Following news of another strong quarter from Input Capital (TSXV:INP), I reached out to Mr. Brad Farquhar to discuss the new records set from January-March 2017. Brad has told me in past interviews that this period is generally the harvesting season for the company's efforts to establish new streams with canola farmers in the Canadian prairies and this year's harvest looks good. This announcement marks record highs for the total level of active canola reserves, the pace of capital deployment, and the number of new streams.

You can find the news release on the company's site here. In fact, the company just released a new presentation deck today, which you can find here. Read on to find out more. Please note that I was not compensated to write this report but do hold shares in Input Capital.

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PB: Hello, Brad. Thanks for connecting with me again. It's been great watching Input grow the last few months.

BF: You're welcome, Peter. I appreciate the ongoing dialogue with long-term shareholders.

PB: Lots to discuss, but let me start with something I didn't see in the release -- average size per stream.

BF: The total capital deployment was $20M, across 126 new streams, which gives about $160,000 capital per new stream. That is right in the range where I figured it would be.

BF: Remember that we aren’t a finance company or a lender. In many ways, it is best to think of Input as a virtual grain company. We buy canola from farmers, and we’re the only company that pays part of the purchase price in advance, for multiple years into the future. All the other grain company only buy the grain after it is grown and delivered.

BF: Because we pay a portion in advance, farmers can use this deposit as a form of working capital and put it to use on their farm, to make it better. We’ve emphasized that angle from the beginning of the company, but as we have built up a track record with our own canola sales, our farm clients have noticed that we more consistently get better prices than they do. A lot of that is a function of our size, and it is also a function of the fact that our canola is sourced from many farms, not just our own, which is the situation in which the farmer finds himself.

BF: So, in effect, we really have two kinds of streams today. They lie along the same spectrum – there’s an upfront payment, or deposit, and there’s what we call a crop payment, which is the final settlement amount we pay to the farmer when the contracted canola is delivered and sold.

BF: There are farmers who are looking for working capital and they take deals that have larger upfront payments, or deposits, and smaller amounts paid on final settlement. Generally, in these “Capital Streams”, both the upfront payment and crop payments are fixed dollar amounts established at the start of the contract. Input takes on the full price risk, and this risk is priced into the deal.

BF: There are other farmers who don’t need any working capital, but are looking to participate in Input’s canola marketing program in order to get a better net realized price for their canola. They can do this with us by taking a stream with a very low upfront payment and a large crop payment. Generally, in these “Marketing Streams”, the upfront payment is fixed, but the crop payment is based on a percentage of Input’s final net realized price on the sale of the canola. The price risk is shared between the farmer and Input, and this is what allows us to do deals like this.

BF: Some farmers want the best of both worlds, and so they sign up for a Capital Stream and a Marketing Stream, giving them a boost in their working capital based on some of their production, as well as accessing Input’s marketing program with another portion of their production. 

BF: The typical stream for farmers who need working capital is around $300,000, based on typical farm sizes. These other farmers who want to benefit from our canola marketing have much smaller upfront payments or capital deployments, which in extreme cases can be as low as $10,000. As you combine a mixture of those two kinds of streams, you get an average deal size in the $150,000-$200,000 range.

BF: We came up with the Marketing Stream concept just before Christmas after several existing clients said they wanted better access to our marketing program. We soft-launched it with no promotion in January, and up to the end of March, signed up many farmers with these contracts from a standing start. Those amounted to maybe $1 million in deployment out of the $20.2 million deployed in the period, but they were instrumental in contributing to the fact that we signed up 61 new clients in the quarter.

BF: As you know, we have modelled our business on the metal streaming companies. These marketing streams have a high degree of similarity to a royalty. These are different in the sense that all that canola passes through our hands and hits our revenue line. We keep a relatively small percentage – typically in the 5% to 25% range, depending on the arrangement, and that’s what hits our bottom line. But at the end of the day, there’s not a lot different between a Marketing Stream and a Net Smelter Royalty.

