Caution On Sanderson Farms Isn't Being Chicken

By Stephen D. Simpson, CFA | May 28, 2012 AAA

Investing in commodities is hard enough, but investing in those companies that produce intermediate commodities stuck between uncontrollable cost and uncontrollable prices is even more difficult. Stocks like Sanderson Farms (Nasdaq:SAFM) can definitely outperform in periods where protein supplies are scarce and/or costs suddenly drop, but it's difficult to make long-term money in stocks like these.

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Good Expense Control Boosts Fiscal Q2
Sanderson Farms stock has been doing pretty well lately, as protein producers like Tyson (NYSE:TSN), Pilgrim's Pride (NYSE:PPC) and Sanderson push through higher prices for chicken and investors expect a robust corn crop to lead to lower production costs.

Sanderson's fiscal second quarter was largely as expected in most respects. Reported revenue jumped 24% this quarter, with net poultry revenue up nearly 27%. The company's volume sold jumped nearly 11%, helped in part by a new facility, while the company increased realized prices by 15%. That latter number is better than that seen at Tyson or Pilgrim's Pride, and was definitely helped by a doubling of wing prices and strong pricing in leg quarters (which is usually fueled by overseas demand).

Sanderson posted an as-expected improvement in gross margin, with gross margin moving from breakeven a year ago to early 10% this quarter. Better capacity utilization certainly helped, as did a four cent-per pound decline in feed costs.

Where Sanderson really outperformed was at the SG&A line. Holding a tighter line on SG&A helped the company reverse a year-ago operating loss and drove a 15% beat in earnings per share.

SEE: Understanding The Income Statement

There is Only so Far the Good News Can Go
Conditions at Sanderson Farms were better than expected this quarter, and expense control is the sort of reproducible good news that investors should really value. What's more, the company filed an 8-K earlier in 2012 regarding its bonus program that suggests 2012 should be a decent year (given the company's history of setting high, but attainable, goals in its bonus program).

Still, investors need to have some caution here. There's only so far that any of these companies can push pricing. Shoppers are already turning away from costlier groceries and substituting cheaper goods like processed foods and private label. Chicken may be the protein of last resort, but its not price inelastic. Likewise, restaurant traffic continues to flow towards QSR outlets like McDonald's (NYSE:MCD) and Yum Brands (NYSE:YUM) and that can limit pricing power as well.

On the cost side, the weather isn't cooperating with the cheap corn thesis that investors were hoping for earlier this year. It's still early, but investors should keep an eye on the crop reports.

SEE: Earning Forecasts: A Primer

The Bottom Line
I have a hard time getting too excited about domestic protein producers. The expected recovery in chicken margins does seem to be materializing, and the stock is up strongly from the fall of 2011. Still, these are deeply cyclical markets and it's hard to push a fair value target much beyond the mid-$50s.

SEE: 5 Must-Have Metrics For Value Investors

On the flip side, I think there is better growth and capital gains potential in companies more leveraged to processed/packaged/branded product growth (like Hormel (NYSE:HRL)) and those companies levered to take advantage of growth in protein consumption in emerging markets like Russia, Brazil and China.

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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