Several months ago, we highlighted the bull thesis for Sanderson Farms (NASDAQ:SAFM) and the catalyst of sustained low corn prices that would enable the company to generate strong free cash flow for the coming years. Since then, many authors on Seeking Alpha have echoed similar sentiments and the stock has bounced significantly from its lows at ~$65/share.
Reviewing the bull case now, we think the same catalyst is still in play as corn inventories remain elevated and the last harvest season experienced exceptionally strong volume. Furthermore, the market has begun to appreciate SAFM's high P/FCF multiple, and valuation has started moving materially higher despite weakness in the overall equity market. Recent price-action suggests SAFM has a long runway to go, and short interest has moved down meaningfully for the second half of December. We think these developments clear the runway for SAFM to hit our price target of ~$95/share in the coming months, assuming earnings are uneventful.
Catalyst Remains Intact As Corn Remains Oversupplied
The USDA's Grain Stocks report for January was just released today, and corn inventories edged again with farm stocks up 4% and off-farm corn stocks up 6% compared to a year ago. As mentioned in our earlier analysis, low oil prices have led the EPA to roll back their target for the ethanol fuels mandate, which has resulted in drastically decreased demand for corn. As oil prices edged lower, the EPA has stuck to their guns and lowered the ethanol mix requirement this year to nearly half of Congress' original target. When we first wrote about this issue in late August, the targets for 2016 had yet to be finalized. However, it seems certain now that these goals will be significantly lowered if oil prices remain low.
The final requirements issued by the EPA are for both 2016 and 2017, and the volume step-up from 2016 to 2017 is far lower compared to previous years. Given that converting land use from growing corn to other crops is a slow and tedious process, we think low corn prices are here to stay, and the recent ruling has added confirmation to this line of thought. Big corn growers are evidently pissed off (see lawsuit here), and this confirms our suspicions that the process to moderate supply will be a long and painful one for them - their pain should become SAFM's gain. As the market realizes that the poultry cycle has changed and that high FCF isn't temporary, it should drive the virtuous cycle of a higher stock price, short covering and consequently even higher share prices (it certainly helps that SAFM is one of the most heavily shorted stocks at over 40% of their float).
As Bird Flu Dies Down, Pricing Pressure Should Abate
We witnessed one of the worst bird flu outbreaks ever in 2015, yet SAFM continued to generate high FCF despite the pricing pressures due to higher domestic volumes as a result of export bans. This effect was the strongest in the market for dark meat, which is typically exported as Americans have a preference for white meat. Prices for dark meat fell off a cliff as inventories rose. As of the latest USDA update, dark meat inventories are up 6% month on month and 33% year on year.
Obviously this spells trouble for pricing pressure in 2016. However, there have been several encouraging indications that export bans may be pulled back sooner than expected. Recently, South Africa re-opened their borders to US poultry exports with an agreement that provisions for increased quotas every year. This is possibly a first step for the world to regain confidence in US poultry exports after the massive bird flu outbreak. We know from history that once a few countries start accepting exports again, it drives a chain reaction as credibility grows. Hence, there is a high likelihood that key markets China, Mexico, South Korea and others will lift the ban on US poultry exports in 2016, which should ease pricing pressures significantly.
Even if this does not come to fruition, SAFM has shown resilience in the face of lower pricing. Although it affected their Q4 results, it is worth noting the company is increasing volumes significantly due to the ramp-up of their new facility at Palestine and the proposed facility at St. Pauls, NC. Over time, we believe their organic expansion strategy will increase tangible assets and gain market share over smaller competitors. Thus, even if temporary pricing pressures persist longer than expected, the future remains bright.
Allocating Capital Efficiently
Those familiar with the company will know SAFM's policy of growing organically by reinvesting FCF and avoiding debt. Due to the large amount of cash generated every quarter, the company has been expanding production volumes with new facilities and signing up a larger network of growers. These initiatives should continue to generate a strong ROI in the long-term.
If the current FCF run-rate is maintained, we would also expect a sizeable special dividend in 2016: the company's policy has always been to pay out a small regular dividend, which will be supplemented with a larger special dividend if results are particularly strong. With corn prices remaining low, the cash profit spread should prompt management to reward shareholders as they have done in the past.
Grain and chicken inventories are key figures to watch for, and the situation on export bans should alleviate in a couple of months. We will remain wary of pricing pressure due to higher inventories, particularly the oversupply of dark meat in the domestic market. As it stands, 2016 looks to be a great year for SAFM as bullish catalysts continue to play out.
Disclosure: I am/we are long SAFM.
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.