U.S Fuel Corp. (fka USFF)

[openwave_options_guy]

Last weekend's Barron's Magazine had a good writeup on ADM. It says that ethanol will account for a third of ADM's projected 2006 operating profits.

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Monday, April 3, 2006


Power by the Bushel

By KOPIN TAN

CORN GROWS ON EVERY CONTINENT EXCEPT ANTARCTICA, and last year 82 million acres were planted in the U.S. The 11 billion bushels produced found their way into feedstock, onto dinner plates and sometimes, through chemical wizardry, into the plates themselves.

But lately, it's the corn in your gas tank that has investors afire. As oil prices soared, ethanol -- a cleaner-burning fuel made from corn -- has been hailed from Wall Street to Pennsylvania Avenue as the fuel of the future. And one company towers above the field with its knack for turning corn into ethanol: Archer Daniels Midland.

Because the Decatur, Ill., company produces 29% of the country's ethanol -- the next-largest player has a less than 5% share -- Archer Daniels has attracted shrewd investors betting on a surge in ethanol demand. The company's stock (ticker: ADM) has risen 37% this year, to about 34, its highest ever -- even though ethanol accounts for only about one-third of projected 2006 operating profits. The company also transports, stores and processes a vast array of grains, seeds, beans and agricultural products.

Analysts agree that Archer Daniels' stock will be driven in the short term by perceived ethanol demand -- even if they can't seem to agree on its magnitude. And the truth is, the Street may well be underestimating the potential for ethanol price increases.

To see why, just consider how ethanol prices are set. Ethanol contracts between Archer Daniels and its customers are negotiated in advance and then set in place for six-month cycles that typically run from October to March, and then from April to September. For instance, talks would have begun in April 2005 for the six-month contract that kicked in last October. While the company would not disclose details about pricing, some analysts estimate that the six-month stretch that just ended in March had featured an ethanol price of $1.35 per gallon. That price was negotiated almost a year ago, reflecting demand at the time.

For the new six-month cycle, starting in April, some analysts believe that negotiations in recent months yielded a price of about $1.85 per gallon -- up 50 cents from the previous cycle. And every 10-cent rise in ethanol price will add a hefty 12 cents to Archer Daniels' per-share earnings on an annual basis, estimates David Driscoll, a veteran Citigroup analyst who urged investors to buy shares months earlier. Last year, the company earned $1.42 a share.


Corn, the essential ingredient in ethanol, should be in steady supply for some time. That should keep costs under control for producers of the fuel.


The increased ethanol price of this April cycle could well have been anticipated by the stock's recent rally. But what the street may not have factored in yet are even-higher prices in future cycles, with many analysts taking a wait-and-see stance.

The commodities market, however, clearly sees further increases. Ethanol has risen above $2 a gallon in recent months, and May future contracts indicate a price of about $2.53 a gallon. That means that Archer Daniels executives now sitting down to discuss prices for the October 2006 cycle should have considerable leverage to bargain for prices well above $1.85 a gallon. One New York hedge-fund manager who expects ethanol prices to continue rising sees Archer Daniels trading above 45 within a year, up by more than 30%.

Even without ethanol's ballast, the stock should continue its upward trek. Because the planet's growing population must eat, and food must be schlepped from farmers to consumers, the $22 billion company has quietly become one of the most steadily growing behemoths around.

"Many of Archer Daniels' key businesses have moved past the trough portion of the cycle, " Driscoll says, with segments like soybean processing, high-fructose corn syrup and cocoa processing all becoming more profitable, with favorable trends in both supply and demand.

Analysts expect earnings to climb nearly 25% for the fiscal year ending in June, to $1.77 per share, and to $2.03 per share in 2007. Even after its recent rally, the shares are trading at about 17 times '07 earnings -- well within the historical range of 10 to 21 times.

The balance sheet looks solid, too. The company now pays an annual 40 cents dividend, and in fact has made 297 consecutive quarterly payments. Steady cash flow has helped reduce its net debt-to-capital ratio to about 17%, from 29% in 2001, and earned Archer Daniels an investment-grade single-A debt rating from Standard & Poor's.


If the future, as that famous line from The Graduate claims, can indeed be summed up by the word "plastics, " then Archer Daniels wants to be ready: Three weeks ago, the company announced plans to build a plant in Iowa that will make plastics from corn and other biodegradable sources. The facility won't open before 2008, but with most plastics today made from petroleum products, and oil prices expected to stay high in the long haul, the demand for cheaper plastics could make this yet another profitable seed planted today.

THE CITY OF DECATUR is 1, 794 miles and many years removed from Silicon Valley of the '90s, but these days the mood is strikingly similar. "There is a 'dot-com' atmosphere in the home of the largest ethanol producer, " says Prudential Equity Group analyst John McMillin. "The big difference is that ethanol is making strong profits."

