Playing Chicken With Tyson

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About: Tyson Foods Inc. (TSN), Includes: PPC, SAFM
by: Kevin Mackie

Summary

Using different methods of valuation can yield WILDLY different results. Which one should be trusted?

Cash is King, but there are other things to consider.

Based on valuation, I believe TSN is well positioned to beat the market average in the next five years.

My recent plunge into discounted cash flow analysis has brought me immense insights. Chief among them is the fact that it is by no means a perfect way to value a company. Trusting perfectly in DCF analysis is to put 100% faith in what Warren Buffett says about what a company is worth:

It is the discounted value of the cash that can be taken out of a business during its remaining life.

Personally, I can't subscribe to that idea, at least not completely. My reasons for this are:

1) There are a lot of market participants, and not all of them subscribe to the above. Therefore, market prices will fluctuate under influences apart from estimates of discounted cash flows.

1.1) I will never own an entire business. I can only trade its common stock in the market place. Therefore, I have to concern myself with much more than how much cash I can get from that business. If I were to purchase an entity outright, then certainly I would only be concerned with it's cash generation capabilities. But as a buyer and seller of securities, I also have to be concerned with acquisition premiums, overall market sentiment that has nothing to do with the business itself, the impact that the buying and selling of any ETFs it is included in will have on the stock price, etc. While cash is king, ignoring the queen, princes, princesses, dukes, archbishops, generals, jesters, commoners, peasants, paupers, revolutionaries, and piss boys is to forget that a kingdom is made up of much more than just the man at the top. Market place dynamics require us to look at much more than just cash, sire-ship notwithstanding.

2) There is a universe of estimates that could be included in any DCF analysis. Tweaking any of those variables could have outsized impact on the end result, especially the calculation of a terminal value. Can any of us really know how long any business will last, let alone how much it can grow cash in that time frame? No one can estimate anything with perfection, which throws into question the efficacy of a DCF analysis. The result is only as good as the inputs.

Given these truths, I am going to value Tyson foods (TSN) using a variety of methods and then use all of them to come up with a value at which I can expect compounded annual returns of 12-15%. DCF is a useful part of the exercise, but I am not blind to its short-comings. In short, Tyson has been range bound around ~$60 for months. Is now a great time to get in?

EPS Growth Capitalization

My first step is to do a quick, back-of-the-napkin check on where shares should be trading in a few years based on conservative EPS growth estimates. If Tyson manages to grow EPS by only 5% a year through 2024, then they will have $10.44 worth of earnings. Assuming the P/E multiple remains around its current five year average of 14.79, that would result in a stock price of $154.40. Requiring a 15% return per year between now and then discounts that value back to a present value of $66.75, a 7.8% discount to Nov. 8 closing price. Frankly, I think Tyson can manage to grow earnings by more than 5% without much trouble. So the only thing standing in the way of an easy 15% return is a multiple contraction.

The earnings multiple is around 8 right now, as the market punishes TSN in the face of tariff headwinds. The current tariffs from Mexico and China on imported meats has reduced the demand for Tyson products internationally. In conjunction with overproduction, this had led to a domestic meat glut, with many producers literally having freezers full of goods they can't sell. This will naturally weigh on commodity prices and hurt margins. However, recent developments have shown both parties of the tariff battle willing to come to the table to work something out, at least between China and the US. Sentiment around TSN will improve if these talks lead to resolution. This should allow the multiple to perk back up, but not until the oversupply situation resolves itself will the multiple resume historic levels. The only thing that will solve these issues is time. Between now and then, there may be a lot more short term pain. While I don't give much credibility to analyst price targets, it is at least worth noticing that some analysts are predicting a price target of $40 for TSN in the next twelve months. While I would be surprised if the stock contracted that much, I would not be shocked to see further downside when they report earnings next Tuesday. While much bad news may already be priced into the name, direct peers Sanderson Farms (SAFM) and Pilgrims Pride (PPC) both had heavy misses on both earnings and revenue for Q3, and if the miss is outsized at TSN it could be a bad day.

DCF Analysis

Here is where things get more nuanced. Let me first explain my assumptions for each component of my analysis, and then discuss the results.

Revenue - I predict revenue to growth at a CAGR of 4% through 2024 for Tyson. This is roughly in line with the rate at which experts are predicting global protein demand to grow at (3-5%) during the same time period. Now, I think this is a rather conservative prediction. Due to Tyson's scale, dominant market share, and the strength of their brand, I think they will be able to capture an outsized portion of that 3-5% growth. But I am sticking with the 4%.

Operating Costs - Tyson has been able to improve margins over time. As they have diversified into beef and pork, their margins have become less exposed to commodity swings in any one of those categories. Furthermore, they have a large and growing line of value added products that they have stronger pricing power over. As they continue these initiatives, I believe that TSN will be able to continue strengthening margins over time, albeit not immensely. Here are my margin estimates through 2024:

2019 2020 2021 2022 2023 2024
Operating Margins 7.2 7.4 7.6 7.8 8 8.2

Taxes - I assume a tax rate of 24%, in line with management expectations.

CAPEX - To arrive at a capex number, I simply calculated how much capex TSN has as a percentage of revenue each year for the past ten years, and then average those values. While imprecise, it does provide a decent approximation of how CAPEX will trend.

Working Capital - I usually follow the same process with change in working capital as I do with CAPEX. However, TSN is a bit of an anomaly when you look at the numbers. Here is what working capital (bottom) has been for the past ten years in relation to revenue (top):

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
26862 26704 28430 32266 33278 34374 37580 41373 36881 38260
2258 2382 2073 2406 2573 2594 2424 1846 2126 2226

Even though revenue has grown at a decent clip, working capital hasn't budged. I think this is something to be applauded. TSN has figured out how to systematically synchronize all the moving parts of the business so that it can grow without requiring excess working capital. This being the case, I am only figuring in a change in working capital of 500,000 for each year.

Terminal Value - I presume a perpetual growth rate of 3% for TSN.

After plugging in all these numbers for each year through 2024 and discounting the resultant free cash flow back to the present, I add those values together with the discounted terminal value. Then, I subtract current debt and divide by shares outstanding. Using 12% as my required rate of return, I end up with an intrinsic value of ~$27 per share. This is of course WAY below current trading levels. So what gives? The outlier here is debt. They carry over $10 billion worth of debt on the balance sheet. If TSN were debt free, the intrinsic value would be in the mid 50's, not at all far off from the current trading range. In fact TSN saw $56 back in August. I think that the best way TSN can reward shareholders right now is by paying down debt expeditiously. No dividend raises. No acquisitions. Pay down debt, and perhaps buy back some shares if things go south. The name of the game is capital allocation. I am eager to hear the earnings call transcript to hear how management plans on navigating the future given the situation on both a macro and company level.

Conclusion

Had I dug into valuation earlier on and with greater detail, I would have played TSN differently. After getting in around $60 in the middle of 2017, I excitedly watching Tyson rocket to ~$84. Once it retraced back down to the mid $70's, I bought more for no other reason than the fact it had dropped a lot. That old truism came into play: just because the price has dropped doesn't mean it won't drop more. I am okay with my cost basis, but will certainly add if TSN goes back down to the mid-$50s or lower. Using both DCF and EPS growth capitalization to come up with an intrinsic value (especially as debt goes down), I believe that a $55 price will bring long term returns of 12% a year. I will wait until then before adding to my position. But make no mistake, the headwinds are real and could persist for some time. No when knows when international trade will be worked out, and no one knows when supply will normalize. However, I feel strongly that TSN is well positioned to bring returns slightly better than the market average over the next five years or so, mostly due to valuation.

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.