This report was sent to subscribers on November 17, 2010.  Join our free mailing list to receive this actionable info 48 hours before the public…

EXECUTIVE SUMMARY:

• A global currency war has pushed the value of cash lower, and the corresponding prices of soft commodities higher.

• Producers of foodstuffs are struggling with higher commodity input costs, and are largely unable to pass these costs on to customers in the form of higher prices.

• However, businesses involved in the production or distribution of these commodities stand to benefit from the inflationary environment.

• Below are three expected winners, as well as three bearish trade opportunities, to help you profit from the dramatic long-term price trends in commodities:

Winners:

• Deere & Co (DE)
• Monsanto Co (MON)
• CSX Corp (CSX)

Losers:

• Kroger Co (KR)
• Smithfield Foods (SFD)
• Chipotle Mexican Grill (CMG)

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As governments across the globe attempt to spur economic growth, a currency war has emerged, with each participant attempting domestic devaluation.  Lowering the value of one’s currency is expected to make exports cheaper (and thus stoke the domestic economy).  However, as a number of nations embark on the same strategy, the end result appears to be a global reduction in the PURCHASING POWER of many currencies.

To the average consumer, this is quite disturbing.  As the purchasing power of global currencies declines, the nominal price of many commodities has risen sharply.  The result is an increase in price for necessities such as food, textiles and even energy — and we are already seeing an increase in the percentage of income applied to consumer staples.

The picture isn’t much better when looking at many of the companies that produce these necessities.  Food manufacturers must pay higher prices for inputs like grain, corn and soy commodities. But with a relatively weak economy, they are largely unable to pass these higher costs on to their customers.

Higher costs and low pricing power is resulting in crimped profit margins for a number of players in the stream.  There are several areas where these pressures will show up, including wholesale food distributors, consumer grocers, and even restaurants.

While the picture may be bleak for companies caught in the margin squeeze, there will also be winners in this game as higher commodity prices and shifting global trade results in opportunities for players attractively positioned in the supply chain.

Higher nominal prices for soft commodities will likely benefit companies serving the farming industry.  When it comes to food consumption, higher prices have a relatively inelastic effect on demand – meaning we are still likely to consume these commodities even if the currency war pushes prices higher.

Companies which offer equipment or crop supplies to farmers may actually see an increase in demand, as the farming community scrambles to take advantage of higher selling prices for their crops.  Efficiency will be key, and in addition to our favorite fertilizer producers, we will likely see strength in other ancillary businesses which serve the farming industry.

We’re also expecting to see strength in the transportation of bulk cargo (primarily on the domestic front).  The rail industry is also likely to see stable to growing demand for bulk shipments of fertilizer, as well as ag products such as corn, wheat, livestock and the like.

So lets take a look at some of the winners and losers in the commodity inflation game…

Deere & Co (DE)

• Global distribution of farming equipment offering geographic and political diversification.

• Experiencing positive revenue trends – management expects strong sales to continue.

• Positive pricing power creates margin stability.

• New products for emerging markets such as India may significantly boost growth.

The John Deere trademark is one of the most well-known brands in the United States, and over the past few decades the rest of the world has come to respect the farming and agriculture company.

As global demand for commodities grows, Deere is in the enviable position of already having a worldwide presence and offering products that are needed to increase supply.  The company has already begun to see revenues rise after a recessionary pause, and management is guiding investors to expect strong growth in the coming quarters.

For the fourth quarter, investors have been told to expect net sales to increase by 32% over last year, and positive pricing indicates that demand is robust.  In fact, for the company’s key Agriculture and Turf division, operating profits were up 72% in the third quarter.  The increase was due to a combination of higher volumes and “improved price realization.”

The company’s presence in emerging markets such as India is especially exciting.  This year, Deere is introducing a new line of tractors in India which are designed to be cost effective, fuel efficient, and meet the specific needs of the emerging farmer.  These tractors have lower horsepower than the company’s standard offerings, but the style of tractor lines up well with the cost constraints and output needs of local farmers.

Analysts are currently expecting the company to earn $5.14 per share in 2011 — and those expectations have been rising.  Investors are paying less than 15 times forward earnings.  A premium price could be justified as the industry picks up traction, and with a conservative increase in earnings estimates along with a multiple near $20, a case can be made for a stock price north of $110.

Monsanto Co (MON)

• Attractive portfolio of products including modified seed and herbicide lines.

• Recent crop reports continue to point to increased yields for farmers using Monsanto products.

