Input Capital Corp: If You Build it, Farmers Will Come… [Part II] by Above Average Odds Investing

Now onto Part 2 of our ongoing series on Input Capital…
 
Editors Note: Like part 1, part 2 was originally authored towards the end of last year and is therefore dated. Nonetheless, for those looking to garner a number of unique qualitative insights into what makes this one of a kind business special, Part 2 remains every bit as applicable as the day it was written.   
 
As Input Builds It, the Farmers Will Come

We then arrive at music, the knowledge of harmony. Are the parts concordant with the whole, and is the whole concordant with the world at large? How does the business harmonize with its community, employees, competitors, shareholders and the environment?

                              – Chris Begg, East Coast Asset Management

In part one of our ongoing analysis on Input Capital, we laid out the high-level case for Input in our usual qualitatively focused manner.  In part two, we’ll kick things off with a discussion on why we believe Input has all the pieces in place to become a billion dollar company over the next five years. Indeed, we expect Input to navigate the path to a billion with relative ease. If that sounds crazy, humor us for a moment as we flesh out and illuminate a number of qualitative insights that should make it sound decidedly less so (if not downright reasonable).

For example, to become a billion dollar company, we figure Input will have to raise ~$250m and deploy ~$300 to $400m in total over the next five years, with the difference between the two figures coming from the redeployment of internally generated cash flow. Furthermore, if the average deal Input inks going forward amounts to ~$1 to $2 million, so an amount in line with what we’ve seen so far, we can reasonably figure Input Capital will need to source ~150 to 200 individual streams between now and the end of year five.

Yet, each of these streams represents a decision by both the farmer and Input.  As such, part two of the Input Capital thesis will focus on the fabulous economics for both the farmer and Input as well as reiterate the multi-layered downside protection embedded in Input’s business model. After all, in our mind handicapping the road to a billion largely comes down to answering two questions with conviction.

  1. Will the average cash strapped Western Canadian small farmer with a self identified need for working capital find Input’s value proposition compelling?
  2. Will private capital looking to invest in the agricultural sector view financing Input’s streams as an attractive investment on both an absolute basis and relative to other options in the space?

Regarding the first question, our analysis tells us the answer is a resounding yes. More like a F*ck yeah followed with a fist pump, but hey, why split hairs here. In all seriousness though, given these deals appear to unlock a tremendous amount of value on a regular and ongoing basis for farmers (see the detailed breakdown on said topic below), the idea that Input would have trouble sourcing a few hundred partners out of an addressable market that stands 50k+ strong in Western Canada alone is simply not credible. In fact, I wouldn’t be surprised to see Input Capital do 200 streams in a single season a couple years from now once the concept of ag streaming is well known and broadly understood.

As far as the second question, again, the idea that Input would have trouble sourcing ~$250m over the next five years is absolutely preposterous given the risk-adjusted return profile associated with these deals are about as good as it get’s on an absolute basis. The thing is, approaching the question from a relative basis is even sillier. After all, from what I can tell ag streaming appears to generate the highest returns on capital across the entire agricultural value chain!! So maybe its me, but the idea that Input will have trouble raising a mere $250m in total over the next five years doesn’t pass the smell test. Heck, if low quality E&P wildcatters can raise ten’s of billions overpaying for third rate shale assets, Input shouldn’t have too much trouble hitting the above goal.

At any rate, the thesis with Input remains the same, as it is very much a business that “deserves to win” (as the guys over at East Coast Asset Management recently put it). And why wouldn’t they! Given the company has created the proverbial key that fits mom and pop canola farmers “productivity unleashing lock”, we envision an environment where everyone involved should thrive. Indeed, we expect the company’s breakthrough value proposition will create tremendous amounts of wealth for all involved for many years to come.    

Farm Level Economics: Why the Heck would a Farmer give up 40% to 50% of his most profitable crop?

With over 50,000 canola farmers in Western Canada, the market is not institutionalized with the average farm in the range of 3,000 acres. Modern farming requires a significant amount of capital (land, labor, equipment, seed, fertilizer, water, etc.) which is by no means cheap. Additionally, in a farming family the working capital of a farm is stripped out every generation for Mom & Dad’s retirement.

And while the truck commercials we watch every Sunday during NFL games (Shout out to your Editor’s undefeated hometown KC Chiefs!) romanticize farming, the capital intensity of the business often means a farmer is attempting to keep all the proverbial plates spinning by “robbing Peter to pay Paul”. Perhaps it’s a bank line that is able to be drawn to pay for some new equipment, or taking a new tractor with a note instead of scrimping on high quality seed this year, and so it goes. The truth is the vast majority of Western Canadian farmers are not properly capitalized and typically find themselves busting their tails simply to make ends meet.

You may ask: isn’t there alternative financing available to farmers that doesn’t give a 30% IRR to the financier?  The answer is yes but only for certain types of assets.  Acreage can be mortgaged, equipment financing is available through the manufacturers, and there is seed & fertilizer credit available from the crushers and grain elevators on undesirable terms.

For example, there is only traditional fertilizer credit available two weeks before planting season so the farmers don’t blow the capital on something else… Guess who knows that?  Fertilizer companies.  So the price of fertilizer rises dramatically when the credit is available thus dis-incentivizing the farmer from purchasing the optimal amount.

So what can a farmer really cut back on?  They need land, large farm equipment to harvest the crop at the optimal time, obviously they need labor and water to grow the crop. So again, what are the only variables that farmers can cut back on?  That’s right – fertilizer and seeds (of the less productive and reliable variety) – the inputs that offer the highest returns on incremental capital (by many orders of magnitude) and that at the end of the day, make all the difference. I guess they can take solace they’re still in the game, but I think we can all agree that’s a steep price to pay for being working capital poor. Depressingly steep.

Sadly, the scenario described above is typical. You’ve got farmers leveraged to the proverbial hilt, which forces them (out of necessity) to cut back on the very part of the equation (fertilizer) which would maximize their crop yields in both bushel and dollar terms. To us, that is the definition of suboptimal!

