Testimony before the Senate Agriculture Committee

April 27, 2000

David C. Nelson

What's going on in agribusiness? The financial performance of agribusiness companies and agribusiness stocks has been poor. Since January 1997, my Agribusiness Stock Index is down by one-third, during one of the greatest bull market runs in history - a time over which the S&P 500 has doubled . This is due to negligible returns on capital, slow and volatile earnings growth, and an implied unattractive outlook for future returns in this sector.

Poor stock price performance reflects weak earnings growth across the sector in the past, but what stock prices reflect are the market's forecast for future profitability. It is clear from the voting booth of the stock market, that investors are voting with their feet to dis-invest in agribusiness

Why have returns been so poor? A few thoughts:

The value chain across the entire food industry is contracting. There is a power shift taking place from food companies to retailers, but also from retailers to consumers. The profit challenge being faced by farmers is not unique across the food chain.

Customer and consumer needs and preferences change, and are changing at an increasing rate. Corn movement, for instance, has shifted from being based largely on exports to being more focused on the domestic processing industry. With this shift, substantial assets and investments have become out of place and of little to no value. Shift happens in our economy of creative destruction.

Commoditization. Companies need to generate differentiated new products to maintain consumer interest and pricing power. Innovations are rapidly duplicated and the ability to capture value, even when successful, is often short lived.

New competition. As an example, soybean processors are getting new competition from Brazil and China - as well as from domestic cooperatives. These players have different economics and different return objectives that make competition difficult for profit oriented companies with public shareholders.

Essentially, we have too many companies fighting for too few profits. Agribusiness will not attract the capital it needs to make the investments farmers say they want until profitability improves.

Why do we see consolidation and integration? Industry consolidation and integration occur for two main reasons.

One, companies and individuals often need to sell their business because they are unprofitable or unviable in their current structure or configuration. This can happen for many reasons, perhaps the most frequent of which is that businesses fail to change appropriately with a changing environment. In agribusiness, these are primarily family owned operations, frequently within a generation of leaving the farm.

This is a natural selection process at work. This is the reason we have the most productive and efficient food system in the world. This is the reason we have a healthy economy and a reason why other economies with more intrusive policies have high unemployment and dis-investment.

Two, we are seeing integration occur to meet the demands of customers and consumers. We are hearing a lot of objections, for instance, to packer ownership of livestock these days, particularly in the pork sector. This is not because raising hogs is sexy or glamorous and something packers want to do. It is because they have to. Customers (retailers and restaurants) and consumers want quality and consistency. You cannot have quality and consistency without coordination or integration. As an analyst, I would rather see companies investing forward in the production chain to add value through further processing or branding. These companies are investing backwards in the chain not because they want to, but because they have to serve the consumers' demands for quality and consistency.

It is important to note that not only are customers of food manufacturers more demanding, but they too are consolidating. The top five supermarket chains have gone from roughly 25% market share in 1995 to 40% share today. These chains want and need suppliers with regional and national distribution. Supermarkets are trying to simplify operations by reducing the number of suppliers, like all businesses. They also need suppliers that have made the substantially and continually increasing investments in information technology necessary to extract supply chain cost savings. Food industry consolidation has been much less than at the retail level, and what has taken place is partially in response to what is taking place among their retailer customers.

A Wall Street perspective on proposed legislation to impose higher standards on agribusiness mergers and acquisitions. Our review of certain proposed legislation that would impose additional USDA oversight and approval regarding agribusiness mergers and acquisitions, leads us to believe such legislation would negatively impact investment in agribusiness and agriculture. Under such a scenario, these companies' ability to defend themselves in a rapidly changing economy could become compromised. This risk creates uncertainty that would reduce the value of existing assets. The ability of agribusiness companies' to generate a return on capital and attract important new capital would be negatively impacted.

These are capital intensive industries that require substantial reinvestment merely to stay in the game. For instance, IBP has announced plans to double its capital expenditures over the next year to near $400 million, in large part to fund new equipment and technology for case-ready meat to make their beef and pork products more competitive with chicken. In addition, the meat industry has invested at least $300 million in the last three years to fund food safety initiatives, in particular related to new HACCP requirements. Expenditures necessary to meet environmental standards are also rising rapidly. Packers need to be sufficiently profitable to meet competitive, food safety and environmental standards, or we will continue to see dis-investment in this industry and producers will simply have fewer places to sell their livestock.

This high degree of capital intensity is an unattractive feature to investors. This is why meat packers such as IBP and Smithfield trade at price to earnings ratios near 5x, while the overall market is at 27x. This obviously reflects that capital is much more expensive for packers than for industry as a whole.

Policy considerations.

1. Make a conscious decision on the nature and direction of agricultural policy. In my opinion, we need to make a conscious decision regarding what sort of farm policy we want in this country. We passed the Freedom to Farm Act in 1996 but since then we have also seen bailout packages every year. Those that provide the money to finance this industry would prefer predictability in policy, rather than these one-off packages we've had in recent years.

2. Level the playing field on trade policy. Agricultural trade and production continue to be highly distorted by the large production and export subsidies of the European Union. U.S. farmers and U.S. based agribusiness is inherently handicapped by this distortion.

3. Help farmers adapt to the changing economy, rather than further entrench them in nonviable operations. Our economy is based on creative destruction. Farmers and other businesses need to adapt to changes in our economy, or find other ways to make a living. Most non-farmers now have many different jobs throughout their careers and often have to move their families around just to keep up with changes in the economy. Change isn't easy, or even pleasant. But maybe agricultural policy should be more focused on helping farm and rural families to adapt to the new economy rather than trying to preserve them in operations that simply aren't viable.