Sanderson Farms (Nasdaq:SAFM) may be one of the best-run protein producers in North America, but that is not worth much to long-term investors, as big institutions run hot and cold on the shares based on the cyclical moves in poultry profitability. With the poultry market perhaps bottoming out and Sanderson's stock already off its lows, is there still time to play the eventual rebound in this business?
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A Tough Second Quarter
Sanderson definitely had a tough fiscal second quarter, but it could have been quite a bit worse. Revenue fell 2% this quarter (and rose almost 12% from the prior quarter) as increased production volume was offset by lower pricing. Although whole-chicken prices rose and leg-quarter prices increased on resumed Russian imports, boneless breast prices have been quite weak, and wing prices have plummeted.
At the same time, feed prices continue to march higher. Sanderson reported that feed costs rose 41%, and that pretty much corroborates what has been going on in the grain futures markets (chicken feed is usually about two-thirds corn and one-quarter soybean meal). Unlike Tyson (NYSE:TSN) and Pilgrim's Pride (NYSE:PPC), though, Sanderson Farms does not hedge grain exposure to a large degree.
With that in mind, it was not a major surprise to see gross margin fall from the 15.4% level of a year ago, but basically producing zero gross profit (just a slight loss) was actually a pretty good result. Likewise, the negative operating margin this quarter reversed a year-ago profit, but it did represent sequential improvement and the company is doing well to limit the damage from this down-cycle. (For more, see Cyclical Versus Non-Cyclical Stocks.)
Here We Go Again ... Again
If there is good news in the downward part of a cycle, it's that Sanderson has been through this before and investors should feel confident that prices will rebound. If leading producers like Tyson, Pilgrim's Pride and Sanderson Farms are having a tough go of it, smaller producers are certainly suffering even more. Like other cycles in the past, some of those will go out of business and that will take supply off the market.
Likewise, as the economy recovers, so too will global poultry demand. There's a known correlation between animal protein consumption and income and demand is going up again. Even though this will arguably benefit foreign producers more (Industrias Bachoco (NYSE:IBA) in Mexico, JBS and Marfrig in Brazil, for instance), it is still a positive influence on prices.
Of course, every cycle is a little different. Even if poultry prices rebound, there is no guarantee that feed costs will abate (or that poultry price increases will outpace them). What's more, there's no guarantee that Sanderson will see favorable pricing across all products. The demand for chicken wings, for instance, was a major boon to an industry that could once barely give away those parts. Now while Buffalo Wild Wings (Nasdaq:BWLD) cannot single-handedly change anything, the point remains that the particulars of demand are always in motion.
Production is also a big unknown. Tyson and Pilgrim's Pride don't have the same feed cost pressures and can arguably withstand worse pricing for longer than Sanderson. In addition, Sanderson itself has been adding capacity. (For more, see Prepare Your Portfolio For Higher Food Costs.)
The Bottom Line
If 2011 is the bottom of the cycle, 2012 is a strong rebound year, and if the rebound is similar to past trends, Sanderson Farm shares look too cheap today. Unfortunately, though, the move off the bottom has already taken up some of that underpricing and the shares aren't really priced at a level that makes them a compelling bet. As has been the case for a while now, investors looking to play the protein sector are probably better off looking at foreign producers than North American companies. (For more, see The World Moves On Its Stomach.)
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