Sanderson Farms: Modest Upside, Possible Short Squeeze

Sanderson Farms (SAFM) is the third largest publicly traded chicken producer in the US, behind Pilgrim’s Pride (PPC) and Tyson (TSN). Stocks of chicken producers have been badly battered in the last couple of years, first by the avian flu scare and then by the high cost of corn feed. The sharply rising cost of corn was, of course, an indirect result of the rising cost of oil, and the federal subsidy of 51 cents per gallon of ethanol used to supplement gasoline (a subsidy which has been referred to as the stupidest federal subsidy). With a conversion ratio of 2.7 gallons of ethanol per bushel of corn, the subsidy amounts to $1.48 for every bushel of corn used. As a result, corn prices have jumped from $2 at the end of 2005 to around $3.75 today.

Chicken producers are cyclical commodity stocks and they always will be. They have minimal control over the market price of their products and the only thing they can do during a downturn is to cut back production and eat their losses while waiting for prices to recover, which is what all the major chicken producers did during late 2005 through 2006. Sanderson Farms nevertheless went ahead with plans to build a new processing plant in Waco, Texas. In 2006, all other chicken producers saw declines in revenues, while Sanderson Farms had flat revenues, suggesting an increase in market share.

The fortunes of the poultry producers have recently started to turn. Spurred by the huge profits in corn, farmers have reported to the USDA that they plan to plant corn wall-to-wall this year, with most agricultural economists are predicting a moderate drop in the price of corn. More importantly, the wholesale price of chicken (a common proxy is the Georgia dock price) has been continuously rising since Jan 2007, as have prices of all other major meats, especially beef.

Sanderson Farms started as a family company and the Sanderson family still manages the company and holds significant amounts of stock after it went public. Management is considered to be highly competent and shareholder friendly. In late 2003 and early 2004, after persistent under-valuation of their stock by the market despite a large share repurchase effort, management issued a special one-time dividend that doubled stock price. The company pursues a strategy of focusing on quality and value-added products to mitigate against the commodity nature of the poultry business. On the downside, the company has a shareholder rights plan (aka “poison pill”), so a takeover by a larger company is unlikely. Promised increases in corn production may not materialize due to bad weather, and another bird flu scare is always possible. in addition, in 2006, the USDA floated a proposal to allow imports of cooked chicken from China (the chicken has to be cooked and “shelf stabilized”, which essentially means only canned chicken), but the proposal has been widely disparaged, especially in light of the recent poisoned pet food scare. In my opinion, the US has always been an exporter of chicken (the only imports have been a microscopic amount of chicken from Canada), suggesting that the highly industrialized and vertically integrated poultry industry here is substantially more efficient than that in other countries, and would be competitive with any foreign chicken imports.

Management has stated that the base capital expenditures runs around $20 to $25 million annually, and any excess expenditures above that is to fund expansion of production facilities. The company has traditionally relied on internally generated cash to fund expansion, but in 2006, management broke with tradition to borrow $70 million to fund facilities expansion, a decidedly risky move at the time that now looks prescient. The company just released its latest 10Q; while analysts predicted $0.29 per share earnings, the company came in with $1.34 (suggesting that many analysts are badly misreading this company). Economists are predicting a good year for chicken companies, with per capita chicken consumption increasing at the expense of beef consumption due to rising beef prices. Historically, from 2003 through 2005, SAFM has managed $70 to $90 mil income annually. If earnings go back to $70 million ($3.50 per share), assuming a historical average PE of 12, the company is fairly valued at $42. However, the company has substantially increased in production capacity since 2005, and has likely also made gains in market share.

These factors, combined with a likely increase in per capita consumption of chicken, may well send earnings to $100 million or more. Strangely, SAFM sports a high short interest of 27% of float as of April 2007, vs short interest of 8.9% and 3% for PPC and TSN respectively. This state of affairs is a complete mystery to me. While PPC is larger than SAFM, it is more highly leveraged (with a debt-to-equity of 1.6 for PPC vs 0.4 for SAFM), and I fail to see any special factors that accrue to SAFM but not PPC (if anything, PPC may lose more market share to SAFM as it continues to digest its Gold Kist acquisition). I strongly suspect that someone inexplicably failed to cover their avian flu shorts on SAFM in 2006, and may now be forced to do so in a big hurry.

Going forward, I have a price target of $55 per share on SAFM. I want to see short interest drop below the 10% mark before even considering selling my shares. In addition, I want to see management pay down the debt they have accumulated to save during the good times for the next rainy day. And I hope to see Sanderson Farm expand its distribution network to the Northeast, so that I can at last find a Sanderson Farm chicken at my local supermarket.

Disclosure: Author has a long position in SAFM

SAFM 1-yr chart

Comments

[Ralph F:]

Excellent analysis. If a more sensible energy policy is implemented -- say a broad tax on energy consumption instead of distortionary subsidies -- all the stocks that have been impacted by high corn prices, both positively and negatively, will move.

The question is when that will happen. Bush is opposing Merkel's calls for global co-operation on global warming as I write.

2007 May 30 12:31 PM

[ing_rivera:]

Low debt, focus and great management (specially the CFO which started in 1998 and has turned things around dramatically) in a very fragmented industry, gives Sanderson a competitive advantage which have allowed them to perform better than its peers in the last couple of years, returning around 5% better on equity. Their fair value is $40, I'll buy for $24 at 0.6 their value to assure a 50% year over year return.

The author was right on his 42 number but at the end he said 55 which is too much and was based on increased market share and increase per capita consumption....well first Tyson is a great competitor and won't allow those share gains so easily, second people won't eat more chicken, beef, pizza or whatever next year...well at least I won't do you? Food habits are pretty stable.

Jan 30 02:05 PM