Description

Here is a company that trades at $38/share and is poised to generate $6-8/share of cash flow in 2004, or roughly 1/5 of its current Enterprise Value. That said, Cal-Maine Foods is nonetheless overvalued and makes for a fantastic short. In short, Calm is a boring company in a commodity business, which happens to be currently benefiting from record high egg prices. However, Mr. Market is overcapitalizing future earnings (surprise!). Margins in the egg business will soon enough return to a level apropos with historic performance, serving as a catalyst.

Company Overview:

Cal-Maine Foods is primarily engaged in the production, cleaning, grading and packaging of fresh shell eggs for sale to shell egg retailers. The Company had sales of approximately 571 million dozen shell eggs during the fiscal year ended May 31, 2003 (fiscal 2003). It primarily markets shell eggs in the southwestern, southeastern, mid-western and mid-Atlantic regions of the United States. Shell eggs are sold directly by the Company primarily to national and regional supermarket chains.

Thesis Overview:

Looking at a 1 yr stock chart of CALM reveals that the company’s share-price has appreciated from $3 to $38 in less than one year. The entire increase is due ONLY to an increase in the ASP of eggs from $.62 to $.94 for the most recent quarter vs last year’s quarter. And because the price of producing eggs is relatively fixed, that took Cal-Maine’s operating margin from 5% to 26% for the same periods. Historically, operating margins in this business have been very volatile, but have averaged roughly 7% over the past 7 years. An impending return to this normal margin implies a significantly lower share-price, even if the company continues to generate massive cash-flow for a considerable period.

Industry Background:

Producing eggs is not rocket science, and may even be simpler to understand than Bowd’s hypothetical goat farm. Producing eggs is a commodity business with low margins for the following reason:

-Eggs are fungible, there is no way to add a unique feature, or differentiate the product in any way that is not easily duplicable by other industry players

-There are over 65 egg producers in the US, and although Cal-Maine Foods has 13% of US market-share they are far from a monopoly and the industry certainly isn’t an oligopoly by any stretch of the imagination

-There is no proprietary technology, patents, or special know-how that adds significantly to production efficiency that is not accessible to other industry participants

-No economies of scale/scope (SGA/dozen does not decline as production capacity rises. E.g. over the past 28 quarters Cal-Maine Food’s production capacity has grown over 80% by both organic and inorganic means, yet SGA/dozen shows no trend, remaining steady around its average of 7.9cent/dozen.) So in short, Cal-Maine doesn’t get any points for being big.

Basically, there is nothing within the company’s control that can meaningfully boost ROIC for any meaningful period of time. In short, all egg producers are victims of the tides of fortunes driven by 2 factors: Market Price of Eggs, and Feed Prices. This brings us to the determinants of egg spot prices: Supply and Demand.

Capacity and Demand:

The egg producing business has been in a long term decline due to a secular trend away from eating eggs, as per capita consumption in the US has been declining ever since 1948. Recently however, low-carb diets such as Atkins and favorable health studies have contributed to a reversal in demand. Egg producers were caught flat-footed going into 2003 when demand unexpectedly kicked up, and as a result, the average prices received by farmers in the US is up 50% over the past 12 months. The current $1.14 for NY Grade A is at an all time high, and allowed Cal-Maine to earn a 26% operating margin in the most recent quarter.

So now you are no doubt wondering how long it will take for prices to come down. Let me answer that with the following: Firstly, it only takes about 3 weeks to hatch a new hen, and 20 weeks for that hen to start laying eggs. Facility expansions can take longer, but still only about a year. In addition, there is great motivation for industry participants to expand capacity if they feel industry prices will remain high. For example, I am projecting that egg ASPs for 2004 of $.94. Running $.94/dozen through Cal-Maine Foods’ P/L gets me to and operating (EBIT) margin of 25%. Combine that with an asset turnover of 1.5 gets you to a 37.5% pre-tax ROC. (Pretty insane for a commodity biz.) If we use more realistic, but still high egg price of $.80, we have a 12% OM * 1.3 Asset turnover gives us a 15.6% pre-tax ROC. So clearly egg producers have incentive to expand capacity at these prices, and since all of them now have access to internally generated cash-flow to fund expansion, margins will eventually be driven back down to the historic 7%.

