the company went public in the middle of 2013.
For starters, Input has started to generate cash as well as proven itself in a variety of key ways over the last year. Whether we’re talking about basic blocking and tackling like arbitraging canola pricing for partners, sourcing capital on increasingly attractive terms, deploying that capital back into new streams at even better terms, etc. it seems pretty clear the business has come along way. Indeed, the only question marks that remain revolve around the absolute size of Input’s addressable market and how quickly the company can scale, two questions I intend to address in detail throughout this update.
Regardless, the business has largely turned the corner and management continues to execute on all fronts. The result is an investment opportunity that has been substantially de-risked, which is why I think it makes a ton of sense to use this latest pullback to either initiate or add to a position. After all, if my appraisal of the situation is even in the ballpark of being correct, time to get in cheap may be running out.
Game Changing Inflection Point
Perhaps the most surprising aspect of the current set up is that “capital deployment season” is right around the corner, and yet the market appears unwilling to assign any credit for the step change in cash flow that should result if management executes according to plan.
Realize that INP will be deploying another $40m + into new streaming contracts at IRR’s of 20%+ over the next few months. Contracts mind you that (at current canola prices) should not only lower INP’s all in costs but come with substantial embedded optionality should pricing ever revert to a level more commensurate with long-term supply demand dynamics. And that’s to say nothing of the fact that the move will effectively double the value its existing streaming portfolio in one fell swoop, further diversifying it’s revenue streams and the geographic diversity of the business.
Point being, I think success on this front should be a “game changer” for INP in the truest sense of the term, effectively demolishing any and all concerns surrounding demand for Input’s services and the scalability of it’s high quality business model.
Which brings me to Input’s present valuation.
Assuming Input successfully invests the $45m in “deployable” cash currently sitting on its balance sheet by the end of the first quarter, the implied pro forma multiple on INP’s normalized or “fully loaded” cash flow would be in the mid to high single digits depending on your view of mid cycle canola prices. A multiple that is far too low in light of the companies management, low risk, high quality operating model as well as the open ended growth runway in front of it, amongst other qualitative factors that have yet to be properly incorporated into Input’s share price.
So riddle me this dear readers. Does it make sense for a competitively entrenched market leader operating in a rapidly growing niche in a growing industry…one capable of sustaining a rapid rate of highly profitable growth driven by accelerating market adoption and funded entirely by internal cash flow for years to come no less…to trade at a mere mid single digit multiple to normalized cash flow?
What about if that same business is run by a proven group of visionary owner operators who not only own ~20% of the company, but possess an objectively superb paper trail vis a vi strategy, operations, and capital allocation?
I think not.
Especially when its highly attractive model has already been recognized by investors as particularly lucrative. After all, all one has to do is look at the valuations of most comparable publicly traded businesses of a similar nature to get an idea of what I’m getting at – as each and every one trades at multiples approximating twice where Input trades today.
Note too that in Inputs case we are talking about a business whose flexible model should be able to compound at 20 to 30% a year simply through organic cash deployment. Of course the actual rate of compounding could prove materially higher depending on future equity raises, but at this point per share value should grow exponentially without raising another dime.
Yet the implied valuation on INP’s “fully loaded” cash flows doesn’t reflect any of this.
At any rate, management continues to deliver on the pioneering strategic plan laid out shortly after the company went public last year. And I’ve never been more confident in their abilities or the long-term prospects of this business. In fact, I’d argue the company’s goal of forging an enduring compounding machine set to absolutely dominate a massive and dramatically underserved segment of the agricultural value chain is all but assured at this point. Especially considering the threat of a successful new entrant is extremely low, at least over the medium-term.
(And besides, given the size of the total addressable market there should be plenty of room for two, or three, or even four players …not saying we’ll see that, just that the “TAM” appears large enough to support more than one player without driving down returns on capital.)
So for these reasons and more, odds appear rather good that the days of an unsustainably low valuation at Input Capital are numbered. But to understand why that is, let’s turn to how Input got so cheap in the first place.
Why’s it so Cheap?
At the core of the current downdraft, I think a number of factors are at work – all of which are helping to drain investor confidence:
- Energy & agricultural markets are making people nervous (especially in Canada given relative focus on energy vis a vis the US)
- Soft canola prices are making people nervous
- Slow capital deployment is making people nervous
- A myopic, quarter to quarter view makes people nervous
The thing is, none of these things make me nervous. And for good reason. Heck, investor confidence should be getting better. Much better but it is what it is. In the meantime I’ve simply been adding more.
