Sanderson Farms Could Be The Next Smithfield Foods

| About: Sanderson Farms, (SAFM)
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Investment thesis

Sanderson Farms (NASDAQ:SAFM) is a prime takeover target given the low valuation and attractive company-specific qualities. The combination of rising chicken prices and lower feed costs should provide a strong tailwind that results in significant price appreciation regardless of a takeover.

Company overview

SAFM is the third largest poultry processor in the U.S. with weekly capacity of 9.375 million chickens. SAFM sells fresh and frozen chicken products to retailers, distributors and casual dining operators in the U.S. as well as to customers who resell into export markets.

SAFM has the wind at its back

The recent positive financial results should continue given rising chicken prices, falling feed costs, increased consumption and a near term, industry-wide capacity ceiling.

In the mrq, revenue rose 18.3% to $739 million driven by a 15.4% average sales price increase and a 2.7% increase in the number of pounds sold. The high operating leverage resulted in net income rising 137% to $67.9 million.

Going forward, a significant catalyst is the falling price of corn, which takes time to flow through to the income statement*. This is a welcome change compared to 2011 - a period in which the industry suffered twice due to the falling price of chicken and rising price of corn.

Favorable summer weather conditions for corn and soybeans (and the first year in three without a drought) drove prices down in recent months (as shown in the chart below) due to an expected higher crop. Management said on the most recent conference call that 4Q cash outlays would be $65 million lower compared to the year ago period based on current prices.

Another catalyst for lower corn prices is the fact that the EPA is finally considering reducing the ethanol requirements. Even a small reduction would have a significant impact given that ethanol consumes 28% of the total corn crop.

Chicken is currently benefiting from two key demand drivers. First, the high price of beef is driving stronger supermarket demand for chicken. The second driver is more long-term in nature.

The recent addition of chicken wings to the Mcdonald's menu reinforces the ongoing trend of fast food and casual dining restaurants adding more chicken products (e.g. wraps, boneless wings). This trend should continue for three reasons. First, restaurants earn relatively higher margins on boneless wings so there is a strong desire to "push" this product compared to others. Second, chicken is healthier compared to beef (this translates into higher supermarket demand as well). Third, chicken has more "menu staying power" compared to previous additions such as the not so popular McLobster.

The industry faces a near-term capacity ceiling as management said that its primary breeders could only start to meaningfully expand starting in 2H14.

*The falling price of corn does not immediately impact the cost of sales as it is recognized on a FIFO basis. The result is a lag period of ~1.5-2 months between the time of purchase and the time the cost is reported in COGS.

Strong export market + recent positive catalyst

As the chart below shows, the increasing global demand for chicken continues to drive strong export growth with overall industry export volumes up 2.1% in 1H13.

This growth is even more impressive given that in 2010 China imposed anti-dumping duties on U.S. chicken products, which resulted in a 80% decrease in exports of broiler products such as chicken wings and leg quarters. However in August 2013, the WTO ruled that China violated the rules and must drop the duties within 60 days or appeal. This is a significant opportunity as exports to China in 2009 were 729 million pounds compared to only 209 million pounds last year.

Shareholder friendly management with the right focus

In February 2012, SAFM expanded its repurchase plan to 1 million shares. The commitment to repurchasing shares issued as part of the incentive plan is refreshing given that so few companies even acknowledge the very real threat of repurchases being effectively offset by share grants.

In September 2013, SAFM increased the quarterly dividend 17.6% to $0.20 per share.

Management has the right incentives given that compensation is dependent on meeting EPS as a percent of sales and ROE targets over a two year period. The long-term oriented focus on profitable growth (not just growth at any price) is similarly refreshing considering many companies only focus on EPS growth, which can be "manipulated" through repurchases*. For example, management said it would not be "forcing product through there at a loss, but making a profit margin".

Unlike most companies, SAFM employees have the opportunity to meaningfully share (not just a token amount as is often the case) in overall profitability as evident by the fact that most salaried employees can earn up to 25% of their salary as a bonus if EPS targets are met. This results in a highly motivated workforce and should not be overlooked. For example, it is widely known that Costco employees are paid more than those at Walmart yet the former still manages to deliver superior financial and stock price performance. This proves that paying workers the absolute minimum does not automatically translate into higher profits.

*A simple yet effective way to accomplish this would be to lever up the balance sheet (especially given the low rates) and repurchase a significant amount of stock. This way EPS could go up regardless of top or bottom line growth. However the company would be inherently riskier given the higher debt load.

