Consolidation in the heartland

 A closer look at grain co-op mergers and acquisitions, 1993-97








Anthony Crooks, Agricultural Economist
USDA Rural Development

hen the directors of two small cooperatives in North Dakota approached USDA Rural Development in July 1997 for technical assistance regarding a possible merger, they probably had little idea of how large a trend they were joining. About 95 other grain cooperatives also merged or were acquired in 1997.

Both of these Dakota cooperatives one a petroleum and farm supply cooperative with grain assets, the other a grain elevator cooperative were seeking to strengthen their operations and improve financial performance. In addition to consolidating assets, these cooperatives wanted to expand a rail load-out facility owned by one of the cooperatives and add to an agronomy center near another facility. They also wanted to reduce grain shipping costs and to generate additional revenues from spring fertilizer sales. Both goals appeared to be financially rational at the time.

However, both cooperatives and their plans were soon superseded by an even bigger merger: that of Cenex and Harvest States Cooperatives. The merger of two giant, regional co-ops was the biggest wave in the recent tide of mergers, consolidations, alliances, joint ventures and acquisitions that has swept over the U.S. grain industry (as reported in this magazine in the Sept./Oct.1998 and 1999 issues).

The small Dakota petroleum cooperative was an affiliate of Cenex and a competitor of Harvest States. And thus the merger and improvement plans of these two small Dakota cooperatives was placed on an indefinite hold because of the merger of the two regional cooperatives.

About this time, a $4 million joint venture was announced by Harvest States and one of its Dakota affiliates, a move which would lead to the construction of a terminal facility just down the road from where the two local co-ops had planned to expand their load-out facility. Except for their relative size, the two planned mergers shared many similar characteristics. Each merger involved farm supply operations merging with grain marketing operations. Each co-op hoped that the merger would offer new business opportunities in one partner's specialty area while helping the other to restructure its operating costs. In addition, the co-ops were attempting to link their farmer-members into a production-marketing chain which would take the grain from field to buyer. They wanted to lower operating costs, share or redistribute business risk and expand operations.

It is easy to focus on the more sensational aspects of this story: two small, seemingly independent cooperatives being swept onto the economic sidelines by the decisions of the much larger regional cooperatives they belonged to. However, it is more instructive to view these four cooperatives as role players in the ongoing, widespread economic consolidation trend in agriculture. Strikingly similar occurrences have been witnessed repeatedly in recent years.

A soon-to-be-released report from USDA Rural Development (Research Report 180, "Consolidation in the Heartland, 1993-97: A Closer Look at Grain Cooperative Mergers and Acquisitions") analyzes the operational and financial characteristics of co-ops that were merged, consolidated, went bankrupt or were closed for other reasons during those years. These businesses will be referred to as M/C ("merged or consolidated") co-ops in the balance of this article, which presents M/C and surviving cooperatives in the context of agriculture's economic restructuring. Lessons learned from mergers, consolidations or other reasons for cooperative closures also provide some insights into the challenges that lie ahead for grain cooperatives hoping to thrive. Some of the highlights of this research follow.

Tracking co-op closures
The Rural Business-Cooperative Service, an agency of USDA Rural Development, began keeping detailed statistics on mergers, acquisitions, consolidations, bankruptcies and related activities in 1993 (table 1). During 1993-97, it counted 367 M/C events. On average, this is equal to about 8 percent of all large co-ops and 10 percent of all mid-sized cooperatives each year. In general, the majority (198, or 64 percent) of these M/C events occurred in 1996 and 1997 and among cooperatives having less than $15 million in total sales. Most activity was in the nation's heartland. Eighty-seven percent occurred in the Corn Belt and Southern Plains regions (table 2).

Of the 367 cooperatives that were merged, consolidated or otherwise went out of business, 330 had total sales of at least $5 million and were located in four principle grain producing regions. The USDA research into this issue focuses on these 330 cooperatives. Figure 1 illustrates the number of cooperatives involved in each type of M/C activity during the 1993-97 period. Almost 74 percent (246 of 330) involved cooperatives that merged with other cooperatives. A small number of cooperatives were involved with investor-owned firms (IOFs) in either a merger (8 of 330) or an acquisition (14).