On the above points…
1. Commodity/energy issues are driving Markets, which is making people nervous
Obviously there isn’t much anyone can do about macro driven market fears, other than to stay focused on the fundamentals (and the “right things” generally), which as far as canola is concerned remain by all accounts quite solid. Of course what happens in the energy markets (barring say a junk bond induced contagion across the capital markets as whole) is irrelevant anyway. And the long running period of tough agricultural prices we’ve seen of late can’t go on forever. If anything, the time to invest is when the short-term challenges are already well known/priced in and hence set to abate sooner rather than later. So periods like today.
That, and it would seem that the long-term viability of Input’s business is no longer in question. If anything, it’s long-term prospects look better than ever. Add in a rock solid balance sheet and an ability to fund growth via internally generated cash flows that makes the health of the capital markets largely irrelevant and I’m at a loss for why long-term shareholders would be nervous. I mean it’s not as if Input needs access to capital at attractive rates to execute its business plan. Indeed, trouble on the capital markets front may actually accelerate progress in that regard.
Then there is the additional comfort that comes from knowing that Input’s financing unlocks real value for farmers on a regular, ongoing basis. A fact that is far more important than say cyclical swings in canola pricing when it comes to to approximating future demand for Input’s services.
For example, one good way to gauge the overall level of demand for Input’s services is to consider just one of the structural drivers briefly touched upon in parts 1 and 2, namely the massive intergenerational transfer of farms set to take place in Canada over the next five years.
With the average age of a Canadian farmer approaching 55 to 60, Canadian farmers as a whole aren’t exactly spring chickens, nor are they likely to get any younger barring the discovery of the fountain of youth. Thus it shouldn’t surprise anyone then that reliable survey’s estimate that a whopping ~75% of these farmers plan to retire at some point over the next 10 years. The thing is, according to those same survey’s, nearly all of them lack a succession plan of any kind.
In light of that, a couple of points should immediately stick out…
For one, we are talking about an absolute fu*k ton of farmers looking to retire and thus, a truly massive market opportunity before Input. Remember that there are over 52k Canadian farmers, so if almost half plan on retiring over the next ten years, then we are looking at a sea of sellers potentially tens of thousands strong. Actually, a tidal wave is probably more accurate given the sea in question amounts to roughly 25k farmers on the high end of the range. Heck, let’s cut that number in half and we’re still looking at a number approximating 13k farmers looking to retire. That’s a lot of farmers no matter how you slice it.
If it’s not exactly clear how INP stands to benefit from the above data point stay with me…it will.
For those of you in this camp, for now I’d think about the market opportunity like this: if recent estimates are credible (and I believe they are), roughly 50% of Canadian land assets worth some $30 billion are set to change hands over the next five years – and that’s just in Saskatchewan alone. Clearly then, we are talking about a truly massive market for any company who can make good money facilitating said transfers.
Second, it doesn’t take a genius to realize these farmers can’t work forever (makes one wonder how many active farmers continue to work past the age of 75…or 70 for that matter). And given that, it seems rather likely that the average farmer will need to find a buyer at some point over the next ten years. After all, farming is by its nature a high impact endeavor that takes a very real physical toll – so this isn’t investing where retirement can be put off indefinitely as long as your mental faculties remain in tact. Far from it.
Third, of those farmers planning to retire, realize that nearly all of them MUST sell. As they’ll need to recoup their capital for retirement…otherwise they’ll have nothing to live on. In other words, over the next decade it seems relatively certain that say 10 to 20k farmers will need to get out of the farming business to fund their retirement, that is unless they plan on working until they literally drop dead.
Hint, this is where it gets interesting…
To make matters worse (or better depending on your perspective), given the relative scarcity of youngish farmers with the necessary financial wherewithal to take these farms of retiree’s hands, it should be clear to even the densest of observers that these older farmers have a significant problem. Especially when you take into account that the average 4k acre small farm in Saskatchewan goes for about $6 million and change these days – and that’s before labor!! Which is a lot of dough for anybody, but especially for cash strapped farmers in their early 30’s and 40’s who simply aren’t old enough to have amassed that kind of wealth.
Keep in mind too that Canadian farms have been appreciating at a tremendous clip for years making an already difficult situation even more difficult. In 2011 for example, land values increased at ~14.3%. In 2012, land values increased ~19.5%. In 2013, land values increased ~22.1%. I could go on but I’m sure you get the point.
