Chicken Or Egg? Which Will Build More Wealth?

| About: Cal-Maine Foods, (CALM)

Summary

Cal-Maine Foods converts cereals and soybeans into eggs very profitably. Its market valuation has grown at 16% CAGR since the IPO.

The company has a long record of successful organic and inorganic growth and prudent capital expenditures.

The highly fragmented US egg industry provides numerous opportunities for accretive acquisitions.

Uncertainties include avian flu outbreaks and anti-trust litigation.

The stock is suitable only for "buy and hold" investors who have extremely long time horizons.

The first picture in my first article on Sanderson Farms (NASDAQ:SAFM) showed the long-term returns on various poultry farming and meat processing companies. While I didn't mention it, it showed an awkward fact: SAFM was not the best of the group - that title belonged to Cal-Maine Foods (NASDAQ:CALM).

Since 1997, CALM share price has appreciated at 16.5% CAGR, while the SAFM share price has appreciated at 11.2% CAGR.

These numbers clearly beg for answers to a big question: how did CALM outperform SAFM for such a long time?

Business Model and Growth Strategy

CALM produces, packages, and markets shell eggs and specialty shell eggs, accounting for ~23% of total US egg production. The business is vertically integrated: CALM breeds its own flock, manufactures feed, and produces eggs in its own facilities.

The company has grown by conducting strategic acquisitions and capacity expansions on existing production facilities since 1989. It has protected its margins by investing in process automation, and more recently, by shifting its product mix toward higher-value, cage-free eggs.

The egg business is both cyclical and seasonal. Feed represents 60-70% of COGS, and is driven by cereal and soybean prices. Consumer demand is also seasonal: egg sales are greatest in fall and winter, and lowest in spring and summer.

Industry Fragmentation Mean Acquisition Opportunities

As of December 31, 2015, CALM was the largest producer, representing 23% of domestic egg production in FY 2016. 96% of industry capacity was owned by 56 producers that each had flocks exceeding 1 million layers. The breakdown is given below:

CALM is the largest egg producer in the US by an enormous margin. The degree of fragmentation means the company will have ample opportunity to expand by buying bite-sized egg producers.

Recent Revenue Growth and Profit Margins

Revenue growth in recent years has been driven by a combination of production expansion and rapidly rising market prices for shell eggs and increasing sales of "specialty" versus regular shell eggs.

Sales & Production in '000s

FY 2016

FY 2015

FY 2014

FY 2013

FY 2012

FY 2011

Regular Shell Eggs

Sales ($)

1,243,377

1,059,070

990,073

900,259

809,163

684,470

Dozens eggs

791,058

830,770

812,032

772,140

739,915

689,045

Average price/dozen

$1.572

$1.275

$1.219

$1.166

$1.109

$0.993

Specialty Shell Eggs

Sales ($)

534,754

416,127

337,243

293,201

256,559

217,766

Dozens eggs

241,603

210,606

174,364

155,569

144,359

132,375

Average price/dozen

$2.213

$1.976

$1.934

$1.885

$1.777

$1.645

Looking even further back can show how cyclical CALM is. The following graphs will show that the company's profits have not been so "calm" in the past:

Owner Earnings were calculated according to Buffett's formula. Maintenance capex was estimated using the annual increment in depreciation of Property, Plant, and Equipment. The average net income margin and owner earnings margins during this period were 5.65% and 5.99%, respectively. The two metrics of profitability show internally consistent results, which is a good sign.

Three periods stand out with unusually high margins: 2004, 2007-2010, and 2013-2016. The next section will explain the cyclical behavior of profits.

Commodity Price Differentials Determine Profitability

CALM is a "commodity upgrader" business that earns the difference between input and output commodity prices. Wheat and corn provide the bulk calories that chickens require for metabolism, while soybeans provide the protein that the flocks convert into body mass and eggs.

The main commodity inputs and outputs can be summarized by a simple conceptual equation:

Wheat + Corn + Soybeans = Eggs

Since feed costs are 60-70% of COGS and egg sales are all the revenues, the relationship between feed and egg prices explains almost all profit margin fluctuations over the long run.

For the following chart, wheat, corn, and soybean prices were taken from IndexMundi. Egg prices are US city average prices provided by the US Bureau of Labor Statistics.

The circled portions of the graph correspond to the time periods of interest, as identified by unusually high profit margins. The trends here show:

  • FY ending 2004 - Egg prices and soybean prices rose, but wheat and corn prices did not. Margins fell in FY 2015 as egg and soybean prices returned to previous levels.
  • FY 2007-2010 - Egg, wheat, corn, and soybean prices rose proportionally and in parallel. FY 2008 profits were qualitatively identical to FY 2007 profits, but "magnified" because input and output prices moved in lockstep.
  • FY 2013 - Soybean prices soared, while all other prices did not change much. This coincides with the low profit margins for that year.
  • FY 2014-2016 - Egg prices rose, while wheat, corn, and soybean prices all fell in lockstep.
  • FY 2016 - Egg prices rose drastically, since the 2015 avian flu outbreak caused US egg production to drop. Since the outbreak was located away from CALM's facilities, the company earned spectacular profits.

Long Record Of Excellent Capital Management

CALM's balance sheet is currently spotless - lots of cash, and negligible debt.

The following table shows how Owner Earnings was calculated and how CALM spent its annual Owner Earnings. Maintenance capex was estimated with the annual depreciation of the PPE account. Growth capex represents investments in PPE.