Input Capital

Alas, the sad truth of the matter is that a truly shocking amount of hard working farmers get sucked into a vicious cycle of suboptimal farming that is extremely difficult to dig themselves out of. That’s not to say it’s impossible but the more we’ve studied the dynamic the more we’ve realized it is a much trickier trap than we initially thought. What’s even more depressing about it is that even when these farmers are able to work themselves out of it, it’s scary how easy it is to fall right back in the trap.

All this is obvious if you take the time to do the leg work and really discern the issue. When you do you realize it’s the type of thing that simply screams out for a solution, but the very viciousness of the dynamic makes a solution so difficult to come by. Which is why what Input Capital has done is truly amazing. As you can’t really understand how game changing it is until you understand how hard it is for all but the best capitalized and most experienced farmers to make a decent living. Indeed, they’ve cracked a code that is generally assumed to be unbreakable…”it’s just the way it is” and there’s nothing that can be done except to put your head down and start digging your way out, inch by inch… or at least that’s the operating assumption of practically every farmer in Western Canada today whose struggling to make ends meat. Yet for the first time ever there is a better way!

Granted, it took management almost ten years of working side by side a select group of farmers to figure it all out, but they did. And their solution is by all accounts the real deal – offering a proven, surefire way to put the days of “just getting by” permanently in the past and a chance to spend their time no longer worrying about surviving, but thriving. For many, we imagine the very idea is flat out thrilling.

That in mind, let’s pull up the hood and take a look at the mechanics of how these deals actually work…

Working Capital for the Whole Farm?

Input Capital’s agreements not only support the farmer’s canola crop but also the other 2/3rd of his crop.  How does this work?  Input’s stream to the farmer will provide up to $300 per acre of the farmer’s total farm (even though the contracted payback stream is only on canola).  To that farmer, this is an exceptional trade-off as it allows the farmer to maximize his whole farm while keeping roughly half his previous canola crop.

A standard farming rotation for a Canadian canola farmer is 1/3rd canola, 1/3 wheat/durum/barley, and 1/3rd peas/lentils. The farmer must rotate his crop every year to (1) maintain proper soil chemistry as the different crops extract and provide complimentary nutrients to the soil and well as (2) minimize disease that can spread if farmers fail to rotate their crops.  As Input management says “canola then snow then canola is not a crop rotation!”  So when a farmer considers Input’s offer and recognized his ability to optimize his entire farm by lowering his cost of capital by buying fertilizer off peak and delivering his crop at an optimal time he jumps at the chance. In other words, the farmer understands his economics and the overall value proposition Input Capital offers immediately.

Yield Enhancement

Input has a view that the amount of working capital required to run an optimal agronomic program is about $300 per acre each year. Assuming a farm of 3,000 acres that’s a working capital need of $900,000 which is no small task.  So farmers typically underutilize fertilizer and thus spend about $200 per acre.  When applied to canola a typical haul for a $200 working capital acre is in the neighborhood of 25-30 bushels per acre.  Yet with the $300 per acre and the requirement to have a soil agrologist, the farmer stands to achieve crop yields much closer to the land’s inherent productive capacity of 60 to 65 bushels per acre.

Suffice to say that if a farmer can double his output on a per acre basis which requires no extra land or labor he will do so… To make the math simple, if the farmer was doing 25 bushels per acre and doubles his output yet pays only half his crop he is flat economically with respect to canola.  So when considered in the context of his yield maximization of the other 2/3rds of his acreage the deal is a “no brainier” for the farmer. After all, the return on that incremental capital deployed is astronomical. Which is just another way of saying that by investing a little more he can make his farm A LOT more money.

In summation, if a farmer can lower his cost of capital, increase his crop yields across all of his farm, and retain upside to half his historical canola crop all for no capital outlay (read having to pony up any money of his own) he is going to jump at the chance.

Input Economics: With 20% IRR’s on base tonnes & 30% pre-tax IRR’s inclusive of bonus tonnes, can it be that these returns are simply matter of funding off season fertilizer purchases?

As shown above, a farmer is able to post material gains by utilizing excess working capital efficiently. Yet how can Input Capital expect to earn a reasonable return on investor capital when the farmer is reaping these types of rewards? Therein lies the magic of canola streaming and the whole reason Input is focused on the crop in the first place.

As described in detail in part 1, canola has many attributes as a cash export crop yet we saved one pertinent detail for this part.  The key component is as follows: Canola has properties such that proper fertilizer and agricultural techniques can double the crop yield (as opposed to a 20% yield enhancement in wheat and peas).  Yes.  Double – as in a 100% increase.  Yet many farmers aren’t doing it themselves…

Here is how Input models their contracts: they target a 20% IRR by contracting a fixed number of base tonnes assuming future prices utilizing the canola and soybean forward rates.  Now, 20% is a real figure especially when Input begins receiving cash during the first 12 months of the contract (note that the company wrote its first contract on Feb 1, 2013 and got all their first year revenue from that farm before October 15,2013 but we digress).  Since the contract is for tonnes as opposed to dollars, Input can earn vastly in excess of their targeted 20% return if/when canola prices rise.  Conversely, if canola prices fall, Input makes a lower IRR yet in the vast majority of scenarios Input still has a positive IRR.  So assuming some contracts will earn less than 20% from price declines and some will earn more it’s reasonable to assume 20% IRRs on base tonnes going forward with reasonable confidence.  Not bad at all!

However, we have neglected one key return stream for Input – the bonus tonnes.  To describe bonus tonnes in financial parlance – they are akin to performance fees for hedge funds.  If/when the capital allocator performs above and beyond they are entitled to extra compensation.

For Input, this compensation is 15% of all tonnes over 30 bushels per acre. Ok so that might be nice but how valuable could this really be? Take a look at the below – the bonus tonnage opportunity adds nearly 10% in very reasonable scenarios and up to 20% in most scenarios.  Recall this bonus tonnage IRR must be added to the base tonnage IRR such that a 30% IRR is a very reasonable scenario.  How many businesses do you know with this type of yearly IRR potential?

Input Capital

Current metrics put the crop productivity for the year in the ~36 bu/ac range.  As illustrated in the above chart, with canola at $500 per bushel and ~35 bu/acre Input can expect an IRR of ~31% before overhead and taxes this year.