• Commitment to reinvesting capital back into the company yields a strong development platform.

• Increasing estimates lead to stronger investor confidence.

Monsanto is perhaps best known for its Roundup brand, which is used both commercially by farmers and is also available in various forms for general retail purchasers.  Farmers rely on Monsanto to not only protect against weeds, but to provide them with seeds and crop treatments that result in higher yields – and thus better profits.

The statistics speak for themselves.  Across a wide variety of crops, measured in diverse locations, farmers who use Monsanto products typically enjoy a significant yield advantage per acre versus crops that are not using modified seeds or crop treatments.

As prices continue to increase for agriculture products, farmers will have a growing incentive to generate larger crops and realize strong margins on their harvest.  This argues for robust demand when it comes to Monsanto’s products, and we should see global sales increase over the next several quarters.

One of the more attractive features of this company is the intellectual property which continues to accumulate.  Monsanto is committed to plowing (pardon the pun) capital back into its development pipeline and continuing to come up with new products to benefit farmers.  This year management expects to allocate $600 million to $700 million to capital expenditures, which should continue to support long-term growth.

Analysts are expecting 16% earnings growth in 2011 (fiscal year ends August 31) and another 19% in 2012.  Now these numbers are obviously subject to change (the prevailing trend is for MON estimates to increase) but based on the potential for ag-inflation, it wouldn’t surprise me to eventually see the stock testing its 2010 high near $87 — a good 47% above Tuesday’s closing price.

CSX Corp. (CSX)

• Leading transporter of commodities across the US and Canada.

• Low industrial inventories resulting in an increase in number of units shipped.

• Significant exposure to agriculture products both domestically and for export.

• Pricing power gives CSX earnings leverage on top of revenue growth.

CSX Corp appears to have strong fundamental momentum as the company benefits from industrial inventory builds along with the robust trade in agriculture products.  The company is a leader in North American bulk transportation, and is leveraged to the the US grain belt as well as positively exposed to resource-rich Canadian rail lines.

During the third quarter CSX saw revenues increase by 16%, attributing that growth to an increase in both unit volume and pricing power.  The ability to pass on fuel surcharges to customers is evidence of the pricing power in the industry, and has helped CSX maintain a healthy profit margin.

Q3 earnings were significantly higher — up 48% over last year as the company leveraged its revenue growth while keeping costs in check.  Management is investing heavily in future earnings growth as well, plugging $1.8 billion into capital spending on “high value projects” expected to yield a strong return.

Since CSX is a stable, cash-flow positive business, investors expect the company to return a good bit of free cash flow to shareholders.  CSX has a history of dividend increases, and while the yield is only 1.7% – that’s more a function of a strong stock price than an anemic dividend payment.  The company is also actively engaged in a stock repurchase program, with management expecting to complete nearly $650 million in share repurchases by the end of the first quarter 2011.

After an expected 40% increase in earnings for 2010, analysts are expecting growth to slow to 18% in 2011 as the consensus numbers call for $4.70 per share.  CSX should be able to take advantage of robust trade in agriculture markets even if the industrial and housing segments slow.

If investors are willing to pay 20 times these estimates based on strong visibility and steady earnings trends, then the stock could trade above $90 (for a 50% return) in the next several months.  The key for us as traders will be picking the right inflection points — the ones that offer the best returns while still protecting against potential losses.

Kroger Co. (KR)

• Razor thin margins will likely face more pressure as a result of higher commodity costs.

• A weak consumer means that the company will have difficulty passing higher costs on to the final customer.

• Labor unions pose a risk to profits at a time when margins are already constrained.

• Competition will likely increase as discount chains vie for customer loyalty.

Even in the best of times, operating a grocery chain is a difficult endeavor.  Profit margins are historically very thin, and competition is fierce.  The  grocer business model is very much a commodities game – providing standard goods at the best possible price and cutting out all excess costs.

Of course there are a few exceptions…  Whole Foods Market, Inc. (WFMI), for example, attempts to compete by offering premium natural goods.  But as a general rule, the grocery business is at the mercy of supply and demand — both when stocking their shelves and when selling to customers.

In today’s environment, the situation is even worse.  Rising commodity costs lead to higher wholesale prices for inventory.  But at the same time, a high unemployment rate coupled with a reluctantly-spending consumer means that it is very difficult to pass these higher costs on to customers.

