An Ag X Special: A Hypothetical Story of a Company Called ADM
When the news broke that ADM would revise earnings within its nutrition business, Easy Newz commented that it was unusual for two reasons.
The speed: the company would delay earnings and have engaged outside accountants.
The vagueness of the announcement: the company was moving quickly but provided few details.
If I read between the lines, this seems like how public relations might handle something that would make a company or management look bad, not a liquidity event. A liquidity event usually precipitates insolvency of some form. In commodity land, this would be a company that cannot meet a margin call.
Part I: Ag X (Twitter) does its thing
It’s important to understand that X (Twitter) was designed as an engagement tool that delivered a new nuclear button: the Retweet. It was not intended to provide facts or context but amplification.
If you think something is dumb, retweet with a question mark emoji. If you think something is brilliant, retweet with emphasis. The algorithms don’t care what is correct or could lead to you losing money. The more retweets and likes, the better.
Here are a few examples of what followed after:
Successful people with large followings demanded new standards for major food and trading companies.
If ADM ever did have a liquidity event (read blowing up), I expect the government to step in. The bankers were bailed out; it would be a travesty if our farmers were not too.
If this assumption is correct, public reporting standards should be maintained and increased in a world of Too Big to Fail (TBTF) businesses. John is still correct to point out (post above) the misalignment of trading companies’ incentives, public companies responsibilities, and TBTF agribusiness.
Suggestions that the company could leave farmers holding the bag are irresponsible.
These posts create an atmosphere of uncertainty and fear. The below image shows a farmer posting in an ag chat that he liquidated his ADMIS trading account.
ADMIS carries none (or very little) of the risk of ADM regarding a futures brokerage account. The point of centrally cleared futures is mitigating counterparty risk.
Lifting hedges and liquidating accounts will expose a farmer to far more costs and risks than ADM via ADMIS ever will.
There are intelligent posts out there, but they are becoming harder to find.
Part II: Why the puts matter
What caught my attention was the size of the pre-market sell-off. I immediately looked into the options activity to see if there was an indication someone knew. On January 5th, block purchases of short-dated puts (high-risk, high-reward downside bets) were made on the first liquid trading day of the new year.
Easy Newz broke the story of the windfall profits Monday morning. Now we have something. A potential scandal to fan the flames of a mega-fraud. An Ag X fairy tale in the making.
Next, I checked to see if this had happened before. It looks like this may have begun two to three quarters ago. See the put volume and open interest spikes in the chart above. The open interest rolling off quickly in previous quarters indicates they are short-dated or not held long. This provides some further insight.
If I were to guess (emphasis on guess), a story could play out something like this.
The Nutrition business gets quite a bit of exposure and some employment turnover. Employees leaving would be aware of potential issues. The below graphic is from ADM’s Q3 earnings report. Revenues down 5% is understandable. Profits down over 23% is no bueno.
ADM utilizes a type of cost-based accounting. The company reports earnings by netting positions against the original cost base. I am avoiding the word basis here for agricultural reasons.
This means open soybean hedges and cash ownership may not net out in the PNL (Profit and Losses) this quarter but will over time. The gains and losses in future quarters, all things being equal. This gives the street an idea of how much of the PNL is real (versus unrealized due to a mismatch in timing).
“Hey, our oil seed processing revenue jump is from hedge gains on open futures. We expect new crop cash ownership in Brazil will offset most of this, so $125 million of our oilseed hedge gains will reverse next quarter.”
The implication is that the cash basis is rallying relative to futures hedges falling. The books get closed, the executives sign off, and the company pays compensation bonuses and taxes based on the official (GAAP accepted) figures.
It looks like excessive compensation paid from a business segment with revenues falling and profits falling even faster. This is a bad look for management. The company may even have to go back and “restate things,” admitting that “hey, we might have screwed up.”
Now, the complicated part.
Part III: Sarbanes-Oxley
Here is the rub: if management reports “profits” and then pays compensation and taxes. It needs to be pretty darn sure it did it right. If it is incorrect, it would be a violation of GAAP and could be against the law. The law refers to Sarbanes-Oxley Act (link here).
The Act contains provisions affecting corporate governance, risk management, auditing, and financial reporting of public companies, including provisions intended to deter and punish corporate accounting fraud and corruption.
The Sarbanes-Oxley Act (2002) was passed specifically because of the frauds uncovered during the collapses of Enron and Worldcom and the corporate governance failure of Tyco. I prefer to distinguish Tyco for pure largesse reasons. Enron and Worldcom shared the auditor Arthur Andersen, who was found to have helped facilitate the frauds, going so far as to destroy records.
ADM’s problems go from, “Hey guys, this new business is not going according to plan” to “We know this looks really bad, and we need some outside financial guidance ASAP.”
Traders and executives gossip in all industries. If it played out along these lines, then people would know, but more importantly, they would assume it is only a matter of time, and most likely during an upcoming earnings report. I am making this leap of logic.
So, back to the puts. Someone may have known or could figure out the possibility of a story like I just outlined.
Part IV: The speculation will continue, don’t act rash
There has been a lot of speculation, and it will continue. There is industry chatter that compensation around transfer pricing is the focus. Here is why this is probably not the issue.
Transfer pricing is the practice of internal pricing between business units. There should be no net gain or loss to the company. If executives use incorrect transfer pricing, it’s difficult to keep hidden because one business unit’s gain is another’s loss.
Traders and executives know replacement costs and public companies must use standardized practices. It is obvious when a food unit says our marketing group is adding 50 points of value to the cost of soybean oil. That cost gets transferred to the processing division. The guys who managed the board crush will lose 50 points on the other side.
My personal feeling toward transfer pricing is that it is a colossal waste of time. It ends up being a bureaucratic fight between influential executives and does not add to the company’s bottom line. Accountants spend lots of time ensuring every last dollar gets allocated correctly. After all, it is two people on the same team fighting over that same dollar.
Suppose a business unit buys many companies and delivers corporate speak of synergies and cost savings, which leads to higher valuations and compensation. Sooner or later, this gets written down. This is not a transfer pricing issue. It is a “decisions made by management” problem.
If management did not want to admit it, or worse, hid something, it could be a bigger problem. The cover-up is often worse than the crime. At this point, all we know is what has been reported. And it points to issues in a small division of a strategically important company and a ton of wild speculation.
Hopefully, this highlights why everyone should remain skeptical of what they see on social media and expect more of the same. ADM is a solid company that is not going anywhere.
Most importantly, do not make rash decisions that could expose yourself financially without doing due diligence first. Your hedges and counterparties are safe. Here is a link to the FIA paper above explaining the role of futures clearing members.
Full disclosure: I have no accounting degree or professional accounting background, and I have not traded ADM stock. I wrote a college thesis on financial regulation 17 years ago. I have worked for and consulted with many large agribusiness firms. I spent over a year implementing a new accounting model within a Fortune 500 company. Nico (ArchaiQ)