Commodity Producers and Return on Capital

[jay21]

I started looking into LUK a little more and I am wondering about National Beef.  It is a self described spread based business whose inputs and outputs are both commodities.  I would expect a commodity producer to earn near average returns on capital so I do not get what makes this a good business/acquisition.

 

The two ways I can see profits expanding are through increased turnover and spread widening. 

 

1. Increased turnover - Could be a result of more demand for the end product.  This seems to consistent with LUK's thesis that developing markets will demand more high grade American beef.  However, if this happens, won't more plants be added, which would increase capacity and thus reduce any abnormal profitability?  Right now, the industry is pretty consolidated.  So will this be more of a function of how competitive the 3 or 4 participants are and how they react to more demand?

 

2.  Spread widening - Not sure how this could happen.  Any thoughts?

 

I do not want to restrict this to beef processors.  I am sure this applies to other commodity producers (I don't know much about energy, but maybe refiners share a similar business model).  So, how can/do companies whose inputs and outputs are commodities earn an above average return on capital?

[HJ]

I don't think they bought it thinking it's a good business the way Buffett's businesses are, but a reasonable enough business that's bought at reasonable price.  So whether you get satisfactory return or not over the long term is entirely dependent on their ability to manage the commodity cycle on the cost side and the inventory / consumer preference cycle on the revenue line.  Once a while you may get lucky and be able to take advantage of export dynamics that could boost the industry profitability overall (SFD called out export demand as a driver of their profitability last couple of years).  This all occurs with the macro back drop of US being one of the most competitive country worldwide as far as agricultural productivity is concerned (fertile land, fresh water supply, cheap fertilizer, mechanized farming, genetic science, etc., etc.)  One thing to understand is that the protein market across the globe is pretty protected from international competition, so you don't plan for exports when adding capacity.  But the Chinese government may not be able to keep theirs domestic market under full control for whatever reason, the speed of change in consumption pattern in China is really astounding, and the supply chain there also quite unstable (blue ear desease a couple of years ago, images of dead pigs floating across river, Yum had problem with their chicken supply chain recently, etc., etc. ), which could argue for these spurts of export gains more frequently looking out over the long term. 

 

They would argue that they have very strong relationship with the cattle ranchers to manage the cost side better than average, and to the extent the business was historically run as a coop, profits was not maximized, and there is probably room in the production chain to squeeze out some incremental margin.

 

Precisely because it is a very tough business, that it will not attract new entrants, the competition dynamics of the industry will be held at manageable level for everybody to earn not an extraordinary ROE, but a generically acceptable private business ROE.  Competitive advantage is not obvious from the out set, it's all in how you operate it.

[A_Hamilton]

I started looking into LUK a little more and I am wondering about National Beef.  It is a self described spread based business whose inputs and outputs are both commodities.  I would expect a commodity producer to earn near average returns on capital so I do not get what makes this a good business/acquisition.

 

The two ways I can see profits expanding are through increased turnover and spread widening. 

 

1. Increased turnover - Could be a result of more demand for the end product.  This seems to consistent with LUK's thesis that developing markets will demand more high grade American beef.  However, if this happens, won't more plants be added, which would increase capacity and thus reduce any abnormal profitability?  Right now, the industry is pretty consolidated.  So will this be more of a function of how competitive the 3 or 4 participants are and how they react to more demand?

 

2.  Spread widening - Not sure how this could happen.  Any thoughts?

 

I do not want to restrict this to beef processors.  I am sure this applies to other commodity producers (I don't know much about energy, but maybe refiners share a similar business model).  So, how can/do companies whose inputs and outputs are commodities earn an above average return on capital?

 

I'm not sure it does earn above average returns over time. LUK bought national beef because it has been a stable CF generator, and has the added benefit of being an LLC which means lots of cash comes back to LUK untaxed. This allows LUK to begin monetizing its massive DTA.

[constructive]

It's hard to tell, but my impression was that they bought it at 6x normalized earnings. In which case, the quality of the business doesn't matter nearly as much.

[LC]

think about this model:

 

you have a business which generates 100M every 10 years, but requires 100M in capex at the ten year mark to stay in business. is this a good business? it depends. for ten years, you get to invest those cash flows before needing to pump the capital back into the business. meanwhile you gain use of that "float" so to speak.