That is exciting to put it mildly…

And again, the above rates of return are achieved even though Input Capital only gets paid on the canola. We should note too that the way Input structures their contracts to make the farmer’s decision making for him is friggin brilliant:

  • Input maximizes the entire farm but takes only 50% to 60% of the farmer’s normalized planted canola.  So the farmer still has 40% to 50% upside on his canola crop and the canola can double in terms of bushels per acre so the farmer is still highly incentivized to focus on canola.
  • Yet, the farmer still gets the productivity enhancement on his other crops (think wheat and peas), which he certainly cares about but Input more or less does not. The simplest way to think about this is that any and all benefits from yield increases in the farmers other cash crops is all gravy from the farmers point of view.
  • So essentially Input has incentivized the farmer to max his canola output, giving upside for the farmer in the process. But remember, Input’s payoff is asymmetric: 20% base case return with no bonus tonnes (and farm insurance paying off in excess of Input’s contracted tonnes covering the downside protection) AND the farmer is incentivized to maximize their canola crop per acre so Input’s true IRR is materially > 20% given normalized expected bonus tonnes.

C’mon!?! Govn’t Guaranteed Downside Protection attached to Deals with Exponential IRR’s?!?

Now that we understand how yield enhancement tactics with respect to canola as the primary driver of exceptional rates of return for both Input and the farmer, let’s return to the downside protection aspect of the risk/reward equation.  I mean a high rate of return has to be risky, right??  Professor Fama from the Chicago Booth Business School just won a Nobel Prize for proclaiming markets efficient.  So there has to be downside does there not?!?!

How about no (BAM!).

Here’s why:

Crop Insurance: 70% of each farmer’s historical volume is insured by the Canadian government and Input Capital deliberately sets their capital advancement threshold below this level. In other words, Input ensure their investment is fully covered in the event of a disaster. Notably, this insurance is backed by the Canadian government at both the provincial and federal level and is based off a 10 year weighted average on volume (with recent years given more weighting than the older years). As far as pricing is concerned, every year the price is set on or around December 15th and is derived based on a combination of forward market conditions and the crop environment. December is chosen based on normalization of price versus yearly volume both in Canada and US.

Keep in mind that given the expected volume increase in each farmer’s canola crop per year and the formula for calculating yearly insurance volumes, Input’s downside protection should actually increase yearly! (And yes, you read that correctly.) This is because every year a farmer produces a solid canola crop not only does Input get paid handsomely – the next year’s insured volume rises in lockstep with the farms increased production, such that most future crop failures (outside of a truly Biblical esque multi-year plague) would result in a farmer getting paid well in excess of the amount owed to Input.

These are some pretty incredible data point don’t ya think?

Crop Substitution: Recall as well that only 1/3rd of a farm is typically planted with canola.  This is not only scientifically superior, it reduces a farmer’s – as well as Input’s – absolute risk. What this means is that if a farmers canola crop fails, not only will insurance kick in but Input Capital can lay claim to a portion of other commodities grown that year to hit their base tonnage requirement (which remember is underwritten at a ~20% IRR). So if the first point wasn’t enough to make the “pulse quicken and pocket book open” (as a young Warren Buffett put it long ago), this second point should certainly do the trick.

2nd Mortgage on the Farm & related assets: Lastly, to ensure the farmer doesn’t spend Input’s upfront streaming payment wastefully, Input takes a 2nd lien mortgage on the farm. This is simply another layer of protection on farmer misappropriation of the proceeds.

Think of it as the third “escape hatch” built into every contract, that along with the others essentially guarantees that Input will (at minimum mind you) compound its invested capital at 20 percent plus. Incredible!

Valuation Shift

In Part one of this report, at a then-trading price of $1.59, we asserted Input Capital was trading at ~4.0x 2014E pre-tax cash flow. While this figure is clearly a much lower multiple than a business of this caliber ought to trade for, let’s circle back to our assertion that Input capital can be a billion dollar company in 4 to 5 years while raising just $250 million in investor capital.

As you’ll see below, we’ve assumed Input raises every dime of this capital at $1.60, which is (borderline stupid) conservative on a number of levels. Note that if one assumes a materially more reasonable premise – so a gradually rising stock price over time where the company issues shares opportunistically at higher and higher prices along the way, Input would be left with far fewer shares than what’s taken into account in our base case below. In other words, per share value would be far higher as would our overall return.

Additionally, we’ve tried to be very conservative as as far as our book value exit multiple is concerned. Most stream finance industry experts tend to use a simple rule of thumb of 3x book – indeed, streamers often trade at 3x book or higher, as do most businesses with long histories of returns on equity/capital above 15%.

In any case, in light of Input’s ability to generate outsized and highly predictable ROIC of ~20%+, an open ended high return growth runway, and a number of other highly attractive qualitative attributes that define businesses of a similar nature, we believe 3x book is on the low side of reasonable. And while not quite as intellectually indefensible as our assumptions on future equity raises, it remains conservative nonetheless.

That in mind, note that in our March 2018 scenario, 3x book gets us to $1 billion.  The key is to get there without issuing any more shares than necessary.

Input Capital

Conclusion

As we have laid out in a macro sense in part one of this report and at a micro-level in part two, Input Capital is an owner operated exponential compounding machine offering a win/win value prop to both farmers and investors. Never before has the power of the streaming model been unleashed in the agriculture space by a public company. Nor has a streamer ever come locked and loaded with this level of downside protection or such predictability built in. Best of all, even after the run-up over the last couple of weeks we think Input remains not only nonsensically cheap but is set to move higher in the near-term.

Clearly we like the risk/reward here. After all, as a first-mover in the space with the requisite knowledge earned through their private equity ownership of Saskatchewan farmland since 2005, CEO Doug Emsley and CFO Brad Farquhar have built an exceptional business which can reasonably be expected to transition its first mover advantage into a durable “moat” as the trusted, “go to “ provider of farmland working capital.

Enjoy the ride!