And the buzz over ethanol is only likely to increase over the next few years. A new energy law effectively will double the consumption of renewable fuel to at least 7.5 billion gallons by 2012. Another boost comes as the U.S. oil industry phases out the use of the gasoline additive MTBE, or methyl tertiary butyl ether, in favor of ethanol. To further encourage ethanol use, the government forks over a 51-cent-per-gallon subsidy to refiners that incorporate ethanol into their blends.

No surprise, then, to see investors scouring for alternative-fuel technology stocks in general and ethanol producers in particular. But few publicly traded ethanol companies boast Archer Daniels' profitability and heft. Management is well aware of this: The company that once billed itself as the "supermarket to the world" has increasingly positioned itself as the gas pump of the future. "Growing energy for today and tomorrow, " its slogan now proclaims.

Some fret that increased ethanol capacity industrywide will hurt pricing, but those worries are misplaced. With ethanol making up just 3% of the U.S. fuel market, its prices are dictated mostly by movements in crude-oil prices.


In fact, the biggest threat to ethanol companies lies in the possibility, however unlikely, of a drastic and sustained pullback in energy prices. A rise in corn prices could also hurt. With corn accounting for about one-third of ethanol production costs, increases in corn prices could easily crimp margins. Says Driscoll, "With no new ethanol capacity until 2008, the main way for Archer Daniels to make more money on ethanol is if ethanol prices increase or if corn prices decline."

Fortunately for Archer Daniels stockholders, the commodities market seems to anticipate generally high oil prices for a while. Corn prices, too, are likely to stay stable. Demand is apt to rise, not only because of the U.S.' appetite for ethanol, but because China is apt to shift from exporter to importer as its population continues to swell, noted Credit Suisse First Boston analyst David Nelson. Supply, however, should hold up well, with advances in genetic technology leading to higher crop yields.

It all adds up to a bright picture for the world's ethanol king. Prudential's McMillin called Archer Daniels' prospects over the next 12 months "sensational, " noting that 20% of the ethanol had already been contracted through March 2007 at about $2.05 per gallon. Brokerage firm Davenport & Co. recently upped its 12-month price target to 40 from 34, partly because of the favorable ethanol market.

THE OTHER PARTS of the Archer Daniels empire are doing just fine. High-fructose corn syrup may be shunned by the organic-food crowd, but it remains a widely-used food and beverage additive whose consumption typically rises over the summer. Unlike the fragmented ethanol market, there are only a handful of North American producers, and Archer Daniels has a leading 35% share.

The fructose-corn business was hurt in the past by overcapacity, and after Mexico imposed tariffs on U.S. imports in the late 1990s. But large companies like Archer Daniels and Cargill have since bought out some of the smaller players, and margins and prices have begun to improve after a prolonged downturn.

The Bottom Line: It's not too late. The shares are up by 37% this year, but they could climb at least another 20% in the year ahead, as the demand for ethanol remains strong.Meanwhile, dwindling consumption by the carb-conscious camp has cast a pall over the wheat segment. But the slack is picked up elsewhere, with oilseed-processing and soybean-crushing profits growing nicely. A partnership with Cofco, China's biggest grain-trading company, also positions Archer Daniels for further investments in that burgeoning market. And in the $5 billion cocoa industry, the trend for chocolate makers to outsource cocoa-grinding has resulted in more business and better margins for processors like Archer Daniels.

In the coming weeks, Archer Daniels is expected to announce a successor to G. Allen Andreas, its 62 year-old chief executive and quite possibly the last in a line of Andreases to lead the company.

While the 33-year veteran helped right Archer Daniels after it was rocked by price-fixing scandals in the 1990s, hopes also run high among shareholders that a new CEO, expected to be chosen with painstaking care by the independent board, could bring fresh ideas for the rapidly changing industries.

The company does face risks. As with any agricultural business, an unforeseen crop catastrophe -- a prolonged drought, a locust invasion -- will thwart raw-material supply and threaten processing margins. But with its vast global storage infrastructure and an extensive network boasting thousands of railcars and barges, Archer Daniels can capitalize on temporary disruptions better than its small rivals. For example, a 2004 drought forced many grain-exporting Southern European countries to import instead, and Archer Daniels was able to exploit that unexpected demand and impose premium rates.

Without question, the stock's recent run has raised concerns that much of the short-term upside may have already been captured. But the ethanol business will grow for years to come, and Archer Daniels is poised to harvest the benefit of that inevitable shift to renewable energy and the planet's push to feed and power itself with what it grows. Just as William Blake once saw the world in a grain of sand, more investors will recognize the power in a kernel of corn.