As far as rising land values, to be clear, I highlight the trend not because I expect it to continue. If anything, I expect it to reverse and probably sooner than later – as it appears Canadian farm assets are priced far above their productive value and with so many farmers looking to sell, there should be substantial pressure on farm values by definition. But I think it’s important to outline in brief as it provides some much needed color vis a vis the current set up.
Anyhow, safe to say then for young farmers still in the early stages of their career, coming up with a chunk of change of this magnitude is no easy feat. Again, given their relative youth, the odds that they’ll have the cash reserves necessary to finance such a large purchase are low pretty much by definition. And even if they could qualify for a loan of that size ($6m +), there would still be some serious doubts about whether such a loan makes economic or strategic sense in the first place.
For example, even if these hungry, capable young farmers could find an institution to lend to them with little to no money down, at an affordable interest rate…lets say at 5%, with a LTV of 100%…odds are they’d still be in a very difficult position. As they’d still be working capital poor, lacking the additional capital needed to optimize what is now a far larger farming operation. To grossly oversimplify the situation – if the farmer in question’s farm is now roughly twice as large, all things equal he or she would require roughly twice as much capital to optimize their farming ops. Capital they still won’t have despite taking on more debt and having a very real need.
So, you can see why the thought of purchasing an additional farm for those with ambitions to do so might be a nonstarter, or at least an intrinsically high risk endeavor with little margin for error.
Luckily for a) the tidal wave of sellers and b) capable and hungry young farmers looking to expand but short on cash, Inputs here to help on both sides of the transaction (cue Superman theme…kidding).
You see by stepping in with the requisite capital and expertise to help these young farmers not only get bigger but materially more efficient as they grow, Input helps maximize the number of buyers in a position to purchase farm assets while maximizing the profits those farmers will earn along the way.
Or to say it another way, Input is in a position to help these young farmers not only grow their acreage in a prudent and measured way (helping them qualify without say taking on too much debt or overextending themselves in the process), they’re able to help them maximize the overall productivity of that newly acquired acreage in lockstep. In the process, Input should do its part to help alleviate the massive shortage of buyers needed to facilitate a smooth transition vis a vi the intergenerational transfer of farming assets on the come, and in a manner where everyone involved is better off.
But wait, there’s more!
Last but not least, note the the above demographic driven bottleneck will be further intensified by what is perhaps the most important point of all. The fact that Canadian law by and large restricts public corporate ownership of farms, thus the intergenerational transfer that must take place must be facilitated between individuals as opposed to corporations. In other words, unlike in the States, where massive, publicly traded agricultural companies drove the consolidation of US farming assets, the future development of the Canadian agricultural industry will look radically different. This is because “Big Ag” is legally prohibited from even attempting a similar consolidation in Canada.
Of course just because “Big Ag” can’t drive a similar consolidation, that doesn’t mean Input can’t do its part. Granted, Input is publicly traded, but remember it doesn’t take an underlying ownership position in the underlying real estate, nor does it take an actual interest in their partners farming assets per se. No, Input is compensated through a specified number of Canola tonnes set to be delivered over a specified number of years. Which is genius, as not only does this arrangement align incentives in a uniquely powerful way with the farmer, it also happens to provide the company with an end around the existing legal framework that larger ag focused businesses lack.
Take a minute and think about that last point, as it’s the lynchpin that will ensure an enormously powerful tailwind remains at Inputs back for years to come. One that should result in steadily growing demand for Input’s services pretty much irrespective of cyclical swings in the price of canola or the health of the general economic environment.
Before I move on, consider the following charts on Saskatchewan farmland transactions…as they illustrate my last point quite nicely.
So, with the above refresher out of the way, I’m sure we can all agree that any firm with the requisite skill set and financial wherewithal to step in and facilitate these transfers sits in a truly enviable position (read: those with the means and expertise necessary to help alleviate this increasingly large problem). Yet to say INP is extremely well positioned to exploit this trend isn’t quite accurate. Indeed, they are quite literally the only game in town and odds are they will remain so for quite some time.
