Published in the May 2020 issue of the Journal of Corporate Renewal, published by the Turnaround Management Association. Link here.
When people think of agriculture, they think of long-term businesses in steady markets. They think of family-owned businesses passing from generation to generation. They think of farmer-owned cooperatives serving their members and feeding the world.
That has been changing in a dramatic manner over the past few years, and the squeeze between supply and demand has never been more pronounced. U.S. consumer tastes are changing. New products are replacing the tried and true. People are choosing different ways to feed their families—different foods, different processing methods, and different delivery styles. Worldwide markets are in play, impacting both the supply and demand sides of the equation for U.S. farmers, processors, and cooperatives.
The impact on borrowers has been significant, as liquidity is being squeezed out of companies while they struggle to respond to evolving supply and demand and pricing structures.
Consider U.S. supply and demand for three different products—fresh apples, avocados, and oranges. These three crops are selected because their supply and demand histories are so different and the crops can be raised in many of the same areas.
For apples the annual supply and demand has ranged between 4 million and 8 million pounds, with demand between 4 million and 6 million pounds and supply between 6.5 million and 8 million pounds (Figure 1). In the late 1980s the gap between supply and demand was at its smallest, with the difference increasing beginning in 2010. When prices to growers are overlaid on supply and demand for apples, a correlation between supply and demand is not apparent in the price increase in 2012-2013, though correlation appears with the price decrease in 2013-2014.
Figure 2 shows supply and demand for avocados during the same period. Supply and demand for that product have moved more closely together and have shown steadily increasing trends since the mid 1990s. With grower prices overlaid on supply and demand, avocados provide an example of an instance when increased demand and supply initially drove prices up—and then created grower price volatility, with prices ranging from $1,540 per short ton in 2011-2012 to $2,720 per short ton in 2016-2017 and down to $2,100 in 2017-2018.
Figure 3 shows supply and demand for oranges over the same period. Supply and demand for oranges have moved in a closer range than those for apples and avocados, but there are significant swings year over year. Prices for oranges have not moved in relation to supply and demand changes and show variability from 7 cents per pound in 2000-2001 to 33 cents per pound in 2017-2018, which was followed by 21 cents per pound in 2018-2019.
When considering agricultural producers and processors and the prices received and paid, it is clear the year-over-year changes in value of the crop are significant.
Added to the puzzle is that supply and demand dynamics in the United States are only part of the equation producers and processors deal with. Worldwide supply and demand also impact U.S.-based producers and packers.
Looking at supply and demand for two nut crops, walnuts and almonds, the impact of worldwide dynamics on U.S.-based food producers becomes obvious.
The U.S. supply of walnuts exceeds domestic demand by a significant amount, as demand accounts for only 25% of supply (Figure 4). As worldwide demand for nuts drops or remains flat, U.S. producers find themselves selling their product into an increasingly competitive global market. To sell their crops, producers or packers need to develop international markets and must be competitive in terms of shipping costs and packaging. Figure 5 provides the same information for almonds, for which U.S. demand is closer to 30% of the domestic supply.
For lenders, it is important to understand that even the best producer or processor faces a combination of risks involving U.S. supply and demand, worldwide supply and demand, and pricing volatility. In recent weeks, producers, processors, and lenders have also needed to evaluate the potential impact of the coronavirus outbreak as well. Amid so much uncertainty, they are attempting to anticipate the impact on demand and supply in the U.S. and elsewhere in the world, as well as their ability to readily transport products. The coronavirus underscores the importance of evaluating uncertainty and preparing for different pricing situations.
Consumer Tastes
Even as demand for a particular product grows in response to shifting consumer tastes, in many situations farmers or producers pivot to produce that crop faster than demand increases. Though a fruit or nut tree may take two to three years to produce its first crop, if many farmers change over to growing those trees at the same time to take advantage of a lucrative market, supply quickly exceeds demand. This puts additional pressure on prices paid for the alternative crop that a farmer or producer was relying upon to save its operation.
For example, decreased demand by consumers for traditional dairy milk and their transition to non-dairy alternatives have caused problems in the supply and demand equation for milk. Figure 6 shows the volatility in milk prices that began in the 1990s. As almond prices were increasing during that period, many farmers converted acreage from dairy farming to nut farming. But as a result of so many farmers shifting to the new crop, nut supply soon exceeded demand, and the value of the nuts decreased. Almonds hit a high in 2015, but increased supply contributed to pushing prices abruptly back down in 2016 and 2017.
The trend lines show an overall increase in almond prices from 1981 to 2019. However, the volatility year over year is more than many producers are able to survive.
Surviving Amid Uncertainty
The level of uncertainty in the food sector means performance stresses occur based on consumer demand, company performance, the regulatory environment, and the international markets and economy. Borrowers survive if they have liquidity and are nimble in adjusting to outside forces. For consultants and lenders, liquidity has always been key in the agricultural and food processing sector, and the issues identified show how important liquidity is for survival.
