Run fast. If the opportunity to buy into the market via replacement females hasn't already passed, it's about out of sight.
“Expanding cow numbers in a herd now is almost a sure recipe for equity loss by the end of the decade,” says Harlan Hughes, Western Edge Consulting, Laramie, WY. “Expanding a herd now definitely will increase the average unit cost of producing (UCOP) a cwt. of calf over the next several years. That leads to reduced profits from expansion.”
This growing reality is multiplied if producers choose to expand via their own replacements vs. purchasing those with a reasonable Net Present Value (NPV) More on NPV later.
“The more we run the numbers (for clients), the more convinced I am few producers should be raising their own replacements unless they're a sizable operation, say 700 cows or more,” says Steve Swigert, a Noble Foundation agricultural economist, Ardmore, OK. “For herds smaller than that, we're seeing a better margin if they purchase their replacements.”
One reason for this mirrors a primary challenge of profitably expanding cow herds at this point in the cattle cycle — the opportunity cost relative to potential returns. In the case of raising replacement heifers rather than buying bred ones, Swigert says the delayed cash flow from a year of non-production is difficult to overcome. As for choosing to expand at all, many replacements' market price has exceeded their economic value.
Both Hughes and Swigert use NPV to calculate whether a heifer purchased today can be profitable over the long haul. Simply put, NPV accounts for the female's purchase price, net income generated by her over a set period of time, ultimate salvage value, and the opportunity cost of spending the money to buy her. Rather than just calculating how many calves a replacement must produce to recover her purchase price, NPV accounts for the size and timing of cash flow associated with the investment, as well as the opportunity cost of the capital.
When Swigert ran such a calculation recently, $1,200 was the price a producer in his part of the world could spend for a bred heifer this fall, if he wanted to earn 6% on his money (basically the long-term interest rate). That's based on getting calves out of her for the next seven years, with steers weaning at 550 lbs. and heifers at 525 lbs. That is, if annual cash carrying costs for the new purchase are $325.
Lower calf weights by 25 lbs. in this scenario, and NPV goes down $70. Increase purchase price, carrying cost or opportunity cost, and NPV goes down, too.
Likewise, reduce the number of calves produced and NPV takes a dramatic dip. The only ways to increase profit at the same purchase price is to increase production, reduce carrying costs or reduce opportunity cost (return on investment).
That's why Hughes believes now's the time to consider selling breeding livestock. “Producers should sell every calf born when prices are at their peak, and build financial reserves for the tough times,” he says.
Swigert knows of several operations that took that advice an extra step, opting to liquidate their cowherds and run stockers until the economics change.
“The only producers we're currently seeing grow to meet grass availability are those who have income outside the ranch,” Swigert says. “In cases where all income is ranch-related, we're seeing producers looking to sell down in this market.”
There are exceptions, however. For instance, Swigert says there's a major difference between an operation with an annual cow cost of $250 and one paying more than $500. He's seeing some of the lowest cost producers expanding now because their costs make the NPV work at current prices. Plus, the expanded herd size will help them reduce cow costs further.
Moreover, current tax laws provide incentive for some to invest in breeding females.
Specifically, William Edwards, Iowa State University Extension economist, says the opportunity to write off up to $100,000 worth of expenses for new breeding stock each year (Section 179 Expensing), rather than depreciate it over time, allows some to shelter a portion of their income until the females are sold. This is especially appealing to folks in higher tax brackets. However, owners of the breeding stock must be involved in the business, taking some risks and providing management imput, not merely leasing the livestock. When the animals are ultimately sold, the depreciation is recaputured and taxed as ordinary income. Raised replacements also have some tax advantages. When these females are ultimately salvaged, the sales revenue is taxed at capital gains rates which are lower than the income tax rates they would have had to pay.
Snubbed to a different post, at this stage of the cycle, Edwards sees more people considering cow leases or cow-share agreements. Investors are looking to shelter money, while producers want to manage risk and/or expand their herds (see sidebar).
Hughes cautions, however: “I think people believe lease cows generate more profit. In fact, leasing doesn't increase profit, plus any profit from leased cows is shared.”
Managing high-priced risk
Other tried and proven procurement strategies can help manage the risk of high-priced replacements.
First, know the costs of your operation to accurately calculate NPV for prospective purchases. Find more detail for calculating NPV, as well as price charts for long-term planning, at Hughes' Web site: www.beefcharts.blogspot.com.
Next, calculate the economic tradeoffs of buying vs. developing replacements. Swigert emphasizes, “It's been a while since we recommended anyone raise their own replacements.”
Finally, Swigert suggests buying quality rather than just adding numbers.
“We're seeing more opportunity for margin after the calf leaves the cow than when the calf is still on the cow. With retained ownership, as a cow-calf producer, all I'm risking is the margin I have in the calf,” Swigert explains.
Unfortunately, ensuring that a replacement equals or beats the performance of the female being replaced is much easier said than done.
“Relatively few producers can tell you how their individual cows perform, even if they raised them,” Swigert says. “We could pay a lot of money if we knew a certain replacement's calves would beat the average.”
Far as that goes, Swigert emphasizes purchased replacements bred to calve early in the season return a lot more — 30-45 days of calf weaning growth each year — than those calving later in the season.
“This may be the time to really look at quality in your cow herd,” Swigert says. “If some cows aren't working, maybe it's time someone else owned them.”
Sharing cow risk
“I've never been a big fan of sharing the pie, if it's a good pie,” says Steve Swigert, Noble Foundation agricultural economist, Ardmore, OK. But, dwindling opportunities to purchase replacement females on a profitable basis at this stage of the cattle cycle are making the economic pie less appetizing.
Combine this with the added investor interest that typically accompanies high cattle prices — plus ongoing tax incentives — and William Edwards is seeing more interest in cow-share agreements from both investors and producers.
Edwards, an Iowa State University (ISU) Extension economist, explains cow leases differ from share agreements in that producers leasing cows shoulder all the production and market risk; they're paying a set fee for use of the cows no matter how the cattle perform and no matter what the market does. Conversely, with share agreements, he says both parties share expenses and receipts; they're sharing market and production risk.
Edwards and his ISU peers recently developed an online spreadsheet to help producers calculate such agreements' economic potential. Find it at www.iowabeefcenter.org.
“One of the keys to figuring an equitable share agreement is knowing your cost of production, and deciding which party should pay for what,” Edwards says.
For instance, while feed costs are typically the primary contributor to total costs (40% or more), Edwards says both parties often ignore it in their negotiations. Meanwhile, other vital details such as health expense, death loss and replacement strategy are often afterthoughts.
Instead, Edwards explains, “I'm most often asked how the income should be shared. People tend to over-value both their labor contribution and ownership of the breeding stock.” For the record, he says both usually come in at 20-25% of the value.
All this should happen before deciding the share agreement's duration, and how parties should exit the agreement.
“These agreements need to be in place a minimum of five years to give them a chance to work, and to get past the year-to-year variations,” Edwards says. As for the exit clause, he suggests a minimum of one year for the termination notice.
Perhaps unsurprisingly, one of the biggest mistakes Edwards sees people make in constructing share agreements is among the most preventable. Never mind the potential benefit of including actual lawyers in drawing up the contact, Edwards says, “Just getting people to put together a written agreement is a major accomplishment in a lot of these deals. Putting it in writing also provides valuable information for income and estate tax filing.”