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Diversify or expand?

It was the winter farm meeting season of 2006 and I had just driven through a blizzard to find myself hearing the same words. “Think outside the box,” I was told yet again. “Look to new paradigms.”

“Don’t keep expanding production of what you already know how to do,” speaker after speaker told us. “Diversify, diversify, diversify.”

The take-home message was clear. We needed to create more net income, not increase production.

On the way home, the snow had stopped but my head began to ache with discouragement. We were trying to be like farmers all across this country…hard-working, risk-taking, smart people who are the absolute experts at increasing our productivity and reducing our costs.

Now we were being told that this wasn’t enough. How could that be?

Fast-forward a mere six years. Pastures have been ripped up, hog barns depopulated and organic vegetable warehouses are now conventional distribution centres. Some value-added and secondary businesses have flourished, of course, but at the same time, those crazy, tough-headed negative-margin farmers who slowly bought lower-priced land instead of planting grapes or setting up a bed and breakfast look like geniuses.

Today, farmer optimism abounds. In the 2011 Farm Credit Canada national vision panel survey, 58 per cent of farmers said they plan to expand or diversify their operations within the next five years, up about five per cent from three years ago. In total, 27 per cent said they’ll expand, 11 per cent said they’ll diversify and 20 per cent said both.

Which is the smartest strategy, diversification or expansion or both?

Diversification has traditionally been a risk management tool. If one enterprise didn’t do well, the farm had other enterprises on which to rely. Returns were generally not as high as with specialization, but year-to-year variability was less. On the downside, however, that risk-fighting benefit could be completely overwhelmed by the fact that you had foregone the opportunity to decrease your production costs on your main enterprises through enhanced economies of scale.

Although our farms are bigger and more specialized, Canadian farms are still amazingly diversified, especially in some sectors. More than half of FCC clients have a secondary enterprise; 77 per cent of their dairy customers, 65 per cent of grain and oilseed farmers and 50 per cent of beef farmers have secondary enterprises.

Yet while there are some glowing successes in value-add ventures, the trend is actually toward less diversification.

Five years ago the number of farms with secondary enterprises was about 10 per cent higher for grain, beef and hog farmers than it is today. Only FCC’s dairy customers have increased their business efforts outside their barns, likely because of the limited supply and cost of quota.

“The trend toward increased specialization suggests that cost savings associated with specialization and size more than offset the benefits of diversification for many farmers,” says George Patrick, agricultural economist at Purdue University.

This trend doesn’t surprise Bob Evans, who operated a crop input business in Saskatchewan for 20 years before becoming an independent consultant and agrologist with McCannell Financial Group in Saskatoon. “Over the years I noticed that the guys who focused on one element of the business and didn’t get distracted by secondary businesses were more successful,” says Evans. “Specializing — whether it be in dairy, beef or grain — is generally more successful than combining those enterprises.”

When pushed he couldn’t think of any wildly successful diversified operations in his area still in operation. On the other hand, he could think of a couple handfuls of grain farmers who had lost or nearly lost their farms after starting up a livestock enterprise. “In general, if the goal is reduced risk then I think specialization is preferable to diversification,” says Evans. “Internal growth is way, way less risky.

“With new businesses often you don’t even know what you don’t know, and that puts your risk levels on high alert,” Evans says. With the core business, farmers are often on the other end of the learning scale and are unknowingly skilled, meaning the required skills are second nature.

Many factors affect risk, including sector history, timing, size and pace of investments, business management acumen and individual skills. A Statistics Canada report called “Failure Rates for New Canadian Firms: New Perspectives on Entry and Exit in 2000” put the likelihood that a new farm business would survive beyond a particular age of agriculture at 74 per cent for the first year, 60 per cent for the second and 50 per cent for the third. Then it goes down by about six per cent per year.

“The success of expansions varies based on circumstances and on whether it’s an internal or diversified enterprise,” says Mike Hoffort, FCC’s senior vice-president of portfolio and credit risk. “There are situations when both or either option can work well.”

There’s always risk

Credit agencies generally rate the risk levels of various sectors according to their historical performance. At FCC the supply management sectors are rated strongly for risk, followed by crops, then beef and then hogs, based on what’s happened in the last few decades.

Farmers investing in non-farm enterprises generally take on another level of risk. The closer in nature the added enterprise is to your core the less risky it is. “The skills required to be a successful manager of non-farm enterprises tend to be a little different,” says Hoffort.

However, when assessing a loan, FCC starts by looking at the applicants’ management ability, experience, business plan, financial strength of their operation, and their understanding of the market, says Hoffort. “This core understanding is something we look at as much as what enterprise they’re looking at to get involved in.”

Of FCC’s $22-billion loans portfolio, 12 to 13 per cent is in value-added enterprises. “These are slightly higher risk than traditional agriculture,” says Hoffort. “If you expand into more commercial types of businesses in addition to the farm, that extends the risk pendulum.”

FCC’s value-added portfolio mostly covers joint efforts between farmers in new-generation co-operatives or new companies with hired staff.

The management factor

“For all expansions you need a strong business plan and you need to ensure that it doesn’t bring down the core business,” says Hoffort.

