Description

CALM (short).  Fair warning: borrow is tight, short interest = ~95%. 

Cal-Maine is an unremarkable egg producer in a commodity industry that, over the long term, earns its cost of capital and should trade at 1x 2009(E) book value instead of 2.3x.  (56% price drop).  Currently, the industry is earning ~100% pre-tax ROC, more than double anything since WWII.  However, by year end the supply/demand for egg layers will rebalance, leading to an 80%+ drop in earnings.  In preparation, non-family insiders have aggressively sold almost every share they have into this rally. 

 

Previously written up on VIC, I would normally hesitate to repeat a good write-up, but industry supply constraints (and earnings) have been much stronger than most anticipated, so I add my analysis.

 

MC: $704M, EV: $708M

Share price: $29.5, Target price $12 - $15 (depends on valuation method)

Expected CY ’08 EPS: $4.7, CY ’09: $0.79

 

Industry-wide pre-tax ROIC: 1959 – 2008

2008:                           98%

Average:                     10%

High before ‘08:         37%

Low:                            -20%

Std dev:                       19%

 

 

Table of Contents:

1)     Background on Supply/Demand imbalance and why will rebalance 

2)     Why this is a commodity business

3)     Prior egg bull markets – analysis

4)     Corn price (feed) vs. egg price relationship

5)     Insider actions

6)     Alternate thesis

7)     Valuation methods

8)     Risks to thesis

 

1. Current supply/demand imbalance – main cause

• Supply of “layers” (hens that lay eggs) dropped 4% peak to trough due new regulations that give each hen more cage space (fewer hens/cage)
• Before, chickens were put in battery cages (7-9 per cage) with an average of 53-56 square inches each, which does not allow for standing or resting.
• Now, US producers have mostly voluntarily agreed to expand hen space to 67 square inches phased in over six years (‘02-‘08).  Using the same facilities/cages, this removing ~15-25% chickens from each cage.  Happier chickens do lay ~7% more eggs, so net/net isn’t so bad.

 

What is the differential opinion/ what did people miss? 

• Everyone knew that cages would get smaller over four increments in 6 years.
• However, nothing I’ve read (including the official paper by the regulator) suggests an understanding that only one of those increments mattered and the other three made little supply difference. (But, practically the only two CALM insider open market purchases ever were Feb and July 2007)
• Why: Cage math –  two common cage size, each behave differently:
• The average large egg producer was mostly already complying with the 2002 regulations. Hence, little change at first incremental step.
• 24x20 cage (~50% of market):  The small incremental size changes (3 inches) meant that the 9 inch space change caused by removing one bird only need to happen once per three steps.
• 16x20 cage: Although two hens have to be removed, the first one hurts less because the remaining hens get more productive (lower mortality, more eggs per).  The second hen removed doesn’t matter as much.
• How/ When
• Post October 2006 hatches had the new size restriction, which meant April/May 2007 was when those hatches were mature and started laying, the same time that supply cratered.
• The industry is used to 1-2% supply changes, and can’t adjust that quickly to something of that magnitude

 

24x20 cage – hens per cage by year
 

Year	Regulation limit inches per hen	Actual space/hen	Hens/cage
April ‘02+	56	60.0	8
Oct ‘03+	59	60.0	8
Oct ‘06+	64	68.6	7
April ‘08+	67	68.6	7

 

16x20 cage – hen layer productivity goes up as space per hen increases

Year	Hens/Cage	Eggs/Hen	Productivity change	Total Eggs per cage	Net Egg Loss
April ‘02+	7	185		1295
Oct ‘06+	6	194	+4.9%	1164	-10.1%
April ‘08+	5	198	+2.1%	990	-14.9%

Sources: United Egg Producers; Caged Laying Hen Well-Being, An Economic Perspective

 

 

Data on new hens points to balanced supply picture late ‘08

• Current: YoY egg layer (hen) count down 2.4%
• Q4 ’08: 1.6% YoY increase
• November – December ‘07 pullet hatches (young hens) were +7% and +8.8% year over year (these will be layers by May/June, 2008).
• Pullet hatching YoY: Good forward indicator for prices 6-12 months later
• Late ’06: hatch rates down 7%, 2007 egg pricing high
• Late ’04: Pullet hatching up 10%, 2005 prices cratered
• Mid ’07: Hatch rates down, 2008 prices sky high

