I've stuck to my guns that giant protein producer Tyson Foods (NYSE:TSN) was not an interesting stock until and unless the shares started trading for below book value. Now with worries about rising grain costs and limited additional pricing leverage, the stock may finally be cheap enough to own, but investors must also consider the risk that conditions could get substantially worse before they get better.

Disappointing Third Quarter Performance
Tyson's fiscal third quarter results were disappointing, and management's outlook for the near future was not particularly encouraging either.

Revenue rose less than 1%, as generally higher pricing was offset with weaker volume. Poultry saw a 4% volume decline coupled with an 8% increase in realized price, while the numbers for beef and pork were -13.9%/+15.2% and +2.5%/-6.9%, respectively. Packaged food sales were surprisingly weak (to me, at least), at negative 5%, as realized price fell about 4%. This quarter marks the first time in over two years that Tyson reported a year-on-year sales decline in packaged food.

Margins were weaker than expected. Gross margin did improve (up 40 basis points from last year and 30 basis points from the second quarter), and operating income was up 8% on broadly similar improvements in operating margin. Although both beef and chicken margins improved, the chicken margin was weaker than expected and pork margins significantly worsened.

SEE: Understanding The Income Statement

Will Price Fatigue Pressure Margins?
Anybody following the Teucrium Corn (ARCA:CORN) ETF, ag stocks or even just the news in general has heard about the worsening drought across the United States. That is going to hit Tyson squarely in the pocket, as although the company is hedged for the remainder of 2012, higher grain prices could add hundreds of millions of dollars to production costs in 2013.

Tyson management seems to think that they can manage at least some of this cost inflation with higher prices, but I'm not so sure. As this quarter's performance demonstrates, there's a pretty consistent relationship between price and volume, and Tyson may start finding diseconomies of scale if they hike prices too much (and experience the resulting volume declines). If there's a bright side to this story, it's that large producers like Tyson, Pilgrim's Pride (NYSE:PPC) and Smithfield (NYSE:SFD) are much better able to weather these tough times than smaller producers; smaller operations are already starting to accelerate their slaughter plans because it's becoming too costly to feed their livestock.

Packaged Still the Way to the Future
I won't pretend that Tyson is ever going to build its packaged/processed operations to a point where it outweighs the impact of the more commoditized protein operations, or at least not in a timeframe that's relevant to today's investors. Nevertheless, I think building up these operations is, and ought to be, a key focus of management's attention.

I don't think the company is necessarily going to go after big game like Hillshire Brands (NYSE:HSH), but smaller operators and/or individual brands of larger companies could be on the menu. At the same time, companies like ConAgra (NYSE:CAG), Hormel (NYSE:HRL) and several Brazilian protein/food companies are shopping for basically the same sort(s) of companies, so Tyson may have to be more disciplined on price.

The Bottom Line
I still don't like the long-term cash flow-based valuation on these shares, and I do not believe that protein producers typically make for good long-term holdings. What's more, potential investors have to at least entertain the possibility that the drought gets even worse and/or that the company sees its margins hammered in the next year.

SEE: 5 Must-Have Metrics For Value Investors

That said, trading at more than 10% below book value, Tyson shares are finally at that point where history shows that the shares tend to outperform. More aggressive investors might want to start paying closer attention to these shares, and perhaps also looking at technical analysis as a means to time potential rebound trades.

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

Tickers in this Article: TSN, SFD, HRL, PPC, CAG, HSH

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