At the most recent meeting of the Boston College Investment Club, we had three stock pitches – a sell pitch for Wachovia (WB), a buy pitch for Astra-Zeneca (AZN), and a buy pitch for Cal-Maine (CALM. Because Cal-Maine is by far the most underfollowed of these, I found it most interesting that someone would find (and then present) this idea. While the numbers on Cal-Maine make it look attractive, I believe there are a number of red flags that make me exceptionally wary to agreeing to a purchase.
Cal-Maine is the largest domestic producer of eggs, as well as the only publicly traded egg producing company. After a huge run-up of late, the company has a market valuation of just over $700 million. Cal-Maine had a huge first quarter this year, and turned more in profit than it did all of last year combined. This gives the stock a very low P/E (about 5x and change), and profitability ratios (i.e. return on equity) that look extremely attractive. Betting on CALM here is betting that things really are different this time, because the absolute worst time to buy a cyclical stock is when the earnings multiples are lowest. Maybe we are in the middle of a great supply/demand situation for egg farmers that will hold into the future, Cal-Maine will continue to be highly profitable, the stock runs 20 points and I look stupid. Maybe, however, this is a case of the longs in a stock getting confused about why things look so good (see: the tech darlings of 2007) – because Cal-Maine is not part of the secular agriculture boom. If anything, they’re hurt through it via higher feed prices, and I’m feed prices will stay high as long as our government continues the subsidizing of corn, wheat, soybeans, etc., through the burn your food, fuel your car program known as ethanol – a program so insanely contrived, it is literally responsible for death and political unrest all around the world. But I digress…
I believe the presentation unfairly glossed over this fact, as there was a lack of adjustment for seasonal factors, leaving the implied annual earnings and dividend yield far too high. It’s the equivalent of pretending every quarter for a retailer is like the last six weeks of the calendar year… ok, perhaps a bad analogy in light of how terrible retail sales have been, but hopefully you catch my point. But to make it concrete: gross margins in Q1 2008 were 37%; in Q2 2007 gross margins were 24% - obviously making for some wild intra-year swings.
Another point made by the two presenters was that CALM has a very low correlation to the BCIC portfolio as a whole, so while it might be a risky or volatile stock in itself, adding it to our portfolio will add diversification benefits. Specifically, it was pointed out that our exposure to consumer nondurables was low after our sale of Village Supermarkets (VLGEA) – a sell pitch that I was responsible for. This would be a chance to essentially practice “moat arbitrage” and eschew a company like Cal-Maine that has a very narrow moat at best in favor of an established food producer that can command a premium for its products – examples include Campbell Soup (CPB), General Mills (GIS), Kellogg (K), and Kraft (KFT). While none of those companies offer the hypothetical upside a Cal-Maine does in a scenario where, say, egg prices soar to new highs, they also won’t get crushed like Cal-Maine will when this commodity business rolls over the cycle.
There, I said it. Cal-Maine is a commodity business – albeit the biggest player in it, which offers some scale advantages, but not enough to make it anything special. More problematic, supply in the egg industry is constrained only by how many chickens can be hatched and how many cages can be built. While the latter point has worked in favor of the egg industry of late, it is assured that more capacity can be brought online – unlike in a hard asset commodity business like oil, copper, etc., where there is a finite amount of the stuff in the ground… but I digress. Sticking to agricultural commodities, I think eggs are even less favorable than grains, because land used for grain planting has been in decline for a prolonged period of time, and there is a relatively low ceiling on the amount of production that can be taken from any planting area in a finite time. Eggs, on the other hand, can be produced by stacking dozens of cages on top of each other and having each chicken produce a couple hundred eggs per year. What does the evidence point to in terms of industry supply trends? Yes, supply has been constrained – but it looks to be gradually expanding, as pullet chicks hatched is at a multi-year high, as is eggs under incubation – in other words, farmers are breeding more chickens to capitalize on the high prices. As invariably happens in a commodity business, this will cannibalize margins and profits.
Along the lines of cannibalizing profits, while Cal-Maine will realize cyclical prices for its eggs (again, egg prices have fallen 25% since Easter and will fall further), they are going to be hit by much, much higher prices for feed – somewhere in the neighborhood of 50% higher than the same time last year is possible, judging from industry data. And this is where I believe people have it wrong about this stock: Cal-Maine has traded like it is part of the secular agriculture boom, when its main source of revenues is probably a 1-2% growth business. On the flip side, its cost inputs will be affected by the secular move up in the inputs that go into feed – namely corn and soybeans. This is why I’m betting…
Shorts have been all over this stock. CALM has an enormous short position that has continually been ratcheted up even as the stock rose. More than 75% of the float is short. Now read that again. We all know what a short squeeze is, and so do the hedge funds that are behind this short position. When the shorts are willing to place this large of a bet against a stock, that alone should tell you something. But when that underlying stock is an extremely cyclical business with profits at a high and a stock price that follows… I have to believe that the shorts are right here, and Cal-Maine’s profitability (and stock) is going to get hit.
The Powerpoint on for the CALM buy pitch is uploaded for viewing on my site.