Cal-Maine Foods (Short):“The kid is back on the escalator…” -Mall Rats.A long time favorite short of mine and bandit871, Cal-Maine foods is a well run egg producer, going thru yet another strong cycle. However, eggs are a habitually cyclical commodity business, and Cal-Maine’s profitability will roll over and decline to at most historical levels within the next 6-9 mos as new capacity comes online.
Company Overview: Cal-Maine Foods is primarily engaged in the production, cleaning, grading and packaging of fresh shell eggs for sale to shell egg retailers. The Company had sales of approximately 700 million dozen shell eggs during the fiscal year ended May 31, 2007. It primarily markets shell eggs in the southwestern, southeastern, mid-western and mid-Atlantic regions of the United States. Shell eggs are sold directly by the Company primarily to national and regional supermarket chains. Thesis Overview: Looking at an historic chart of the company’s share-price, you can see that it has had huge swings from $1.50/share in 2002 to run almost vertically to $18/share in early 2003, followed by a waterfall decline to $6/share in ’04 and ’05.
It has once again had another near vertical run, and will once again decline back to a more reasonable valuation of $10-$12 share. The most recent run is entirely due to a sudden spike in the ASP of eggs from their usual $.60-$.70/dozen to current $1.15-$1.20/ dozen. Excluding feed, the cost of producing eggs is relatively fixed, which means that Cal-Maine’s operating margin went from the low single digits to over 15% in the most recent quarter (and if pricing holds they will run over 20% for the current quarter). Historically, operating margins in this business have been very volatile, but have averaged roughly 4% over the past 10 years. In addition, this average 4%, is made of hugely cyclical swings: Over the past 40 quarters we’ve seen operating margins as low as -12.5%, and as high as 20.3%. On a rolling 4 q basis, margins have ranged from -8%, and 19.5%. An impending return o this normal margin implies a significantly lower share-price, even if the company continues to generate massive cash-flow for a considerable period. Industry Background: Producing eggs is not rocket science and is a commodity business with low margins for the following reason: -Eggs are fungible, there is no way to add a unique feature, or differentiate the product in any way that is not easily duplicable by other industry players. -There are over 65 egg producers in the US, and although Cal-Maine Foods has 15% of US market-share they are far from a monopoly and the industry certainly isn’t an oligopoly by any stretch of the imagination-There is no proprietary technology, patents, or special know-how that adds significantly to production efficiency that is not accessible to other industry participants -No economies of scale/scope (SGA/dozen does not decline as production capacity rises. E.g. over the past 40 quarters Cal-Maine Food’s production capacity has about doubled by both organic and inorganic means, yet SGA/dozen shows no trend, remaining steady around its average of 8 cent/dozen.) So in short, Cal-Maine doesn’t get any points for being big.Basically, there is nothing within the company’s control that can meaningfully boost ROIC for any meaningful period of time.
All egg producers are victims of the tides of fortunes driven by 2 factors: Market Price of Eggs, and Feed Prices. This brings us to the determinants of egg spot prices: Supply and Demand.Capacity and Demand: The last big bull market in eggs occurred in the ’03-’04 time frame when producers were caught flat-footed as a result of the sudden popularity of the ‘high protein’ Atkins and south beach diets. In 2005, the industry put a substantial amount of new capacity online, flooding the market with fresh shell eggs and destroying pricing power. Cal-Maine’s gross margins went to nil in the August quarter of 2005, and posted a negative operating margin of -12.5%: The worst in the companies history. The horrible pricing environment, combined with rising feed costs, caused growers to cut back dramatically on their flocks, reducing them to a 4 year low by the spring of 2007. This has once again created a tight supply situation.
Demand has also picked up, due to the weak dollar increasing our exports of egg derivatives (most shell eggs are sold fresh, and therefore there is a minimal export component of only 3-4% of annual production). So now you are no doubt wondering how long it will take for prices to come down? It only takes about 3 weeks to hatch a new hen, and 20 weeks for that hen to start laying eggs. Growers have been reluctant to commit to expanding their flocks due to the bath they took in ’05, as well as corn and soy (the primary costs in raising a hen) are up 50%. Because the national flock is still about 12 mil hens short of its previous peak, we know that production can grow a minimum of 3-4% before facility expansion is necessary. Pullets hatched for egg production, has been running in the high single digits all summer, and they should be up and laying by early next year. The only head wind is that we have a moderately old flock due to the dearth of hatchings in the ’06 time frame.
Fun with Graphs:The following graph is of the Hen Flock size, as well as the number of ‘egg type’ chicks hatched (according to the USDA). As one can see, when hatchings exceed the 2 year average (green), the flock sized eventually expends (blue), and vice versa: http://www.geocities.com/doobadoo1/layers.JPG
The following graph shows Cal-Maine Food’s Gross margins (green), relative to and inverse of the USDA’s flocks size lagged 6 months (blue, most recent 2 dots are my estimates based on hatchings): http://www.geocities.com/doobadoo1/margins.JPG
Valuation: I use 2 methods for valuing Cal-Maine, a DCF and an historic EV/unit of production (a hen). For the DCF my assumptions are: - 4.2% for terminal value’s EBIT margin (Over the past 40 quarters, Cal-Maine Foods EBIT margin has averaged 3.7%) - 10% discount rate, with a 15x terminal multiple on NOPAT - Effective Taxes at 36%- FY08 Egg ASP’s at $1.20 cents/dozen then returning to the 4.2% EBIT margin for ’09 and beyond Using all the above I get a TEV of ~320mil, minus net debt of $60 mil and divided by 23.6 mil share count= $11/share or about 40% of the current share price. For those of you who love stress testing variables, using normalized OMs from 3% to 7%, and terminal multiples on NOPAT from 12-22x we get valuations from $7.25 to $24 (all below current levels). Or more realistically, OMs from 4 to 5% with term multiples from 14 to 18 yields valuations from $10 to $15/share.
Historic Enterprise Value/Unit of Production: Before 2004, this company has never traded for more than $0.54/dozen of annual egg production (in 2007 dollars). The average is actually $0.42 (2007 dollars). Even during the Atkins spike of 2004 it never traded above. $0.90/dozen. Today the company is trading for more than that, at $1.02/dozen egg of annual production capacity. Again, nothing has fundamentally changed about this company except that egg prices are currently out of control due to a short flock. For a quick look at my spread sheet, which includes all the graphs and numbers, visit: www.geocities.com/doobadoo1/calm.xls
Risks: Growers don’t expand their flock to historic highs for a period of time because they are afraid of high grain prices, and day traders take the stock to $50/share. Mark-to-Market Risk: Cal-Maine is have in very strong quarter and may earn $0.90-$1.30/share this quarter depending on egg and feed pricing which is highly volatile.
Margins returning to more normal levels in early 2008, followed by the stock trading back to intrinsic value of $10 or forward book value of about $6-7/share.