Tyson Valuation Update

| About: Tyson Foods (TSN)

Company: Tyson Foods, Inc. (NYSE:TSN)

Rating: Change from Buy to Neutral

Price: $24.93

Target Price Range: $21.35 - $28.22

Market Cap: $9,584

52-Week High/Low: $13.99 - $25.22

*All referenced numbers in this report provided via Tyson's earnings releases, conferences and webinars enless otherwise stated.

COMPANY OVERVIEW

Tyson Foods, Inc.

Tyson Foods is the second-largest food production company in the Fortune 500. It has operations in approximately 130 countries with production facilities in the United States, Brazil, China, India, and Mexico. The company has five operational segments; chicken, beef, pork, prepared foods and other. The vertically integrated chicken segment is number one in market share (22 percent) within the United States and third in market share for Mexico. It is the second-largest pork producer in the United States (Smithfield Foods (NYSE:SFD) is number one). The prepared foods segment is the second-largest food manufacturer in the United States relating to flour tortillas, corn tortillas and chips. Tyson's primary customers are consumers (43 percent of revenue), food service (34 percent of revenue), and international customers (17 percent of revenue). The problem Tyson is looking to solve is to provide convenience through its prepared foods segment (value-added products) as well as provide internationally safe food. The company strives to be the best in quality and taste and does not focus on being a low-cost provider.

STRENGHTS

  1. Tyson Foods is currently in a leadership position. This leadership position has allowed Tyson to tolerate increases in production costs mostly related to regulatory burdens and flawed political policies such as the use of ethanol. Larger companies can absorb these costs while smaller companies/farms either go bankrupt or merge with larger companies. This provides a strong barrier to entry as well as a decrease in competition. An example of this can be seen in hog farms. In 1977 the average head per operation was 87.39; there were 504,000 farms that had between one and 99 heads and there were no farms with 5,000-plus heads. As of 2011, the average head per operation rose to 960.36; there are only 49,000 farms that had between one and 99 heads and there are 3,300 farms that have 5,000-plus heads. (source: Pork Facts 2012). These increased costs also create barriers to entry.
  2. Protein diversification. Proteins vary in price and respond differently to the business cycle. Tyson has operations in chicken, beef, and pork, which provides it with relatively stable earnings compared with companies that operate in a single segment. A combination of proteins, as well as a combination of buyers (food service, retail and international) provide a "natural" hedge.
  3. Tyson's product focus is in the chicken market. Chicken takes nine months to alter supply, where as beef and pork take 39 months and 20 months respectively to alter. This allows Tyson to alter supply quickly to meet consumer demand, which allows it to have more stable earnings relative to the company's focusing solely in the beef and pork segments.
  4. Chicken operations in Brazil. Currently the European Union does not allow chicken imports from the United States. However, it does allow them from Brazil. Therefore, Tyson can export chickens from the production facility in Brazil to the European Union.
  5. Modernized production facilities in China. Tyson has been promoting healthy chicken consumption in China and investing large sums of money to increase production capabilities there. There is a short-term headwind due to the YUM chicken scare but in the long run this should provide a tailwind as consumers return to the market and seek chicken that they can verify has been raised properly.

WEAKNESSES

  1. In February, Tyson launched the Nature-Raised Farm's Brand. It will specialize in gluten free, whole grain, no antibiotics, and 100 percent natural products. I believe the market for food will increasingly be focused on healthier products in the United States. This step puts Tyson ahead of many large competitors. However, for the time being I am including it as a weakness because it has not yet shown it can penetrate the market with the new product. Also, I believe the major growth will be in the organic market. These new products are 100% natural but not organic.
  2. 13.8% of sales and 17.1% of accounts receivable are from Wal-Mart. If something detrimental happens to Wal-Mart it could drastically affect the profitability of Tyson.
  3. Tyson's profitability like all others in this industry will always be susceptible to volatile feed costs.
  4. The Environmental Protection Agency as well other regulatory bodies/regulation will continue to hinder growth. Flawed regulation regarding the use of ethanol has driven the price of feed higher. The USDA recently published a report stating that 42% of corn production in the United States is used for ethanol.
  5. The food industry as a whole will suffer from low job growth in the United States (95% of Tyson's revenue is derived from the United States).
  6. Tyson does not produce hogs without ractopamine. Russia has recently banned all imports of hogs from the United States because of this. China also announced that starting March 1, it will only allow ractopamine-free hogs to be imported and they must be verified by a third party.
  7. As a whole, the food industry is facing headwinds as supermarkets have seen a large number of consolidations resulting in a larger but fewer number or grocers. This has lead to increased buyer power, which allows grocers to negotiate lower prices for products from suppliers such as Tyson.

COMPETITORS

Large domestic competitors of Tyson Foods are Smithfield Foods, Hillshire (NYSE:HSH), Hormel (NYSE:HRL), Sanderson Farms (NASDAQ:SAFM), and Pilgrim's Pride (PPC, parent company JBS). In addition Tyson faces competition from unbranded private label competitors. The advantage of barriers to entry is shared by many of the larger constituents as well as the weaknesses such as passing through inflation to input costs, consolidating grocery stores and limited shelf space.

