This morning, Quad 7 Capital's BAD BEAT Investing discussed Tyson Foods (NYSE:TSN) as a buy strong buy under $60. Here is the deal. With fears over inflation, rising feed and labor costs, and international tariffs, investors have been jumping ship. We believe at $59 a share, the Street is mispricing the stock. In this column, we will describe what we are seeing in this leading world supplier of proteins to industry and retail supermarkets. Currently, we have seen an extended selloff and we believe it is time to get long.
Investors have slowly sold off shares of Tyson (and that of comparable businesses) in recent weeks. Both traders and long-term investors should be excited at these levels. The stock is cheap on a valuation basis at 7 times trailing earnings and even cheaper on a forward basis. The problem is that investors are both profit taking and selling on inflation/cost fears. Shares have pulled back significantly in 2018 and are at $59 at the time of this writing:
Source: BAD BEAT Investing
While Tyson has been a great trading vehicle, specifically on the short side of late, it is our belief that the stock is a strong long-term buy that investors should be taking advantage of following this extended dip. We believe another buying opportunity is here not just because shares are declining, but because we have been encouraged after the recent earnings.
Revenues have been growing at Tyson, in part helped by acquisitions and in part by organic growth. Take a look at Q3 over the last few years:
Source: SEC filings, graphics by BAD BEAT Investing
Momentum coupled with performance relative to the Street's expectations drive action in a stock. Right now, momentum is a bit negative, but the value case is building. While the revenues came up slightly short on the top line versus consensus projections, sales still grew. For many quarters, Tyson has exceeded our projections, and so while a revenue miss is concerning, we are not concerned with the long-term implications of the sales number.
We were looking for revenues of approximately $10.20 billion, and at $10.05 billion, Tyson missed our expectations by $150 million. Yes, this is a miss, but year-over-year, the company saw sales that were up 2% in Q3.
We felt this top line could weigh on earnings, but expenses were well managed and this boosted to the bottom line.
Despite coming in just short of our expectations, with a 2% increase in revenues, we have to be on the lookout for increases in the expense category which could weigh on income. Rising sales are nice but only if it translates to stronger earnings. After all, we invest in companies that we see as boosting earnings over time.
That said, we were pleased that the cost of sales were up just slightly (1%) to $8.75 billion from $8.65 billion last year. With a 2% rise and sales and nearly flat expense increases, gross profit increased almost 9% from last year.
After factoring in selling and administrative expenses, operating income rose. In fact, operating income rose significantly to $802 million, up from $697 million or 15%. When we make adjustments for items impacting comparability from last year, this backs out certain key expenditures. This increase was underappreciated by the Street in our estimation, even when making adjustments, operating income was up 8% from last year. When we account for the expanded operating income and a more favorable tax rate, we see earnings per share rose:
Source: SEC filings, graphics by BAD BEAT Investing
The company saw its adjusted earnings per share come in at $1.50 per share, up 17% year-over-year from $1.28 per share last year. Given that the top line came up a bit short, and expenditures were well managed, our earnings expectations were exceeded by $0.02. These earnings further surpassed consensus estimates by $0.04. These are promising results. To help understand where the sales and expenses are coming from, let us look at each segment in more detail.
The chicken segment is volatile thanks to the movement in poultry prices and feed costs. This segment saw key growth. Tyson saw sales volume that was essentially flat while pricing rose 3.7%, year-over-year. In Q3 2018, the company saw sales of $2.973 billion versus $2.870 billion last year for chicken products. However, expenses have weighed in this category, along with most others. Thanks to higher expenses offsetting revenue increases, adjusted operating income fell to $196 million versus $298 million last year.
Sales volume were about flat due to sluggish demand for certain chicken products, partially offset by incremental volume from business acquisitions. Average sales price increased due to sales mix changes and price increases associated with cost inflation. Due to increased labor, freight, and growth expenses, in addition to $89 million of higher feed ingredient costs, adjusted operating margin narrowed. We want to point out that the company's cost fitness program should help benefit operating margins moving forward.
Beef is the largest contributor 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, though in the present quarter, we saw prices recede.
In Q3 2018, the average sales price for Tyson's products fell year-over-year by another 2.8%. However, this did not weigh on demand as volumes were up 2.7%. Sales were flat at $3.993 billion versus $4.000 billion last year. We were pleased to see that operating income widened significantly to $319 million from $147 million thanks to improved costs savings on live fed cattle expenses, despite increased labor expenses, and higher freight costs.
The pork segment was also once again volatile as well and margins were compressed. The segment saw a decline in sales of 9.4%. Sales fell thanks to a decline in volume of 2.1%. This was compounded by a 7.4% decrease in prices. As such, revenues took a hit, and this is where much of the top line miss was generated. What is more, thanks to declining revenues, Tyson's operating income fell here to $67 million from $136 million in last year's quarter.
With sales prices falling, margins were hit. In addition, operating margins were hit hard thanks to higher labor and freight costs. We will be closely watching this segment as the company's cost savings program develops this year with the expectation that the company can get margins back on track.
Turning to prepared foods, the addition of AdvancePierre benefited the segment here in Q3. Sales were up 9.7%. They came in at $2.132 billion from $1.944 billion. Both average sales price and volumes increased heavily. Sales prices jumped 6.8% while volume rose 2.7%. Operating income also widened to $249 million from $195 million, while margins expanded from 10.0% to 11.7%.
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 as well as associated feed costs.
Domestic protein production looks like it will rise this year into next, though heavy exports and high domestic demand could offset some of these rises. In fiscal 2018, USDA indicates domestic protein production should increase around 2-3% 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. With the trends we have seen year-to-date, as well as the weakness in pork, we are updating our 2018 outlook.
Given the trajectory of sales and strength in most segments, we see sales rising in the mid- to high single-digits. We are looking for $40.25 billion to $41.2 billion for the year on the top line (revised lower from the top end $41.4 billion). Including the positive impacts of tax reform and assuming comparable expense growth this year, we anticipate adjusted earnings per share of $6.55-6.85 (up from $6.50 on the low end).
We like the stock here, especially after a several month selloff. The outlook remains solid and in our opinion the selloff is overdone.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TSN over 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.