Financial characteristics
The goal of the study was to answer some general questions about the financial health of grain cooperatives involved in mergers, acquisitions and other activities. Cooperatives that were involved with other co-ops and those that merged with, or were acquired by, IOFs are compared to each other. To compare M/C cooperatives with national averages for grain co-ops of their same relative size, a five-previous-year average was constructed for each (remaining) cooperative for each year of observation. In this way, M/C cooperatives were compared only with their cohorts. Grain cooperative balance sheets and operating statements were used to construct a set of generally recognized financial ratios. The ratios selected are associated with four general aspects of a business: profitability, liquidity, efficiency and solvency (table 3).

Profitability indicators generally compare the returns of the business (local net savings, from the operating statement) with another aspect of the cooperative's business By each of the four profitability measures, M/C cooperatives, regardless of the size of the surviving firm, accrued modest returns over the five-year period. In every measure, M/C co-op performance was less than both the benchmark (used by CoBank) and the national average among grain cooperatives remaining in business.

Cooperatives and their creditors have a strong preference for a margin of safety against the operating uncertainties to which they are subject. Liquidity refers to a cooperative's ability to generate short-term cash in case of unexpected expenses. M/C cooperatives had liquidity difficulties. Except for large cooperatives that joined IOFs, M/C cooperatives failed to meet either national or benchmark standards for liquidity.

The relatively strong working-capital-to-sales performance posted by large cooperatives that merged with IOFs suggests a very good reason for these cooperatives' relative attractiveness as merger targets. Of course, it's possible that these values reflect relatively low sales. On the other hand, what firm wouldn't like to acquire a ready stream of working capital as part of the bargain?

Efficiency indicators provide some measure of how well the firm is managed. Because there is no direct measure for "management ability," these indicators serve as a proxy for two aspects of a manager's job: holding down costs and making the best use of the business' resources. M/C cooperatives showed relatively strong performance in efficiency. Regardless of other shortcomings, these co-ops were apparently blessed with management that made sure overall expenses (particularly labor) were kept low compared with income and that sales income was kept high compared with inventory. Efficient operations may have been the single most attractive feature to firms aspiring to acquire these cooperatives.

Solvency indicates a cooperative's long-term financial health. Solvency indicators include guidelines for the firm's interest expenses and liabilities relative to its income and equity. M/C cooperatives generally had mixed results regarding solvency. While large cooperatives that merged with IOFs were more solvent than those merging with other cooperatives, mid-sized cooperatives merging with other cooperatives were more solvent than those merging with other cooperatives, mid-size cooperatives merging with other cooperatives were more financially stable than those that merged with IOFs.











Are best co-ops cherry-picked?
A common perception is that the most promising cooperatives are quickly purchased by IOFs. This study refutes that belief in two ways. First, while both groups of cooperatives were in poor financial health, those that merged with other cooperatives outperformed those that merged with IOFs. Table 3 reveals that for large cooperatives, those that merged with other cooperatives outperformed those that merged with IOFs in 8 of 13 indicators. Medium-sized cooperatives that merged with other cooperatives outperformed their counterparts that merged with IOFs in 9 of 13 indicators. In other words, cooperatives that merged with other cooperatives were generally more profitable, liquid, efficient and solvent than their those that merged with IOFs.

I Second, a very broad measure of financial health was given to the 330 cooperatives that went out of business and their merging partners. Firms that performed no worse than 90 percent of the benchmark level for at least six of the 13 indicators were considered healthy. Firms that failed to achieve the 90 percent performance level for seven or more indicators were considered in poor financial health.

Table 4 summarizes the financial health of the 330 M/C cooperatives and their partners. Sixty-five percent (82 of 126) of mergers that occurred among large cooperatives during 1993-97 involved two firms in poor financial health. Thirty-one percent (39) of the mergers occurred among a healthy and a not-so-healthy firm. And only 4 per-cent (5) of all large cooperative mergers during that period involved two healthy firms.

While a slightly larger percentage of medium-sized cooperative mergers (38 percent, or 63 of 204) involved at least one healthy firm, the implication remains the same for both groups. For the most part, cooperatives that went out of business during 1993-97 were performing poorly, or at least not as well as their surviving neighbors. In most categories, whether the average M/C cooperative was involved with a cooperative or becoming part of an IOF, its financial indicators were weak-er than national averages and well short of benchmark values.