Remember it took Input’s management nearly 8 years of working side by side with farmers in their prior venture to develop the relationships and expertise necessary to put the puzzle pieces together in the first place. Trust is key and not easily won, and besides, it takes years of building up the requisite domain expertise to be able to look at an individual farm and effectively handicap how the farmer looking to partner can realistically farm both better and smarter. Not to mention all the experience necessary to structure the contracts in a way that properly protects the downside in case things go wrong. After all, not only is every farm different, every farmer is different and hence every farmers needs will be idiosyncratic – thus, the solution to operate their farm in a way that maximizes results and minimizes risk will be different every time. Naturally, underwriting such contracts effectively isn’t a skill set that one acquires quickly or easily. Anyway, I could go on and on but I’ll spare all of you by simply stating that anyone that thinks capital is all one needs to compete in this business is flat out delusional.
On more thing before I wrap it up and move on.
Note that the only other player set up to help ease the burdens of this generational transfer – at least as far as I’m aware – is Farm Credit Canada (FCC). FCC is owned by the federal government and therefore in a great position to help and make some good money along the way. And thank God for that as absent government assistance its hard to imagine how it all would shake out otherwise. Note too that this help is actually beneficial to Input (in a backdoor kind of way) given that when the buyer uses FCC’s low-cost mortgage financing, they will almost always use up all their working capital on the downpayment, which of course leaves a working capital hole in the wake – again, one that Input is ideally suited to help with.
I guess my main point concerning the FCC is that the great thing about family farms is that they need to be recapitalized every generation. And Input is here to help.
This is a BIG market with real barriers to entry and INP is the first and only company with the ability to leverage it for financial gain in a number of hard to replicate ways. And again, none of that is likely to change anytime soon. So getting nervous over weak energy and agricultural markets to the point of getting shook out of your position is crazy as well as embarrassing. Please don’t be “that guy (or gal)”.
It’s also a VERY big deal! For the first time ever, a small company like INP can hold and maintain unique advantages in the most attractive niche in the agricultural value chain – a niche that the company itself created. If INP can capture even a fraction of this market over time, the upside from the current quote stands to be substantial, easily multiples of the current stock price. That much should be obvious.
Which again, is a great reminder why worrying about weak agricultural markets or stock market volatility driven by short-term swings in the price of canola, let alone the price of oil and gas, is honestly flat out nuts. Or at least that’s how I see it.
2. Soft canola prices are making people nervous:
Here we have yet another non-issue for a number of reasons. If anything, the tough period in agricultural commodity prices of late offers savvy investors an opportunity. Granted, I, nor anyone for that matter, has any ability to predict where prices will be six months or even a year from now. Yet even so, that doesn’t prevent me from saying with a relatively high degree of confidence that looking out over the long-term, all signs point to higher prices over time – at least based on the fundamentals and a number of other factors such as the crops structurally attractive supply demand dynamic.
Now if my opinion and quasi forecast bores you, I for one certainly wouldn’t blame you. In fact, perhaps I should just get straight to the point by stating the best cure for low prices is low prices and leave it at that. I honestly think it would be sufficient.
In any case, for those of you who want a bit more than that, realize that the importance of agricultural products like Canola continues to grow globally thanks to a number of secular tailwinds that show no signs of letting up. This makes Canola’s demand profile not only unique but unusually resilient and largely recession resistant relative to most commodities. It also helps explain why demand has grown at well above average rates pretty much non stop year over year, every year, for well over a decade – and why this trend should continue for sometime to come.
So while in many ways your editor is a professional worrier, in this respect I’d counsel you to have no fear. Why? Because despite the recent negative supply/demand imbalance in canola that has undergirded recent price weakness worldwide canola demand remains both strong and growing, primarily thanks to healthy growth across a number of canola’s diversified set of secular demand drivers. Drivers that should easily absorb the recent glut in supply in short order.
That said, for any of you looking for a refresher on the above drivers, note they include Canola’s growing applications in various industrial uses, as well as it’s clear health benefits, and a very real “healthy living” megatrend across the developed west that shows no signs of letting up. That, and in a world that continues to produce more and more middle class people the demand for higher protein diets should increase in tandem. This is because it takes 3x more grain to feed cattle than it does a person, so it’s easy to see how a growing middle class will naturally give way to steadily increasing oilseed (canola) demand for a very long time yet to come.
