3 Stocks to Profit From the Beef Price Surge

Includes: PPC, SAFM, SFD
by: StreetAuthority

By David Sterman

The USDA began tracking the size of the nation's herd of cattle back in 1973. Since then, it has never noted such a severe plunge in the number of cows -- until now. Ranchers are expected to raise only about 99.4 million head of cattle this year, the lowest level on record. Blame it on corn and record drought. Prices for this basic feedstock have risen so sharply and the ongoing drought across the South has been so severe, that many ranchers are bringing their cows to auction, causing supply to dwindle.

As ranchers cull their herds, an interesting dynamic is setting up that should have investors taking notice. In coming weeks and months, consumers will get a dose of sticker shock as they shop for beef products. Restaurants will feel a similar strain. Pork and chicken, and the companies that produce them, will most likely move back into vogue as demand shifts.

Wholesale ($1.92 per pound) and retail ($4.44 a pound) beef prices are at levels not seen since 2004 and look headed even higher in coming months as fewer cows are slaughtered and supply shrinks. Prices are also surging because beef exports are up nearly 30% this year, thanks to the weak dollar. But what should really interest investors is that the price spike is likely to boost the relative appeal of pork and chicken. Simply put, it may soon become too expensive to serve up steaks and burgers to the family, so pork and chicken dinners could be the alternative.

This is great news for pork and chicken breeders. The rising price of beef means they can sell more of their products, or even raise prices and still remain well below beef prices. For an industry that has had a hard time sustaining profits, 2012 could shape up to be a banner year, so this should a good time for investors to take action. Analysts that track pork and chicken producers are only beginning to raise their profit forecasts, but get ready for a steadier stream of upward revisions as the supply, demand and pricing dynamics for 2012 come into sharper focus.

Forget the chicken titan
You would think that Tyson Foods (NYSE:TSN), the world's largest supplier of chicken, would make for an ideal pick. Trouble is, Tyson has steadily expanded into beef in recent years and isn't the chicken "pure-play" that many might suspect. Beef now accounts for 34% of Tyson's sales.

Three other livestock processors, however, should more likely benefit from the rising appeal of pork and chicken.

Smithfield Foods (NYSE:SFD), the world's largest pork producer, struggled in recent years to find a sustainably profitable formula. From fiscal (April) 2003 through fiscal 2008, it generated a cumulative free cash flow loss of $590 million. The company was repeatedly whipsawed by volatile expenses for corn and other feeds, while suffering from a global glut of pigs that pushed prices down. These days, management appears to have a much better grip on the business by locking in feed costs at hedged prices while moving up the food chain and acquiring branded food products that carry higher prices and profits.

Now, results are good and getting better. The company earned $3 a share in fiscal 2011.It is also looking to boost EPS to $3.60 in the current fiscal year that began in May and to $4.10 in fiscal 2013, according to D.A. Davidson. Although Davidson has the most bullish profit forecasts on the Street, the firm's analysis appears to address the effect that rising beef prices will have on this pork producer more precisely. Shares trade for just five times Davidson's 2013 profit view, and the firm expects shares to appreciate 30% up to $28.

The current low multiple stems from the fact that Smithfield carries ample debt and is on the hook for $250 million in annual interest expenses. However, as cash flow rises, debt should be paid down, so investors should reward shares with an expanded multiple.

Best of breed

Sanderson Farms (NASDAQ:SAFM) is clearly the class of the chicken industry. The company has always maintained a strong balance sheet, managing costs well and appearing well-positioned to capture margin gains as surging beef prices eventually provide a lift to the chicken market in terms of demand and pricing. Analysts say the company can earn close to $3 a share in fiscal (October) 2012, but this could prove to be quite a conservative forecast if industry demand and pricing dynamics improve fairly quickly, as I suspect. Still, shares aren't cheap, trading for more than 10 times the likely highest end of what the company may earn next year.

A poultry turnaround?
If you're looking for deep value in the space, you'll have to dig into a company with a checkered recent past. Pilgrim's Pride (NYSE: PPC), a major chicken processor, generated a $1 billion operating loss in fiscal (September) 2008, which pushed the company into bankruptcy that year, forcing it to accept a bailout from Brazilian meat-packing titan JBS (OTC:JBSAF). JBS, which now owns two-thirds of Pilgrim's Pride, not only provided money, but also expertise that has helped Pilgrim's Pride become more efficient. An executive with JBS was recently named Pilgrim's Pride's CFO.

Pilgrim's Pride's new CFO has his work cut out for him. Just-released second-quarter results show a company still losing money because chicken farmers are producing too many birds. But if you dig into the company's results, you'll find the seeds of an eventual change in industry dynamics. The company notes major egg producers have started to throttle back output, which should reduce the supply of chickens heading into this winter. (Changes in cattle production can take up to two years to affect the market, thanks to much longer gestation and fattening cycles.)

In addition to an eventual expected upturn in chicken prices, management is also banking on a projected $400 million in operational savings in the current fiscal year. Pilgrim's Pride has started to make major inroads in the poultry export market, too, boosting foreign sales by a 65% pace thus far in 2011.

You'll start to notice the coming spike in beef prices in the next few months. As that happens, analysts are likely to turn increasingly bullish on the prospects of the rival protein producers discussed above. Sanderson Farms appears to be the lowest-risk play, albeit with only moderate upside. Smithfield Foods is the best way to pay the pork angle, while Pilgrim's Pride has significant upside if poultry farmers can show the output restraint they now appear to be promising.

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

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