Investors are certainly feeling a little more carnivorous these days, as optimism over improving prices and margins has pushed the shares of companies like Tyson (NYSE:TSN) to all-time highs. It certainly has hurt matters even slightly that Smithfield (NYSE:SFD) just bagged a takeout offer at a premium price as well. That leaves investors with a tough choice with the country's third-largest poultry producer Sanderson Farms (Nasdaq:SAFM). It's very difficult to goose the numbers high enough to make this stock look cheap on a long-term basis, but the near-term momentum could make selling today look like a chicken move.
Second Quarter Results Come In Broadly On Target
Sanderson reported a 4% increase in revenue for the fiscal second quarter, as industry production cuts seem to be firming up pricing. Industry-wide “Georgia dock” prices were up 10% for the quarter, and Sanderson did see higher pricing offset lower volumes (due to intended production cuts. While Sanderson's relationship with customers like Sysco (NYSE:SYY) and Buffalo Wild Wings (Nasdaq:BWLD) means that industry-wide pricing trends aren't always directly relevant the point stands that the company is benefiting from firmer pricing even as consumer demand in the restaurant space has softened a bit.
Lower production and higher feed costs were a bad combination for margins, but the results weren't all that different than expected. Gross margin declined about 40bp on a 14% increase in feed costs, while operating income fell 5%. Operating margin fell 60bp for the quarter, but at over 6% they're still substantially better than those at Tyson's poultry business or Pilgrim's Pride (NYSE:PPC).
SEE: Analyzing Operating Margins
Smaller Flocks Vs. Smaller Yield
Sanderson Farms has always generated a meaningful portion of its business from exports, and that portion currently stands at around 20%. Companies like Brasil Foods (Nasdaq:BRFS) offer ample evidence that poultry export markets can be exceedingly volatile, though Brasil Foods concentrates more on the Mideast and Japan while Sanderson Farms focuses on Mexico, Russia, and Central Asia. With about 15% of the Mexican breeder flock recently culled due to a bird flu outbreak, demand in Mexico (and the risk of oversupply) should be relative favorable for the company.
On the other hand, the outcome of this year's corn and soybean crop in the U.S. is still a big unknown. The big seed companies, Monsanto (NYSE:MON) and DuPont (NYSE:DD), have reported very strong demand and acres under cultivation should be at or near another record. But the crop was planted later this year and that can sometimes be a bad sign for yields, to say nothing of the risk of drought or damage from severe weather. With corn and soybeans (soybean meal) making up over one-third of the cost of goods for the industry, a bad crop would have serious negative ramifications for the industry's cost structure.
SEE: America’s Biggest Food Companies
Could Sanderson Get A Bid?
With Shanghui paying a hefty price for Smithfield, it's worth asking whether Sanderson Farms could attract similar attention. At less than 10% of the U.S. poultry industry, Sanderson Farms would be digestible for an acquirer, and the company already has roughly 10% export exposure to China. Likewise, just as Shanghui may have been attracted to Smithfield as a source of clean pork for a market (China) where contamination and food safety issues pop up over and over again, a U.S.-based producer could be seen as asset for a Chinese company wishing to hedge its risks/exposure to China-based sourcing (including epidemics of bird flu).
With Sanderson already at an all-time high price for the shares, it's a little more challenging to project a bid price. Shanghui was willing to pay a premium to the normal valuation range for Smithfield (and protein producers in general), so I suppose it's not ridiculous to think that a buyer could still pay up for Sanderson Farms.
SEE: Earnings Guidance: Can It Accurately Predict The Future?
The Bottom Line
I've complained before that protein companies are tricky to evaluate with standard cash flow analysis, as investors don't seem bothered with the low long-term margins and cash flow production when they believe there's a trade to be made on lower input costs and improving margins/prices. To that end, even if Sanderson can grow revenue at a long-term rate of 5%, with a five-year growth rate of 6% based on management's guidance of 4% volume growth, the company will have to record historically exceptional free cash flow margins to make today's price look cheap.
I know better than to step in front of a moving bus, and that is how I feel about these shares today. Investors want to like protein stocks and even if I don't see much long-term value, I don't believe that's going to slow the momentum in the near-term. Accordingly, I'll just say that anybody considering these shares today ought to be nimble and willing to keep disciplined stops if that enthusiasm wanes and multiples go back to normal historical levels.
At the time of writing, Stephen D. Simpson owned shares of Monsanto and Brasil Foods.