 

CALM Gross Margins vs. Hen Flock size.  As one would expect in a commodity industry with stable demand (usually), changes in supply drive margins.  Seasonality drives some higher margins (around Christmas and Easter egg prices are higher)

 

Quarter            Flock size YoY           CALM GP       Stock Price

Q4 02              +0.0%                         24%                 $1.8

Q1 03              +0.3%                         21%                 $1.9

Q2 03              -0.1%                          23%                 $2.7

Q3 03              -1.3%                          34%                 $3.8

Q4 03              -0.8%                          35%                 $18.4

Q1 04              +1.4%                         28%                 $17.8

Q2 04              +3.1%                         10%                 $14

Q3 04              +3.4%                         5%                   $11

Q4 04              +2.5%                         17%                 $12.1

Q1 05              +2.5%                         3%                   $7.9

Q2 05              +0.3%                         1%                   $6.1

Q3 05              -0.4%                          13%                 $6.3

Q4 05              +0.7%                         20%                 $6.8

Q1 06              +0.1%                         14%                 $7.3

Q2 06              +1.8%                         7%                   $6.9

Q3 06              +0.8%                         18%                 $6.6

Q4 06              -0.5%                          25%                 $8.6

Q1 07              -1.0%                          24%                 $13.5

Q2 07              -1.9%                          18%                 $16.4

Q3 07              -1.5%                          34%                 $25.2

Q4 07              -1.1%                          46%                 $26.5

Q1 08              -1.0%                          38%                 $35.2

Q2 08E            +0.1%

Q3 08E            +1.2%

Q4 08E            +1.6%

 

 
Also, some investors have confused hatchings with flock size, and said that because hatchings were up 1% last year, than flock size ergo must go up, more eggs laid, prices down, etc.  However, this has to be looked at in conjunction with the flock age.

 

Flock size = existing hens – deaths – moltings – missings (exports) + hatchings.

 

Since the flock size was quite old last year (due to spike in hatchings in 2005, which die in 2 years), the 2007 hatchings went to replace those dead birds, and weren’t even sufficient.  The current flock age is several % below average vs. several % above average last year.

 

Still, precision is not available, as things happen (diseases, etc).

 
 

2. Why this business is a commodity business

1)     No returns to scale.  Since 1993, Cal-Maine SG&A per egg has increased 2.2%/year even as volume has increased 80%. The economics are local.

2)     Highly fractured market.  61 companies have flocks of 1 million hens (280 million hens nationwide).  Interestingly, there have been exactly 61 producers with 1 million hens or more in the years 2006, 1996, and in 1985.

3)     Ease of entry high over medium term.  Poultry farms are generally on very poor soil without alternate uses.

a.      Capex: Bigger cage facility costs are only 3-6 cents/dozen eggs more.

b.     Environmental: A poultry producer (chickens, not eggs) near my town said the PETA people and environmental people are being tougher on the small owners, which often run looser, but overall not a big deal for most producers which already run on tighter standards (they have to – WMT and MCD don’t want to have hen abuse added to their list).

4)     Strong power of customers:

·       Sales are based on the wholesale egg index, and are short-term contracts.

·       Customer concentration high.  Top 3 customers are ~50% of sales (WMT, Sam’s Club, and HE Butt Grocery/HEB).

·       Eggs not branded - Eggs at HEB show the address of one of CALM’s plants, but no name of who makes it.

 
 

3. Prior egg bull markets: - causes and analysis

 
            1948-58       1973-91         2003-2004      2007+

Length/yrs                           10                    18                    2                      ?

ROIC                                ?                      20%                 20%                

EBIT %                             24%                 12%                 13%              35%

Population g/yr                   2%                   1%                   1%                   1%

Per capita usage/yr             2.1%                -3.5%              1.7%                -1.0%

Cage space.hen                                                                -1.6%              -2.5%

Exports                                                                             Flat                  +0.3%

 

Note: Are calendar year figures.  CALM uses a different fiscal year.