FINANCIAL OVERVIEW

I believe revenue momentum will continue to be positive as the number of consumers increase. This stems from the constant increase in global protein consumption since 1960. (Please see the chart located at the end of this report. Source: Tyson Fact Book 2012.) Also, as a higher percentage of Tyson's revenue is derived from international sales, spend per user will be increased. Currently, Tyson is finishing a project that is designed to allow greater access to China. This project is a third of the way to being finished. It also has production facilities in India and Brazil (as a note, I do not put a heavy increase in demand stemming from India because most of the population is vegetarian). I also believe revenue momentum is supported by increased export demand. Low domestic supply of proteins has helped support higher prices (please see chart below). Currently, U.S. consumers have not reacted to these higher prices.

Margins have felt some pressure from consolidation of distributors. However, margins are strongly influenced by commodity prices, which are a function of supply and demand. In my report last July, I stated a major tailwind for Tyson would be a drastic decrease in commodity feed prices, which would lead to margin expansion. I now have a neutral outlook on commodity prices and believe Tyson's margins will remain stable.

Tyson has paid an uninterrupted quarterly dividend since 1977. It recently increased the dividend by 25%.

MANAGEMENT REVIEW

The Chairmen of the Board and CEO have been separated since 2006. There are nine directors of which seven are independent. All nine are over the age of 50 and have significant experience in their respective fields. Each committee is chaired by independent directors.

Although the board meets many quality tests of being independent, investors must take caution. I believe the board is not truly independent because Tyson LP has 71.52% voting rights. John Tyson and Barbara Tyson have significant say and this allows Tyson to fall under the "controlled company" exemption from various corporate governance requirements. This situation has not presented any major issues in the past but must be recognized by investors because it may delay or prevent change that may be favorable to shareholders.

Management has been effective at reducing employee turnover as well as lowering work-related injuries and illnesses. This has helped reduce costs. By its measures, it has achieved $715 million in operating efficiencies in the poultry segment alone.

Management has been effective at lowering the company's debt to equity, which stood at 75% in 2009. The company recently achieved investment grade ratings and thus has reduced its interest-rate expense. Management states that its goal is to first reinvest funds into the company for growth, then pay down debt, and lastly return cash to shareholders. In the last three years, Tyson has bought close to $500 million worth of its stock. Also, Tyson has reduced the use of fixed pricing contracts to less than 10% of total cost. This should help profitability in the future.

PROJECTED FINANCIAL METRICS

To derive the value of Tyson, financial projections were modeled for Tyson and competitors. Comparable companies chosen are Smithfield Foods , Hillshire Brands , Hormel Foods , Sanderson Farms , and Pilgrim's Pride (NYSE:PPC). Metrics used to determine value were; price to free cash flow multiples, discounted cash flows using exit multiples and Tyson's historical multiples. Key assumptions are listed below;

  1. Revenue estimates considered conservative relative to managements targets.
  2. Average sales price for the chicken segment significantly increasing for FY13 with moderate decreases in FY14 and FY15. Chicken Volume increasing slightly for FY13 with significant volume increases in FY14 and FY15 as chicken sales in China ramp up due to future completion of the Chinese production facilities.
  3. Average sales price for the cow segment significantly increasing for FY13 with modest increases in FY14 and FY15. Volumes are modeled to drastically decrease for FY13 and moderately increase in FY14 and FY15 as Japanese laws begin to take affect and exports begin.
  4. Average sales price for the pork segment moderately decreasing in FY13, FY14, and FY15. Volume of hogs decreasing in FY13 with slight increases in FY14 and Fy15.
  5. Volume of prepared foods volume should increase. Lunch meat in prepared foods has been dragging earnings because of shutdowns while upgrading. It should be another two months before they are completed.
  6. Cost of feed modeled to be flat for the remainder of FY13 while decreasing in FY14 and FY15.
  7. Operating margins in the chicken segment are modeled to increase for FY13 into the mid 4 percent range and increasing to the low 15 percent range in FY14 and FY15.
  8. Operating margins for the beef segment modeled to show margin compression relative to FY2012. Decreased to 1.25% for FY13 increasing to the high one's and low two's in FY14 and FY15.
  9. Operating margins for the pork segment modeled in a range between 7% and 7.5% for FY13 through FY15.
  10. Operating margins for prepared foods modeled in a range between 4% and 4.25% for FY13 through FY15.
  11. Tax rate of 35.5% per managements expectations.
  12. Management has stated capex for 2013 will be at least $550 million. I have assumed close to $582 million for FY13. FY14 and FY15 capex has been modeled to decline because announced projects will have been completed and no new projects have been announced.
  13. The increased dilutive shares have been adjusted higher for the dilution of convertible bonds.
  14. Please note, adjustments have been made to the financial statements that reflect off-balance sheet items. I have adjusted Tyson's 2012 10-k to reflect these adjustments and have also incorporated them in the projections for 2013 and 2014. These include pension adjustments and conversion of operating leases to capitalized leases. Specific impacts to note are the unfunded liability and capitalized leases have been added to debt.
  15. Discount rate used: 7.4%

