Is vertical integration at CPS (TSX: AGU) hurting agri innovation?

Seeing as tomorrow is Earth Day, it’s fitting to talk not just about the health of the Earth and the state of environmentalism, but also one of the largest resources provided to us by our Earth -- food.

We’ve heard about climate change and whether we believe climate change is due to human influence or not, we know its effects are only becoming more acute. An unrelenting drought in California, a state that’s been known for so long as the “breadbasket of the world”; longer, more extreme winters that repeatedly delay crop planting; shifting and increasingly unpredictable weather patterns. All of this has put a heavy, in some cases unprecedented, strain on today’s global agribusiness.

Add stress like this to the impact of diminishing crop yields brought about by soil degradation, over-development and farmers forced into improper crop rotations, and you have real concerns about where today’s agriculture industry will be in the next twenty to thirty years.

To give you an idea of just how alarming soil erosion and soil degradation has become, at a forum held on World Soil Day last year, the Food and Agriculture Organization (FAO) reported that if the current global rate of soil erosion continues unchecked, the world’s topsoil might be gone in the next sixty years. Putting it more poignantly, activist Volkert Engelsman commented at the forum that, “We are losing 30 soccer fields of soil every minute, mostly due to intensive farming".

Despite these new pressures, agriculture production not only has to be sustained, it has to grow. After all, based on a recent Pew Research Center report, the global population is expected to increase 38 percent from 6.9 billion in 2010 to 9.6 billion by the year 2050. Other research points to similar population projections.

We’ve all read stories about communities going hungry, even in industrialized nations. With a global population set to grow by 38 percent over the next thirty-five years, how will agribusiness be able to feed all these people?

New technology is the simple answer to the tricky question, and it’s a good answer. Like in centuries past, new farming technology and previously unthought-of agricultural innovations will allow agribusiness to break through new pressures to feed growing populations.

But, this begs a second question - is the agriculture industry, as we know it today, set up in a way that will allow new technology and innovation to enter the industry?

Unfortunately, the answer is no.

Agribusiness and the agriculture industry are terms often interchanged, and that says something. Growing crops has become a mega business, one with all the economic pressures, trends and patterns of any other business.

One of the trends that’s become particularly pronounced in modern agriculture is vertical integration.

The common definition of vertical integration is the instance where one company, often called an integrator, owns a number of points in the production path of a particular product.

Vertical integration in the agriculture industry began arguably in the poultry industry starting in the 1940s. Before that time, the poultry business was composed of a multitude of different hatcheries, farms and processors, most of them independently owned and occupying their own niche in the production of chickens. Starting in the 1940s, however, companies began to integrate and combine various points in the production path into one corporate umbrella.

It’s frightening to see how quickly vertical integration has come to dominate modern agribusiness. We’ll continue to use the poultry business as an example. As has been well documented (see Food Inc. for all the details you want), the poultry industry is now dominated by a few mega corporations.

Following in the footsteps of the poultry business, other agriculture industries have also seen a consolidation in their respective production paths. As commented on in a recent Fortune article, Nebraska pig farmers, a group that’s been at the mercy of large meat corporations, once more had to fight this year to assure that corporations wouldn’t be able to own hogs (thus giving corporations one more avenue of control in the pork production path).

Consolidation and concentration of control has also found its place in other segments of the industry, in, for example, the production of fertilizers used for global crop production.

Non-organic fertilizers make up the majority of fertilizers used in crop production. These are fertilizers that are mined and brought to market.

Historically, fertilizer production, like other parts of the agriculture industry, was made up of small, localized companies. However, over the past several decades, the global supply of non-organic fertilizer has become consolidated into the hands of corporate giants, like PotashCorp, Mosaic and Agrium.

Agrium Inc., a Canadian-based company that had over U.S. $15.7 billion in revenue in 2013, provides an interesting example of just how concentrated fertilizer production has become.

The company also provides a cautionary tale for how limiting vertical integration can be when it comes to agricultural innovation.

Besides being a global wholesale fertilizer supplier, Agrium also has a retail wing that supplies seeds, crop protection products and other things that farmers need to grow their crops. Agrium also happens to be a parent company of Crop Production Services, or CPS, a large retail chain that provides a wide assortment of farm supplies to farmers in the United States and Canada and that has over 1,250 retail locations across North America.

It’s the vertical integration within Agrium and its subsidiary, CPS, which provides the cautionary tale.

