Should You Put Your Eggs in Cal-Maine's Basket?

As I've argued previously, I don't believe this is a good time to invest in egg producer Cal-Maine (CALM) because:

1. The business is highly seasonal
2. The business is highly cyclical
3. It is a commodity business allowing for no real competitive advantages

There are a few related points (i.e. buying cyclical stocks when the earnings multiple is low typically leads to poor returns), but those three above are my central concerns. Since I've seen all sorts of estimates for what the "fair value" of CALM should be, I thought I'd take a few minutes and construct a rough estimate.

Looking at results over the last decade yields a few key data points. Gross margins from 1998 through 2007 averaged 15.5%, return on assets averaged 3.26%, and with average leverage of about 3x Cal-Maine's simple average return on equity was 8.5%. The ROE is what I really want to key in on here, because while I don't tend to agree with much of classical economic theory about perfect competition, etc., it does have some use in cases like this.

Companies with sustainable competitive advantages can earn consistently high returns on capital; companies without sustainable competitive advantages tend to earn only average returns on capital – that figure normally converging on some approximation of cost of capital for the business. So how can we estimate as cost of capital for a commodity business like shell egg producing? A pair of ideas:

That 8.5% ROE can be viewed relative to a broad market index, in the sense that one could either invest in replicating a shell egg production facility, or invest in, say, the SP.

Another proxy could be corporate bonds. Right now, triple-B debt (Baa) is yielding 6.67%; Merrill's high yield debt is yielding 10.12%. The average of those is approximately 8.5% as well, and since an egg producer would likely be rated as somewhere low on the investment-grade scale to higher on the speculative-grade ratings, 8.5% again seems roughly reasonable.

A key point of consideration is whether or not any structural differences are in place that will affect the numbers going forward, or whether or not the company will essentially revert to mean as cyclicals are wont to do. This argument could be made for gross margins themselves, as some CALM shareholders apparently believe they will remain high, but what about other factors? Looking across the time series, SG&A have more or less remained constant given the fluctuations in gross margin, as has tax rate and asset turnover. Cal-Maine has deleveraged somewhat, and I believe that will carry forward to the future to smooth out cyclical fluctuations, but otherwise things in the egg business don't appear to have changed much over time.

How, then, to value CALM with this info? If we simply take 8.5% of the latest net equity on Cal-Maine's books, we get a future annual profit estimate of $21.2 million. This does seem low, as Cal-Maine has been able to benefit from advantageous market conditions in the few prior quarters to strengthen its financial position. What if Cal-Maine can add as much equity in the next year as it did in the prior year? That would give Cal-Maine total equity of $343 million at this point next year; earning an 8.5% return on that equity gives a future profit estimate of $29.2 million. Put another way, if I'm in the ballpark on the idea that the competitive nature of the egg industry will drive returns toward long-run averages, CALM is trading for an estimated 26.9x normalized earnings.

With structural egg demand likely to grow at 1-2% per year, this is an outrageously high price to pay for CALM. Against shares outstanding, the above profit estimate equates to $1.23/share. On a 14.3x multiple (which I believe is quite high, all things considered), CALM would be a $17.50/share stock – about half its current price. This would also put CALM's book multiple valuation at about 1.2x – again, a price I think is reasonable given that the industry is commodity-based and does not allow for building sustainable competitive advantages.

Disclosure: No position.

Comments

[firboy4:]

Great article to help me better understand this business! I made great money on this stock a couple of weeks ago, but not planning on any long term investment. I was thinking of actually holding onto the stock for a while, but it seems that might not be such a good idea. So, you might have saved me all of the money I made on it so far.

2008 Apr 30 10:55 AM

[nailman:]

"Earnings are spectacular because egg prices have gone through the roof,". "And while the stock has run up, it still trades at a low multiple of six times earnings."

2008 May 01 07:43 AM

[yetisoup:]

Evaluating CALM's fair value (whatever THAT means) by comparisons to corporate bond yields is like evaluating a car's performance by looking at the glove box. It all comes down to egg prices and where you think they are headed. That will tell the story of the stock. Don't forget that 1/3 of earnings are now payed as a divvy - surely that raises the acceptable multiple.