VALUATION CONCLUSION

Valuing Tyson using the public company comps. approach, provided a median value of $23.13 and $21.32 using the FY13 P/FCFF and FY14 P/FCFF multiples respectively. Two DCF approaches were also used. The first being a DCF model using P/FCFF multiples ranging between eight and 12 as an exit multiple. The second being a DCF model using Tyson's historical P/FCFF multiples over the preceding 10 years. The first DCF model provided a median value of $28.22 and the second a median value of $25.86. Combing the median of these four valuations provides a valuation range between $21.32 and $28.22.

INVESTMENT THESIS

On July 17, last year (2012), I gave a buy rating for the packaged food industry as a whole with specific buy recommendations on a handful of stocks. Tyson was one of those stocks given a buy rating and closed trading that day at $15.45. This recommendation was based on what I viewed as extreme price increases in animal feed, which would eventually fall leading to margin expansion. I viewed Tyson as having a high return potential at low risk. Due to the share price appreciation and my neutral outlook on feed prices I am changing my buy recommendation to neutral. I now view Tyson as having low risk with moderate to low return potential.

Based on currently available information, my recommendation on investing in Tyson Foods consists of the following: if you currently hold shares continue to do so and look to add to the position should the stock drop into the 21 dollar range and dispose of the position should the price reach the 28 dollar range. If you do not own the stock be patient and wait for the share price to depreciate or appreciate to the levels stated above. At that point start to build a long position or begin developing a short position. I do not believe now is an opportune time to initiate new positions in Tyson Foods because in my opinion there are better risk versus return tradeoffs elsewhere in the markets.

FINACIAL PROJECTIONS AND SUMMARY

INCOME STATEMENT

2013P

2014P

2015P

Chicken Segment

$12,408

$12,775

$12,954

Beef Segment

$13,896

$14,524

$15,037

Pork Segment

$4,551

$4,504

$4,458

Prepared Foods

$3,221

$3,269

$3,335

Other (Dynamic Fuels)

$169

$170

$172

Total Sales

$34,244

$35,243

$35,956

Cost of Sales

32,220

32,678

33,042

Gross Profit

$2,024

$2,565

$2,914

Gross Margin

5.9%

7.3%

8.1%

SG&A

$925

$916

$935

Goodwill Impairment

0

23

0

Operating Profits (loss)

$1,100

$1,626

$1,979

Operating Margin

3.2%

4.6%

5.5%

Interest Income

($9)

($15)

$0

Interest Expense

$109

$104

$104

Other, Net

$0

$0

$0

Income (loss) from cont. operations B4 income tax

$981

$1,536

$1,875

Income tax expense (benefit)

348

545

666

Income (loss) from Cont. Operations

$633

$991

$1,210

Less:Net Loss Attributable to Noncontrolling Interest

$6

$0

$0

Net Income

$639

$991

$1,210

EBIT

$1,100

$1,626

$1,979

EBIT Margin

3.2%

4.6%

5.5%

EBITDA Reconciliation

Depreciation

$467

$480

$482

Amortization

16

15

15

EBITDA

$1,582

$2,121

$2,476

EBITDA Margin

4.6%

6.0%

6.9%

Pretax Income

$981

$1,536

$1,875

Taxes

$348

$545

$666

Tax Rate

35.5%

35.5%

35.5%

Net Income

$639

$991

$1,210

Net Margin

1.9%

2.8%

3.4%

Fully-Diluted Shares Outstanding

384

384

384

EPS

$1.66

$2.58

$3.15

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Fiscal Year Ending

10/30/2013

10/30/2014

10/30/2015

EBIT

$1,100

$1,626

$1,979

Less: Taxes

$348

$545

$666

EBI

$751

$1,080

$1,314

Plus: Depreciation & Amortization

$483

$495

$497

EBIDA (EBI + DA)

$1,234

$1,575

$1,810

Less: Changes in NOA

$94

($59)

($44)

Less: Capitalized Investments

($582)

($493)

($503)

Free Cash Flow

$745

$1,022

$1,263

Discount Period (1)

0.47

1.48

2.50

Discount Factor @ 7.4%

0.97

0.90

0.84

PV of Cash Flows through 2014

$721

$920

$1,057

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DCF Assumptions

Discount Rate

7.4%

Tax Rate

35.5%

Terminal Value Assumptions

Free Cash Flow - 2015

$1,263

Valuation Multiple

10

Terminal Value at 2015

$12,629.39

Discount Period

2.50

Discount Factor @ 7.4%

0.84

PV of Terminal Value

$10,571

Total Enterprise Value

PV of Cash Flows through 2014

$1,641

PV of Terminal Value

$10,571

Total Enterprise Value

$12,212

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.