|Shares Out. (in M):||0||P/E|
|Market Cap (in $M):||640||P/FCF|
|Net Debt (in $M):||0||EBIT||0||0|
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Sanderson Farms, Inc. (ticker: SAFM) is the fifth largest chicken producer in the United States with a 4% market share and annual sales of approximately $1 billion. It is the chicken industry’s most profitable, fastest growing and best managed company, yet trades at just 9x our estimate of normalized earnings. The consensus expects SAFM to earn $1.90 over the next twelve months. However, at current chicken prices and corn prices, Sanderson will earn $3.50, nearly double the consensus and equal to 11% of the company’s $32 stock price. The short interest represents 19% of the company outstanding shares, driven primarily by the bears’ view that high corn prices is bad for chicken profitability. Not only is this not true – more on this topic below – but SAFM has hedged its corn costs through July 2007, partially mitigating its exposure to crop risk this summer. Finally, we note that at the peak of the last cycle, SAFM earned $4.58 and traded at $55. By the end of this fiscal year (October), SAFM will have 45% more production capacity than it did during the last cycle, giving it peak earnings power of $7.00+. Most importantly, in our opinion, the cycle is going in the right direction, and we expect the industry to enjoy a cyclical peak sometime in the next 24 months.
Chicken production is a very cyclical, commodity business. Unlike commodities such as oil and copper, which have long cycles due primarily to the lead time it takes to add supply, poultry production cycles are short. Meanwhile, demand is surprisingly volatile for a consumer staple such as food.
Despite the industry’s cyclicality, Sanderson Farms has an impressive track record of creating value. Since 1997, Sanderson has increased its production by 150% or 11% annually (all organic), well in excess of the industry’s 3% annual growth rate. Significantly, Sanderson’s 150% growth has been achieved with just a 70% increase in its capital base and no increase in the shares outstanding. Moreover, the company’s profitability has allowed it to finance virtually all of its growth internally, as its cumulative operating cash flow of $495 million has more than covered the $407 million reinvested in the business to achieve this growth during this period. Accordingly, book value per share has tripled over this time, growing 13% annually, while the balance sheet has remained virtually debt free. Together, these factors have manifest themselves in strong overall returns, albeit cyclical, with ROE averaging 14% and ROCE averaging 17% since 1998.
Sanderson’s track record is particularly impressive when compared to that of industry leaders Tyson Foods and Pilgrims’ Pride. Since 2000, Tyson’s chicken business has grown its revenues just 2% annually and averaged operating margins of 4.3%. Pilgrim’s Pride, the industry’s second largest player, has grown its revenues 23% annually since 2000, driven by its acquisition of ConAgra’s chicken business in 2003. Its operating margins have averaged 3.0% over this period. This compares with Sanderson’s 11% annual growth and 7.9% operating margins over the same period.
Background on how this came to be a compelling investment
The chicken industry entered a down-cycle in late 2005 with the outbreak of Avian Influenza (AI), which led to concerns of a global pandemic. While bird flu was never detected in the U.S., its discovery overseas and the subsequent avalanche of press coverage that the topic received led to sharp declines in chicken demand outside the U.S. and modest declines in the U.S.
These factors combined to drive chicken prices substantially lower, beginning in the fall of 2005. Specifically, prices for leg quarters declined 65% and prices for boneless breast meat declined by 28%. These dramatic conditions quickly drove the chicken companies into the red.
The Investment Thesis
Our investment thesis is as follows: (i) we expect the capacity reductions taken during the 2006 trough will substantially tighten the supply-demand balance in the chicken markets, driving margins meaningfully higher in 2007; (ii) we believe the market is significantly over-estimating the negative impact of $4.00 per bushel corn on the chicken business; (iii) we believe that Pilgrim’s Pride’s January 2007 acquisition of Goldkist (NASDAQ: GKIS), the industry’s third largest producer, is a material positive for long-term industry profitability (following this deal, 52% of the industry’s production is now controlled by the top two producers as compared to five years ago when the top two controlled just 33% of the market); and (iv) we do not believe that Avian Influenza is likely to cause permanent damage to the industry.
In addition, we believe Sanderson Farms is the industry’s low cost producer, the best managed company, has the strongest balance sheet and has the most attractive long-term growth outlook. We also are attracted to the high short interest in the stock, as 3.78 million of the 20 million shares outstanding are currently short, representing ten days of average daily trading volumes. We address each of these points below.
The first part of our investment thesis centers around feed costs, especially corn. In the last six months, near month corn futures prices have spiked from around $2.25 per bushel, its long term average, to over $4.00 per bushel, on the back of booming demand for ethanol. Since corn is the most significant cost of raising a chicken, part of the bear case on SAFM is that high corn prices will permanently depress margins for chicken producers. We disagree with this conclusion. Rather, we view chicken producers in the same way we view oil refiners – that is, they are in the business of converting raw materials (in this case corn and soybean meal) to a higher value use (in this case fresh and frozen chicken) and selling that higher value product to a diverse customer base. Thus, any input cost increases that materially increase the cost curve for the entire industry do not materially alter the industry’s economics and can and will be passed on to customers in the form of higher prices. We therefore believe the normalized profitability of "upgraders" of corn and soybean meal is largely a function of the supply of this "upgrading capacity" relative to demand for the output (i.e., chicken), and not the price of the raw materials.
