Analysis: Despite talk of farm bubble, Farmer Mac woos investors

Farmer Mac - the farm loan equivalent of its cousins Freddie Mac and Fannie Mae - owes its existence to the last time a U.S. farm bubble burst. Now, the company is trying to convince investors it would survive another one.

The market isn't giving the company a vote of confidence yet. Just five years ago, Farmer Mac had to be rescued by its creditors after its large positions in Lehman Brothers and Fannie Mae went sour. Now, the revived company must prove to skeptical investors that it can withstand a sharp decline in the price of farmland that analysts expect to come in the next year. That open question - and the inability of Congress to pass an updated five-year farm bill, which provides crop insurance and other subsidies that farmers rely on - has been weighing on the company's stock price.

Shares of Federal Agricultural Mortgage Co. - a government-sponsored enterprise that functions as a secondary market for farm, rural utility and rural development loans - are up approximately 6 percent for the year and 35 percent over the last 12 months. This year has seen a widespread market rally that has pushed the benchmark Standard and Poor's 500 index up more than 20 percent.

After collapsing to around $3 in late 2008, the stock price has since recovered to pre-crisis levels of around $34. Still, the stock trades at a price to earnings ratio of 5.5, close to half the valuation of small lenders like PennyMac Financial Services and of its own five-year average P/E of 10.1, according to Thomson Reuters data.

The company has been actively courting small-cap fund managers, institutions and endowments by pitching itself as a conservative way to play the booming U.S. farm sector. In February, for instance, the company presented at the Bank of America/Merrill Lynch Global Agriculture Conference in Miami, and in April it gave a presentation to the California Municipal Treasurers Association. In all, it has made seven presentations to potential investors in New York, Baltimore, San Francisco and other locations this year.

At all the events, chief executive Timothy Buzby argued that a decline in farm prices would not affect his company as much as the market expects. Farmers can always sell a few hundred acres of a larger farm or their excess equipment before defaulting, he said.

"We only make real estate loans, not operation loans. If there's a bursting of a bubble, the last lender to get hurt is the one who has the loan on the farm," he said.

He points to the company's low 0.01 percent default rate and the fact that the firm "lost zero" during last year's drought - the most extensive in at least 25 years - as evidence of the resilience of the sector.

RUN-UP IN PRICES

The widespread concerns that farmland is a bubble ready to pop comes from an unprecedented run-up in prices. Between 2003 and 2013, the average acre of farmland in the U.S. jumped 213 percent in non-inflation adjusted dollars, according to research by Brent Gloy, an agricultural economist at Purdue University, an average annual increase of 12 percent.

By comparison, prices rose 127 percent in real terms between 1971 and 1981, a rally that ended in the late 1980s farm crisis when land prices tumbled 40 percent. That steep decline brought down several community banks and led Congress to create Farmer Mac.

"If prices don't start to slow down soon, that would be a major red flag," said Gloy.

Farmer Mac has responded by tightening its lending standards and the portfolio's loan-to-value ratio has fallen to 60 percent from 70 percent, Buzby said.

That has helped the 90-day delinquencies rate in its farm and ranch portfolio fall to 0.69 percent of loans in the second quarter of 2013, compared with a 1.30 percent delinquency rate in the same quarter of 2010. Freddie Mac, by comparison, reported that 2.79 percent of its loans were seriously delinquent at the end of 2012. Over the same time, Farmer Mac's core capital rose to $564 million from $461 million.

The company has also tightened its own standards for its liquidity portfolio, said Buzby, who became chief executive of the company in 2012. The prior management team was using the portfolio to boost earnings, he said. When its large position in Lehman tanked, the company was forced to sell $65 million in preferred shares to its lenders as part of a rescue plan.

Most of the portfolio is now invested in low-yielding U.S. Treasuries, Buzby said, meaning that the company is losing money on its capital after inflation. Like other government-sponsored enterprises, the company has the implicit backing of the U.S. government, but does not offer the same level of security as a Treasury bond.

To be sure, the company remains highly leveraged, like other government-sponsored enterprises. The company has a leverage rate of approximately 25 to 1. While that has fallen from a peak of 45 to 1 before the 2008 crisis, it remains higher than regional banks, which typically have leverage rates of 12 to 1.

"When you talk about what you could be concerned about as an investor in this company, that would certainly figure into the analysis," said one hedge fund manager whose fund owns shares of Farmer Mac and who did not want to be quoted by name.

VALUE PLAY

Some value investors who own the stock say that the company has stronger fundamentals than the market is giving it credit for.

"If you look at the leverage within the farm system, it's not nearly as high (as in residential mortgages) and it isn't going out of whack like the residential space was," said Howard Lu, a portfolio manager with First Wilshire, a Pasadena, California-based money management firm with $650 million in assets under management which owns Farmer Mac stock.

The Kansas City Fed estimates that the debt to asset ratio in the farm sector is currently around 10 percent, well below the 25 percent mark associated with the collapse of the 1980s. By comparison, debt to asset ratios topped 25 percent in the residential mortgage sector leading up to the 2008 financial crisis.

Lu said that the company is still "significantly" undervalued because of its earnings growth. Farmer Mac reported core earnings of $1.48 per share in its most recent quarter, a 27.9 percent gain from the same period last year.

The company is little followed by Wall Street, in part because its market cap is so small that large-asset funds can't invest much more than $20 million in the company without becoming a significant holder in the shares and distorting prices. As a result, its shareholders tend to be small mutual funds and hedge funds.

The one analyst polled by Reuters who covers the company, Evan Hutto at Compass Point, rates it a buy, with a target price of $42, a roughly 25 percent increase from its current price of approximately $34. New York-based Sidoti & Company initiated coverage Wednesday with a price target of $44.

Hutto looks for positive price moves after Congress passes a farm bill and when concerns abate that Farmer Mac will be hurt by falling farm prices. Rising interest rates could also push Farmer Mac's loan volumes higher. Unlike Freddie Mac and Fannie Mae, Farmer Mac has largely been exempt from Republican bills that would unwind government-sponsored enterprises.

"This is a company that's had tremendous growth but has been falling under the radar," Hutto said. "Now they need to prove that they're for real."

(Reporting by David Randall; Editing by Claudia Parsons)