Friday, July 24, 2009

Capital & Crisis Hotline -- Greetings From Vancouver

Agora Financial
Agora Financial's Capital & Crisis

Capital & Crisis Hotline -- Greetings From Vancouver
July 24, 2009

"You can pay your grocer or you can pay your doctor."
-- A reader in Vancouver, quoting wisdom from her mother

Dear Capital & Crisis Reader,

Greetings from the back of the conference room at the Fairmont Vancouver, in Vancouver, Canada. I've been here all week for the Agora Financial Investment Symposium. I've enjoyed speaking and meeting with readers. And the presentations of the various speakers have been full of good ideas.

My main presentation to the group here was about the opportunities in agriculture. The title was 100,000 Pounds a Second: The Coming Breaking Point in Agricultural Markets. A hundred thousand pounds is about how much grain the world consumes every second.

A book called A Thousand Barrels a Second, published in 2006, which predicted the spike in oil prices in 2008, inspired me on this front. Many of the same dynamics that were in play for oil in the 2008 run-up are similar to those for agricultural goods today.

In brief outline, here were the key points:
  • Grain inventories are at low levels we have not seen since the 1970s. Low levels hint as possible shortages. Grain inventories peaked in 2000 and have been in decline ever since
  • Demand is rising, powered by growing populations. Also, we see dietary patterns shifting in the emerging markets. They are eating more meat. And this creates an exponential demand for grains
  • We face the prospect of weak fall harvest, as drought has hit many of the important growing regions. China, for example, is the world's largest producer of wheat. Yet a third of the crop is at risk due to drought.
It all basically boils down to those three reasons: tight supply, rising demand and a potential supply-side shock in a weak harvest brought on by drought. But longer term, there are other indicators that grain markets should be tight for years yet:
  • Gains in crop yields are falling. Since 2000, the average increase in crop yields has been less than 1% annually; over the last 40 years, we averaged more than twice that
  • More and more our energy demands are competing with our demand for food. Nearly every oil-consuming country has put biofuel targets in place. To meet these targets over the next 5 years would require 240 million acres dedicated to biofuel production. For perspective, that's about 50% of North America's and 6% of the world's arable land
  • As if all this weren't bad enough, there is also a falling supply of arable land -- thanks to desertification, development, pollution, water shortage and other reasons. That's why you see a number of countries making deals for food.
There is one other wild card in all of this. It's called Ug99 fungus or "wheat rust." It started in Kenya and is spreading. Some 20% of the word's wheat crop -- which feeds 1 billion people in Asia and Africa -- is in imminent danger. Crop scientists fear that it could eventually wipe out 80% of the world's wheat crop! That is scary, and it's a story I am watching.

So all of these factors point to an agricultural bull market. We're going to need to produce a lot more food. It's good for agricultural equipment makers, fertilizer companies, seed companies and more. The agricultural commodities are on their way up.

On commodities generally, there was a good interview with Jim Rogers in today's edition of The Globe and Mail, which the Fairmont Vancouver delivers every day to my hotel room door. Rogers called the great commodity bull market and he is himself a rich man thanks to his investing prowess. As a result, people seek out his opinion on commodities. (Alan Knuckman, my colleague and commodity trading whiz over at Resource Trader Alert, considers Jim the "big" force in the field.  To hear what he said about Jim in Vancouver, click here.)  

Even though commodities of all kinds have taken a hit in this crisis, the longer-term dynamics still look strong. As Rogers put it: "Did the stock market bull market in end in 1987, when stocks fell around the world fell 40-80%?" No, it didn't.

The point Rogers makes is that even in the course of longer-term bull markets, there can be stiff corrections. Even now, though, the fundamentals for owning commodities -- and the stocks that benefit from rising commodity prices -- are still intact. As a result, they look very appealing in this uncertain market.

As Rogers says: "I'd rather own commodities than just about anything I can think of… Commodities have a long way to go; the fundamentals have only gotten better in the last year. The best place to have your money is in commodities… Most of them are going to make new all-time highs."

I tend to agree. We're in good position to benefit from the unfolding commodity bull market.

*** Food, Inc.

I also talked briefly about a documentary called Food, Inc. It's a terrific documentary on just where our food comes from and how we make it. There is an ugly side to the industrial food complex.

There is a great line from the movie when Michael Pollan, author of The Omnivore's Dilemma and a sort of hero in our household, talks about how you can't even trust the produce section in your grocery story.

Pollan points out that when you buy a tomato, you are not really buying a tomato. You are buying the idea of a tomato. You are buying something that is picked green and ripened with ethylene gas. It's industrial food.

Industrial food is cheap food, of course. And Americans, somehow, have come to believe that cheap food is good food. The bottom line is that much of this food is making us sick. In my workshop presentation yesterday, a woman shared with me with the quote I have at the top of this letter.

And it's true. The food that is really good for you is often more expensive than the industrial food equivalents. Americans spend only 9.5% of their income on food. It's the lowest percentage of any people on the face of the planet. If we really want to lower health care costs, maybe we should radically change how we think about our food and where it comes from.

Anyway, I highly recommend you watch the film. It touches on many important issues, and it ties in well with all this stuff I've been writing to you about with regards to food production.