Vertically integrated operations and valuable assets

As a vertically-integrated processor, SAFM is better able to control the entire process from the hatching of eggs to feed manufacturing to growing to processing and packaging. This is especially important in the food industry given that a small quality problem in one part of the processing chain can have devastating effects. SAFM is one of the most efficient processors in the industry with modern and automated equipment, which drives additional margin expansion and increases quality.

SAFM owns almost all of its major operating facilities, which are carried on the balance sheet at the depreciated cost. However an acquirer (see below) would almost certainly be willing to pay a significant premium given the time and expense of building new facilities.

The shift towards higher margin, value-added products (and away from the marginally profitable small birds segment) results in less exposure to the volatile price of chicken. Furthermore, its higher quality products (e.g. no additives, artificial ingredients or preservatives and not genetically modified) earn a premium in the market.

SAFM could be the next Smithfield Foods

As the chart below shows, SAFM is attractive on an absolute basis.

However on a relative basis, SAFM is even more undervalued. TSN is included in the peer comp as it is the largest U.S. chicken processor however it also produces beef and pork. PPC is the closest peer given its focus on value-added chicken products.

However, as the chart below shows, SAFM has a higher EBITDA margin and significantly lower debt profile. This deserves a higher multiple.

The recent acquisition of Smithfield Foods by Shuanghui International Holdings (announced in May 2013) briefly drove an industry-wide increase in valuations as investors speculated on the next likely target. The fact that banks were so willing to lend billions to finance the merger highlights the strength of the company and industry. The currently favorable (though slowly changing) financing environment does not automatically extend to every merger target (e.g. Blackberry).

However SAFM retreated though this was most likely due to the overall market pullback as a result of tapering fears. This pullback presents an attractive entry point as the takeover prospects are just a real.

SFD received a 31% premium and an EBITDA multiple of 7.4x. At first glance, SAFM appears fairly valued with a 7.3x multiple. However unique company specific factors deserve a premium. For example, SFD has lower EBITDA margins (e.g. 6.8% in its pork division and 7.6% in its packaged meat division) and a net debt/equity of ~71%. As previously mentioned, SAFM has higher margins and lower debt, which should translate into at least a 1x EBITDA turn increase.

Moreover, SAFM continues to reduce its debt. This is a significant competitive advantage as the strong balance sheet allows it to survive the inevitable "boom and bust" industry conditions unlike PPC, who filed for bankruptcy in 2008.

The most likely buyer will be Brazilian or Chinese given the increasing protein consumption in emerging markets (due to rising incomes) and need for food safety. In the past decade, China's per capita chicken consumption rose 35%.

If the current valuation discount persists, an activist investor such as Starboard Value could take a relatively small stake and encourage the board to pursue strategic alternatives. This attempt is made easier given that the top five institutional holders own ~41% of the stock and would most likely be receptive to any attempt at maximizing shareholder value. Moreover, the lack of insider control (unlike at TSN) and small absolute size leave SAFM especially vulnerable.

Furthermore, the relatively swift approval by regulators* of the SFD merger means that it is now "open season" on undervalued U.S. assets with a strategic interest to deep pocketed foreign buyers. This should alleviate any fears of rejection on "national security" grounds.

*Anytime a foreign company buys a U.S. company there is the inevitable "foreigners are taking over" fear mongering. This is unwarranted for two reasons. First, we are talking about chickens - not JDAMs. Second, the hypocrisy is surely not lost on foreign buyers of Americans demanding access to foreign markets at the same time they fiercely protect their own.

Risks

Corn/soybean meal exposure. SAFM would be negatively affected by rising input costs, which fluctuate based on a variety of factors including the weather, government policies (e.g. ethanol) and overall economic activity. A $1.00 increase in the average price per bushel for corn would result in a ~$23.5 million increase in cash cost while a $10.00 increase in the price per ton for soybean meal would result in a ~$2.2 million increase in cash cost.

Dependent on price of chicken. SAFM has no control over the price of chicken and would obviously be negatively affected by a decrease.

Potential for avian flu outbreak. All chicken processors including SAFM would be negatively affected by an outbreak of avian flu due to increased safety concerns.

Conclusion

The target price of $76.31 is based on a 8.5x EBITDA multiple.

The 200 DMA ~6% below provides a natural place for a stop loss. The time frame is 12-24 months given the multiple longer-term catalysts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.