2008 May 02 10:55 AM

[buyforeclos...:]

This stock is WAY over valued! It made SPECTACULAR GAINS THIS YEAR..it was a 10 buck chuck in January 2008 and went to 40? WHY? Because outrageous commodity prices/eggs/coffee/sug... those prices have to come down and this stock will hit about $27 a share before a short, but violent short squeeze kicks in propelling it back to $34 -$36 or more....im waiting on that squeeze as they have about 10 days to cover

2008 May 02 02:45 PM

[BW334:]

You may know all the new math, (your reasoning made my head hurt) you sure don't know the egg business. There has been a huge consolidation in producers, It's extremly expensive to add new production, big increase in demand, in most places it's easier to get a new oil refinery than chicken or hog houses. This is an extremly well run company, the shorts are going to get killed

2008 May 07 10:49 AM

[buyforeclos...:]

...looks like 27 may be too pessimistic prior to a squeexe. been finding good support at 30 and almost back to 32. It may be that 30.50 is as low as it goes before a squeeze... time to cover is narrowing

2008 May 11 12:42 PM

[broxton street:]

Just wanted to comment on this article that’s been hangin around this stock :


Firstly: all securities valuations models are based on future earnings and dividends or asset appraisals. see Grahm and Dodd or anything related to this subject. (according to the authors method Enron Stock would still be worth something) So lets start at or around any currently recognized valuation methodology.
Secondly although interest rates have some bearing on equity values; Bonds aren't a good proxy for individual equity values
Thirdly: seasonality is no reason not to own a company; see KO and PEP
so i guess no I do not really believe that a 10 year avg ROE is where you start on this stock; its not real world

Also the author comments that CALM has de-leveraged somewhat..
the company has generated enough cash to pay off 100% of debt in 9 months.So saying that the company has deleveragered somewhat is a little bit of an understatement

CALM is not cyclical in the traditional sense..so I guess the author is saying something to the expansion and contraction of layers effecting the $ per dozen. This works in deflationary or a stagnant inflation environment ,inflationary environments are somewhat different. Currently layers would need to expand and contract along an inclining trend line to create the same effect in this environment. See Inflation effects of
also this is a commodity business with no competitive advantages?
Specialty eggs are 15% of the company's revenues and they are operating with 3 or 4 growing brand names. Actually if you deduct the copack revenues its 18% of their revs. so their brand names like egglands, which have lower cholesterol, sell for a 80% premium to generic so I might (anyone might) consider this a competitive advantage. I guess that I don’t need to go into marketing 101 as well.

Low multiple = do not buy? You aren't at the high point in the cycle so the foregone conclusion of this statement is that the prices peaked (doesn’t look like it).
Typically the multiple expands as the earnings do,.
Reality: there are no visible capacity increases and it looks like 2009 will bear higher prices..
so this is pretty similar to steel coming out of the 20 year slump..X traded at 6X or 15 bucks in 2004 before going to 150.00 so it takes a little while for investors to realize that things have changed. yes its great to pull down 10 years of Reuters data and pen some baseless comment from it but one should ask this question
If this industry is going to blow out as it is wont to do
why are the number of layers trending down for the last 18 months on the back of a 100% upmove in combined regional prices?

So maybe a good short someday but the guys that shorted X @ 16 or 30 aren't around to pick up the phone anymore and their Hedge Funds are gone. So possibly you should wait for confirmation of the additional capacity or something in the pullet #s before.... drawing predetermined conclusions on dubious methodology?

2008 May 13 01:23 PM

[broxton street:]

Breaking stock prices can normally precede table egg prices and breaking stock quotes are moving higher
USDA QUOTE: Breaking stock prices were higher with checks and undergrades unchanged.
Demand was usually moderate while offerings continued tight to adequate.

2008 May 15 04:44 PM

[Stockpicker...:]

James Cullen,

I suggest you listen to User192632 as your analysis is deeply flawed and narrowminded. Since you are graduating BC in 2009 I suggest you take some additional classes to refresh your knowledge of financial models. This article should not have been published as it gives SA a bad reputation for unintelligent authors.

Dean

2008 May 15 06:13 PM

[wujo601:]

Just found this article: www.businessweek.com/m...
Also, as to CALM: I think that it's better to look at the bigger picture, i.e. how this stock was doing, say, last year.

2008 May 30 04:52 PM

[ing_rivera:]

The author is right CALM won't make more than 8.5% on equity going forward, 12% with good luck, I won't pay more than 14 for it.

Jan 30 05:52 PM