Well, that's enough of that. This week, we got a slew of earnings reports, so let's dive into those before this e-mail gets ridiculously long…

*** PotashCorp

PotashCorp (POT:nyse) presented light earnings again this week. The company also gave lower guidance for the rest of the year, cutting earnings to $4-5 per share. The story is still the same as it has been for the last couple of quarters. Farmers are holding back on fertilizer purchases. They are being cautious, like everyone else, in this shaky economy.

As a result, we've seen the largest deferral of demand the industry has even seen, according to CEO Bill Doyle. That's the situation today, but that's not the situation that will exist long in a world where grain inventories are falling and demand for those grains is rising as population climbs.

I have not had time yet to really dig into PotashCorp's earnings report. The company gives a detailed and meaty presentation, but on the surface, this quarterly report did not change much.

I think PotashCorp is one of the best agricultural companies in the world to own. It's going to be a bumpy ride, but the stock will ultimately move a lot higher -- especially if we have a weak harvest, as I expect, and grain inventories fall further. There will be a lot of pressure and incentive to grow more food next year -- and to use more fertilizer.

As it is, times are not really so bad for PotashCorp even now. As CEO Bill Doyle pointed out, the present potash price of $460 a tonne is still pretty healthy. "If this is as bad as it gets, it's pretty darn good."

*** Astec Industries

Astec (ASTE:nasdaq) is our infrastructure company that mainly makes the equipment that makes asphalt for roads. Given the poor condition of infrastructure, this should be an area that does pretty well. Yet road building has also felt the bite of the financial crisis. Spending is down this year, and Astec's numbers reflect that.

Compared with the same quarter a year ago, Astec's net profit fell 63%. And the backlog of work is half what it was a year ago. It looked like an abysmal report, and it was. But this was largely expected. The bigger question is what the future looks like.

The stimulus package has actually helped Astec somewhat, as CEO Don Brock commented: "Although the stimulus package funds allocated to roads and bridges were only 3.5% of the total stimulus package, it has been helpful for the asphalt and mobile asphalt paving segments of our business. We anticipate that the impact of the stimulus package will continue to be beneficial over the next 18 months."

Brock's conference calls are usually informative. I have not yet had a chance to listen to this one, but will soon and report back to you. Over the longer term, Astec is in good position. Let's give this one some more time to work out for us.

*** Nabors Industries

"As we all know," CEO Gene Isenberg said on Nabors' (NBR:nyse) conference call this week, "this is a poor market. And as we all know, even though not everybody is going to admit it, none of us knows exactly when it will end."

Well, that about says it all. Nabors' earnings report was pretty weak, though it still topped the Street's estimates.

So we know the environment is difficult. The important thing to watch is the strength of that balance sheet. Nabors has done a good job here. At quarter end, the company had $1.3 billion in cash. And even through this trough, the company will still generate $300 million in free cash flow this year.

Besides maintaining financial strength and still generating free cash flow, there are other trends on the business front that bode well for Nabors.

As Isenberg noted on the call, the company is involved in more and more technically difficult and innovative drilling projects. This trend toward increasing complexity plays well to Nabors' strengths versus the competition. After a few years of spending billions of dollars upgrading its rig fleet, Nabors has a fleet of mostly new high-performance rigs. These should find work at the expense of older, less capable rigs.

As a result, Nabors has built up a good position in the difficult-to-drill shale plays. For example, in the big Haynesville shale play, Nabors' market leadership is three times that of the next largest competitor. These are the areas that will produce an increasing share of America's natural gas.

Nabors is a buy. It trades for about 15 times this year's depressed free cash flow. The stock also trades below nominal book value. In good times, the drillers can trade for 3-4 times book.

This is a contrarian and even an uncomfortable buy here. Natural gas is in the dumps and natural gas stocks are widely hated. Lots of sells are out there on this stock right now. That is often the best time to buy.

*** Ensco

Ensco (ESV:nyse), our offshore driller, reported good results, given the tough market we are in. Profits fell, but far less than the market expected. It continues to generate healthy profits. And most importantly, Ensco maintains a rock-solid balance sheet. It finished up with nearly $900 million in cash against long-term debt of only $282 million. The company continues to build its deep-water rigs and fund the whole thing with internally generated cash flow. These rigs, once they are put to work, will add significantly to Ensco's earnings.

Ensco is above our buy price, and the stock is up 70% for us so far.

*** ABB Ltd.

ABB Ltd. (ABB:nyse) is our builder of power grids. As with most everyone else these days, ABB reported a drop in sales and earnings. The biggest drag in results is from the mature markets of North America and Europe. The company enjoyed much stronger results from China, India and the Middle East. (Business is still good along the New Silk Road).

Even so, the company continues to generate a lot of cash. For the quarter, the company finished with $5.8 billion in cash, up from $4.8 billion at the end of last quarter. So it has plenty of dry powder to take advantage of any opportunities. And the future looks bright for the company, given the huge demand for power in emerging markets.

Have a great weekend, and I'll write you again soon.


Chris Mayer

P.S. Last week, a few of you caught a typo in our alert.  We apologize for the confusion about OPEC's future contributions to world energy.  The fact is pretty daunting, that's why we wanted to point in out.  By 2030, IEA predicts that 50% of global oil production will come from OPEC, versus the 30% OPEC delivers today. 

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