BF: From a metrics point of view, it is important to keep in mind that the farmers who are using us as a way to improve their marketing receive smaller upfront payments and larger payments on delivery. You may have noticed a significant increase in reserves and in crop payments on those reserves in the Q2 operations update, and this is precisely because of the introduction of these Marketing Streams. These streams will also be associated with a significant increase in gross revenue, going forward, because we add large amounts of canola to our book with smaller up-front payments.

PB: We've talked about tweaking the contract design and offering a broader menu of contracts before, but hearing how this will affect the financials is helpful. Are you seeing a relationship between farmers who take smaller upfront payments and smaller streams, overall?

BF: Yes and no. Even for the farmers who are only looking for additional working capital, we have reduced the size of those deals relative to the past. We have come down from streaming 25 bushels per acre to 10, which limits deals to around $100/acre farmed. If you have 3,000 acres, then you may be able to get a $300,000 stream if you pass through our filter.

BF: These other farmers who don't need the working capital are generally smaller streams but our returns, based on IRR for capital deployed, are almost double the other streams. The nominal profit per tonne is smaller because we pay a larger amount at delivery, but these streams have much lower risk because the capital involved is very small and the crop payment is not fixed in dollar terms, but in percentage terms. So, our downside is very limited. And from a counterparty risk perspective, the farmers who stream with us only to access our marketing program tend to be strong counterparties because they don't need additional working capital.

BF: One thing we don’t know about yet, but that we think is highly possible, is that there may prove to be more capacity for these capital-light deals to be completed in the middle of the growing season because that is when farmers are thinking about selling the crop that is growing. Farmers are not thinking as much about capital requirements during the growing season because they dealt with that at the beginning of the year. I am hoping that leads to more client acquisition during the summer than we are used to seeing.

PB: Thanks, Brad. This new type of stream is very interesting. One thing that the original streams had was a fixed price, which gave us a clear sense of your breakeven price. Do you have any sense of the breakeven price with these new contracts?

BF: Yes, it is around $200. In the history of canola, prices have never been as low as our break-even price on those Marketing Streams.

PB: Wow. That is quite interesting given the relatively short history of canola and the record lows for inflation-adjusted prices of other grains that we have seen recently. Now, the original vision of the business was that farmers are under-served on the capital side, but it is great to see that you've found something else there with farmers who are under-served on marketing side.

BF: There are some advisors who give advice on selling your crop, but it is still up to the farmer to do it. What is remarkable is the number of farmers who tell us that they like farming, but hate marketing. They want to focus on doing the farming and making good agronomic decisions. Marketing is seen as a hassle for many. When we can take care of that, get a good selling price, and even pick the crop up from their farm, these Marketing Streams become even more attractive for them.

PB: We're halfway through the fiscal year and you're at $32M capital deployment.

BF: Right, we are at $32M on our $50M target. We will see if we get to $50M, but we are tracking nicely. Our first quarter was double last year, and this second quarter has doubled last year, as well. Last year's total deployment was $25.8M. If we keep doubling the rest of year, then we will get to $50M. Maybe we'll only get to $40M, but we’d rather have $40 million of the kind of deployment we’ve been seeing this year than $50 million of the deployment we were doing two and three years ago. The deal quality of the last 18 months is head-and-shoulders above some of those earliest legacy deals. And along the way, we've gradually been right-sizing those deals to metrics that we like.

PB: Interesting to hear that this change has been developing over the last 18 months. How different is 2017 from 2016?

BF: This year has been more focused on our “Land and Expand” strategy. Small marketing streams are a good way for a farmer to try us out, and once we show them what we can do for them, I expect we’ll be able to expand our relationship. Even just look at the last quarter – we signed 126 contracts and added 61 farmers. Some of them did a Capital Stream and a Marketing Stream, but we also ended up doing a lot of repeat business with satisfied clients.