A little known company called EarthRenew and what happened to it.

Despite the dominance of mega agriculture corporations, there are smaller companies out there that are trying to bring new perspectives to the industry, not to mention new technology.

The EarthRenew Corporation was one of those companies.

Formed in 2006, much like Agrium, EarthRenew produced fertilizer. However, unlike mined fertilizer, EarthRenew produced organic fertilizer.

There are plenty of organic fertilizer producers in the industry. However, EarthRenew brought new technology to the industry and a new way of producing organic fertilizer.

In order to manufacture their fertilizer, EarthRenew cooked cow manure at extremely high temperatures, producing granules or pellets dense with plant nutrients. Using clean burning natural gas to cook the cow manure, besides producing nutrient-rich fertilizer pellets, EarthRenew’s manufacturing process also generated electricity as a byproduct that could be sold on the grid.

\What’s more, because EarthRenew’s fertilizer was treated at temperatures so high (as high as 535°C (1000°F)), it killed off most, if not all, weed seeds, pesticide and herbicide residues, which has been a common source of complaints in organic fertilizer. In addition, EarthRenew’s fertilizer pellets served as an ideal vehicle for fertilizing crops since it significantly increased Plant Nutrient Uptake (“PNU”), while reducing the farmer’s need to constantly re-fertilizer their crops.

In bringing to market this new form of organic fertilizer, EarthRenew had a serious chance of gaining a foothold in the large fertilizer marketplace. In fact, in 2010, the company had already prepared a prospectus with the intention of eventually going public and, more immediately, was in negotiations with the Royal Bank of Canada to finance an expansion of their operations in Western United States.

What happened then?

To EarthRenew’s later regret, it was at this time, in April 2009, when EarthRenew began business negotiations with Crop Production Services (CPS).

From face value, the negotiations between EarthRenew and CPS centred on mutual and respected self-interest. Understanding that EarthRenew offered a new technology and a new type of fertilizer that farmers would demand and that, moreover, would be a perfect fit for their retail outlets, it was in CPS’s interest to establish a purchase contract with EarthRenew. EarthRenew, on the other end, needed the buying power of an established party like CPS to finance their continued expansion.

With those interests in mind, in May 2009, EarthRenew and CPS entered into a signed, contractual agreement in which CPS was given the exclusive right to retail EarthRenew’s fertilizer in the Western United States with the understanding that CPS would purchase, on a monthly basis, a minimum of 80 percent of EarthRenew’s total fertilizer output.

A day later, EarthRenew and CPS published a press release announcing their newly formed business relationship.

The events that transpired after this is the subject of an ongoing lawsuit between the two parties.

In a strange series of events, shortly after signing the contract with EarthRenew, CPS backpedaled on their agreement, first claiming that the contract was invalid because the executive who signed it did not have the authority to do so, and then filing a complaint for declaratory relief in order to legally extract themselves from the contract. As taken from this legal brief, in a final move, one that may be revealing of less benign intentions, CPS contacted the Royal Bank of Canada to inform the bank that the contract between themselves and EarthRenew was no longer valid.

As a result of CPS’ reneging from their contract with EarthRenew, EarthRenew was unable to secure the financing they needed to expand their operations. Almost certainly as a result of this, the company went into receivership.

At this point, it’s important to recall that Agrium is the parent company of CPS. As such, Agrium holds a definite influence in what sorts of companies CPS conducts business with. EarthRenew produced a highly innovative organic fertilizer, a product that had a definite chance of revolutionizing the industry. In this way, EarthRenew and its technology posed a real and direct threat to Agrium’s main line of business.

Would Agrium want one of its child companies to conduct business with a potential competitor? Of course not.

Is this the reason why CPS had to renege out of their business contract with EarthRenew? A logical mind would say, very likely.

The failed relationship between CPS and EarthRenew and the influence that Agrium had in causing this relationship to fail indicates just how powerful vertical integration has become. It demonstrates that there is an invisible wall blocking new parties from coming into the agriculture space and bringing to market new ideas on how we grow our food. It represents the danger of large mega corporations becoming too large and dominating too many parts of the production path.

As much as the U.S. and Canadian governments have tried to limit the level of concentration and monopoly in the agriculture space, EarthRenew’s fall as a company, its inability to find a foothold in the fertilizer industry - at no fault of its own - shows that a lot more needs to be done.