If anything then, supply will be the issue as Canola consumption is expected to grow ~20% over the next three years based on independent demand drivers that remain in a strong secular uptrend. If you doubt this, note the oilseed complex as a whole has only seen demand contract year over year one time in the last 25 years. Think about it like this: historically speaking, whenever a negative imbalance between supply and consumption materialized, supply led pricing pressure ended up whetting the appetite of end users sufficiently to cause consumption (demand) to rise even faster, eliminating the temporary oversupply pretty quickly. So unless your a malthusian or a card carrying member of the doomsday crowd, why you wouldn’t expect something similar to play out here is beyond me. Indeed, the above dynamic is as old as time and exactly what should happen here. Eventually.
Again, low prices will continue to be the best cure for low prices.
And besides (while we’re at it), why anyone interested in a potential investment in Input, at least those in their right mind, would prefer higher prices given Input is set to deploy potentially ~$90m + over the next few years, is beyond me. As a soft canola price environment is a wonderful environment in which to sign new streaming deals. Not only does it lock in lower all in cash costs, but it sets up a dynamic that could drive substantial operating leverage over the life of the contract as Canola prices normalize.
I mean how many more silver streams do you think Silver Wheaton would like to have done at $8 silver?
Now perhaps your concerned that the demand for INP’s streams in a low price environment will meaningfully slacken. Which is another way of saying that you worry that the company won’t be able to put all that capital to work given farmers understandable preference to strike a streaming deal in high price environments (as much as you wish they could). I get it, if only because it’s 100% natural for farmers to prefer to do deals in high canola price environment’s as the all in cost of those deals will be less expensive than when prices are low by definition.
Why is that? Well, when these deals are struck remember that they obligate the farmer to deliver a fixed amount of tonnage every year over the life of the contract, so any deal struck when prices are low automatically becomes more expensive if prices rise/normalize after the fact. In other words, the ideal time to do a deal from the farmers point of view is at a cyclical top, not a cyclical bottom like we have today.
Even so, I think this worry is a complete non issue as there are offsetting factors that are beyond the scope of this discussion, as well as a number of great reasons for farmers to do streaming deals completely outside of cyclical price considerations (usually these deals will be more related to accomplishing strategic goals such as purchasing a neighbors farm). Of course with deployment season right around the corner, we will know soon enough if recent lows in canola end up restricting INP’s ability to put money to work.
Another reason to look at cyclical swings in pricing as a relative non factor worth worrying about when estimating Input’s intrinsic business value has to do with the way these deals are set up. Specifically as it relates to the length of each contract. For example, because Input’s contracts are only 6 years in length (compared to the life of the mine with metal streamers), the company’s portfolio is akin to a cycle neutral bond ladder that responds to the price cycle. And because food is always consumed instead of stacked up like gold or silver, there’s always a fresh new market to supply every year.
Moving on, let’s address the topic that is probably on everyone’s minds by now – what is a proper “mid-cycle” or “normalized” canola price? Or said a bit differently, has your previous estimate from part 1 & 2 changed at all? And if so, why?
The answer to the latter question is no. As far as the former, it appears most industry observers believe that an appropriate mid cycle canola price estimate approximates $500/t, or a level exactly in line with my own, which remains the same as it was late last year.
Also, management estimated as much in a recent call of mine – noting that they see prices fluctuating between $400 and $600 over time, with the understanding that the higher or lower the price, the less time it will stay there. Interestingly, they expressed they’d be willing to bet that the spot will fluctuate between $450 and $550 about 80% of the time over the life-cycle of a contract.
Q: While a $500 mid cycle price is great and all, but what happens if prices stay depressed or go lower from here for a long time before returning to $500 or above (as you estimate)? Could Input start burning significant amounts of cash for a sustained period of time? How much flexibility does the business have if your completely wrong about the direction of canola pricing in the medium and long-term?
Well, for one, that would be fantastic for all the reasons already discussed above. So let’s hope they do. The more money INP can invest while prices stay low the better if my estimate is correct. As far as the question on burning cash, my answer is that there is basically zero chance of this happening…at least for any significant period of time. In fact, as you’ll see below, odds are extremely high that this is a business that should generate excess cash at every point in the cycle.
As far as the last question, I’ll defer to others on that answer but it’s a great one, as it gives us a great opportunity to discuss/highlight some important insights about the substantial advantages that come from operating such a high quality model (not to mention the enormous downside protection it provides).