Producers. Producers are dealing with yield and price equations, layered against their cost structures. In addition to the need for operating expense management, debt structure decisions also impact producers.
Using the price of milk over the past 30 years as an example, a farmer must consistently produce milk at or below $12 per hundredweight (cwt) to post profits each year. At minimum, a farmer needs to be able to produce milk at a cost structure and leverage position which would allow the producer to survive a year of milk prices at $12 to $13 per cwt.
Using the price of almonds over the past 30 years as another example, a farmer would need to consistently produce almonds at or below 80 cents per pound to post profits each year. Using only the last 10 years for the profitability test, a farmer would have to produce almonds at no more than $1.45 per pound to post profits each year.
When producers have excess equity, they can weather downturns in prices by leveraging their assets. However, at some point, unless the producer’s cost structure and debt service requirements work across a reasonable range of low prices for the crops or products it supplies, a producer could be leveraging into disaster.
The bottom line is, a producer needs to:
Develop a low-range price to drive production costs decisions.
Evaluate its overall leverage position and not exceed a level of total debt that could be reasonably serviced on an interest-only basis at the low-range price, if necessary, during a particularly stressful time.
Avoid, on an ongoing basis, using equity in assets to fund operating performance issues. A producer can only use that equity once and must treat it carefully.
Resist the impulse to chase the next big thing. Carefully evaluate supply and demand for a new crop or product before changing production.
Packers and Processors. Processors operate in the space between growers and consumers and can take many ownership and legal forms. These entities pack fresh products for consumer use and process fresh products into bottled, frozen, canned, etc., forms. The price paid by consumers or the entity between the processor and consumer, such as a grocery store, does not move in correlation with supply and demand dynamics.
While the combination of yield and price per pound impacts revenue in any given year, yield issues in the U.S. are dealt with in part by a robust crop insurance program. However, price per pound changes are still a key driver for entity profitability, whether from the perspective of a producer or processor.
From the perspective of a packer or processor, the impacts on prices paid to producers weigh against prices received from customers. The stresses of supply and demand put the processor in the middle, between a producer that expects a high price and a purchaser that pits processors against each other to maintain or expand its yield. Consumers do not experience variances in prices in the supermarket or at restaurants at the same level that producers, packers, and processors do.
To remain viable, packers and processors should:
-Evaluate profitability at various production levels. The packer or producer must be able to operate at different utilization levels and understand how to perform at the various levels.
Develop plans to move costs based on production levels and implement the plans immediately. Do not wait for changes in the market to create a turnaround for the operation. Manage the internal cost structure and perform an internally driven turnaround.
-Evaluate producers. Consider total production, as well as quality and yield, by producer. Consider firing producers.
-If the entity is a cooperative, evaluate members for production levels, quality, and yield against overall industry standards. Consider changes to the pricing structure and the patronage dividend approach to maintain co-op performance.
-Evaluate contracts with customers. Consider timing of product delivery, pricing, and quality requirements. Evaluate storage, transportation, and packaging costs.
Develop customer profitability by product and by overall customer.
Consider fixed and variable pricing. If hedging is available, consider it. Clearly evaluate the cost benefit and risk of hedging options. Consider creating internal hedging with a mix of customers and a combination of fixed and variable pricing.
-Use equity carefully.
-Cease chasing the next shiny object.
Lenders. The key items listed for producers, packers, and processors provide a road map for lenders to use in evaluating their borrowers:
Is the borrower taking steps to evaluate its performance from a profitability and leverage perspective?
Does the borrower manage its cash on a daily and weekly basis?
Are financial statements timely?
Is stress testing information available?
Meet with management to determine their level of financial and operating management skill, keeping in mind the necessity of managing cash and evaluating performance options. If, at the beginning of each crop year, a borrower is looking for the recovery to occur next crop year, clearly there is a management problem. But, even good managers will revert to a wait-and-see approach to maintain relationships with their suppliers and customers. That is when cash management, financial performance, and stress testing measures are critically important.
Weekly cash-flow management tools are key, with weekly and cumulative performance of budget to actual results from a revenue and expense perspective as well as a borrowing base perspective. A key benefit of that cash-flow management is that it serves as an early indicator of otherwise unanticipated performance changes. Lenders should push to receive weekly reporting of both cash flow and borrowing base components.
Daily, weekly, and monthly key performance indicator reports are critical to monitoring performance. Timely monthly financial statements must be provided. Expected changes in labor, raw materials, production, consumer demand, and overall expenses are important to anticipate and evaluate through key indicator reporting and financial statement reporting. The components of working capital must be monitored.
Forecasting tools should include a sensitivity analysis which adjusts performance based on variations in unit sales prices, volume, taxes and tariffs, and other factors. Company performance needs to be stress tested.
The food growing and processing sector is certainly one where the adage “cash is king” should be the guiding principal. An adequate supply of cash allows an entity to survive temporary performance issues. A lower leverage position allows an entity to survive more protracted periods of performance issues.
Reporting requirements and the push to conservative financial management are key to long-term survival for lenders in this volatile sector.
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