PB: For people who have hard time wrapping their head around what you're doing, I guess it will make it that much more difficult for them.

BF: I suppose it will, but we will try to be clear that bigger crop payments means smaller upfront payments and a higher IRR. Already, I’ve heard a few people confused that our rising crop payment profile means our returns are declining. In fact, the opposite is true – our portfolio IRRs are rising due to Marketing Streams.

PB: Sounds like the challenge of doing something that doesn't quite fit the mould.

BF: That's right. You know well that no-one's ever done this before. People may have a spreadsheet to calculate what they think Input Capital is worth, but how many of them have actually come to see us and really worked through it? Two people have come to see us in five years.

PB: Sobering. These are the markets; don't you feel comfortable.

BF: Regina just doesn't make it up on people's destination list, particularly in January or February!

PB: And the farmers -- there's always this question about uptake. I guess the numbers speak for themselves, really.

BF: They do and we are going to keep putting up good numbers. Ultimately, the strength of the business will be borne out by the numbers. There have been teething pains along the way, but we have worked our way through them.

BF: I think that when we look back in two years, this quarter will be the inflection point. It is hard to think of how these contracts could break. A $100,000 contract is immaterial to a $100M book of streams, and is relatively immaterial to the farmer. I really like all the trajectories that I see.

PB: That was my sense with the last quarter, when I saw the shift towards smaller streams and then talked to you about how the structure of the streams was changing. To see the growth numbers now is pretty impressive.

BF: We went back and forth about this on twitter, about our market cap versus our deployment.

PB: Right, I thought the total deployment as $115M but I was mistaken. Sorry about that. The release is clear: "cumulative deployment is $155.7M" and the market cap is $155M, as well.

BF: That's OK. Like I said in my response to you, two years we were trading at 2-3x capital deployed plus cash. Two years ago, on March 31, our shares closed at $3.30. We had a book of business that was one third to one half of the size it is today. We were doing around one third of the revenue, had less proof-of-concept, and had around one third as many clients. Yet, our market cap is 41% lower now than it was 2 years ago.

BF: Keep in mind, there are a lot of people who get it and have locked these shares away in their accounts or coffee cans and haven't transacted anything.

PB: Well, it may be that agriculture is not in fashion right now.

BF: That may be part of it. Ag is not attracting as much attention as it did a few years ago. What may have helped us two years ago was that oil was so weak. People focused on Western-Canadian small cap stocks in the natural resources space had to look around for other opportunities. They've gone back to thinking about oil now, since agriculture can be tricky to understand, particularly if you don’t have a background in it and not a lot on Bay Street do.

PB: That's right – ag is lumpy, it's slow.

BF: It's unpredictable. And we are adapting as we go, which makes it even harder to predict some aspects of Input.

PB: For what it's worth, my sense has always been that it's appropriate to give you a bit more leeway because you are doing something that hasn't been done before.

BF: Well, we appreciate it. Our skin is in the game, with insiders owning about 15% of the business, and it is in our interest to figure out the best ways to drive the business forward. We have done that before in this sector. People need to have some patience, which can be in short supply in the public markets. The world wasn’t built in a day.

PB: It's ironic that long-term thinking would not be the norm, given that low interest rates make stuff in the future worth more now on a present-value basis. One thing that jumped out at me in the release was Mr. Emsley's comment that Input has "more streams than any publicly traded company".

BF: "More revenue-producing streams than any publicly traded streaming company," that's right. The metals streamers have a lot of assets, but most of them are exploration-stage. That is great and I hope they payoff in the long-run, but every one of those 126 deals we signed this quarter will produce revenue by Christmas.

PB: Wow, that's hard to believe.

BF: We think that, someday, somebody big is going to figure all this out.

PB: There are always questions about your ability to create a sufficient number of new contracts to replace tonnes that are delivered, any comments?