As a result, Kroger has seen earnings drop in three of the last four quarters, even while revenue has been flat to positive in each period.  Not exactly the kind of statistics you want to see in a potential investment!

The management team is doing a good job of addressing Kroger’s challenges.  Just last week, the company was able to refinance a large portion of its debt, and the company also appears to be making headway in negotiations with various union chapters.  But there is very little management can do about the broad economic challenges that are likely to remain in place for some time.

The recent strength in the stock price (due both to the refinancing as well as to generally positive market trends) has pushed KR to a place where it now looks like an attractive short.  I don’t expect investors to be willing to pay a double digit earnings multiple for very long, and a 15% to 20% drop in the stock would still leave the stock over-priced if earnings begin to drop.

This week’s bearish trade could be an excellent opportunity to establish an initial short position – with horizontal and vertical exposure to be added at key inflection points along the way.

Smithfield Foods Inc (SFD)

• Historically high commodity prices leads to higher costs to raise hogs.

• Temporary lift due to low pork supplies (better pricing power) not likely to be sustainable.

• High debt level leads to interest expense that is a significant portion of operating earnings.

• Future earnings declines may lead to lower stock multiple.

After posting losses in 2009 and 2010 (fiscal year end is April 30), Smithfield is expected to return to profitability this year.  The company reported “record” first quarter profits in September after realizing just a 7% increase in revenues.  Unfortunately, these record earnings do not look sustainable.

Management admits that they are facing historically high priced raw materials, which increases the costs to grow new hogs.  But the industry has cut back on production levels, leading to a temporary shortage in pork on the market.  This has resulted in decent pricing power, but in order to continue to take advantage of this opportunity, SFD will need to increase its production levels — thus taking on the higher costs of raising its hogs.

So despite the temporary strength, the industry appears to be caught in a catch-22 where profitability will be low if production is low, but increasing production simply means realizing higher input costs while still being forced to deal with lower pricing power.

Smithfield Foods is also vulnerable because of the significant amount of debt the company carries.  At this point, interest costs cover a full third of the company’s operating profits, and 2010 interest expense is actually 13% higher than it was last year.

Investors are currently paying about 10 times future earnings for SFD — assuming the analyst pricing models are correct.  But with commodity price trends higher, and plenty of uncertainty as to how the company will adapt to the environment, there is a good chance the stock will back off.

With no dividend yield to support prices, one could make a good case for the stock trading at 6 to 8 times earnings.  This would be typical of a mature no-growth company operating in a difficult pricing environment.  We are picking our spots and looking for key inflection points to lay out short exposure.

Chipotle Mexican Grill Inc. (CMG)

• Increasing food costs likely to negatively effect profit margins.

• High unemployment and underemployment should eventually affect the quick-service-restaurant industry.

• Lack of premium natural ingredients could affect brand image.

• Premium stock price leaves investors vulnerable to shifting sentiment.

Chipotle Mexican Grill has been an incredible success story.  A spin-off concept incubated by McDonald’s Corp (MCD), CMG has now grown to nearly 1,000 locations across the US.  But unfortunately, one of the advantages which has fueled the company’s success, may ultimately turn out to be its Achilles’ heel.

The company has prided itself on “food with integrity” — using higher quality ingredients which naturally (again – pardon the pun) are more expensive.  Up to this point, the company has been able to pass the higher costs on to customers who buy into the concept of better food even at a higher price.  But two things are likely to test this business concept in the very near future:

• Food cost inflation may ramp to a point where the disparity between CMG’s cost and the closest competitor becomes a “deal killer” for the consumer.

• Chipotle may be unable to find enough ingredients meeting its high standards — especially considering the increasing number of stores operated by the chain.

Despite a phenomenal historical growth rate, analysts now expect CMG earnings to increase by 20% in 2011.  That’s not a bad metric for a company approaching $2 billion in annualized sales, but it’s a far cry from the growth rates investors have become used to.

Since the stock is currently trading at roughly 35 times next year’s expected earnings, investors are betting heavily that analyst expectations are low.  As reality sets in and CMG struggles with the same challenges its competitors have been facing for some time now, the stock price could lose half of its value — and still trade at a premium to most other stocks in the industry.

Picking a top in this cult-stock is a difficult game and we have been watching the bubble inflate since well before CMG was featured in our bearish restaurant report.  But that’s what trading is all about…  Identifying targets and then patiently waiting (or even taking a shot or two while managing risk) until the inflection points are breached and the opportunity is converted to profit.

CMG may very well be approaching that window.