International investors can still get exposure to the industry, although not directly and therefore without total control.
Land rush on Brazil’s frontier
by Rob Dwyer
Transport costs have made the country’s agriculture industry uncompetitive. But new infrastructure projects should transform the opportunities some have seen in land values.
First, for those international investors interested in Brazilian agribusiness, the good news: the country’s poor infrastructure is crippling the competitiveness of Brazil’s farms. With little or no onsite storage, farmers are forced to ship harvests straight to port – becoming price takers at peak times of supply (and therefore low prices) and incurring peak freight costs. The journey from the interior of the country, which is where most of the agribusiness opportunities are located, is roughly 2,000 kilometres by truck. Roads are poor, railways are virtually non-existent. Delays at ports are costly in time and money. Logistics costs exceed those in other countries such that planting often isn’t economic. Also, regulation is not helping: new rules governing truck drivers’ working conditions are forcing up already sky-high freight costs and the Brazilian government has now restricted foreign ownership of farmland.
The bad news? This situation is changing fast. Key infrastructure projects should come on stream over the next few years and lower logistics costs will make the country’s frontier lands globally competitive. The wave of investments that began in the mid 2000s to develop farmland in the heart of Brazil will continue but those that are making handsome returns from the transformation of scrubland into highly productive arable farms say that the business model has about five years to run. Of course there will be further opportunities to make money out of Brazil’s emerging superpower status as an agricultural producer, but in all likelihood years of outsized returns are numbered.
Since about 2003 the demand for food has entered another super-cycle, where a change in the diets of emerging market populations is leading to a multiplier effect on the demand for grains. This phenomenon, known to economists as the income-growth effect, was last seen in the 1960s and 1970s when rising incomes in the US and Europe led its populations to demand more protein – essentially meat – which is more grain-intensive to produce than a diet of base goods (such as bread and vegetables). Now the growth in wealth in the emerging markets – largely China – has sparked another such cycle of agriculture demand. And this time it is not just dietary shifts driving demand: growth in bio-fuels is competing for farmland, creating further competition for productive farmland.
In the 1960s and 1970s the response to the leap in demand for grains was a revolution in agricultural technology and, through that, productivity. This time technology will also be critical, but new lands in Brazil are set to benefit. A Macquarie report summarizes the situation: "Brazil is the embodiment of the next revolution. Through the last decade we have seen them embrace agriculture as a source of wealth creation. The combination of this with their beneficial climate and abundant arable resources gives them the best ability to respond to that demand shift."
As Macquarie notes, Brazil is blessed with its climate, and specifically by water. The country has an estimated 13% of the world’s water resources, which is, of course, critical for crop production. That source of water is vital, and shouldn't be underestimated, according to forecasters. For example, China is likely to outsource more production to Brazil’s water-rich regions, which will, in essence, be a trade in water. Brazil is also extremely stable in its climate, which boosts production, and also is the most latitudinally diverse of agricultural producers – its territorial span from near the equator in the north to lands in the south is unrivalled by any other grain producer. Only Africa has the same span and then not within a single country. The main traditional grain producers in the northern hemisphere run roughly along the same latitude and droughts that affect one tend to affect the others. So Brazil has the natural hedge to its already stable climate with latitudinal diversification.
For decades Brazil has also been investing heavily in agricultural technology and that has had revolutionary results. It was discovered that the cerrado biome – a type of scrubland that covers roughly 25% of Brazil, and mainly in the interior states of Mato Grosso, Mato Grosso do Sul and Goias, can be made fertile – tremendously so – by the relatively simple addition of limestone and fertilizers to the acidic soil. This opened to arable production, in an instant, huge swathes of land that were either unproductive or relatively unproductive pasture land.
Brazil’s farmers moved to this new frontier land and the capital-intensive nature of starting the operation and the open savannahs led to a natural development of large corporate-style farms, with scale helping to dilute capital expenditure. As these producers began establishing operations, so too did consultancies and financiers. Informa Economics FNP, based in São Paulo, is one of the leading consultants to the Brazilian agribusiness sector and Mauricio Mendes, its chief executive, says that there was a notable intensification of international appetite for the industry following the 2008 crisis. "After 2008 the international investors came to Brazil looking for real assets, looking for long-term alternatives," he says. The government slammed the window shut in 2010, mostly because it feared the establishment of sovereign-owned enclaves of land in the interior of Brazil, but the restrictions of foreign land ownership effectively ended direct FDI in agriculture by foreign businesses.