Input Capital Q&A – Value Investors Club 

The Q&A has been organized by subject, with the question and subsequent responses each noted. The content has been lightly edited for grammar and the questioners handles have been removed for privacy’s sake. Otherwise, questions that could have been grouped together under a same subject have been kept with their original titles.

***

Subject: Book Value
Initial Message
Author: xxxxxxxx
Date: 11/02/2013 

Hi AAOI – two quick questions. If I did the math right, it’s trading for roughly 2x book value right now? Also, the crop protection is only on volumes right, not if canola prices fall? Thanks!

Re: Book Value
Response 1
Author: AAOI
Date: 11/03/2013 

If you’re using invested capital as a proxy for book value, yeah, a little less than 2x I think. That said I believe the optimal way to value a business like this is on its cash flows, not asset value. 10 to 15x seems more than fair.

On price vs. volumes, yes. Crop insurance is based off of a 10 year weighted average on volume (with recent years given more weighting than the older years). The price is set once per year on or around December 15th based on forward market conditions and the crop environment. December is chosen based on normalization of price versus yearly volume both in Canada and US.

In terms of getting comfortable with canola price dynamics, the average cost of production is hard to measure because it’s always yield dependent. You can spend $300/ac and get 30 bu/ac or 60 bu/ac, depending on weather. In one case, your cost is $10/bu and in the other $5/bu. In retrospect, I probably should have added some analysis here.

That in mind, with the price of other agricultural commodities where they are, you would expect farmers in aggregate to reduce the number of canola acres grown if the price fell below $400/tonne (so that’s your downside price support). Earlier this year, canola was over $600 per tonne. Ultimately, the price will rise and fall with the vegetable oils complex, which is driven by soybean and palm oil supply/demand/prices, but that range ($400 to $600) is a decent working range in the current post-trade war (ended in 2006) environment.

Hope that helps!

AAOI

Re: Re: Book Value
Response 2
Author: xxxxxxxx
Date: 11/03/2013 

Thanks AAOI. The only thing I’m not clear about is you said price was set Dec 15th. Is that for the crop insurance, so that you are protected if prices fall below that Dec 15th price; or does crop insurance have nothing to do with price levels, but is just volume insurance?

Re: Re: Re: Book Value
Response 3
Author: AAOI
Date: 11/03/2013 

Ah yes, my bad. The answer is that crop insurance is volume insurance, but the price is known.  There are several options to insure the price part – this is very well outlined in this document: http://www.saskcropinsurance.com/cropinsurance/publications/guide01_e.pdf.  See pages 10, 11, 14-17.

This year, the base price for canola coverage is $545 per tonne (against a Nov 2013 futures price just above $480 per tonne – this is because prices were high when the price was set).

So a farmer with a crop insurance claim this year will get paid a higher than market price on lost yield (except for the fact that the crop was so good this year, there is likely no one with a claim).

If prices are low at the time the price is set, a farmer can opt for the variable price option, which allows him to pay a higher premium to capture some upside price movement, if it happens.

Make sense?

AAOI

Re: Re: Re: Re: Book Value
Response 4
Author: xxxxxxx
Date: 11/03/2013

Yes, got it, thanks for the explanation.

Subject: Increased Crop Yield Impact on Price? 
Initial Message
Author: xxxxxxx
Date: 11/03/2013

If many of Input’s farmers bump production per acre by close to 100% as you suggest and assuming others are able to do this as well to remain competitive over the medium/long term, won’t this cause canola pricing to collapse; and if that does happen, won’t that significantly impair Input’s business model?

Or, should this not be a concern because it is too far down the road; and/or Input Capital’s farmers and others who copycat Input will make up too small a percentage of the overall market to make a difference?

Re: Increased Crop Yield Impact on Price?
Response 1
Author: AAOI
Date: 11/03/2013

You nailed it with the latter part of the question. Remember demand is growing at a solid clip too on a secular basis, usually a few percent faster than overall supply. That said, during the few periods where a negative supply imbalance has persisted for any material amount of time, lower prices tend to reignite demand at a faster rate than supply, which typically works through such short lived imbalances rather quickly.

At any rate, perhaps I’ll start worrying about INP’s effect on canola prices when Input Capital’s 20x its size.

Subject Crop Yield Increase
Entry 11/04/2013 09:27 AM
Member: xxxxxxx 

As you point out, what makes this so interesting is that the company is making the pie bigger . . . much bigger.

I talked with the one farmer I know well — a Nebraskan corn farmer — and asked him about the idea of such large increases in crop yields based on the factors you raised.

First, he does not know the specifics of rapeseed. And he acknowledged that crop yields could quickly double (for example, in some parts of Africa) where better/more seed, use of fertilizer, rotation of crops, irrigation, etc. could easily more than double yield in one season. Obviously, the exponential growth of crop yields is what is responsible for capitalism and Malthus being wrong (thus far).

However, he also found it difficult to believe that there were large numbers of farmers in the U.S. or Canada that would be that inefficient before the arrival of Input. “Farmers that are that stupid are not in business for long.”

My comments are obviously anecdotal and from a corn farmer in Nebraska so we should all take with a grain of salt, but two questions:

  • Is there something unique about rapeseed farming (e.g., its novelty, industry structure, regulation, etc.) such that there are still such large pockets of inefficiency? Is it all a lack of capital or just ignorance?
  • Have you verified independently with rapeseed farmers that there is such inefficiency? One thing my friend noted was that you cannot simply look at crop yields versus the average as land and irrigation quality play a huge role and make some land much more yielding than other land.

Thanks

Subject RE: Crop Yield Increase
Entry 11/04/2013 10:10 AM
Author: AAOI

xxxxxxxx,

Great questions, I had a corn farmer in Iowa react similarly. The more I dug the more I learned it was about much more than the insular nature of Saskatchewan farmers.

