The appointment of Patricia Woertz as CEO at Archer Daniels Midland Co. (ADM) underscores how substantive the alternative energy push has become. She comes from Chevron Corp. (CV) and ADM, a major agribusiness concern, produces ethanol, a grain-based alcohol whose chief attraction is that it can blend with gasoline and thereby cut at least some of the oil need.
ADM believes that ethanol's share of the U.S. gasoline market can rise from 3 percent now to at least 10 percent. It plans to boost ethanol production capacity by 50 percent. Having a former oil executive running the company should give them a leg up on navigating the U.S. energy market and deliver on all of that new supply.
As important as ethanol is to Archer, it does not dominate the company's financial statements. It's accounted for as part of the company's Bioproducts segment which, including products other than ethanol, accounted for 16.7 percent of operating profits in the fiscal year that ended June 30, 2005. That's quite a contrast from Pacific Ethanol Inc. (PEIX), a pure play ethanol producer whose shares have risen about four times faster than Archer's so far this year.
Archer's 2006 share price gain, 50.6 percent through late-morning May 1, is nothing to sneer at either. The pace has been partly weighed down by ADM's more traditional, slower-growing businesses. The flip side, of course, is that because the lion's share of profits come from processing corn and soybean oil and the like, there's downside profit protection in case ethanol fails to live up to expectations.
Archer's share-price valuation metrics show there's something of a cushion if the company doesn't perform exactly as expected. Its trailing 12 month (TTM) price/earnings and price/sales ratios are 23.46 and 0.67 respectively vs. S&P 500 averages of 21.52 and 2.98. We estimate that the stock would be reasonably valued if the company's earnings per share can grow at an average annual rate of 6 percent or better over the next five years. Based on the consensus Wall Street long-term growth rate projection of 9 percent, our target is looking doable.
By way of contrast Pacific Ethanol has no earnings (and, hence, no P/E ratio) for the TTM period. For calendar 2006, its loss per share is expected to widen to $0.44, from $0.22 in 2005. No projections are presently published for 2007 or for a long-term growth rate. The stock's TTM price/sales ratio is a considerably-more-risky 14.45.
Valuation metrics aside, any time stocks rally like ADM and PEIX have, investors need to think about the possibility of a correction. Slipping oil prices could do it, for one. With ADM, there are acceptable ways to hedge against a possible drop in the share price.
As of late morning, a January 2007 Archer put option with a slightly out-of-the-money strike price of 35 traded for $2.95. If we add that to the Archer's stock price, the five-year EPS growth rate needed to justify investing in the stock would rise from 6 percent to a still-reasonable 7.6 percent, meaning it wouldn't be the end of the world if the put option were to expire worthless. On the other hand, an investor would begin recouping losses if Archer shares were to correct by more than 15 percent.
If one were to hedge with the in-the-money January 2007 40 put, which last traded at $5.50, the core Archer valuation would turn neutral (to justify investing, Archer's five-year EPS growth rate would need to match the 9 percent analyst's consensus expectation), but losses would start to be recouped if Archer stock corrects by 8.4 percent or more.
It's a lot harder to hedge against a correction in Pacific Ethanol. Puts that could also begin recouping losses at or near mid-teens percentage levels exist, but premiums on those contracts are high, amounting to more than a third of an already uncertain, from a valuation standpoint, stock price.