Tyson Foods: How We Are Playing The Protein Giant

Summary

• Tyson Foods stock has pulled back heavily from its highs of $84 a few months ago and following the Q2 earnings we are intrigued.
• The company's segment performance is highlighted to inform trends in the top and bottom line performance.
• The Street is underappreciating adjusted operating income growth as well as the company's cost savings initiatives.

This morning, BAD BEAT Investing highlighted Tyson Foods (NYSE:NYSE:TSN) as a buy at $65.25. In this column we wish to describe to our followers what we are seeing in this leading world supplier of meats/proteins to industry and retail supermarkets. We have been back and forth on the name over the years, generally calling for buys when the stock was at a discount, and then becoming more cautious when such discounts dissipated. Currently we have seen a selloff and we believe this is an attractive level to get long shares once again.

Recent price action

Shares have pulled back significantly in recent months, and are at $65.25 at the time of this writing:

Source: BAD BEAT Investing

While Tyson has been a great trading vehicle, it is our thesis that the stock is a strong long-term buy and hold. However, as you can see, the stock has been steadily pulling back in recent months, and as such, we believe another buying opportunity may be upon us here after the recent earnings.

In the present column, we will discuss performance relative to our expectations for the name, and highlight key strengths and weakness you need to be aware of. Further, we offer our updated 2018 projections.

Top line considerations

When it comes to the top line, we see that revenues have been growing at Tyson. Take a look at Q2 sales the last few years:

Source: SEC filings, chart created by BAD BEAT Investing

Momentum coupled with performance relative to the Street's expectations drive action in a stock. For many quarters, Tyson has exceeded our projections, but we will be the first to say that the company came up short this quarter, a least on the headline numbers.

We were looking for revenues of $9.85 billion, and at $9.77 billion, Tyson missed our expectations by $80 million. Yes, this is a miss, but year-over-year, the company saw sales that were up 7.6% in Q2.

Of course, the stock is seeing a bit of pressure thanks to the weaker than anticipated top line, which also weighed on income metrics. Still, these consistent sales increases in recent years are strong, and are both organic and acquisition related. The question we have is that with revenues growing at such an impressive pace, are earnings following suit, or are expenses weighing on the bottom line?

Income metrics commentary

Despite coming in just short of our expectations, with a 7.6% increase in revenues we have to be on the lookout for any changes in the expense category which could weigh on income. Rising sales are a benefit but the bottom line needs to expand as well when we are looking at a name from a long-term viewpoint.

That said, we were slightly disappointed on the income front given that the cost of sales rose to $8.75 billion from $8.04 billion last year, weighing a bit on profit. Gross profit fell 1.9% from last year, and this was perhaps the weakest takeaway from this quarter. what about operating income and earnings?

After factoring in selling and administrative expenses, operating income fell. In fact, operating income fell significantly to $498 million, down from $571 million. When we make adjustments for items impacting comparability from last year, this backs out certain key expenditures. Controlling for such expenditures, adjusted operating income rose to $694 million, a sizable increase from $623 million last year. This increase was underappreciated by the Street in our estimation. When we account for the expanded operating income and a more favorable tax rate, we see earnings per share rose:

Source: SEC filings, Chart created by BAD BEAT Investing

The company saw its adjusted earnings per share come in at $1.27 per share, up 26% year-over-year from $1.01 per share last year. Given that the top line came up a bit short, and expenditures weighed a bit on gross profit, these earnings further missed our estimates by $0.03, as we were looking for $1.30. To help understand where the sales and expenses are coming from, we need a segment by segment breakdown to understand the most recent quarter in more detail.

Chicken segment

The chicken segment has been volatile with poultry prices in recent years. This segment however notched important growth. Tyson saw sales volume and average sales prices that rose 2.0% and rose 3.6%, respectively, year-over-year. In Q2 2018, the company saw sales of $2.959 billion versus $2.798 billion last year for chicken products. However, expenses have weighed in this category, along with most others. Thanks to higher expenses offsetting revenue increases, operating income fell slightly $231 million versus $233 million last year.

Sales volume for chicken products were up due to strong demand, but let us not forget the incremental volume from the AdvancePierre acquisition. Average sales price increased a lot, but this was due to sales mix changes. Operating income benefited from cost savings programs. The positive incremental impact of AdvancePierre and slightly lower feed costs, but higher labor and freight expenses weighed on the company.

Beef segment

Beef has become the flagship product for Tyson in terms of the contribution to the top line. However, this is the one commodity that still concerns us, as too high a price can hurt demand. The price of beef really has been rising quite heavily the last 5 years, and as we all know, a steak dinner consisting of quality cuts for a family of four is growing to be prohibitively expensive.

In Q2 2018, consumers saw the average sales price for Tyson’s products rise year-over-year by another 3.7%. However, this did not weigh on demand as volumes were up 1.8%. Sales were up to $3.681 billion from $3.487 billion. However, operating income fell to $92 million from $126 million thanks to higher live fed cattle costs, increased labor expenses, and higher freight costs.

Pork segment

The pork segment was also once again volatile as well and margins were compressed. The segment saw a decline in volume of 1.1% which stuck out. However, this was compounded by a 1.8% decrease in prices. As such, revenues took a hit, and this is where our top line miss was generated. Revenues were up slightly to $1.265 billion from $1.302 billion last year. Tyson's operating income fell here to $67 million from $141 million in last year's quarter.

This was a result of average sales prices falling. Margins were hit hard thanks to higher labor and freight costs and a one-time cash bonus to frontline employees of $12 million. We will be closely watching this segment as the company's cost savings program develops this year that came to pass after the AdvancePierre acquisition.

Prepared foods segment

Turning to prepared foods, the company had been struggling but the addition of AdvancePierre benefited the segment here in Q2. Sales were up to $2.147 billion from $1.751 billion. Both average sales price and volumes increased heavily. Sales prices jumped 10.6% while volume rose 10.9%. Operating income also widened to $123 million from $87 million, while margins expanded from 5% to 5.7%.

As we look ahead, we continue to expect growth in prepared foods and chicken, while pork and beef are sensitive to the overall protein markets.

2018 projections

Looking ahead it seems that domestic protein production my rise according to the company but heavy exports and high domestic demand could offset these rises. In fiscal 2018, USDA indicates domestic protein production should increase approximately 3% from fiscal 2017 levels, but strong export markets should partially absorb the increase. Through a combination of synergies from the integration of AdvancePierre and stringent cost controls, Tyson's cost savings program is estimated to result in net savings of $200 million in fiscal 2018, $400 million in fiscal 2019 and $600 million in fiscal 2020 including additional savings of $200 million. This reality is underappreciated by the Street, so we are taking advantage of the selloff today.

In addition to having AdvancePierre, the tax reform law should significantly benefit the bottom line. Given the trajectory of sales and strength in most segments, we see sales rising in the high single-digits. We are looking for $40.25 billion to $41.4 billion for the year on the top line. Including the positive impacts of tax reform, and assuming comparable expense growth this year, we anticipate adjusted earnings per share of $6.50-$6.85.

Final thoughts

We like the stock here especially after a several month selloff. Sales will continue to rise at a strong pace as well, and so long as demand remains strong, we expect solid performance in 2018 and beyond. Although the dividend is low, there is room for growth there. The outlook remains solid and we would add to long-term holdings at $65, and we did so this morning

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Analyst’s Disclosure: I am/we are long TSN. 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.