When a cooperative went out of business, it was in poor financial condition. To become part of another business whether as a cooperative or an IOF the co-op tended to accept the terms offered by its benefactor, not to dictate the terms. Few, if any, negotiations were carried on by these cooperatives from a position of strength.

Roughly two-fifths of the 291 cooperatives that stayed in the "cooperative family" were financially sound. However, of the 22 cooperatives that merged with or were acquired by an IOF, there was only one solid performer. So, if we look at the best among a group of relatively weaker cooperatives and ask if they were "cherry picked" or "stayed in the family," the answer is that they stayed. Of the 121 available "cherry" cooperatives that went out of business during the period, only one was "picked" by an IOF.

























Predicting mergers and acquisitions
USDA wanted to know if a grain cooperative's financial health is able to say something about how likely it is to merge with, or be acquired by, another firm. An economic model was constructed to evaluate the likelihood of a grain cooperative going out of business in the near term, given its financial performance record.

Each of the 14 financial ratios listed was used as a predictor to determine which variables, if any, could do a better job than the rest of predicting a cooperative's failure. A three-variable "best fit" was selected from among the 14 ratios using a special statistical procedure (RBS Research Report 180 provides specific details).

The odds of large grain cooperative going out of business were most successfully predicted by the three ratios: return-to-total assets (-), expenses-to -sales (+), and labor-to-income (+). The "minus" sign after the "return-to-total assets" variable indicates that the likely-hood of a cooperative going out of business increases as return-to-total-assets decreases. The results also show that it's more likely a cooperative will go out of business as the value of expenses-to-sales and labor-to-income increase, hence the "plus" signs after those variables.

The fact that out of all 13 variables, these three were selected as having the most power for predicting which large grain cooperatives will go out of business says a lot about the challenges that confront remaining cooperatives. That one variable indicates profitability and the other two efficiency speaks to the relentless marked pressure in which survival hinges on paper-thin profit margins. Managers are faced with seemingly impossible goals: making every asset a source of revenue while simultaneously reducing operating costs. The bigger challenge still is to remain in the game as every player gets bigger and more competitive.

This analysis suggests that merger targets among large grain cooperatives are likely to have the following financial characteristics: a positive, but relatively low return-to-total-assets (3-4 percent range), expenses-to-sales approaching 10 percent, and labor-to-income significantly exceeding the 35-percent benchmark (40 percent and above). Given these conditions, another 32 large cooperatives are likely candidates to go out of business in marketing year 2000.

Medium-sized grain cooperatives that went out of business were most successfully predicted by the three ratios: return-to-local-assets (-), expenses-to -sales (+), and return-to--fixed-assets (-). Again, the negative sign attached to two of the variables (local return-to-local-assets and return-to-fixed assets) indicates that, as these ratios increase, the likelihood of a co-op being forced into a merger, consolidation or some other reason for ceasing to operate as an independent entity.

Much like their larger counterparts, medium-sized cooperatives must balance profitability and efficiency. However, while the large cooperatives concern themselves more with efficiency, medium-sized co-ops must shift their emphasis toward profitability. It is significant that two of the three most important variables involve returns.

Of particular importance is the relative contribution of return-to-local assets. It is well known that many otherwise struggling local grain cooperatives have managed to survive from one year to the next on patronage received from regional cooperatives. The results of the model suggest, however, that those days are ending. Local returns are primary to a grain cooperative's success.

Merger targets among medium-sized grain cooperatives are likely to have the following financial characteristics: a local return-to-total-assets of less than 2 percent, expenses-to-sales approaching 10 percent and a return-to-fixed assets of significantly less than the 30-percent benchmark (18 percent or less). Under these circumstances, another 60 medium-sized cooperatives are likely targets for consolidation in 2000.

To survive, large cooperatives need to be profitable and efficient, with an emphasis on efficiency, while medium-sized co-ops need to be efficient and profitable, with an emphasis on profitability. And even more importantly what does "survival" mean for grain cooperatives in the context of agriculture's wide-spread economic restructuring? Perhaps what has been learned about M/C cooperatives will provide some important keys to the challenges that he ahead.















Consolidation implications
Even the most cursory look at the M/C cooperatives during the 1993-97 period suggests two predominant patterns: cooperatives in poor financial health seeking a partner to avoid bankruptcy; or, strong cooperatives seeking out stronger partners and/or expanding internally to position themselves strategically for the future.