BF: Generally, our streams have a 6-year life so, roughly, 1/6 of those reserves are drawn down each year and need to be replaced. That hasn't always been the math, but is pretty close to that now that we have standardized around 5-6 year contracts.

PB: Thanks, that's a helpful guide. I noticed that this year is a new high-water mark for total active reserves.

BF: Yes, with 465,000 tonnes. It was 261,000 tonnes six months ago, but was as high as 328,000 back in 2015. We now believe that number will continue to grow quickly, especially with these Marketing Streams gaining traction -- they give a lot of tonnage for every dollar of capital deployed.

PB: That is a very interesting point. 

BF: It's all about aggregating volume and increasing our presence in the market. Being in control of larger volumes of canola has certain benefits, in terms of pricing. Ultimately, that may be what draws some attention from the industry. If we aggregate 2M tonnes of canola in our reserves, which is equivalent to 10% of a typical year's production, then someone else may decide that they want to control that. Particularly since we have such a low cost of acquisition. If I was a canola crusher, I would be wondering how to drive down my acquisition costs for canola and Input may provide one way to do that.

PB: That makes a lot of sense. And the long-term relationships with the farmers inherent in the streams is nice, as well. All of this reminds me of the rationale for farmers to buy shares in Input. It's interesting to note that there are so many potential buyers for the shares, but few plans to issue new shares. However, these deals with lower initial capital payments seem to make it even harder to try and forecast out what things might look like.

BF: It makes it harder for us, as well. You just have to make some assumptions and adapt them as you go. 

PB: And then there's the question of how the market should approach valuing Input.

BF: One way is to use options theory to describe what we do. A streaming contract is like a multi-year call option on canola that is deep in the money. If you put all the variables for our contracts into the Black-Scholes equation, then you find that every dollar you deploy is worth about $3. You could argue that 3x canola interests, rather than deployed capital because it includes some capital that has been repaid, plus cash is a straight-forward valuation metric. We used to trade not far off that, by the way.

BF: Another way to approach the valuation is to use total active canola reserves and our expected selling price. We have 465,000 tonnes in reserve and we have to pay $170/tonne, on average when the crop is sold. At a selling price of $450/tonne, that is approximately $130M of net revenue. Adding in cash of approximately $25M, you get a total value of $155M, which is the same as our market cap today.

PB: Interesting.

BF: You could think of that approach as a "wind-up value" for the business because it is based solely on the existing streams. In a sense, you could say that there is no growth priced-in to our stock at these levels. Yet, we grew our client base by 50% in the last quarter.

PB: To be fair, that 465,000 of total canola reserves is a new number. In the last quarter, that number was much smaller and there may have been some growth priced-in. It also doesn't discount the crop sales six years from now, but it strikes me as one of the most basic things someone could do to value the company -- just looking at existing canola reserves.

BF: If I owned this business and couldn't deploy another dollar, then what could I get out of the existing business by just winding it up? That is approximately today's share price.

PB: Then, putting all of this against a backdrop of being independent of capital markets. When you initiated the dividend, we talked before about how you do not plan to come back to the market.

BF: Indeed. Maybe, over the next few days, people will crunch the numbers and determine if this is an even more compelling bargain than previously thought. Maybe some of them will be some of the institutional shareholders who used to hold shares, but do not anymore.

PB: Any thoughts why they got out?

BF: They went to risk-off mode when we announced the terminations of those contracts in November 2015. Now, they have either forgotten about us or are waiting for the right cue to get back in.

PB: It may prove hard for them to get back in since there are no financings planned. It seems to me that the niche group of people who may be interested in agriculture, are used to the mining model with financing after financing.

BF: They will have to get their head around being an open-market buyer – we intend to issue as few shares as possible, and hopefully none, as we build out the business.

PB: That serves as yet another example of how different things are for Input Capital here. Congratulations on a great quarter, Brad. Thanks for talking with me.

BF: Thank you, Peter. My pleasure.