Maintenance capex was estimated with the annual depreciation of the PPE account. Growth capex is the portion of cash flow from investing dedicated to buying PPE. Acquisition capex is the portion of cash flow from investing dedicated to acquiring businesses.

All amounts in millions

Net Income

Depreciation And Amortization

PPE Depreciation (Est. Maintenance Capex)

Changes in Working Capital

Owner Earnings

Dividend Payments

Growth Capex

Acquisition Capex

Net Borrowing

FY 2016

316

45

35

4

330

120

76

34

-23

FY 2015

161

41

34

-13

155

49

82

8

-10

FY 2014

109

37

27

-29

90

25

59

12

-11

FY 2013

50

34

27

-20

37

31

26

75

-11

FY 2012

90

31

27

19

113

20

27

0

-12

FY 2011

61

31

23

-26

43

25

21

0

-49

FY 2010

68

32

28

21

93

19

21

1

4

FY 2009

80

30

25

-3

82

35

26

91

32

FY 2008

152

25

21

-20

136

20

31

0

-16

FY 2007

37

21

19

0

39

1

23

12

-2

FY 2006

-1

21

10

-1

9

1

12

24

-3

FY 2005

-10

16

10

5

1

1

12

0

-7

FY 2004

66

17

15

5

73

1

11

0

-18

FY 2003

12

17

13

-5

11

1

13

0

-17

FY 2002

-11

17

12

-7

-13

1

16

0

7

FY 2001

7

18

15

3

13

1

14

0

-9

FY 2000

-17

16

15

-4

-20

1

28

36

42

Several features from this sea of numbers are noteworthy:

  • Dividend payments began in earnest in 2008. This coincides with the same year that the market "recognized" CALM as a good investment and began trading it at a higher P/B multiple.
  • Significant capex only occurred during or immediately after years with windfall profits. FY 2008, 2012, 2014, and 2015 illustrate this.
  • During FY 2004, CALM earned a windfall, and management apparently understood that given the past several years of poor profits, hoarding it would be wiser than spending that capital.

Recurring Risk #1 - Concentration and Antitrust Litigation

CALM represents 23% of egg production in the US. This makes the company a natural target for antitrust litigation. Over the past few years, individual suits by miscellaneous purchasers were amalgamated into class actions, some of which have been ruled in favor of CALM, and some of which may be ongoing still. Since this is not in my circle of expertise, I will not discuss any details.

Investors should be aware that as the company grows its share of total US egg production, the uncertainty caused by possible future lawsuits will also grow. Long-term CALM shareholders should keep an eye on these legal developments.

Recurring Risk #2 - Avian Influenza

Avian Influenza outbreaks have multiple consequences for poultry and egg producers: some negative, some positive. Much depends on the element of luck.

  • Flock destruction is short term. Since poultry require ~3 months to reach reproductive maturity, flocks are easily repopulated. The spring 2015 outbreak led to culling of 12% of the layer flock in the US. Flock numbers have largely recovered by now.
  • Producers unaffected by large outbreaks can enjoy temporarily fatter profit margins. Since eggs are a staple food and eggs represent a microscopic expense for households, almost all households can afford to buy eggs regardless of the price. This means small changes in supply can cause massive changes in egg prices, since consumers can mostly ignore the price.
  • Since eggs are highly perishable, neither producers nor consumers can accumulate inventories that can dampen price changes. The chart below, taken from my last SAFM article, shows how CALM share prices benefited from the 2015 outbreak and were bid up to spectacular highs:

  • Foreign import bans. While exports are a negligible component of CALM's revenues, the sensitivity of egg prices to the balance between supply and demand means the effects of foreign import bans on eggs on egg prices is very difficult, if not impossible, to calculate, since egg prices are influenced by so many factors.

    For instance, if Japan and Russia banned egg imports in response to avian flu in the USA, the negative effect of reduced foreign demand would cancel out the positive effect of reduced domestic supply. The difference between supply and demand changes would be one among innumerable other influences on egg pricing, and is probably impossible to separate from other contributing factors. Any effort spent on quantifying such fluctuations would probably not yield actionable conclusions.

Miscellaneous Risks

  • Customer concentration: In FY 2016, Wal-Mart (NYSE:WMT) and Sam's Club were the 2 largest customers, accounting for 28.9% of sales. The 10 largest customers accounted for 70.6% of sales.
  • Miscellaneous political pressures: Large customers and animal rights activists pressure suppliers to raise animals in conditions that conform to their demands.

Valuation and Conclusion

The following graph shows CALM's market valuation, tangible book value, and return on assets since the IPO. This will allow us to relate the company's operating performance and share price returns.

Before 2007, CALM traded at book value. Starting in 2008, the stock consistently traded above book value. The company began paying dividends in 2008, which should largely explain the valuation boost.

The most important takeaway here is also the most boring one: over the long run, share prices change according to profit margins.

Some brief valuation calculations (based on figures from the Owner Earnings chart):

  • 10-year average owner earnings (2007-2016) = $111.8M
  • Current tangible book value = $802.3M
  • 15x Average Owner Earnings = $1,677M
  • Book value + 10x averaged owner earnings = $1920M

Currently, its market cap is ~$1,830 million, suggesting that CALM is fairly valued. Investors with a time horizon of at least 10 years should be well rewarded.

Supporting Documents

  1. Financial_Data.xls
  2. Commodity_Prices.xls

Disclosure: I am/we are long CALM.

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.

Additional disclosure: I have a toy-sized long position in CALM.

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