Avian Flu Panic May Present Profit Opportunity

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Includes: CALM, PPC, SAFM, TSN
by: John Zhang

Summary

A single case of Avian Influenza was reported on a farm in Indiana.

Despite lack of evidence suggesting a major outbreak, the stock price of major egg and poultry producers have moved as if a severe outbreak is inevitable.

This divergence presents a favorable risk/reward in terms of accumulating poultry names or a long/short pair trade.

Trading on this short-term phenomena may be considered risky, and hence the strategy needs to be re-evaluated with each new piece of information.

Just a few hours ago, major news outlets in the U.S began reporting on a single case of Avian Influenza in a poultry farm in Indiana. Bloomberg was the first to pick up the news, followed by other networks like CNBC and the Wall Street Journal. In response, the share prices of poultry producers such as Pilgrims Pride (NYSE:PPC), Sanderson Farms (NASDAQ:SAFM) and Tyson Foods (NYSE:TSN) went into a nosedive, with SAFM and PPC finishing the day down ~8% and ~5% respectively. Even after taking into account that the S&P 500 (NYSEARCA:SPY) was down ~2%, the magnitude of these moves were certainly unusual and excessive.

On the other hand, egg producers like Cal-Maine Foods (NASDAQ:CALM) shot up by over 5%. The memory of severe egg shortages due to the mass culling of egg-laying hens in the previous outbreak in 2014 remains fresh. At face-value, this seems like a reasonable reaction as we witnessed a large build-up of poultry stocks and decrease in egg inventories in the previous outbreak. However, the current price-action seems unwarranted when we consider the facts, which does not suggest that the case marks the start of another major outbreak.

Facts Do Not Support Panic

The influenza case reported in the farm in Indiana is a single case with no evidence of similar cases in neighboring farms. Furthermore, only turkeys were affected and no egg-laying hens displayed any symptoms. The strain was identified by health and safety investigators as the H7N8 virus, which different from the H5N2 strain that caused the previous outbreak. This means this case is not a continuation of the previous wave and is more likely to be an isolated case. Moreover, the USDA's biosecurity protocols have improved significantly since the previous outbreak, and the depopulation process is almost complete as of writing (the USDA-APHIS has a policy of depopulation within 24 hours).

Fanning A Very Small Flame

It is interesting to observe how the media reacted to this news, with almost every news source sounding the panic bell. Misleading and exaggerated titles such as "Bird flu returns to U.S. poultry industry with Indiana case" (which implies a larger industry-wide outbreak) are fueling a negative perception and consequently a major sell-off in companies with healthy financials, whilst also causing an unwarranted spike in others. We think the mean world syndrome is in-play here, and coverage is likely to intensify with more speculation of a wider outbreak even if no new information emerges. The actual probability of that scenario materializing is low given the currently-known facts.

Poultry and egg stocks tend to react violently to any newsflow regarding Avian Influenza. This is partly because the most recent outbreak lasting from end-2014 to mid-2015 was the worst in U.S. history in terms of the birds culled and area affected. Another reason is that the short interest is enormously high in these stocks. Opinions are quite polarized and the shares freely floated are reduced significantly due to a high short interest. For instance, the two largest movers on the day, SAFM and CALM, have 36% and 26% of their float shorted, which contributes to the high volatility for both stocks.

The key point to note in this developing story is that the market is already pricing the equity in poultry and egg producers as if a major outbreak was on the cusp. In reality, there is a glaring lack of evidence to support this assumption. This makes a counter-trade attractive from a risk/reward standpoint, especially since the newsflow over the next week or so will either confirm or invalidate the market's assumption.

Taking Advantage Of The Panic

As of now, we favor accumulating quality names on weakness. We believe the bull thesis on Sanderson Farms is playing out, and any current or existing shareholders should take this opportunity to build a larger stake at what seem to be temporarily lower prices. Tyson is also another name one might consider, but we think the valuation is excessive and the upside potential is limited compared to peers.

If the divergence between the performance of poultry and egg stocks widens even as evidence shows a decreasing likelihood of a major influenza outbreak, we favor a pair trade being short CALM and long poultry stocks. However, this strategy could be considered more risky and should only be attempted in the case where the newsflow favors a low chance of outbreak yet the above-mentioned equities continue to trade on the assumption of an outbreak.

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.