"It lost Brazil a lot of money," says Gabriel Pesciallo, a division manager at Informa Economics FNP. "There were a lot of huge companies that were planning to come to Brazil that had to hold their investment or give up. And of course everyone in the industry is putting a lot of pressure on the government to study [the situation] and work with us to reach a better point for everyone. It is not good for the country to stay the way that it is." Many in the industry are confident the situation will be resolved with a more commercially friendly outcome, which will offer upside to land valuations as money from abroad returns to flow in substantial volumes.
International investors can still get exposure to the industry, although not directly and therefore without total control. However, there are still plays: SLC Agricola is an example of the large-scale corporate farming that has become common in the interior. It is listed (with a free float of 49% - the Logemann family retains a controlling 51%) and foreign ownership of its Bovespa-listed shares fluctuates between 80% and 90%. Such an equity investment is an obvious and simple way for foreign participation in the sector and would seem to offer opportunity. The company faces the ever-present logistical challenge, but it owns 70% of its land directly, as well as 50% of its remaining land, and yet the share price doesn't seem to reflect the rapid gains in the real estate portion of the asset. "I think the market is still learning how to value companies like SLC," says Giovana Araujo, analyst of agribusiness at Itaú BBA. "If you look at historical trading, the stock price has been more volatile than the value of the land – it is disconnected with the value of the land, or the net asset value. So one conclusion is that it seems the land is more a floor in terms of value of the stock, which is still linked to the dynamics of the farming business."
Araujo says the NAV – or the value of liquidation – is R$32 a share and the stock was trading under R$20 on 11 December. "The market is not giving the full NAV because the returns of the farming are still low." Araujo says the NAV valuation approach is easy and has the benefit over the discounted cashflow approach in that you don't need to factor in assumptions about commodity prices and logistics costs."
Without a doubt these logistics costs are hurting Brazilian producers. Despite having lower cost of production for soya beans and corn than the midwest of the US, the transportation costs are so much higher than for the north American producer that it often breaks the economics for the producer.
According to Amaury Junior, founding partner and chief investment officer at Vision Brazil, which is an asset manager that sources international capital to finance the development of farms and farmland, the cost of transporting soya beans from the centre of Mato Grosso to the southern ports of Santos or Parangua is $120 a tonne, compared with the internal logistics costs of between $15 and $20 a tonne for US producers. The cost from the ports to China is then between a quarter and a third of the internal cost of logistics.
Compounding the problem, there is a severe lack of on-site storage in Brazil. The ability to store crops mitigates the farmers' exposure to peaks in transportation costs that come at harvest time, and also enable them to sell crops off-peak season when prices are higher. Junior estimates that the state of Mato Gross alone needs 20 million tonnes of storage. The demand far outstrips supply, agrees Pesciallo of Informa Economics FNP, with farmers who want to build concrete storage silos being told by suppliers that they face waits until 2015 until work can begin. Sales of silo-bags – essentially big plastic bags – have spiked, with 70,000 being sold in Brazil in 2013, but these are imperfect solutions to the problem. At harvest time, an estimated 20% to 25% of Brazil’s total grain production is in trucks on a 2,000-kilometre journey to port – or at port in queues of up to six days just to deliver the crop to the port’s conveyor belt. It leads to the dryly told joke that the biggest manufacturers of grain storage in Brazil are Mercedes-Benz and Scania.
"Brazil has a huge logistics problem – the price differential for logistics between the US and Brazil is absurd, which is a benefit [to investors currently] as these infrastructure challenges are being resolved and Brazil is becoming more efficient over time," says Junior. Vision Brazil’s business plan is to take unproductive farms and make them more efficient. Usually these farms are on the frontier and face the greatest logistical challenges – and costs – but this is the basis of the alpha that underlies these projects. "Our approach is to take large-scale opportunities – usually between 20,000 and 30,000 hectares – where we can develop the soil and build infrastructure. We go into regions where the entry price is low and effect land transformation – making non-productive productive – and monetize the price convergence with the price of productive land in other regions of Brazil. That’s our alpha." Junior says there is often beta to the projects as well, such as general appreciation in land values, but this can be flat and is never the source of the project’s economics.
Vision Brazil is already divesting its 2007/08 vintage of projects and reports strong returns. Junior can’t disclose returns on individual projects and is wary of talking about the expected returns he discusses with his international institutional investor base, but a rough guide is a two-times return on investment over the four-year to five-year project.
