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I’ve been reading up on the food industry for a research report and have come across several useful overviews of the sector. One is Scott Phillips’ book, "Buying at the Point of Maximum Pessimism," where the prospects for agribusiness are laid out in Chapter 7.

The thesis, in a nutshell: rising living standards will lead to improvements in the diets of citizens in emerging nations. Specifically, per capita intake of protein will rise through greater consumption of beef, chicken and pork.

America is positioned to export protein to China, India and other fast-growing countries. It has a comparative advantage, says Phillips, thanks to its relative bounty of clean water and other factors that go into raising chickens, cattle and hogs.

Although Phillips gives a good account of the demand side, he doesn’t mention or discuss any companies in the meat industry. To the rescue comes an online presentation by Stephens Inc. analyst Farha Aslam, "A Wall Street View of the Protein Markets." In it, she discusses the following U.S. "protein" stocks:

• Tyson Foods Inc. (TSN)
• Smithfield Foods Inc. (SFD)
• Pilgrim’s Pride Corp. (PPC)
• Sanderson Farms Inc. (SAFM)
• Cal-Maine Foods Inc. (CALM)
• Hormel Foods Corp. (HRL)

Aslam believes shares in these companies should not be viewed as long-term holdings, despite the secular growth story in less developed regions. Because of volatility in grain prices, unpredictability in protein prices and poor long-run returns, protein stocks should be regarded as trading vehicles, she declares.

Volatile input costs

Indeed, the prices of grains used to feed livestock have had substantial run-ups in recent quarters and the U.S. Department of Agriculture predicts record prices at the farm-gate in the second half of 2011. During the spike in grain prices in 2008, several companies went bankrupt because of poor hedging strategies or cash crunches due to margin calls on futures contracts – for example Pilgrim’s Pride.

In this environment, Aslam seems favourably disposed to poultry processor Sanderson Farms. It has kept leverage low and enjoys some of the best margins in the industry.

Restricted pricing power

Protein companies supply large retailers and restaurant chains, which have a great deal of buying power. It’s not easy for rising input costs to be passed onto them. Margins could therefore come under pressure. The protein industry needs to consolidate and gain more bargaining power in order to enhance margins, suggests Aslam. So it wouldn’t be surprising to see some acquisitions and the emergence of larger entities.

U.S. demand

Growth in U.S. per capita consumption of beef, pork and poultry is relatively flat, rising roughly in line with annual population growth of 1%. The solution for generating growth is product innovation, as the case of Hormel Foods illustrates. I personally can vouch for that: our family now buys only Hormel’s Ready-to-Cook bacon [under the Kirkland label at Costco (COST)]. It’s quite convenient to pop it in the microwave for a few seconds — and it comes out looking and tasting like regular bacon.

Global demand

Meat consumption, as mentioned, is growing at much higher rates in the emerging countries and now constitutes a major source of growth for U.S. producers. However, there are some caveats.

One is trade barriers. The extent to which exporters enjoy sales growth in foreign markets depends on how much free trade is allowed between countries. The level fluctuates depending on the outcome of free-trade negotiations and/or flare ups in trade frictions. U.S. poultry producers, for example, now face tariffs in China in retaliation for U.S. restrictions on tire imports.

Another risk is health scares. The Mad Cow, Bird Flu and Swine Flu episodes show how foreign markets can be completely shut off at the drop of a hat. And the restrictions can last for years.

Global supply

Brazil has, Phillips and others say, even more of comparative advantage in the protein sector than the U.S. thanks to lower costs of production and ability to expand acreage. It has, in fact, emerged as the dominant supplier on global markets. Brazilian companies are becoming large, globally diversified companies thanks to acquisitions, many of which have been U.S. companies.

Other countries are currently importing meat products but could later become net exporters. Russia is said to be a prime candidate in this department.

Source: 6 Protein Stocks