A VARIATION on the old joke about the lottery winner who said he would use his winnings to keep farming until it was all gone is, how do you become a manager of a small investment fund? The answer is to start by managing a big fund and invest in agriculture.
The agriculture industry is characterised by volatile returns on investment that, averaged over time, are low. Australian fund managers and private investors know that and tend to put their money elsewhere. Those promoting investment in local agricultural projects know they know, and go after foreign investors.
Some suggest a better option is to invest in input suppliers such as the rural distribution companies Elders and Ruralco. Now is a good time to examine that idea as these two, plus their major competitor Landmark, have just reported financial results for the period ending September 2012.
Elders Rural Services, the main division of Elders, reported earnings before interest and tax (EBIT) of $18.7 million on turnover of $1,850 million. Ruralco’s turnover was $1,136 million, up 13pc, while EBIT was fractionally up at $37.1 million.
Landmark reported EBIT before depreciation and amortisation (EBITDA) of $74 million for the 10 months to the end of September, a big increase over the prior year. The company’s financial year ends in December and Landmark’s results are now included in Agrium’s, so more details are not available. Nonetheless, ignoring seasonal variability, this equates to an annual figure of $89 million and suggests EBIT of around $80 million.
Return on investment, or more properly return on equity, reflects what a firm’s owners (ie shareholders) receive for their investment. This is normally calculated as a ratio of profit after tax to net equity, but EBIT to net equity is also useful as it excludes the effect of tax and method of funding, giving a pointer to underlying performance.
Elders’ ratio of EBIT to net equity (ie shareholders’ funds) attributable to the Rural Services division is an abysmal 6.0pc. Even if the company had no debt to service, Elders’ shareholders could have generated almost as much by putting their money in bank term deposits.
The ratio of EBIT to net equity at Ruralco is 26.4pc. This allowed it to fund debt (still relatively low despite borrowing the funds to buy 12pc of Elders) and tax, and pay a small dividend to shareholders. The ratio of profit after tax to net equity was 8.9pc.
Calculating the same ratio for Landmark is difficult because of a lack of information. Agrium paid $1.24 billion to acquire AWB including Landmark two years ago, but then sold the commodity businesses (for $925 million) and acquired 25 more stores, so its net equity is not known. It is also acquiring 17 new stores from Viterra.
Most observers believe Agrium paid more for AWB than it was worth as it was competing with Graincorp, leaving a lot of equity in the form of "goodwill". I suspect EBIT to net equity is somewhat less than that of Ruralco, meaning return on equity is probably also less.
What all this indicates is that none of the three is generating high returns. It is not difficult to find companies that consistently deliver over 10pc return on equity, while top performers produce over 15pc. Anyone contemplating investing in Elders or Ruralco has plenty of better performing options.
What attracts investors to firms that deliver low returns is the potential for growth. If Elders were to be taken over and returned to its former glory, for example, the share price would rise sharply. Landmark is improving its margins due to the global strength of Agrium, which enables it to negotiate more attractive fertiliser and chemical prices from suppliers.
One of the factors depressing returns on investment in agricultural production is the cost of land. There are enough hobby farmers, lifestyle investors and people willing to speculate on future land values to keep prices above what they would be if driven by strict return on equity criteria.
But there is no such factor in rural services. Returns are simply chronically low. That raises a fundamental question - is the business model for rural services still suitable in the current environment? True, it has survived 150 years largely unchanged, but can Elders, Ruralco and Landmark continue to fulfil the role of information aggregators in an age of instant communications? Can they continue as product aggregators with the growth of online ordering, including ordering direct from manufacturers?
And if the answer to these questions is yes, however qualified, how can they profitably serve a farming community that is rapidly splitting into either large commercial enterprises or much smaller operations underpinned by off-farm income, with not much in the middle? A one-size-fits-all approach is clearly not viable.
Landmark and Ruralco both believe their future lies in offering additional services to existing customers. For Landmark this means rolling out its North American strategy of private label products and bundling crop chemical and fertiliser sales with extra services, such as application to the crop. For Ruralco it means a range of knowledge-based services, from grain marketing to water and environmental services.
Perhaps they will succeed, but I suspect a new model will emerge that challenges all three of them, perhaps even their survival. Just as there are individual farmers who consistently generate outstanding returns on equity and ultimately buy out their neighbours, someone will develop a better model for servicing farmers that overturns the model used by Elders, Ruralco and Landmark. And it just might make investing in agriculture worthwhile.
David Leyonhjelm is an agribusiness consultant with Baron Strategic Services. He may be contacted at firstname.lastname@example.org