Sanderson Farms: A Tough 2019, But Optimistic For 2020

Dec. 24, 2019 9:02 AM ETSanderson Farms, Inc. (SAFM)1 Comment

Summary

  • Sanderson Farms currently is trading at 70 times its FY 2019 profit.
  • The market already is anticipating a substantial improvement of the company's financial performance in the current financial year as the outlook is improving.
  • This doesn't mean Sanderson Farms is still cheap, and the outlook beyond FY 2020 remains volatile.
  • The higher volatility results in higher option premiums and writing out of the money put options might be the best strategy here.
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Introduction

Sanderson Farms (NASDAQ:SAFM) had an excellent 2019 as its share price will end the year approximately 80% higher than where it started on Jan. 1. An excellent achievement, especially considering the negative impact of the higher corn prices in the final quarter of its financial year, caused by late harvests. 2018 was a weak year, 2019 was slightly better, but Sanderson Farms appears to be quite optimistic for the current financial year and beyond as it expects its EBIT and EBITDA to show a substantial increase.

ChartData by YCharts

2019 was a better year than 2018

It was a relatively weak fourth quarter where Sanderson Farms saw the market price for boneless breast meat for food service customers (requiring a big bird) decrease to historically low levels after Labor Day. This means the trend in 2019 was similar to 2018 when Sanderson also had to deal with a weak fourth quarter. Fortunately this was just a temporary issue as poultry prices started to increase again in November and December and Sanderson appears to be relatively optimistic about the start of the current financial year.

Source: financial statements

Back to FY 2019. Sanderson Farms reported revenue of $3.44B, an increase of just more than 6% compared to FY 2018, but unfortunately the cost of sales also increased by a similar percentage. However, the SG&A expenses fell by almost 5% and that saved the day as that kept the total increase of the operating expenses limited to just 5%. And the difference between a 6% revenue increase and a 5% increase of the operating expenses had a huge impact on the operating income of this low-margin business as the operating income more than doubled to just short of $68M.

Unfortunately the interest expenses increased, but Sanderson Farms was still able to report a pre-tax profit of almost $64M and a net income of $53.3M or $2.41/share. This means Sanderson Farms is currently trading at approximately 70 times its FY 2019 net income and that obviously is quite expensive, so perhaps the cash flow result provides more reasons to be optimistic about Sanderson Farms at the current valuation.

The overall cash flow performance was disappointing, but Sanderson expects improvements

The operating cash flow in 2019 was $206.8M, but after adjusting this result for changes in the working capital position, the adjusted operating cash flow in FY 2019 was almost exactly $205M, compared to $184M in 2018, so there clearly was a noticeable improvement of just over 10%.

Source: financial statements

Additionally, the capex in 2019 was still quite high at $250M which means Sanderson Farms was essentially free cash flow negative (again, as the $309M capex in 2018 also prevented Sanderson from posting a positive free cash flow result). However, a large part of the 2019 investments were focusing on growth and the presentation on the Investor Day shows the maintenance capex was just $135M, almost exactly in line with the $133M in annual depreciation expenses.

Source: Investor Day presentation

This means that despite the tough year, on a sustaining basis, the free cash flow result was around $70M ($205M in adjusted operating cash flow minus the $135M in maintenance capex). Still not great, but at least Sanderson remained free cash flow positive in a tough year.

While the free cash flow result in 2019 was a bit disappointing, Sanderson Farms is confident in a better performance in 2020. The consensus estimates are pointing in the direction of a $200-250M increase on the EBIT-level, and a similar increase of the EBITDA towards a result of in excess of $450M. These expectations might seem a little bit aggressive but Sanderson Farms’ management team confirmed these assumptions were realistic during the full-year earnings call.

According to Sanderson, approximately $50-80M of the anticipated EBIT increase will be generated through internal efforts while the company also is banking on increased poultry exports to China as the Asian swine flu is still spreading around the world and China is looking at other sources for protein needs. Sanderson expects a combination of internal cost savings and efficiency gains with potentially higher poultry prices and higher production numbers to contribute to a higher EBITDA and EBIT result. Additionally, the new facility in Tyler, Texas, is still running at just 75% of its capacity so it wouldn’t be unfair to expect a higher utilization rate and additional economies of scale at that plant.

Investment thesis

Sanderson Farms hasn’t generated free cash flow in the past two years due to the investments in growth but as the sustaining capex is just $135M and the capex guidance for FY 2020 will be $200M (including growth investments) which means Sanderson Farms should be free cash flow positive including the growth investments and should make a substantial amount of sustaining free cash flow (which only takes the maintenance capex into account).

But as the share price already has increased to $175, it looks like the market already is pricing in a serious improvement of Sanderson’s financial performance in 2020. But with a net cash position of around $40M, Sanderson’s balance sheet remains quite robust and this obviously also attracts investors.

I could be interested in Sanderson Farms, but only at the right price and I’d like to wait for a pullback or write an out of the money put option as for instance the P150 expiring in May is trading at $3.50-4.10 which is an acceptable option premium while waiting for Sanderson’s share price to reach "buy territory."

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This article was written by

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We zoom in on capital gains and dividend income in European small-caps
As I'm a long-term investor, I'll highlight some stockpicks which will have a 5-7 year investment horizon. As I strongly believe a portfolio should consist of a mixture of dividend-paying stocks and growth stocks, my articles will reflect my thoughts on this mixture.

Disclosure: I/we 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.

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