Sanderson Farms - Appeal Is Limited With Excessive Margins Likely Not Sustainable

| About: Sanderson Farms, (SAFM)


Investors are disappointed by third quarter earnings headline results due to higher variable compensation.

This is as the operating conditions for the poultry processing business remain very rosy.

This results in very appealing valuation metrics at current levels, however current margins are not sustainable through the cycle.

Investors in Sanderson Farms (NASDAQ:SAFM) were not really pleased with the company's third quarter results which the company released towards the end of August.

Despite posting steep earnings, the investment community expected even higher earnings from the poultry processing business. While the business shows great growth, operates with a strong balance sheet and trades with appealing valuation metrics, I don't think that the current margins are sustainable in the future. As a matter of fact, shares are quite expensive based on ¨average¨ margins.

As such I refrain from making an investment at current levels despite appealing headline valuation metrics.

Third Quarter Highlights

Sanderson Farms posted third quarter sales of $768.4 million, a 4.0% increase compared to the year before. Despite the modest growth, sales came in quite a bit below consensus estimates of $789.2 million.

Earnings growth was more spectacular with reported net earnings coming in at $76.1 million, a 12.1% increase compared to the year before. On a per share basis, earnings rose by thirty-five cents to $3.30 per share. Despite the steep earnings growth, earnings still fell short compared to consensus estimates calling for earnings as high as $3.82 per share.

Looking Into The Numbers

CEO Joe Sanderson was pleased with the results amidst the favorable market conditions. Poultry product prices have been higher amidst historically high Georgia Dock bird pricing on the back of strong grocery demand. Despite boneless breast meat prices coming in below last year's highs, they remained at very comfortable levels.

The company experienced significant gross margin expansion with margins increasing by some 290 basis points to 21.0% of sales. These margin gains were partially made undone by a rapid increase in selling, general & administrative costs which rose to 5.9% of sales, up from just 4.0% last year.

Overall operating margins came in at 15.1% of sales which is a full percent improvement compared to last year, thereby aiding earnings growth on top of sales growth.

Of course results are highly sensitive to realized prices and input prices. Boneless breast prices rose some 2% while simple average whole chicken prices rose by 5.3%. Jumbo wings prices fell by some 10.9% while bulk leg quarters were down slightly as well.

The real aid to the reported profits were the lower input prices in the form of a 28.7% drop in corn cash prices, partially offset by a 17.6% increase in soybean meal prices. Furthermore the strong market conditions resulted in higher accruals to the bonus award program and employee stock ownership plan. In total the company made accruals worth $17.5 million during the quarter on an after-tax basis, the equivalent of $0.76 per share.

Total production came in at 770 million pounds which is about 45 million pound less than previously anticipated due to lower target live weights and volumes.

A Quick Look At The Business

Back in June, Sanderson Farms presented itself at the Stephens Investment Conference. According to the WATT PoultryUSA survey for the month of March the company is the third largest poultry business in the USA behind Tyson Foods (NYSE:TSN) and Pilgrim's Corporation (NYSE:PPC).

The company currently has 9 facilities with a total capacity of nearly 9.4 million heads a week, expected to increase towards 10.6 million following the opening of the new plant in Palestine Texas next year.

The company stresses key strengths of the business including rapid and steady historical production growth, its status as a low cost producer and a strong balance sheet, net holding cash. The company has a strong and diverse set of end customers including all the major food retailers, diners etc. The business remains very much focused on the US with only 10% of 2013's sales being designated for exports which went pretty much all over the world.

A useful rule of thumb, the company's sensitivity to input prices is being discussed as well. Based on full year 2013 production the sensitivity to a $0.10 price move in corn prices per bushel impacts earnings by some $9 million. In terms of reliance on soybeans, a $10 move per tonnes will impact earnings by some $8 million per year.

A Strong Balance Sheet, And Appealing Valuation

At the end of the past quarter, Sanderson Farm held little over $139 million in cash and equivalents while the total debt load amounted to just $20 million. This results in a comfortable net cash position just shy of $120 million.

With some 23 million shares outstanding, which are currently trading at $93 per share, equity in the business is being valued at $2.1 billion which in its turn values operating assets at around $2 billion.

On a trailing basis, the company has now posted sales of $2.74 billion on which it has posted earnings of $201 million. This implies that operating assets are valued at 0.7 times annual revenues and 10 times earnings.

Solid Growth, Volatile Earnings

Over the past decade, the company has grown its operations rather rapidly. The company posted sales of just $1.1 billion in 2004, and they have increased to little over $2.7 billion by now as they have grown at an average rate of 9-10% per annum. Note that the total outstanding share base has increased by about a tenth, resulting in limited dilution.

Unfortunately the business is quite volatile as the company has posted annual losses three times over the past decade ranging from about 1% of sales to 6% of sales back in 2011 on an after-tax basis. On average margins came in at just 2-3% of sales while they are at around 7% at the moment on the back of the unusual combination of solid meat prices and lower input costs.

Between 2005 and 2012 this cyclicality was displayed with shares largely trading in a volatile $20-$50 trading range, but structurally higher prices pushed shares even above a $100 per share in July of this year.

Final Implications

Sanderson Farms is a tricky business to evaluate. The company operates in near perfect operating conditions now amidst relatively strong pricing and lower feed costs, yet earnings fell way short compared to consensus estimates due to lower production and higher incentive payments.

The company has a great track record at growing the business, with more growth anticipated following the planned opening of the Palestine manufacturing facility, aimed to be operational in the first quarter of 2015. On top of that the company has plans to built a second plant in North Carolina, a move which could cost some $110 million which is no big issue given the strong balance sheet.

The current profitability, past and anticipated growth, and M&A speculation in the industry have all aided the stock which has risen some 30% already year to date. All of this in combination with a 10 times price-earnings ratio appears to good to be true and it is. The issue is that the company now posts net earnings totaling 7-8% of sales while historically earnings have been very volatile. It must be said that the company is employing some variable compensation practices which is actually hurting earnings now, but may limit losses when an inevitable downturn in the industry might occur again.

Based on average margins of closer to 3% of sales over the past decade, shares trade closer to 25 times average ¨through-the-cycle¨ earnings as the peak margins have resulted in share doubling since the start of 2013.

As such I have some issues with the valuation on a ¨through-the-cycle¨ basis although the balance sheet, long term growth and long term value creation track record is great. As such I would be happy to pay a market equivalent multiple of 17-18 times based on normalized earnings of 3-4% of sales for the business. This translates into a $70-$75 targeted entry point, leaving little appeal for now in my opinion.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.