SLC Agricola has a similar approach through an investment fund it launched with UK asset manager Valiance. The company developed a joint-venture land company with the international investors that are exposed to the transformation of land values in undeveloped, unproductive cerrado biome, as well as general appreciation of productive farmland in its portfolio. The land company subsidiary leases the land to the producing unit and as such doesn't have exposure to production and logistics risks.
Araujo says the stock has upside potential and has a target price of R$32.50 – a discounted cashflow valuation of R$25 a share and the remainder value generated by land transformation. Both offer opportunity, according to Gustavo Lundardi, CEO of SLC Agricola and SLC LandCo, and the company is focused on cost management, of which hedging risk is a central policy. "We fully hedge our commodity and FX exposures when we can lock in our target returns of between 25% and 30% ebitda," says Lunardi, who says that SLC Agricola has about 50% storage capacity to maximize price and minimize logistics costs. He believes new infrastructure will lead internal logistic costs to fall by about one-third in the coming years and plans to double production from the current size of 340,000 planted hectares.
Brazil is currently the world’s marginal producer: when prices are high enough to cover the internal logistics the country’s producers respond swiftly. The year before last corn production in the state of Mato Grosso do Sul was 8 million tonnes. Last year that leapt to 20 million tonnes as global prices were high, illustrating the additional supply that will permanently come on stream when infrastructure develops more efficient freight costs to port.
SLC LandCo raised $236.8 million with Valiance and this capital will be fully deployed by the end of 2014, when the company will raise money for another fund. The land in the current fund appreciated at 17% in the first year and will seek to exit through divestitures or a possible IPO in five to 10 years. "The Landco is a good model to enable international investors to get involved with the land expansion and land appreciation in Brazil," says Lunardi.
Lunardi’s expectation that infrastructure costs will come down by about one-third are widely shared and based on three main improvements that should have a big effect in the coming years. The first is the development of the port of Itaqui in the northern state of Maranhão, which is expected to be able to export 5 million tonnes of grains in 2014 and 10 million by 2016. This will add capacity and competition and it will be much more efficient for producers in the centre of the country to send crops to the north (and also closer to the USM Europe and the Panama Canal) than to the southern ports. The second factor is the development of the north-south railway and connecting railway lines to feed into that distribution network. And the third are key connector roads – mostly notably BR163, which links Mato Gross to Santarém in the state of Pará and will connect with the northern river ports of Miritituba and Santana, providing transit to the north and cutting journey distances and costs. Bunge, a large grain producer, expects to route 1.5 million tonnes via the northern corridor in 2014 and 3 million tonnes in the medium term. But optimism isn't universal. "Because of the amount of soya beans and corn that will be transported on BR163, the construction needs an asphalt layer of 12cm and they have made it with an 8cm layer. So in a couple of years [the road] will be completely destroyed," says Informa Economics FNP’s Pesciallo. "It’s the same with the north-south railway; the sleepers they used are not strong enough to take the trains." But even with these big reservations noted, Pesciallo foresees substantial logistical improvements in the years ahead: "The Itaci port will change the market and we are going to have a very good logistical situation. They are using the very latest technology for loading infrastructure and it is going to be much faster and cheaper to ship to Europe and China."
International institutional investors are increasingly interested in diversification into alternative and real assets, but the window of opportunity to get the returns of the land-value differentials between productive and infrastructure-lined land and non-productive isolated land is closing. "I think the cheap supply of land will last for about five years," says Junior. "There is still a big gap between land values in Argentina and the US and Brazil, although if we are talking to the land valuations in the south of Brazil they are already somewhat similar. But when you talk about the frontier regions, those still have a very attractive price differential that will end up converging with the more expensive land price. There is still a lot of yield to be taken out of that [dynamic] in the next five years."
But there will always be opportunity and Vision Brazil says it has just signed a large deal with a US pension fund for a land transformation project in Brazil that could indicate the future of these types of investments in rural Brazil. The project is a new type of venture for the company; using proprietary capital and partnerships with construction companies, the consortium plans to develop 10 million square metres of rural land into urban land. The project is based on the expansion access of an existing city and will incorporate residential and commercial real estate, as well as leisure facilities and other natural resources investments such as timber, because it’s not just in grains that Brazil has a competitive advantage: timber grows at a rate of between 13 and 15 cubic metres a hectare in the US while the rate in Brazil is 45. Forests become mature in Brazil in about six years compared with 15 years in the US. And so Brazil’s natural resources sectors are set to offer strong growth opportunities in the future. But the returns on offer from today’s central agricultural opportunity – that of the conversion of land to productive and valuable arable farmland – won’t be available for much longer.