So, to illustrate the above advantages, let’s turn to the following analysis from Canadian investment bank M Partners whose report from September lays it out nicely…
“Despite being unfounded, we believe recent weakness in the canola price could hurt INP’s share price, driven by the classic Keynesian beauty contest, “…we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
There are four reasons why we believe short-term canola price weakness should not result in INP share price weakness:
- INP locks in its basis level shortly after harvest and signed delivery contracts at prices that the company considers attractive based on its view of the then upcoming harvest. Input’s quarterly average realized price per MT has been consistently higher than the average cash price each quarter by an average of 11.2% per quarter. At 11.2% above the current Nov14 ICE exchange spot price of $393.60/MT, you arrive at $437.68/MT, well above the average all-in cost/MT of $300.
- Given significant cash on the balance sheet of ~$60M, the company has the ability to shift the sale of canola in and out of quarters in order to best time seasonal market prices. The current canola price weakness is reflective of seasonal weakness as the November contract represents the ‘harvest price.’ Farmers mostly sell into this contract in order to have sufficient working capital for the following year resulting in seasonally low prices (excess supply). INP has the ability to defer sale into the future when prices normalize resulting in its above average selling prices.
- Although INP has the flexibility to shift sales of canola in and out of quarters, as discussed above, most farmers do not. As canola prices weaken and farmers become concerned that the price might dip below the price required to comfortably finance the following years harvest, it provides a great marketing opportunity for INP. The company has already noted that it is capitalizing on weak canola prices to market their model, similar to rail delays causing the inability to sell canola last year. INP’s model de-risks canola price movements as it impacts a farmers working capital.
- Short-term canola price weakness has limited impact on the sum of the parts for INP as the company’s targeted IRR of ~20% is achieved with a 6yr average selling price of $410/MT. In Figure 1 we exhibit a 6yr average canola selling price sensitivity to the company’s IRRs, assuming an average all in cost of $300/MT, the average of its existing contracts. In Figure 2 we exhibit the rolling November contract price going back to 1982. Although the dynamics of the canola market have changed over time, it does exhibit that prices do move cyclically and are generally on an uptrend. Investors must therefore look beyond month-month canola price movement and put it in the context of INP’s 6yr canola contract. In a weaker canola price environment management has noted they can lock in slightly lower all in costs/MT in order to temper some risk of short-term canola price weakness.
For these reasons we believe it prudent that investors utilize a NAV calculation concurrently with P/Adj. CFPS. We use a NAV at a 20% discount rate on INP’s Adj. CF as it encapsulates the life of the existing contracts and a terminal value assuming a conservative 2% growth rate and 10% discount rate. When utilizing a NAV, single or multi-quarter shifts in canola prices downward have a very modest impact unlike a one-year forward CFPS which consensus utilizes to value INP. Within this context we believe any share price weakness reflective of short-term canola price movements should be capitalized on by investors cognizant of the insignificance short-term price weakness has on INP’s 6yr contract IRRs.
Input continues to execute; deploying capital into new contracts, diversifying geographically, and selling canola at an average 11.2% premium to spot, reflecting the strength of the company’s marketing program. We continue to rate INP a BUY, with a $5.00 target, based on 12.5x our F2016E adj. CFPS, supported by 1.0x NAV of $6.10. INP is currently trading at 5.8x F2016E adj. CFPS and 0.4x NAV, this compares to peers at 17.0x 2015E CFPS (SSL at 11.7x) and 1.4x NAV”
All great points for sure!
Lowest Cost Wins…
As readers of this blog know well, wether we are talking about canola or any commodity for that matter, when your operating in a commodity industry whoever has the lowest cost of production wins. Always. After all, things can always get worse before they get better and stay that way for longer than you’d rationally expect. Given that, the odds of staying alive for any commodity driven business are naturally much higher the lower down the cost curve a business finds itself. Thus, if you own a commodity driven business, the lower your cost the better your business and the less you have to fear from temporary price locations in the commodity that supports it.
That in mind, let’s walk through some examples that highlight the fundamental quality and overall flexibility of Input’s business model as it relates to falling prices. After all, at the very least they will help illustrate why INP should generate positive cash flow under pretty much any reasonable future scenario I can imagine. It also offers some very powerful additional data points that should make anyone considering a position stop and think about the many layers of downside protection supporting the present valuation – first liens and government guarantees aside.
For example, assuming my estimate of INP’s average all in COGS of ~$288/t is correct, a number that’s inclusive of both cash costs and the MCapex associated with its upfront payment, note its still well below the absolute lows in Canola ($353/t) in the midst of the financial crisis. In other words, even if we assume a further collapse in pricing along the lines of what happened in the worst recession since the great depression, INP will continue to generate cash.