But to your points:

  1. It is generally not ignorance, although there are pockets of ignorance. It’s the capital intensiveness of it, coupled with a demographic-driven turnover and an industry consolidation all at the same time. Add to that new farming practices and seed varieties which blow old practices out of the water, but which are more capital and input intensive, and practically every small farmer in Canada has a real challenge to keep all the balls in the air. For what its worth, I just saw a trailer for an upcoming movie about farmers – you get a feel for that a bit in the trailer – http://www.farmlandfilm.com/
  1. It is not an instant, straight-line correlation between automatic higher yields through optimal working capital and agronomics. But it definitely works over time – the compound growth effect of doing the right things all the time improves a farmer’s productivity and profitability. But remember that with an inherent cost of capital as high as the farmer has today using existing tools, it is worth the farmer doing the deal with Input Capital anyway. All that yield upside is gravy – for the farmer and for Input. As far as independent verification, one of my partners has been to a few of these farms and discussed the issues with them but these are just two out of tens of thousands of farmers, so not the most reliable of sample sets (obviously). Then again, I can say that every piece of anecdotal evidence I’ve come across points towards a massive inefficiency that is very real.

Hope that helps.

AAOI

Subject Fertilizer / Accounting
Entry 11/04/2013 10:36 AM
Author: xxxxxxxx

Interesting write-up. The enormous operating leverage can’t be overemphasized particularly if they can write deals for more than 6 years.

What are the capital requirements for fertilizer storage? If fertilizer arbitrage is the real business why does INP need to make a 6 year outlay and absorb all of the associated key man risk of a farm?

The gov’t guarantee reminds me of an Allied Cap SBA loan. What is the gov’t view of these transactions? I don’t believe the intent of their put option is to make a potentially usurious investor whole?

What are the mechanics of auditing the streams and physical product w/ small private farmers? The fraud risk for models like SLW and FNV would appear lower given the counterparty.

Re: Re: Increased Crop Yield Impact on Price?
Response 2
Author: AAOI
Date: 11/04/2013
 
xxxxxx,

One thing to keep in mind when thinking about the size of targetable addressable market (“TAM”) here is that Input doesn’t rely on most of the farmers being ignorant (they aren’t) or undercapitalized (they can be) in the first place. This is critical. Input Capital only needs a select few which would benefit from their working capital assistance. For example, this winter that number is 4%.  Or said another way, Input only needs 1 farmer in 25 to need assistance with working capital for some reason or another (acts of nature, growth, family reason, etc.) for there to be ample demand for their streams.

Here is some simple math that highlights the point: Input Capital is looking to deploy tens of millions in cash this winter and is getting in front of the top 1,500 canola farmers to do so. Per Inputs CFO, out of that 1,500 subset, only about 20% of those farmers are so well capitalized they are out of INP’s total addressable market altogether. So that leaves 1,200 eligible farmers for Input to sit down with in the coming months in hopes of striking 20 to 30 valid streams – which again, amounts to less than 4% of the 1,200 top farmers with a self identified need for working capital assistance on one level or another.  When you start to think about it like this you get an idea of how truly spectacular the value creation runway in front of the company is but I don’t want to get off point.

AAOI

Re: Fertilizer/Accounting
Response 1
Author: AAOI
Date: 11/04/2013

xxxxxx,

Just saw this, will circle back later tonight when I have more time to get to the rest. In the meantime, let me try and answer why we aren’t worried about Input’s relations with the Canadian government/farm Bureau.

First there is the fact that doing these deals is a great deal for all involved. So it’s a symbiotic, not adversarial relationship between Input and the small farmer, and everyone knows this. In other words, what Input does is an unambiguously good thing. They just so happen to make a lot of money doing it. There are worse things, no?

With regard to farm insurance, Input does not directly receive the crop insurance in a downside case – the farmer does.  Yet there are two ways Input implicitly accesses this protection: 1) fixed bu/ac and previously mandated prices which (when multiplication is involved) specify minimum dollars to Input instead of who knows what in a variable scenario; and 2) Input takes 2nd lien on the farm. Go ahead and blow the proceeds – Input will just take your farm…

Lastly, a key team member, Gord Nystuen, was the Chairman of the Skw Crop Insurance Corporation. http://www.inputcapital.com/About-Us/gord-nystuen.html. One cannot emphasize his position enough when discussing farm regulation and crop insurance at Input. If the former chairman is involved, we’re pretty sure the government is not going to be an issue going forward. If anything, we think the government will help spread the word.

AAOI

Subject: Crop Yield Increase
Initial Message
Author: xxxxxxxxx
Date: 11/04/2013

As you point out, what makes this so interesting is that the company is making the pie bigger . . . much bigger.

I talked with the one farmer I know well — a Nebraskan corn farmer — and asked him about the idea of such large increases in crop yields based on the factors you raised.

First, he does not know the specifics of rapeseed. And he acknowledged that crop yields could quickly double (for example, in some parts of Africa) where better/more seed, use of fertilizer, rotation of crops, irrigation, etc. could easily more than double yield in one season. Obviously, the exponential growth of crop yields is what is responsible for capitalism and Malthus being wrong (thus far).

However, he also found it difficult to believe that there were large numbers of farmers in the U.S. or Canada that would be that inefficient before the arrival of Input Capital. “Farmers that are that stupid are not in business for long.”

My comments are obviously anecdotal, and from a corn farmer in Nebraska, so we should all take with a grain of salt, but two questions:

  1. Is there something unique about rapeseed farming (e.g., its novelty, industry structure, regulation, etc.) such that there are still such large pockets of inefficiency? Is it all a lack of capital or just ignorance?
  2. Have you verified independently with rapeseed farmers that there is such inefficiency? One thing my friend noted was that you cannot simply look at crop yields versus the average as land and irrigation quality play a huge role and make some land much more yielding than other land.

Thanks

Re: Crop Yield Increase
Response 1
Author: AAOI
Date: 11/04/2013

xxxxxxx,

Great questions, I had a corn farmer in Iowa react similarly. The more I dug, the more I learned it was about much more than the insular nature of Saskatchewan farmers.

1. It is generally not ignorance, although there are pockets of ignorance. It’s the capital intensiveness of it, coupled with a demographic-driven turnover and an industry consolidation all at the same time.  Add to that new farming practices and seed varieties which blow old practices out of the water, but which are more capital and input intensive, and every farmer has a challenge to keep all the balls in the air.

