Archer-Daniels-Midland: Silver Lining Post Accounting Scandal (NYSE:ADM)

Investment Thesis

While the Archer-Daniels-Midland (NYSE:ADM) nutrition accounting scandal proved to be a major setback to the human and animal nutrition company after they disclosed the likely corporate malfeasance early this year, I think the company is turning a corner. With this, I think shares remain cheap, setting up an interesting opportunity.

The suspension (and now resignation) of their former CFO, Vikram Luthar, amid an internal probe into their accounting practices led to a 24% plunge in ADM’s stock price—the biggest single-day drop since 1929. As with any corporate scandal, the biggest impact falls on the integrity of financial reporting and the financial health and operational performance of the firm.

The internal investigation, initially triggered by an inquiry from the Securities and Exchange Commission (SEC), focused on “intersegment transactions” in ADM’s Nutrition reporting segment. These transactions involved the transfer of goods between segments, which raised doubts about their pricing practices and how these transfers were accounted for.

Further complicating the issue, the U.S. Justice Department has begun investigating ADM’s accounting practices, which I believe is most likely to create possible criminal implications and financial penalties if they are found guilty of any wrongdoing.

And as expected, legal challenges have followed in the wake of these investigations. ADM faced a class action lawsuit (which covers April 2020 to January 2024) alleging securities fraud that claims the food processing company made false and misleading statements about their performance and prospects.

But things can be different in the years to come. ADM has already taken several corrective actions, which include revising executive compensation linked to specific segment performance and delayed bonus payments for senior executives. I think it’s a good start to recognize the need for stricter controls and more transparent financial practices.

Adding to this, as global commodities enter the latter half of 2024, analysts expect signs of an upswing that will favor ADM and the industry as well. Post-pandemic economic recovery has been accompanied by inflation because of stimulus measures. As observed, commodities tend to perform well during inflationary periods since they are tangible assets that can store value. In addition, likely lower interest rates will continue to decrease the opportunity cost of holding non-yielding commodity assets, but they also tend to weaken the dollar, which makes dollar-priced commodities cheaper and more attractive on international markets. With higher commodity prices, ADM’s core business segments such as agricultural and metal commodities are likely to drive an uptick in revenue.

For their part, the company is expanding their direct-to-farmer buying programs and enhancing their nutritional segment to capitalize on higher commodity prices through secured supply at lower costs and enhanced margins. They are also leveraging the agricultural sector, where more output following improved weather conditions and increased grain and oilseed supplies are projected.

Despite the massive impact of the scandal, I now believe ADM shares are a strong buy. I have not given up on this company. The favorable commodity pricing environment, strategic initiatives, and their current market position reinforce my confidence in their stock amidst the corporate issues they are facing.

Why I Am Doing Follow-Up Coverage

I previously wrote about how ADM started focusing away from traditional commodity markets towards more diversified and potentially higher-margin business areas. Despite the challenging global conditions, including impacts from the war in Ukraine, the company has still demonstrated resilience and adaptability.

But even with the current and future challenges posed by the accounting irregularities, the company’s fundamental business strengths and shift towards diversified operations will provide a strong case for their recovery and growth. Yes, the stock has been punished, due to the market’s adverse reaction to the financial irregularities, however, I believe that this downturn will only be a temporary setback rather than a reflection of the company’s future prospects.

Background

ADM is being investigated by the U.S. Justice Department for their alleged improper accounting practices, which involves the company’s Nutrition division. The probe was initially spurred by a voluntary document request from the SEC, which led to more severe actions, including grand jury subpoenas directed at certain current and former employees of the firm.

ADM is said to have handled intersegment transactions within the company, particularly between their commodities units and their Nutrition division. These internal transfers and the pricing methods that were employed can impact the reported revenue and profitability of the business segments involved, and affect overall financial statements​.

In response to these allegations and the subsequent investigations by both the SEC and DOJ, the company initiated an internal investigation led by outside counsel and their board’s audit committee to identify and rectify any inappropriate accounting practices and prevent future discrepancies. They concluded that there were indeed material weaknesses in internal control over financial reporting concerning the accounting for intersegment sales. The company has publicly acknowledged these findings and has implemented a remediation plan by making necessary adjustments to the pricing and reporting of intersegment sales. ADM strongly asserted that this will not impact their consolidated financial statements materially, and they delayed their financial reporting and bonus payouts for some senior executives until the investigations are complete and the financial statements have been audited and finalized.

Despite this, the company has successfully transitioned their business focus towards high-value nutrition segments that has partly pushed their forward price-to-earnings (P/E) multiple higher compared to other grain traders (notably Bunge prior to their acquisition activities). ADM pivoted to their Nutrition division involving the development and sale of value-added products, including flavors, specialty ingredients, and other health-oriented food and beverage additives​​. They were able to differentiate themselves from competitors that remain more heavily reliant on bulk commodity trading.

ADM has also focused on innovation by investing in plant-based proteins and healthier ingredients. These areas are expected to see continued growth as global dietary habits shift towards plant-based and environmentally friendly options​​.

