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

| About: Cal-Maine Foods, (CALM)

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