We believe that recent developments in chicken margins support our hypothesis. While the increase in spot corn prices from $2.25 per bushel to $3.50 per bushel between September 15th and November 15th drove spot chicken margins down to close to zero, since then, as feed grain contracts have run off and the industry has had to absorb the high feed prices, chicken producers have been able to pass on these higher costs to their customers. Today, chicken margins are approaching summer 2006 highs and are well above where they were for most of 2006, when corn prices were much lower.
The second part of our thesis revolves around recent developments in chicken supply. When profitability deteriorated sharply in early 2006, the industry responded quickly by cutting production. The last time the industry cut production was during the late 2002 – early 2003 down-cycle, which was followed by the 2004 boom, the strongest on record. After earning a combined $820 million in net income in fiscal 2005 (ending September), the four major public chicken producers (Tyson, Pilgrim’s Pride, Goldkist, and Sanderson Farms) lost a combined $255 million in fiscal 2006. We believe that supply growth will remain muted until profitability returns to the industry for some period.
The third component of our thesis is industry consolidation. Historically, the chicken business has been quite fragmented. However, like most commodity businesses, as growth rates have matured over time, consolidation has followed. Pilgrim’s Pride has been the industry’s principal consolidator, having bought ConAgra’s chicken business in 2003 and Goldkist in January 2007. Beyond being good for industry structure in general, we believe this is a positive for the chicken cycle in the near-term as we expect Pilgrim’s Pride will spend the next year integrating Goldkist and therefore will not be focused on increasing production. Moreover, the Goldkist acquisition was an all cash deal that added $1.1 billion in debt to a company with a market capitalization of $2 billion and an enterprise value of just $2.4 billion. We expect this leverage will cause PPC to operate in a disciplined fashion and to do its part to maximize industry profitability.
Beyond our positive view on the industry cycle, we also are attracted to Sanderson’s growth outlook. Sanderson has grown its production 11% annually over the last decade and we expect the company’s double digit growth to continue. Over the next few years, production growth will be driven by the expansion of the second shift of the second line at its Collins, Mississippi plant (expected in Spring 2007) and the opening of a new plant in Waco, Texas. Waco, which is expected to open in the fourth fiscal quarter of 2007, will add capacity of 1.2 million head per week – or 18% to Sanderson’s existing capacity. When Waco is completed, Sanderson will have total weekly capacity of 7.92 million head, which is 45% larger than it had in fiscal 2004, when it earned $4.58 per share.
Earnings Power and Valuation
Sanderson Farms currently trades at approximately $32 per share, has 20 million shares outstanding and net debt of ~$115 million, giving it an enterprise value of $755 million.
The sell-side currently expects SAFM to earn $1.90 over the next twelve months (ending January 2008). By our estimates, this implies variable gross profit of $0.083 per pound, which is 10% below the long term average of $0.094 per pound. We, in contrast, expect margins over the next twelve months to be above the long term average, driven by the capacity reductions instituted by the industry in 2006 and the benefits from industry consolidation. While it is very difficult to forecast earnings with any degree of precision in this business, our base case assumption is that Sanderson’s variable gross profit per pound will average $0.11 per pound over this period. This would generate earnings per share of $3.60, which would close to double the consensus estimate and equal 12% of the company’s current market capitalization.
Moreover, in thinking about what Sanderson is worth, we also believe one must take into account the peak earnings power of the company and the likelihood of there being an up-cycle in the near term. In this case, because of the supply cuts mentioned earlier and the benefits that we expect from industry consolidation, we think that it is likely that the chicken industry experiences an up-cycle sometime in the next two years. Assuming that Sanderson can earn the same variable gross profit in fiscal 2008 that it earned in fiscal 2004, Sanderson would earn $7.15 per share in 2008. This is 56% more than the $4.58 per share it earned in fiscal 2004, reflecting the 45% increase in capacity between 2004 and 2008. At the height of the last chicken cycle, Sanderson’s stock reached $55 per share or 12x peak earnings. Applying the previous peak multiple to our estimated peak earnings per share of $7.15, Sanderson would trade at $85. Certainly, we do not think the business is worth this much, but it deserves mention because, in an up-cycle, Sanderson could easily generate $6-$7 per share in free cash flow, equal to 20% of its current stock price.
Lastly, as mentioned above, ~18% of the company’s outstanding shares are currently sold short. We believe that many of the investors who are short the stock view $4.00 per bushel corn as reason enough to short the highest valued chicken company. In our view, these investors do not fully understand the economics of the business, the quality of the company or its tremendous earnings power.
The biggest risk to an investment in Sanderson Farms is Avian Influenza and the associated demand disruption that could result from additional discoveries thereof. While it is impossible to accurately handicap this risk, we have closely studied the probability of AI permanently impacting global chicken demand and take comfort in the fact that, historically, food safety scares have proven to be temporary, with demand returning to normal after initial fears subside. There have been many instances of this pattern across the protein sector in recent years, including, most importantly, the relatively quick rebound in chicken demand in 2h 2006 following the 2h 2005/1h 2006 bird flue scares.
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