Let’s get a little more extreme though and use the average price of Canola over the last 30 years (which is really downright silly given how much things have changed over this period but let’s run with it…). Yet even here, it’s still higher than Input’s run rate all in costs, costs mind you that will go much lower as INP pours money into new streams at much lower Canola prices.
Then there’s the global canola consumption/production ratio, a commonly used metric to determine price direction and how it’s supportive of current prices but by now I’m pretty sure everyone gets the point so let’s leave it at that.
Of course we could discuss how the rolling five year average Canola price is ~$535/t, a level that’s substantially above the present spot as well as my normalized estimate used in my valuation estimates, or other reasonable future scenarios and the implications that flow from them but I’ll leave others to explore upside scenarios on their own time.
3. Slow capital deployment is making people nervous: Input Capital’s “deployment season” is highly seasonal
Of all these reasons to get spooked in this stock, perhaps this is the absolute dumbest of them all and the best illustration of how even a full year in to its new life as a public company Input Capital remains poorly understood.
- The company announced only $201K in deployment last quarter, but that is a quarter in which they never expected to deploy capital in the first place. This is because farmers are busy farming.
- In fact, they’ve never deployed a single dollar in the October thru December quarter, yet many analysts still expect them to do so.
To use a farming analogy, the lead up to Christmas is Input’s season to plant a lot of seeds in the minds of farmers and lay the groundwork then harvest that activity in the form of streaming deals in the January through May period, period otherwise known as “deployment season”
Misunderstandings aside, a legitimate concern vis a vis capital deployment – one that I’ve been monitoring carefully since my original investment, is how exactly management has been going about building the backbone of a platform capable of sourcing a geometric increase in deal volumes without sacrificing an inch in terms of underwriting quality or depersonalizing the personal and “hands on” nature of these partnerships. In fact, it’s a critical concern, so naturally I’ve spent quite a bit of time pressing management on the scalability issue. In particular, the specifics of how they’ve been going about creating a premier platform, one capable of rapid scalability and the potential to leverage for years to come.
That said, the good news is that after pressing management for some time now my worries have largely abated. Time will tell as far as exactly how successful they’ll be in this regard, but at the very least the “grand master plan” makes a ton of sense to me and I’m highly confident they’ll get it right. And besides, to date they’ve delivered exactly as they said they would.
For any of you skeptics out there, I encourage you to reach out to management on the topic as I’m sure you’ll get exactly the type of candid, thoughtful answers that is the hallmark of my interactions with these guys. Indeed, I’ve found them to be rather exceptional across the board. Of course I could always be a bit delusional too!
Towards that end then, I’ve copied “an exec that shall not be named” response below from some of my pestering a few months back.
“We are prone to try to under promise and over deliver. I have tried to avoid specific guidance, preferring to let analysts draw their own conclusions. But I will usually tell them where I think they are out to lunch, or where they get materially off course from my own internal figures. The closest we come to guidance is with the future tonnage volumes we publish on page 21 of the corporate presentation, but I really see that as disclosure – that’s actual contracted tonnes, with an allowance for how those tonnes might shift around from year to year.
From the outside, it is easy to assume that $40m a year in deployment should be a slam dunk, and it may well be. But we just don’t know yet. That’s the big remaining question – in fact I think there are two that are related to each other: (1) what is the scalability potential of the business? (2) how fast can we get there
On (1) – there are 52,000 canola farmers, and we currently have 21 of them as customers. We believe large numbers of them can benefit from what we have to offer. But is this a 30,000 potential client business or a 300 potential client business in reality? We don’t know yet. Either way, we can build a solid thriving business.
On (2) – time to get there is a combination of education-driven market-adoption, and our own bandwidth.
During our first deployment season, we did $20 million with one guy (Gord), no back office, and some legacy clients from our pilot testing stage.
During our second deployment season, we did $23 million of deployment with one guy (Gord) + some extra part-time hands whose networks we tapped into, and one guy in the back office (Matt). Those year 2 clients were new to us, so more education was required, and Gord was also handling our grain marketing program for all of the first year crop.
We’re headed into our third deployment season, which started Oct 1.