I just saw a trailer for an upcoming movie about farmers – you get a feel for what I’m getting at in the trailer – http://www.farmlandfilm.com/

2. It is not an instant, straight-line correlation between automatic higher yields through optimal working capital and agronomics.  But it definitely works over time – the compound growth effect of doing the right things all the time improves a farmer’s productivity and profitability.  But remember that with an inherent cost of capital as high as the farmer has today using existing tools, it is worth the farmer doing the deal with Input anyway. All that yield upside is gravy – for the farmer and for Input Capital. As far as independent verification, one of my partners has been to a few of these farms and discussed the issues with them but these are just two out of tens of thousands of farmers, so not the most reliable of sample sets (obviously). Then again, I can say that every piece of anecdotal evidence I’ve come across points towards a massive inefficiency that is very, very real.

Hope that helps.

AAOI

Re: Re: Fertilizer/Accounting
Response 2
Author: AAOI
Date: 11/05/2013 

xxxxxx,

Ok, just getting back in the saddle. The rest of my answer is below…

On fertilizer, this is not a fertilizer arbitrage business. Sometimes, the explanation of the value Input Capital brings to the relationship/farmer can make it sound like there’s an arbitrage. But if there was, the fertilizer companies would be doing it. The problem for the fertilizer companies is that they produce a product all year round that is used in a 60 day window each year. In order to turn their inventory and their cash flow, they need to keep it moving. So the benefit of this can accrue to a farmer with the right storage who has the cash. That’s not the business the fertilizer dealers are in – which is all about turning their inventory as often as possible.

On auditing, there are lots of tools for auditing a farmer, including the crop insurance audit system, financial and accounting audits, pre-harvest yield inspections, and R&D check-off systems. Ultimately, a farmer has to deliver their production somewhere official (it’s not like there is a back alley market for semi-truck loads of canola), and every one of those deliveries is recorded and hence can be audited. Plus, when Input Capital has a farmland-backed mortgage security position on a farm, it tends to discourage bad behavior as you might expect.

Last but not least, personally I think there is greater risk that an ounce of gold goes missing than 2.6 tonnes of canola (1 oz of gold = 2.6 tonnes of canola at market prices, roughly). It’s hard to stick 2.6 tonnes of canola in ones shoe and walk out :).

AAOI

Subject: Unit Economics
Initial Message
Author: xxxxxx
Date: 11/05/2013

As I look at the unit economics, I am having trouble figuring out how this is a good deal from the farmer’s perspective; and ultimately from the company’s.

From the write up for the avg farmer:

  • Yield: 25-30 bu/acre
  • Rev: $150-250/acre

The high end of the range implies an average price $370/ton, and the low end $265 ($265/ton x 25bu / 44.1 bu/ton = $150)

Per the write-up, in exchange for $300/acre the company receives 0.26tons/yr (770tons/year from a typical 3000acre farm in one example and 888tons/year for a $1m investment in another).

Assuming $370 (the high-end of the pricing range) a farmer whose yield stays a 30bu/acre is much worse off:

No deal with the Company:

  • Working Capital: $200/acre
  • Revenue: $250/acre
  • Profit: $50/acre/yr

Deal with the Company:

1st year:

  • Yield: 0.68tons/acre
  • Company’s take: 0.26
  • Residual to Farmer: 0.42 tons
  • Revenue to Farmer: $182/acre (0.42tons*$370+0.26*$100)
  • Net Profit to Farmer: ($68)/acre

This is less than the minimum necessary for the following year’s working capital.

Thus, the farmer has to deplete his $200 by $18 to meet the following year’s working capital needs and $50 for his living expenses (assuming that was the use of his profit when no deal with the company).  After 3 years he’s lost his $200/acre and does not have enough for the fourth year’s working capital.

Obviously, should a bad year require a claim on his crop insurance, he is much worse off:

No Deal with the Company:

  • Revenue: $175/acre, based off of 70%x$250=$175
  • And he has to raise $25 to generate $50 profits the following year and the year after that…

Deal with the Company:

  • Revenue: $105/acre, based off $175/acre -(0.26tons x($370-$100))=$105
  • And he has to deplete his $200 by at least $95 to go back to the scenario above “Deal with the Company”

I might be missing something.  Could you please share your math per acre?

Thank you.

Re: Unit Economics
Response 1 – Part 1
Author: AAOI
Date: 11/05/2013

xxxxxx,

Couple points of clarification:

  1. Recall the farmer is receiving up to $300 per acre for his entire farm while he will typically have one third in canola, with the other two thirds being rotated crops such as wheat or peas. As such the farmer is receiving the ~20%+ crop yield improvements on the other 2/3rd of his farm and keeps 100% of that. Input is focused on the Canola (highest yield disparity), yet the farmer views the stream holistically with respect to his entire farm.
  2. Depending on the increased canola yield, the farmer could actually be flat to modestly negative with respect to canola, yet profit greatly from his other crops’ extra yield. In other words, the fact that the farmer breaks even in terms of canola doesn’t really mean anything. Indeed, it is the rest of the profit from the productivity improvements in the other 2/3rd’s of his acreage that really matters to the farmer’s bottom line.
  3. Input really wants to maximize their canola take, yet needs the farmer to act rationally and his own best interest with respect to the canola crop. As such, Input tries to leave the farmer 40% to 50% of his pre-Input crop when they strike a stream. Leave the farmer any less and he won’t care about the crop; leave the farmer more and Input leaves economics on the table.
  4. The value accreted to both Input Capital and the farmer is dependent on yield improvement. From our understanding, the farmers that are doing streaming with input are vastly under-producing versus their land potential.
  5. From our conversations with management, the $150 revenue per acre pre-Input may be low. We kept the number in there to match company documents. The real output is probably $200 to $250 per acre, which implies a lower yield than 25 bu/ac at today’s prices.

Hopefully that helps! Some clarification as it relates to your comments specifically is coming up.

AAOI

Re: Unit Economics
Response 1 – Part 2
Author: AAOI
Date: 11/05/2013

I’ll come up with a better walkthrough when I have time, but here are a couple more thoughts on your specific example below… [Quotes in italics. Responses in bold]

***

“As I look at the unit economics, I am having trouble figuring out how this is a good deal from the farmer’s perspective; and ultimately from the company’s.