Absolute Valuation: DCF

. Without going into too much details on just how I did my DCF (that’s why you are allowed to post questions), here were my assumptions:

- 7% for terminal value’s EBIT margin (Over the past 28 quarters, Cal-Maine Foods EBIT margin has averaged 5.4%, yet when I graphed CALM’s ASPs vs. USDA’s ‘Prices Received’ index, you can see that Cal-Maine was selling at a significantly lower price than the industry average during ‘99-’00. When I pro-forma their income statement with USDA’s average egg prices, we get a 7% long term EBIT margin)

- 11% discount rate, with 3% terminal growth (which is probably conservative in light of their cost of debt)

- Effective Taxes at 37%

- ’04 Egg ASP’s at 94 cents/dozen then returning to the 7% EBIT margin for ’05 and beyond (The USDA projects Grade A egg prices for ’04 at 88-94 cents/dozen. Grade AA and B eggs sell for less and roughly speaking, ‘all grades’ ASPs should weigh in about 10-15% less than the Grade A’s. So my projection of ASPs for ‘04 should be way above what will actually be realized. The conservative stance is OK seeing how poor USDA price projections are.)

Using all the above I get a TEVof ~330mil, minus net debt of $75 mil and divided by 12.6mil share count= $20/share or just over 50% the current share price. For those of you who love stress testing variables, holding all other variables as stated above the current valuation of Cal-Maine implies:
1) A long term EBIT margin of roughly 15%
or
2) An after-tax WACC of 7.1% (which is below their cost of debt)

(If you want to take a look at all of my excel work which includes, dcf, historic egg prices and asps, historic financials, volumes etc. point to: http://www.geocities.com/doobadoo/calm.xls )


Historic Enterprise Value/Unit of Production:

Before 2003, this company has never traded for more that $0.40/dozen of annual egg production. The average is actually $0.33. Right now it’s trading at approximately $0.87/dozen. Even if we assume that they generate $100mil or $8/share of FCF in ’04, it’s still trading at a value of $0.70/dozen. Again, nothing has fundamentally changed about this company except that egg prices are currently out of control.


Recent Comp Transaction:

In August 2003, Pilgrim’s Pride bought ConAgra’s chicken division, making them the 2nd largest chicken producer in the US. While chicken production isn’t exactly eggs, it’s a similarly a commodity (there is a little branding to it) but they still only paid 1x book. Cal-Maine Foods currently trades at 5x book, and even if you give them that $100mil they may generate in ’04, its still trading at 2.5x book.

Risks:

This is a closely held company and the float is a bit small. The CEO, Fred Adams, owns about 50% of the company (but yet nicely structured it so that he has 66% of the voting power). The ESOP plan makes up another 30%. So that is why the stock is so volatile. Don’t worry too much though, the float is getting bigger due to insider selling.

Mark-to-Market Risk: Cal-Maine is going to post the best year in its corporate history, possibly generating $8/share of FCF or 1/5 it’s EV. This may send the stock to greater heights, at which time you probably should short more.

Doobadoo May Be Wrong Risk: It may take significantly longer than 1 year for margins to go back to 7%, but very doubtful. We may be seeing the beginning of a reversal of a 55 year trend of eating fewer eggs, and in addition this industry may consistently underestimate future demand, keeping egg prices a lot higher than any one thinks. However, I think this is unlikely, and that my valuation assumptions are conservative enough (as well as the margin of safety) for this idea to work out over the next 2 years.

Catalyst

Margins returning to more normal levels in ’05: The great thing about this idea is that EBIT margins for Cal-Maine have been very volatile over the past 28 quarters that they have been a public company. That 7% historic EBIT margin I keep throwing in your face has a quarterly standard deviation of 5.9%. In short, with operating margins running at 25% they can’t get much higher, and with 5.9% quarterly volatility in those margins (with the next move almost certainly down), its hard to imagine a world in which this company does not disappoint over the next 2 years, at which point I believe the stock will get cut in half.

Continued massive insider selling: Pay no attention to those executes blowing out stock! Didn’t want to get into it in my write up, but this company has so many Form 4’s reporting selling over the past few quarters its very annoying to try to find their Q’s. Dimensional Fund Advisors used to own 5.8%, which they bought about 3 years ago and just filed the 13G/A letting us know they are now at 3%.