For bandwidth, we’ve done some additional things as well:
1. Gord has a full-time dedicated team now, and you’ll see these guys on the website. Kim, Dennis Joerg, and Warren give us boots on the ground in each province, and they bring their own backgrounds and networks and experience to the table. Their presence massively reduces turn-around time on new contacts because they already live closer (our Northern Alberta contract is an 8 hour drive from the Edmonton airport, each way, after flying there from Regina, via Calgary). Their networks bring new names to the table. And their own credibility means those are warm contacts.
2. The sales process is supported by a substantial marketing program of farm trade shows (we’ve only ever done one in the past, but are booked for 12 in the next 9 months), print advertising in local weekly newspapers, radio advertising on farmer targeted radio, print brochures (for the first time), and various other outreach methods. This is all run by Kendra, who used to run the marketing and sales management efforts for her family’s farm equipment manufacturing company.
3. Grain marketing is off Gord’s desk and on Brennan Craig’s. He’s our new full-time grain marketing guy, and brings 18 years of canola industry experience to the table with large international grain companies including Seaboard, Viterra, and as a floor trader at the Winnipeg Commodity Exchange with RBC Dominion Securities.
He knows everybody in the industry, and his entire focus is on moving our canola from the farm to the elevator or crusher in a smooth fashion, while garnering the best possible price.
4. On the back office side, we’ve streamlined and standardized more process, and we hired our outside legal counsel’s paralegal to come in-house and manage all our documentation. Faster turn-around, and dedicated in-house experience, plus more cost-effective.
So our sales bandwidth has better than quadrupled, and they are well-supported with an education campaign that we believe will yield results. We’re experimenting with a lot of new channels to see what gets traction. Whatever does will get lots of emphasis.
Nothing you’ve said is crazy, but we’re a new company with a new idea that is different than what most farmers have ever seen. Just like any technology adoption curve, we haven’t yet reached the inflection point where ag streaming goes mainstream, but we will reach that point somewhere along the way. (Just like cell phones and the fax machine. (Who bought the first fax machine, anyway?)
This week, we had a conversation with a current shareholder who used to own a John Deere equipment dealership. He understands what we are doing. He told a prosperous farmer friend about what we do and asked if he would ever do a streaming deal – the answer was “that’s only for guys who don’t have any money”. The reaction of the former equipment dealer was that this reminds him of farm equipment leasing 15-20 years ago. The book on equipment leasing back then was that leasing was “only for guys who don’t have any money” but that now 90%+ of all equipment is leased. The paradigm and strategy had to shift, and it started slowly and then more quickly became a normal part of farm finance.
He thinks we’ll go through that same thing at Input. It starts slowly and builds, and then there’s some kind of catalyst that shifts market acceptance into high gear. We think we’re getting closer to that – we’re starting to get some testimonials which any farmer should find compelling, and the word will start to spread. Soft canola prices right now also help – farmers can’t afford to be too complacent or rest on the laurels of the past few years.
So that’s a long answer to your question. It’s premature on my end to say whether $40 million in deployment this season is conservative or aggressive. The funds might fly out the door by Christmas, leaving us to source more capital before January. Or not. We just don’t know yet, and we’re not about pumping up expectations beyond what we believe to be conservatively realistic. But as you can see from above, we’re putting the machinery in place to ramp things up.”
So, as the above exchange makes clear, management is in the process of laying a thoughtful foundation for the future as far as their ability to effectively deploy a large and increasing amount of capital for years to come. And again, I think they’ll succeed and any concerns surrounding the scalability of the business will ultimately prove unfounded. If I’m right about that, odds seem good the stock will react in a big way – better yet, shareholders should make an enormous amount of money over the next five to ten years, which is infinitely more important than near-term price swings. Here’s to that!
4. A myopic, quarter to quarter view makes people nervous:
Surprise surprise but Input, or any business for that matter, should be analyzed on an annual basis…not that this is a crowd that needs to be reminded of such things, it’s just that the extent of investor myopia never ceases to amaze me. That’s certainly the case here.
Then again, it’s this type of perverse market psychology of quarter-to-quarter results that cues up mispriced assets on the regular so its hard to complain. As without it, the opportunity for investors willing to go against the herd would cease to exist but I digress.
Point being, the fact that management has to consistently remind investors that any quarterly results should not be compared against the previous quarter, but against the same period last year, is frankly baffling. And Input doesn’t have much history to compare against yet.
As, the CFO put it:
“I think those willing to invest before there is a five year history will be the “early bird that gets the worm”.
I couldn’t agree more.
Stay tuned for part 4 soon…