Sanderson Farms: Playing Chicken

| About: Sanderson Farms, (SAFM)

Sanderson Farms Inc. (Nasdaq:SAFM) has a lot of pluck to plan a chicken processing capacity expansion while some struggling competitors are crying out for industry cutbacks to firm up prices.

While demand for poultry is healthy, producers face the big problem of higher costs, mainly for transportation and feed, as oil and other commodities including corn continue to rise.

The fourth-largest U.S. poultry producer, though, hasn’t hit the panic button, and Mississippi-based Sanderson Farms recently announced plans to open a new plant in North Carolina in late 2009, primarily to handle retail-packaged products. Last year, the company brought online a plant in Waco, Texas, to process 1.25 million chickens a week.

For the most part, analysts who follow Sanderson Farms are staying neutral, with four of the five recently polled by Thomson Reuters having the stock at “hold,” and the other deeming it a “strong buy.”

Sanderson Farms began as a rural feed store in the 1940s, started a hatchery to sell more feed to farmers, then began buying back the chickens and selling them. Now Sanderson has plants scattered across the South, producing chill-pack and frozen chicken for the retail market, big-bird processing for commercial use, and specialty foods manufacturing. Russia and China are growing markets for leg-quarter products.

The median price target for the company is $50, about 10% under its historical high of $55.18 in June 2004. On May 29, Sanderson hit a 52-week high of $50.45 and shares dropped as low as  $27.80 on Jan. 22. The stock closed Wednesday at $39.99.

Still, Sanderson executives have bluntly outlined the challenges in several recent presentations. During a June 4 presentation at the Stephens Inc. Spring Investment Conference, chairman and CEO Joe Sanderson explained why the company can better weather the economic problems than its competitors.

“We’ve seen a lot of chicken meat on the market,” he said, noting that Sanderson Farms is trimming supply like some competitors. “And with the economy what it is and gasoline prices, we’re seeing consumers spending more at grocery stores and less in restaurants. That’s reflected in better business in retail,” and fewer restaurant sales.

At one struggling competitor, Pilgrim’s Pride Corporation (NYSE:PPC), CEO Clinton Rivers said at the BMO Capital Markets Agriculture and Protein Conference in mid-May that there need to be industry-wide production cuts of 3% to 4%, to boost retail pricing and help offset rising costs. Based on broiler egg set figures, Sanderson said at the Stephens conference that supply should drop about 2% headed into summer.

In the second quarter of fiscal 2008, Sanderson Farms’ net sales rose 20% to $433.9 million. Despite the drag of rising costs, the company surprised Wall Street for the three months ended April 30 with a profit of $6.2 million, or $0.30 a share, compared with the year-ago profit of $26.9 million, or $1.33 a share. Analysts were expecting a loss of $0.05 a share.

While Sanderson Farms did note that its customers were paying more for its products, feed costs exploded: For corn and soybean meal, the primary feed ingredients, cost increased 28.3% and 46.8%, respectively, when compared with the same quarter the year before. It takes roughly two pounds of feed to produce a pound of chicken.

Sanderson Farms posted a blockbuster turnaround year in 2007 despite rising feed costs — record sales of $1.475 billion, 41% better than the previous year; net income of $78.8 million, compared with an $11.5 million loss in fiscal 2006; and earnings per share of $3.88, versus a loss of $0.57 a share the prior year. The company processed 343.6 million chickens, and the 2 billion dressed pounds were 12% better than in 2006. Efficiencies were demonstrated by a 12.5% profit margin for the year.

In an irritable stock market, one analyst’s opinion can sway share prices drastically, as evidenced by some notes out of Stephens Inc. that created a stir among skitterish investors. Sanderson Farms was upgraded to “overweight” from “equal weight” in early May, triggering a 4% one-day rise. Following Sanderson Farms’ appearance at the Stephens conference, shares dropped 7.1% on June 6, as analyst Farha Aslam trimmed the rating to “equal weight” while maintaining a $50 target price. On a valuation call, Stephens again raised Sanderson Farms to “overweight” on Tuesday, noting the 22% pullback in share price in recent weeks — resulting in another 5% share jump.

Writing nearly as bluntly as Joe Sanderson was BMO Capital Markets analyst Kenneth Zaslow, who didn’t mince words when he updated clients in a late-May update. While keeping his “market perform” rating but raising his target price to $50, Zaslow wrote about the second-quarter results:

We believe SAFM’s performance proves that SAFM is ‘best in class,’ as it is the only publicly traded chicken company to generate a positive (and actually respectable 2.4%) operating margin during one of the most challenging environments in history. SAFM is best positioned to weather the challenging chicken market conditions, in our view, reflecting its pristine balance sheet and operating efficiencies … .

In this game of chicken, Sanderson Farms is not backing down and eventually could become the big bird.

Disclosure: none