Profitability Under Pressure: Analyzing the Impact of Falling Grain Prices on IMC's Financial Outlook
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Falling grain prices likely weigh on profitability In this report we revise financial forecasts and valuation for IMC downgrading recommendation from Buy to Hold and lowering target price from PLN 22.56 to PLN 18.28 p.s.
Since our last company update from Dec 2022, wheat and corn prices fell by 31% and 14% respectively. Falling spot prices reflect ample supply, coming mainly from Russia. USDA forecast 2023e harvest to remain high as well, likely weighing on expectations of future prices. On the side of production costs we highlight falling of fertilizers and diesel prices.
Regarding IMC financial forecast, we lowered our EBITDA estimates for 2023e which is associated with lower grains’ prices and rising costs (IMC makes major cost positions hedges well in advance). Compared to our previous report, we also expect lower volumes sales mainly stemming from higher sales of inventories between 4Q22 and 1Q23. Realized prices will continue to command hefty discount to European market prices stemming from high transport cost.
Weak macro and worsening of operational prospects in current year may take back seat in the light of falling geopolitical risk. Successful Ukraine’s counteroffensive may fuel rerating of Ukrainian companies pushing share prices higher on the optimism surge. For the moment being we assume Ukraine’s risk free rate at 36%/20%/7% in 2023e/24e and thereafter.
We also assume risk premium at 20% in 2023e and 10% thereafter, which in our view reflect the risk of investing in companies operating in a country where full-scale war takes place. From the point of view of cash flows, thanks to the high inventories sales between 4Q22 and 1Q23 cash generation seemed solid, hence for the moment being, liquidity risk lowered considerably. The company said in 1Q23 financial report it managed to extend credit line and pay off short-term debt.
Forecasts and valuation update
Financial forecasts update
In this report, we change our financial forecasts for IMC mainly due to the falling of grain prices since our previous company update released in September 2022. Both corn and wheat remain under pressure which stems from the ample supply as well as economic slowdown (corn is more exposed to the cycle through ethanol fuel enduses).
We point out price discounts IMC is reporting on sales compared to the average spot market prices (76% vs ca. 100% of full-cycle average for corn). High price discount is also associated with rising selling and distribution expenses per ton, likely the result of costly process of exporting grains by railway (in general it’s more expensive than ship) or freight (costs of insurances, freight rates etc.).
Admittedly, the unit cost of sales went down over a few months from ca. USD 60 to USD 30, however volumes sales growth keep sales expense in the P&L at elevated level. We also highlight the problem of rising production costs: admittedly spot fertilizers prices go down recently, but hedging of 2023e costs took place in winter 2022.
In our view, the change of sentiment toward Ukrainian agri companies require either reversing the negative trend on grains prices or falling of geopolitical risk associated with the upcoming Ukrainian counter-offensive.
From the point of view of business environment we’d rather err on the safe side hence the change of recommendation and cut of target prices. However, in case of some optimistic scenarios regarding development on the war front, Ukrainian companies’ shares prices may gain as a result of sentiment change or rerating of market multiples.
FAO grain index dropped in April 2023 to 136 points, the lowest since February 2022 when the war broke out. Most grains suffered losses in April, except for rice. In case of wheat, prices remained under pressure due to the ample availability from Russia and Australia. Beneficial weather conditions in the USA, Russia and Europe as well as EU reaching an agreement over Ukrainian grains transit through neighboring countries (including Poland) also encouraged prices to continue downward trend. In May, USDA raised the estimate of US grains conditions by 2 p.p. to 28%.
The agency also forecast second highest wheat harvest in Russia. Production is expected at 81.5mn tons, 11% down vs. record 2022 but still 2% higher vs 5Y average. USDA also remains optimistic with respect to European harvest, except for drought-hit Iberian Peninsula. European production is expected to come in around 139mn tons, 3% higher yoy and 5% higher vs 5Y average. Regarding corn, falling prices came on the heel of record high harvest in Brazil.
The additional factor dragging prices down are falling spot diesel and fertilizers prices. After pushing out Russian from Poltawa, Sumy, Czernichov and Charkow region, the key problems of Ukrainian agri companies remained export disruptions.
On July 22, 2022, Russia, Ukraine, Turkey and UN signed Istambul Black Sea agreement, which guarantee safe marine grain export from Ukrainians ports on Black Sea.
The aim of said agreement was to reduce the price pressure on global grains market and prevent the famine affecting the poorest countries in the world. The agreement was set to last for 120 days with potential for renewal. In May 2023, the Black Sea agreement has been extended for another 60 days which has been confirmed by Ukraine and Turkey, brokering the deal and guaranteeing its execution. Marine grain transport was responsible for 70% of Ukrainian cereals international sales, whereas railway accounted for only 20% of sales.
Considering the importance of the agreement for Turkey and its bargaining power over Russia, we do not expect the deal will be terminated in the foreseeable future. Nonetheless, there is a non-zero risk of such an event following further escalation of the ongoing military conflict. In mid-April Poland, as well as other countries neighboring Ukraine, introduced unilateral bans on Ukrainian agri produce including grains.
The bold step was preceded by domestic farmers protests, blaming Ukrainian import for dumping prices and increased competition. Kiev as well as Brussels voiced its concerns and disappointment over the ban, whereas the latter said it’s EC jurisdiction to shape common trade policies.
At the end of April, the agreement has been reached which established a ban of produce sales directly in neighboring countries, whilst those countries will let the Ukrainian grain to be transited over their territories further West. It's difficult to say what part of rail export ended up specifically in CEE EU countries, nonetheless the extent of rail export is considerably lower vs. marine transport in general. We do not assume the agreement will have meaningful effect on Ukraine’s export level, which would suffer incomparably more in case of Black Sea agreement termination.
We assume total IMC grain sales at 874k tons this year and 770k tons in following years. We highlight the change of sales structure which reflects different grain acreage structure of corn, sunflower and wheat from 75%/10%/15% to 58%/14%/19%.
Changing production in favor of wheat and sunflower at the expense of corn stems from the need of limiting the usage of gas and power which is indispensable in the process of corn grain drying. Volume sales in 2022 turned out to be higher than we expected therefore proportionally lower sales in 2023 vs our previous expectations. From the point of view of financial results we expect this year considerably lower gain on sales of biological assets, which results from falling grains prices (additionally lowered by cost of transit) as well as higher costs of production.
At the same time, there is a chance of recognizing higher results on sales due to the very low price level used for establishing gains on recognition of biological assets in the preceding quarters vs current spot market prices. We highlight the accounting character of gains recognized on valuation of biological assets which is not tantamount to cash flows the company generates.
Valuation
Our IMC valuation is based on DCF model indicating a 12M target price of PLN 18.26 per share.
We attach 100% weight to this valuation method as it better captures the long-term prospects, company-specific factors and country risk as well as limited number of peers exposed to similar set of risk factors. For illustrative purposes, we have prepared a peer comparison valuation based on 2023E - 2025E multiples which yields a 12M valuation of PLN 27.75