Risk-bearing ability is directly related to the solvency and liquidity of one’s financial position and cash flow. The best sources of historical production and marketing information are the farm records. The records may be supplemented and complemented by off-farm information, forecasts, and predictions. However, the farm records reflect the production and business management capabilities of the specific assets. “There is no substitute for farm record data,” says Purdue’s George Patrick.

At the top farmer seminars held at Purdue, Patrick says the average education level is at post-graduate/entry-level masters. These farmers want answers for specific questions and they want to go directly to universities for insight and advice, sidestepping extension services.

Does that mean part of agriculture’s difficulty with diversification is tied to the level of advice we’re getting on diversification strategies. It’s certainly next to impossible to find historical success rates of farm diversification or benchmarks comparing diversified farms to sole enterprise operations.

“Management, that is the key,” agrees John Anderson, financial consultant with Collins Barrow WCM. “We can discuss time and skills, but if management has assessed their strengths and weaknesses, time and skills will have been assessed.”

The farm enterprise failures Anderson has seen usually happen when management is stretched to a level of incompetence. That can happen either in a straight expansion or setting up a secondary enterprise.

By contrast, the common characteristic of successful expansions — whether they’re diversified or internal — is that the farmers are excellent managers in every sense of the word.

For example, a dairy farmer who is unable to buy much more quota may decide to start buying more land and equipment, adding a cash crop enterprise. However, the contribution margin may not meet the debt service commitment for the land and equipment investment. It ends up bleeding his base enterprise, the dairy.

“It was a reaction to a situation with minimal assessment of the risk and returns,” says Anderson. “So many times the expansion puts the core profit centre at risk.”

Know your limits

Farm diversification can also stretch the human resources. For example, if a farm adds an outlet store that overwhelms the family’s time, human resources and management capability, the entire farm can be put at risk. “They’re not on the farm when they are needed and they’re not in the store when they are needed, so both enterprises suffer,” says Anderson.

Success happens more often when the expansion is thoroughly planned. Anderson is currently working with a large-crop farmer who is considering adding trucking, elevator, drying and marketing enterprises to his business when his son comes home from university. “They’ve done an assessment of their present business. They’ve completed a business plan. They’ve created a timetable for events to occur,” says Anderson.

This family recognized they didn’t have strong skills required for this new venture. So the son is going to work for another agricultural supply business for a couple of years after graduation.

Often diversification projects are structured based on skills, especially in multi-generational farms, says the FCC’s Hoffort. The next generation will come back to the farm with a whole different skill set, ideas and interests, and these take the farm in a new direction.

However, diversification still requires the ability to multi-task, and that usually shows up in the history of the farm. “Does the management have a high capacity to manage multiple projects well?” asks Hoffort.

“Diversification sometimes equals distraction,” says Mark Lepp, owner of FarmLink Marketing Solutions in Winnipeg.

Most of FarmLink’s customers are young and focused on internal expansion in the grain and oilseed business. Lepp says it’s more dangerous for a farmer in the throes of succession to invest outside the core than for an established farmer with little debt and high asset wealth to put some money in a joint venture.

“There’s government funding for farms to do market studies to diversify,” Lepps says. “Why isn’t it available for looking for ways to improve the core farm?”

Upsizing

To expand, farms need the resources and net revenue stream to meet the additional debt servicing. Moreover, prior to making the expansions, farmers should consider the lifestyle commitments and additional labour needs.

Managing the pace and scale of investments is key to the success, says John Anderson. Management must size the operation appropriately to the core farm size so they don’t put the core business at risk.

“The classic in my region of the country is the dairy farm that builds a big new facility but then finds themselves without the quota so the business is being operated at less than capacity and they cannot service the debt or lifestyle needs,” says Anderson. “Expansion does not always increase margins.” 

A better option would be for the dairy farm to rotate cows through the present facility as they expanded their quota holdings and then build the facility or add robotic milkers. However, often the conundrum comes with the lumpiness of today’s production. With new technology the size required for efficient use of machinery or buildings is much larger.

Bob Evans says that outside those sweet spots — which he estimates at 3,500 acres for a combine, 2,000 acres for an air drill — it can be a struggle to compete.

It also makes it more difficult to execute a strategy calling for slow but steady expansion, Evans says.

This may have its greatest impact on young farmers. Traditionally, new farmers would buy a section or two or add to the herd or flock a bit at a time to expand the core operation slowly. However, that startup model is changing.

Hoffort is seeing more part-timers add an enterprise that complements the core business and allows for a smoother transition. For example, the grain farmer’s daughter may buy a quarter section while the parents buy a high-clearance sprayer to do custom work. After five years, the family no longer needs the custom income, so they downsize the sprayer for just their own farm use. The quarter section is paid down and the new farmer has some land equity and experience built up.

It takes a little more creativity and planning than trying a new crop or adding some cows. The bottom line is managing expansion.

Also, diversification is less risky if the secondary enterprise is fairly close in nature and matches the skill set and time resources of the people involved. Expansion needs to be relative in size to the core business and the investment timed according to market demands and cash flow. CG

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Senior Business Editor

Maggie Van Camp

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