From the write up for the avg farmer:

  • Yield: 25-30 bu/acre
  • Revenue: $150-250/acre

The high end of the range implies an avg price $370/ton, and the low end $265 ($265/ton x 25bu / 44.1 bu/ton = $150)”

These figures are not just for canola, but figure in a variety of other crops – this is only meant to give an example of grain & oilseed economics on a non-crop specific basis.  Canola tends to be the money maker, so these numbers are lower than canola numbers.

“Per the write up, in exchange for $300/acre the company receives 0.26tons/yr (770tons/year from a typical 3000acre farm in one example and 888tons/year for a $1m investment in another)

Assuming $370 (the high-end of the pricing range) a farmer whose yield stays a 30bu/acre is much worse off:

No deal with the Company:

  • Working Capital: $200/acre
  • Revenue: $250/acre
  • Profit: $50/acre/yr”

The $370 is not the right number here.  Current market price is around $500/tonne [in November 2013].

“Deal with the Company:

1st year

  • Yield: 0.68tons/acre
  • Company’s Take: 0.26/acre
  • Residual to Farmer: 0.42 tons
  • Revenue to farmer: $182/acre (0.42tons*$370+0.26*$100)

This is less than the minimum necessary for the following year’s working capital.

Thus, the farmer has to deplete his $200 by $18 to meet the following year’s working capital needs and $50 for his living expenses (assuming that was the use of his profit when no deal with the company).  After 3 years he’s lost his $200 and does not have enough for the 4th year’s working capital.”

Substitute $500 for the $370 – note that this yield is still barely just average.  Using the right agronomics, this yield would be considered a major disappointment.

“Obviously, should a bad year require a claim on his crop insurance, he is much worse off:

No Deal with the Company:

  • Revenue: $175/acre, based off of 70%x$250=$175
  • And he has to raise $25 to generate $50 profits the following year and the year after that…

Deal with the Company:

  • Revenue: $105/acre, based off $175/acre -(0.26tons x($370-$100))=$105
  • And he has to deplete his $200 by at least $95 to go back to the scenario above “Deal with the Company” 

Crop insurance isn’t meant to be a money maker.  It is meant to keep a farmer in the game. That’s it.  

(Clearly farmers feel like there is a clear and demonstrable benefit in working with Input Capital , or they wouldn’t be signing up.)

Re: Unit Economics
Response 1 – Part 3
Author: AAOI
Date: 11/05/2013

Hopefully this is a helpful walk though on the unit economics from the farmers perspective…

Think of the farmer’s income statement on a per acre basis. Based on a 40 bu/ac yield and a $12.50/bu price for canola:

  • Revenue: 40 x $12.50 = $500
  • Costs: $300
  • Profit: $200

Cash Flow Statement:

  • Cash at Start of Year: $0
  • Cash from INP: $300
  • Revenue: $500
  • Total Cash In: $800
  • Cash out to INP: ~$90
  • Expenses: $300 (including his own labour)
  • Total Expenses: $390
  • Cash at End of Year: $410

Repeat for 5 more years, but roll the year end balance forward to start the next year.

Here is the P&L and Cash Flow Statement without Input: 30 bu/ac yield (lower) @ $12.50/bu (same price):

  • Revenue: 30 x $12.50 = $375
  • Costs: $250
  • Profit: $125/acre

Cash Flow Statement:

  • Cash at Start of Year: $0
  • Cash from INP: $0
  • Revenue: $375
  • Total Cash In: $375/acre 
  • Cash out to INP: $0
  • Expenses: $250 (including his own labor)
  • Total Expenses: $250/acre
  • Cash at End of Year: $125/acre

Repeat for 5 more years, but roll the year-end balance forward to start the next year. On the face of it, with Input, the farmer has $285/acre more. However, this is before accounting for working capital needs for the following year. And this is where it becomes even more apparent how Input helps the farmer.

The farmer without Input Capital does not have the necessary working capital in the subsequent year to finance his inputs (pun intended), so he has to borrow the $250. Assume he borrows at 10% and that adds $25 per acre to his costs. Then he buys his fertilizer only when the credit is available, so he pays more for it. Let’s say that costs him another $30 per acre. And when he gets to harvest, he is forced by the terms of his borrowing agreement to sell early and that this costs him 5% on the revenue line ($18.75/ac).

So in reality, the situation looks like this for the 30 bu/ac yield @ $12.50/bu scenario when not partnering with Input:

  • Revenue: 30 x $12.50 x 95% = $356.25
  • Costs: $250 + $25 + $30 = $305
  • Profit: $51.25/acre

Cash Flow Statement:

  • Cash at Start of Year: $0
  • Cash from INP: $0
  • Revenue: $356.25
  • Total Cash In: $356.25/acre
  • Cash out to INP: $0
  • Expenses: $305 (including his own labor)
  • Total Expenses: $305/acre
  • Cash at End of Year: $51.25/acre

Repeat for 5 more years, but roll the year-end balance forward to start the next year.

The logic of a deal with Input Capital becomes pretty obvious, unless the farmer wins the lottery or inherits something from a rich uncle.

Make sense?

Re: Re: Unit Economics
Response 2
Author: xxxxxxx
Date: 11/05/2013

Thank you for your detailed response.  I don’t want to seem unappreciative of the time and effort you put into addressing my questions.  However, I think there are a number of inconsistencies.  Let me just mention two:

  1. The write-up mentions $150-250/acre of revenue for a yield of 25-30bu.  Now you say $200-250/acre.

Fine, let’s use that range.  The implied price is $353/ton or $8/bu for the low end and $367/ton or $8.3/bu:

  • $200/25bu=$8/bu  ($353/ton)
  • $250/30bu=$8.3/bu  ($367/ton)

In the response to my question you are using $12.5/bu or $551/ton (despite mentioning $500 as the current trading price).

Naturally, a much higher price than the typical range makes the royalty stream look great…

  1. The write-up states that a farmer must invest $200 to achieve the revenue and yields above (i.e. $150-250/acre and 25-30bu).

In your response you use $250.