In regard to both patterns, historians looking back on the late 1990s may very easily conclude that the "farm" crisis of two decades earlier simply "moved further up the food chain." Many smaller farms were "shaken out" of the industry in the past generation. Now, even among the largest players remaining in agriculture, there is near universal agreement that "only the lowest cost operations will remain."

The buildup of surpluses and declining export demand have driven prices to their lowest levels in decades. Expectations for their recovery are equally as bleak. What was once a cost-price squeeze may now be likened to a hammer and anvil.

Paper-thin profit margins and low expectations are forcing grain cooperatives, and the rest of agriculture, to lower operating costs. That means a firm must grow in size so as to spread operating costs over a larger business volume to gain "scale economies."

A merger with another cooperative is often perceived as a way of gaining a step on the economic treadmill. By acquiring additional assets (such as storage facilities, unittrain loadout facilities, etc.) relatively cheap, by combining two sales forces or accounting departments and other consolidation measures, firms hope the benefits of size will help them to structure their operating costs a notch lower.

This cost-saving behavior among two or more firms at the same level, or "link," along the supply chain is characterized by economists as horizontal integration. Vertical integration, on the other hand, involves the forward or backward linking of two or more firms at different levels of the supply chain.

While supply chain integration is not a new event in agriculture, its increasing pervasiveness in recent years is prominent. A supply chain is formed when one firm usually a significantly dominant player or "integrator" works to control (contractually or through ownership) the activities of firms (groups of firms) at each level of the production process, up to and including delivery to the consumer. These chains seek control.

Integrators assume command of the production and delivery process to assure themselves: a) that product quality meets their customers' specific needs; b) that costs are driven to the absolute minimum, subject to meeting the quality specifications; and c) that the associated risks are managed within acceptable levels.

Supply chain integration long a fact of life in the poultry/broiler industry and becoming one in the pork industry is now underway in the grain industry. The grain delivery system is not quite as complete as in the poultry/broiler industry. A handful of firms have yet to completely dominate seed development, production, processing and marketing with every coordinated step up and down the chain.

However, in recent years, we witnessed the harvest and marketing of herbicide-tolerant corn and soybeans. The so-called "Roundup-ready" varieties are just the first of many crops derived from seed stock that was modified at the genetic level to garner specific properties. Moreover, we also watched several alliances of seed corporations with pharmaceutical firms formed with the specific interest of developing genetically modified seed stock. And, while both international and domestic markets have proved to be less than enthusiastic for genetically modified corn and soybeans at least during the 1999-2000 marketing year continued progress in bioengineering is expected.

In short, the best available genetics were combined with the best (i.e., most profitable) production processes to deliver products intended to meet the needs of an increasingly discriminating consumer.

















The final choice
As the marketing chain structure dominates the grain industry, both cooperatives and their producer members are faced with a straightforward choice: build new partnerships or be left behind. Survivors in the poultry and pork industries successfully adjusted to a shift in emphasis from "commodity marketing" to "product delivery." For producers and cooperatives in the grain industry, this will mean realignment to become an "integrator" themselves, such as Dakota Growers Pasta Cooperative of Carrington, N.D., or, at the very least, a reliable supplier to a cooperative integrator, for example, producers with membership and delivery rights of corn for Golden Oval layers in Renville, Minn.



References
CoBank, National Bank for Cooperatives, "Analyzing a Cooperative Business: Designed for Midwestern Grain or Farm Supply Cooperatives," self-published instructional pamphlet for directors and managers of agricultural cooperatives, undated.

Drabenstott, Mark "Consolidation in U.S. Agriculture Leading to New Rural Landscape and Public Policy Considerations," Feedstuffs 71:19, May 17, 1999, pp. 33,34,43, and 44.

Hanson, Mark "Grain Co-op Votes in Favor of Terminal at Sterling; South Central Has Elevators in Three Towns," Bismark Tribune, March 21, 1998, Metro Edition, pg. 8.

Merlo, Katherine "When Cooperatives Combine," Rural Cooperatives 65:5, Sept./Oct. 1998, pp. 18-23. Wadsworth, James J. "Large Cooperatives Unifying: A Strategic Trend to Monitor," Rural Cooperatives 66:5, Sept./Oct. 1999, pp. 21-25.







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