For chicken’s undeniably nutritious qualities, the poultry industry often finds itself at odds with its namesake. Where chicken provides nourishment, the chicken industry’s history is one of feast and famine: viciously competitive, unrelentingly cyclical, and capital intensive. Profits are a dish served somewhat sparingly. When they are, the chicken coop feasts -- gorging themselves today, at cost of tomorrow’s profits. A self-fulfilling prophecy is realized, as excess supplies push prices lower, profits erode, and the hunger game starts, once again.
But in an industry where discipline is lacking -- as competitors chase growth and chase market share at cost of profits, and recklessly lever their balance sheets -- Sanderson Farms
That’s why I’m buying shares equal to 3.2% of my real money portfolio’s capital.
A Healthy Spread
Joe Sanderson is the sort of gruff, call-it-as-he-sees-it type who everyone would like to count among their good friends. Not because he’s such a great guy -- I don’t know him -- but for his brutal honesty, incisive wit, and wide-ranging intelligence. You want friends -- and managers -- who tell it like it is, with no gloss.
In his nearly 50 years in the chicken business, Sanderson -- a 4% owner of the company -- has fashioned Sanderson Farms into what is unquestionably a best-in-class chicken producer. Where its competitors pursued market share, Sanderson's focus has always been singular: to be the most profitable. If you look at the 11-year period to 2011, Sanderson's operating margins have averaged 5.3%, while its larger peers, Tysons Foods’ chicken division (NYSE; TSN) and Pilgrim’s Corp.
Sanderson’s achieved these results in ways large and small. Recognizing that the required feedstock, corn and soybean, for what the industry calls big birds is around eight pounds -- where the industry average is five pounds -- is less than the industry standard on a per pound basis, it made a strategic decision to tilt its product mix to big bone. Its management team focuses on keeping its facilities new, contributing to operational efficiencies. Most importantly, in a cyclical industry, Sanderson’s kept its debt balances manageable. Competitor Pilgrim’s learned that lesson the hard way, after a stop in bankruptcy court almost four years ago.
Chicken or Egg?
But for the seeming attractiveness of Sanderson’s returns and long-term results, Pilgrim’s visit to bankruptcy court served as a watchword. The chicken business isn’t always healthy: Sanderson’s been unprofitable for 11 of the past 40 quarters, and Pilgrim’s for 15 of them. Despite industry consolidation -- almost 60% of market share is held by the top five -- chicken producers aren’t particularly able to control their destinies. They're price takers on their end-product, chicken, and feed (corn and soybean), are among Sanderson’s largest costs. This, coupled with a fairly undisciplined industry, contributes to sometimes dramatic cyclicality.
The typical cycle looks something like this: Amid strength in chicken prices, producers flood the market. Predictably, chicken prices fall and the industry loses money, or comes close to it. They cut production, raise prices, and profitably returns. Thereafter, the cycle repeats. Sometimes, the cycle takes a slightly different form, as escalating grain costs -- from a drought, lower than expected harvest, or demand spike -- pressure profitability. Here, the cycle looks somewhat similar: Producers cut chicken supply to the market, raise prices, and wait for grain prices to decline (or chicken prices to increase).
Planting the Seed
More recently, corn and soybean prices touched record highs -- they remain 30% above year-earlier prices -- amid an historic drought, elevated demand from ethanol, and increased protein consumption from emerging economies. Some of this is temporary, as crop yields should recover in coming years. But unless farmers plant a lot more corn and soybeans (and logically speaking, they should), the past years’ elevated grain prices will become a more regular fixture, as demand from ethanol and emerging economies isn’t likely to wane across the long-term.
With unprofitability (from higher feed costs) looming, Sanderson shares turned lower. It is against this backdrop that investors who are willing to take a contrary, long-term view are poised to profit. Though the industry’s begun cutting production, and Sanderson shares have recovered nominally at this prospect, they’ve more or less languished. Market watchers question whether recent production cuts -- 2% at Sanderson, after a 4% cut earlier this year -- will be enough to push chicken prices higher, and, even if they do, whether chicken producers can increase prices without impacting demand from consumers. Taking a longer-term view, investors question whether permanently-elevated grain prices will impact industry-wide "normalized" profitability levels.
I’d wager that those concerns are overdone. History reveals a few interesting factoids. First, a Yale Rudd Center study shows that from 1938 to 2007, for every 1% increase in the price of chicken, consumption declined 0.68%. In economist speak, demand for chicken is relatively inelastic, or consumption habits are not particularly price sensitive. That can change; but, if it does, I think it should favor chicken. According to a recent Tyson Foods presentation, a pound of chicken requires 1.92 pounds of feed, pork requires 3.5 pounds, and a pound of beef requires seven to nine pounds. The interpretation is this: Higher grain prices will hit pork and beef a lot harder than chicken, and possibly a lot more.
With retail prices for chicken well-below pork and beef, chicken could actually pick up market share in a scenario where feed cost inflation continues, unless consumers switch to the perennial Hormel
On the supply side, chicken prices might nose up sooner than market watchers think. Several leading indicators of chicken supply point to a tighter market: Cold storage inventory was down 14% year over year at August’s end, pullet hatchlings (chickens that will lay eggs) declined 6% over the same period, and breeding flock (chickens that "produce” pullets) was 9% lower. And even if current market conditions don’t elicit an immediate increase to prices, it should happen eventually. It’s a simple matter of time and economics.
Because Sanderson is a cyclical company, my valuation employs a normalized estimate of free cash flow. I estimate Sanderson’s normalized operating margins at about 7% and, in the near-term, expect grain prices to moderate a bit, and corn prices to increase. My valuation assumes that, in the near-term, grain prices recede to levels seen earlier this year -- a hair above $6/bushel of corn and $350/short ton of soybeans -- and chicken prices increase 5%. In the long run, given chicken’s relative affordability to other protein sources, I expect the industry will be able to price to maintain its margins, or farmers will plant more grains, thereby curbing recent cost inflation.
On this basis, I value the shares at $62 a stub. In the event Sanderson’s earnings power is meaningfully impaired by increasing grain prices (and limited ability to pass costs on), I estimate normalized earnings power is reduced by a third. My estimate of the downside is $32. For what it’s worth, I think the latter scenario is fairly unlikely.
Chief among the risks to an investment in Sanderson is the possibility that higher grain prices materially impair the company’s ability to generate cash in the near and long term. While that seems an unlikely prospect, for the reasons discussed above, it’s not altogether impossible, and certainly worth watching. Additionally, while exports do not represent a huge chunk of Sanderson’s sales, they are material to the industry. Things are fine now, but thorny trade issues erupt with China and Russia now and again, and will at some point in the future.
Lastly, a recession could reduce demand for chicken. Absent a particularly severe recession, I’d call this an opportunity to accumulate more shares. Within that vein, chicken wings recently hit five0year highs, and it’s not altogether clear whether that’s sustainable. The risk is somewhat muted, because wings represent a small part of overall bird weight, but it’s worth watching.
The Bottom Line
The chicken industry’s returns at the company-level and for investors, hasn't always been particularly nourishing. But at today’s prices, Sanderson’s nutritious blend of chicken and cash flow look poised to feed your portfolio.