Why I Am Still Optimistic

ADM’s Nutrition division has been crucial in their strategy to diversify away from traditional commodity business to allow them to focus on higher-margin, value-added products aligned with global consumer trends where a shift in healthier and more sustainable food choices are growing. Despite the scandal, the intrinsic value of the Nutrition division remains intact, in my opinion.

According to CEO Juan Luciano during the company’s Q1 2024 earnings call:

(In Nutrition,) the team is focused on actions across all areas of planned recovery, and we’ve seen expected sequential improvement coming out of the fourth quarter. The impact of these actions will accelerate in the back half of the year, consistent with what we mentioned in the last earnings call -Q1 Call.

In addition, the ongoing conflict in Ukraine and disruptions in the global supply chain have kept food supplies tight, especially in regions that are traditional breadbaskets. ADM operates globally and benefits from a diverse supply network. It is well-positioned to leverage these disruptions. Increased prices due to shortages helped boost the company’s profit margins as it started capitalizing on their vast distribution and processing infrastructure to meet continued demand since the war outbreak in 2022.

I believe that there is a realistic potential for an increase in ADM’s earnings and their valuation multiple. With the ongoing global economic recovery post-pandemic and continued commodity inflationary pressures, consumer demand for food and biofuels will remain robust. ADM will directly benefit from these trends.

Valuation

ADM shares, in my opinion, appear undervalued. Together with a robust dividend and the potential for a new commodity super cycle, this suggests an investment opportunity.

The company’s forward Non-GAAP P/E stands at 11.09, which is below the sector median of 17.69, representing a 37.30% difference.

ADM’s current dividend yield stands at 3.07%, which is higher than the sector median of 2.90%, which offers investors a steady income stream and a strong cash flow generation and financial health for the company.

Market Underestimation of Commodity Super Cycle

I believe the current market does not appear to be pricing in the potential for a new commodity super cycle, which I think can benefit ADM due to their reach in agricultural and food commodities. Global supply chain disruptions, geopolitical tensions, and climate-related impacts on agriculture are likely to keep commodity prices elevated. However, ADM’s global footprint can put them at an advantage with these trends, and drive a higher valuation multiple.

Fair Value Estimation Based on Sector Medians

If the market begins to recognize ADM’s strategic initiatives and adjusts the valuation closer to sector medians, I am confident that there is a potential for significant upside. For instance, aligning ADM’s forward non-GAAP P/E to the sector median would imply a share price of approximately $98.61, based on the current price of $61.82, representing an adjustment of an estimated upside around 59.51%​​.

Fair Value Estimation Based on Trough P/E Multiples

Considering the cyclicality of the agriculture commodities market, a trough P/E of 20 is reasonable. Using a forward EPS estimate of $5.59, this would suggest a fair value of around $112 per share.

How This Compares To My Previous Valuation Estimates

Previously, I valued shares at about $118 given where their P/E and EV/EBITDA multiples were. However, given that the EPS estimates have declined this year (I think management is being conservative), I am cutting my estimates down to reflect reduced profit potential.

Risks

Given the ongoing investigation by the Justice Department into ADM’s accounting practices, I believe that the company could face strong financial penalties. Historically, fines for similar financial discrepancies and violations have varied widely, which are dependent on the extent of the misreporting, the period over which the discrepancies occurred, and the damage to shareholders and the market. For instance, similar cases in the past involving major corporations have seen fines ranging from $10 million to over $200 million. Three of ADM’s former executives were convicted of price-fixing in 1996, and the company paid $100 million in penalties.

The SEC has also imposed a mandate to recoup executives’ bonuses and other incentive pay if their company’s financial statements contain errors, as per regulations passed under the 2010 Dodd-Frank Act. If a company makes a material error in their financial statements, the compensation awarded based on those erroneous financial achievements must be clawed back. This includes both major errors that necessitate financial restatements of previous years and minor errors that only impact the latest year’s results.

ADM, for their part, has reported corrections in past financial results and disclosed these issues in their regulatory filings. However, if these fixes are deemed material and tied to the incentive-based compensation of their executives, the executives are left with no choice but to return their compensation and benefits.

For me, the decisive actions taken by ADM’s management team in response to the accounting issues are a good step towards transparency (albeit this should have been done to prevent the scandal in the first place). It can restore investor confidence and can renew their ethical governance moving forward, however, it may take some more time before the public can fully restore their trust in them again.

In essence, I think they are taking strong ownership of these poor accounting practices. I think this demonstrates the rest of the management team has strong ethics which allows me to keep faith in them and the company.

Takeaway

I believe that in the wake of their accounting scandal, there’s still a compelling case for ADM for a strong buy. The company took swift and decisive actions after the internal probing to identify their errors. They are also focused on diversifying their business toward higher-margin areas, especially in nutrition and ingredients. These align with global shifts towards healthier and sustainable food options. Furthermore, the ongoing global conflicts and supply disruptions, particularly the war in Ukraine, have tightened food supplies, which offer ADM the opportunity to benefit from higher commodity prices.

Given the pessimism currently clouding the stock, I believe the timing is opportune for investors to capitalize on the potential for significant returns. ADM’s shares appear to be undervalued, which offer an opportunity for investors looking for a contrarian bet in the agribusiness sector. The company’s quick response to the scandal, and strategic tailwinds, I believe, will enhance their appeal as a strong buy.