In my opinion, an investor would be well-served to evaluate the royalty stream under typical conditions, which the write-up (and I guess the company’s documents) depict as $150-250/acre and 25-30bu.

I guess I am interested in one thing at this time: is the $150-250/acre and 25-30bu wrong?  If so, which is the correct range for the typical farmer?

Thank you.

Re: Re: Re: Unit Economics
Response 3
Author: AAOI
Date: 11/06/2013

Realize that each number will be different on a farm by farm basis, and both the company and the write-up use numbers that are meant to be indicative of the true economics at work. Your pointing to “inconsistencies” without a difference for a reason I can only presume is that you think I’m playing around with the numbers to justify the unit economics. I mean no disrespect here but please, you’ve got to be kidding.

Without understanding the basic premise that the stream makes each party better off (or they wouldn’t sign the deal), using microeconomics on a handful of farms without material, non public data is useless. Personally I don’t want to walk down that rabbit hole but I will answer your one question as best I can.

Furthmore, the write-up figures you are referencing of $150-250/ac of revenue are all commodities, including canola (the highest value) and other crops in the rotation like wheat and peas.  Those are whole-farm numbers.

Current average canola yield is 30-32 bu/ac at $485/MT ($11.00/bu) = $330 – $352/ac gross revenue per CANOLA acre

So is the $150-250/acre and 25-30bu wrong? 

Hell yes! That is if you think your average farm in Canada only grows canola.  The thing is, there is no such thing as a “canola-only” farm the way there are say “corn-only” farms in the US. Nevertheless, try to understand tht those figures are an accurate reflection of the archetypical farm that is undercapitalized and not using optimal farming practices.

So clearly you are very numbers-oriented, but I really think you are trying to extrapolate oranges from apples, and apples from bananas.  There are many, many moving parts on a farm and in the economics of a farm.  What we’ve tried to do here is create illustrative examples at a very high, but simplified level, because most people don’t want to/can’t drink from a firehose of numbers over the course of a write-up. That, and we wouldn’t want Input Capital sharing details at that level of granularity anyway for competitive reasons. Or said another way, the “differences” you are pointing to are in actual reality just us coming at it for you from different ways – all in a manner meant to be reflective of the same underlying Truths.

Make sense?

In any case,  it’s not necessarily what numbers your looking at that matters here, it’s what those numbers actually mean. For example, what’s important is that farmers are signing up for Input’s program and relatively seamlessly at that – and again, these farmers aren’t desperate.  They could have gone on the way they were, without Input’s capital, gradually pulling themselves up by their own bootstraps.  But again, if they have a need, when presented with this opportunity, it makes total sense to them and Input’s success rate signing up farmers with a self-identified need for working capital is extremely high. So that’s the proof in the pudding that it makes sense. Real farmers in real life are signing up to do deals with Input Capital at a very high rate.

Of course you can play with your micro model all day that says these deals are bad deals based on wrong inputs and a very narrow understanding of how these streams work as well as the myriad of nuances related to farm economics, etc etc – but who wants to do that?

And besides, I would think that you of all people, would understand how dumb it is for a newly public market leader like INP to spoon feed potential investors to the type of degree you suggest. Which again is sheer crazy-ness given the size of the value creation runway still in front of the business, not to mention the extremely large amount of money this high quality economic model should spit out along the way.

For example, come the end of next year INP should be able to deploy say $30m + in cash every year thereafter and at some truly spectacular rates. Better yet, odds seem unusually good INP could grow the $30m dollar amount it could put to work at still wonderful terms by a factor of 20 to 40 fold and yet it would still be a tiny fraction of what the business could ultimately grow to assuming the fullness of time.

Anyhow, the bottom line is that I took this tact because…

a)     most people don’t want that many numbers anyway (that’s just the way it is); and

b)     Input doesn’t want to overeducate potential competition.

It’s that simple.

Regardless, in the meantime I’d encourage you to get to know them yourself and walk through the economics with both management and a farmer or two (if you can manage it).  And I appreciate the pushback and realize you appreciate my earlier responses (rest assured I’m thankful for all the work you did here as well), it’s just that I’m not going to discuss it ad infinitum or run through hoops trying to explain the concept any further from this point on out. After all, why spend a bunch of time walking through the math and various nuances re these deals if all that is likely to come of it is a prolonged session of spoon feeding potential competitors. Definitely not my style these days.

Thanks

AAOI

Subject: Tax Question
Initial Message
Author: xxxxxxx
Date: 11/05/2013

Thanks for a very extensive writeup.

One question – you use pre-tax numbers.  What kind of tax rate should one assume for this entity?  I’m not familiar with the streaming business.  Is there some special tax status or is this just taxed like a normal corporate entity?

Re: Tax Question
Response 1
Author: AAOI
Date: 11/06/2013

27% if memory serves. Normally streamers do have substantial tax advantages but that is not the case here.

Subject: New Hires Re Deal Pipeline (AKA Building Out the Business Development Team)
Initial Message
Author: AAOI
Date: 11/06/2013

For those who are interested, Input Capital just announced some interesting new hires as far as building out this years deal pipeline. Doubt multiple “farmers of the year” would join an organization that did not indeed add tremendous value to the small farmer.

http://finance.yahoo.com/news/input-capital-corp-expands-business-220000701.html

***

REGINA, Nov. 6, 2013 /CNW/ – Input Capital Corp. (“Input“) (TSX Venture Exchange: INP) announced today the addition of three well-known and top quality farmers to its Business Development team.

Kelvin Meadows ( Moose Jaw, Sask ), Warren Kaeding ( Churchbridge, Sask ) and John Cote ( Saskatoon, Sask ) are all previous winners of the Saskatchewan Young Farmer of the Year award, and join Gord Nystuen, Vice-President of Market Development, to greatly enhance Input’s deal generation and processing capacity.

“We are excited to have Kelvin, Warren and John join our team,” said President and CEO Doug Emsley . “They are all well-known, successful and highly respected farmers on the Saskatchewan and Canadian agriculture scene. Their work with Input Capital will enhance our geographic footprint in multiple areas of the province simultaneously, allowing us to rapidly grow our deal pipeline.”