CALM Longs Walking on Eggshells

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.

Disclosure: None

Comments

[G23ROCKS:]

CALM owns its own feed mills. The price of seeds is probably higher, but they are not buying feed out on the market. Their IR page has a video which explains this. I was examining CALM for a possible long (15% ago) but held off as the 5-year chart is parabolic and Q1 has resulted in an operating loss 9 out of the past 10 years. I do like their dividend hike to flush out the shorts, though. Brilliant idea!

2008 Apr 18 09:58 AM

[ari5000:]

Short food stocks during a global food crisis?

Oil is a commodity too -- maybe CALM shorts should be shorting oil too?

Sounds like a good plan if you want to die poor.

2008 Apr 18 10:29 AM

[James Cullen:]

Bluedog,
Cal-Maine does own its own feed mills, but it still needs to purchase the inputs (i.e. corn and soybeans) on the open market.

2008 Apr 18 11:58 AM

[Stockmaven:]

Frankly I found this article to lack the fundamental analysis of the current global food crisis. Beef, Pork and Chicken is all being produced at a loss to the farmer. Eggs are profitable and an inexpensive source of protein.
The last big rise in CALM was the result of the Atkin's Diet and such a fickle source of demand is not there now.
There is a basic food shortage issue and CALM is one of the solutions.

2008 Apr 18 03:26 PM

[James Cullen:]

Key words: global food crisis. CALM is domestic, and eggs are very perishable and thus not an exportable product. You can ship grains and whatnot all over, but eggs... not so much. In other words, I think this stock is being confused as a play on the secular ag boom.

2008 Apr 18 07:13 PM

[globalmacro:]

Industrias Bachoco (IBA) looks like a great alternative at these levels.

2008 Apr 19 03:02 AM

[firboy4:]

Great article and great comments too! I just made a bundle on CALM since April 1st, but own none now. I was wondering what I could expect from it for the rest of the spring into summer. So, James, anyone......can eggs be exported as a processed powder, like what restaurants often use? If so, then the demand and price for them WOULD probably go up. But I really don't know. I'm aking here. Thanks.

2008 Apr 19 09:35 AM

[marchese68l:]

To firboy4..... Your answer is yes! You can buy Dried Eggs in form of Whole,Yolks and Whites. Dried eggs are sometimes used in the bakeshop,though less often than frozen eggs.The whites are frequently used for making meringuep powders. Dried egg products are also used by commercial manufacturers of cake mixes

2008 Apr 19 11:00 AM

[Tom Peavy:]

WELL HE'S WAY WRONG,CAL-MAINE HAS PROJECTED $6.00 A SHARE FOR NEXT QT. AND EGG PRICES ARE WAY UP $2.25 TO $2.35 A DZ. LARGE GRADE A WHITE AND THE CAGE FREE,FARM FRESH ALL THE SPEC. EGGS $3.35 TO $3.69 A DOZ.,ALSO CAL-MAINE JUST PASSES THE COST OF FEED ON TO THE CUSTOMER.$60.00 STOCK SELLING AT $29.00.

2008 Apr 20 12:51 PM

[optimumtrader:]

You are incorrect in stating that CALM is domestic. Here is a line from their earnings statement -> "experienced strong export sales to Europe and Japan.". Please do not write before doing proper research. Obviously you are short or working for someone who is short. The timing of the article coincides with the ex-dividend date approaching, most of which will be paid by the shorts!!

2008 Apr 20 10:03 PM

[James Cullen:]

Optimum,
You are right - I did miss that. As far as I can tell (and I just did several searches), terms like "export, foreign, currency, Europe, Japan" etc. etc. do not appear in recent SEC filings.

While I regret that error, and would appreciate being informed as to what extent I'm incorrect (i.e. what % of sales are exports), I am not being employed by shorts, nor am I part of a broader short conspiracy... although hey, if they'll let me in on it...

2008 Apr 21 02:15 AM

[IRA investor:]

Are there any regulators watching who's lending the shorted shares?
Will it take an action by a state's attorney general to have the SEC do what they are paid for?
How can there be a 98% short position?
I'd like some insight on the rules of shorting if you could.
Have the shares in my IRA been lent by my broker?

2008 Apr 21 10:06 AM

[Josh Stern:]

Here is an article on the factors driving egg costs: www.infozine.com/news/.../

I believe the parent article makes a good negative point that in the long term one would expect egg production to rise to meet demand at some sort of average agricultural profit margin, but it misses several factors that have caused production to lag demand including export demand, changes in de facto chicken care standards, changes in the health view of eggs in the diet, and the general environment of rising food costs where eggs are still very competitive as a convenient protein source.

2008 Apr 21 10:16 AM

[alorchip:]

Mr. Peavy (April 20, 12:51 comment), Please provide your source for statement CALM is projecting $6.00 for next quarter. I have not seen or heard of that. Its not in their ernings release for last quarter.

2008 Apr 22 05:29 PM

[Tom Peavy:]

THE DOW JONES NEWS WIRE MARCH 28, 12:15 PM ET IS MY SOURCE.

2008 Apr 22 08:45 PM

[Tom Peavy:]

RUMOR HAS IT CARGRILL IS THINKING OF OFFERING A CASH BID IN THE MID 40'S FOR CAL-MAIN. ANSWERS.CON 12:15

2008 Apr 22 09:04 PM

[buyforeclos...:]

stock is heading down from highs...no short squeeze?

2008 Apr 23 11:30 AM

[Rappenco:]

u wouldn't be short now? if so; now might be good time to COVER


On Apr 23 11:30 AM buyforeclosu res wrote:

> stock is heading down from highs...no short squeeze?

2008 Apr 23 12:04 PM

[Tom Peavy:]

ALL ABOARD,EVEN BUYFORECLOSURES CAN JUMP ON THE TRAIN,ALL ARE WELCOME.

2008 Apr 23 05:18 PM

[Rappenco:]

it is quite easy to reverse a short position to a long one; just got to suck it up and admit the one position was wrong.


On Apr 23 05:18 PM Tom Peavy wrote:

> ALL ABOARD,EVEN BUYFORECLOSURES CAN JUMP ON THE TRAIN,ALL ARE WELCOME.

2008 Apr 26 10:43 AM

[broxton street:]

These comments are totally wrong: "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."

you don't know anything about modern NPDS and UEP compliant cage systems required today. You can't stack cages and cram chickens anymore.
seasonality doesn't mean anything look at KO and PEP or Scotts lawn
Pullet chicks and eggs under incubation Have Not inclined and the total flock size is smaller than 2007
eggs are an Input cost for the entire baking industry and others
They will pay any price for eggs to make their product
currently egg prices are at an all time June high and may breach 2.00 per dzn this year. The usa eats 213 million eggs a day and the demand is extremely inelastic

2008 Jun 29 08:57 PM