 

Comments on drivers for each market:

1)     1948 – 1958: Post-war boom + high population growth/ demand =+4.1% demand and the longest egg bull market since the 1868-1874 market.

2)     1973-91: Although volatile, prices held up, and had 2x the gross margin (egg price – feed cost) that the 1960s had.  Reasons not obvious –they potentially include a very poor 1960s, which meant that producers were loath to add capital to the system, producers whipsawed by feed prices, and general price inflation could have made it easier for prices to stick.  Risk is that we repeat the 1970s, which I detail elsewhere.

3)     2003-2004: Atkins diet pushed demand/capita up 1.7%.  Also, the late 2002 hen hatch was 5.7% lower than a year prior, which meant low supply in 2003 was coupled with high demand. 

 

 

4. Corn vs. egg prices – a cause of a lot of confusion

 

Corn and egg follow each other since feed is ~50% of all-in cost to produce an egg. Confusing price with margins, some longs have bought CALM as a beneficiary of the agriculture price boom since egg prices are rising, following corn price inputs to some degree.  However, corn price spikes in 1974, 1980, and 1996 didn’t lead to higher margins for any length of time.

 

However, there are risks to margins:

1)     Price down: Producers used to rising corn prices might hedge at a high price, and if corn prices drop quickly, will find themselves without the cash to expand or even bankrupt, leaving non hedgers with large margins.  Without hard data, some articles suggest this happened in the 1970s in some livestock producing industries.

2)     Price up:  Shell-shocked producers might hold back expanding flocks until the picture is clearer. 

 

5. Insider Actions

Insider sales: The top four non-family officers have sold 34%, 64%, 90%, and 100% of their shares since July.  The top two positions (President and CEO, family members) only sold 10% since they have a stated goal of keeping control within the family.

 

Insiders are excellent market timers, and right now almost no exercisable options remain for non-family- they’ve sold all they got. 

 

More examples:

Time               Event                           Stock price                   Stock price in t+ 6 mo.

Q3 ’03             Offer to go private                  $3.7                             $20

Q1 ’04             Insiders sell 600K                   ~$20                           $12

Q4 ’04             Sell last of disposable shares  ~$12                           $6

Q3 ’05             First option grant since ’99:      $6                             $6

Q4 07              500K shares sold over 3 Qs      $20-$40

 

 

6. Alternate scenario:

It’s possible that eggs have above-average returns for a period longer than standard economics would suggest.  Previous egg bull markets have lasted up to 18 years, with the industry having ~20% pre-tax ROC during that time.   This could happen because egg producers say, “I don’t want to add capacity since adding always creates lower margins for me.”  The most recent hatchings of new hens and the unconcentrated nature of competition would dispute that possibility, but it’s possible.  Based on 20% ROC/9% EBIT margin, flat growth multiple of 13x EPS of $1.55/share, and the cash earnings accruing from CY 2008 ($4.7), the stock price would be $25.

 

7. Risks to thesis

1)     Avian flu.  With the US flock indoors, the risk isn’t huge, but having your competitors wiped out is always good for pricing.

2)     Export growth.  Since exports are only 2.7% of US output, growth of ~20%/year is easily adjusted to.  China is only 2.2% of US exports (.058% of total demand).  That said, dried eggs are easily exportable (economics work) as seen in the powdered milk industry.

3)     Roll-up – Cal-Maine could use an inflated stock price to buy competitors.

4)     Changes in US diets.  A new high protein diet fad could change demand.  On the flip side, increased prices in the 1970s (prices 2x) caused a 11% decline in per capital usage (72 – 76), the largest five year decline since the great depression, so current high prices might cause egg users to cut back a bit. 

 

8. Valuation methods:

‘1) Book value: Cal-Maine’s Hillandale acquisition in 2005 was 1x book value (added 5M hens to 18M hens (+28%))

·       Based on a single digit pre-tax return on capital over the long term (admittedly with high variation), ~1x BV seems correct ($13/share)

2)     P/E: 13x 2009 P/E of $.77/share = $10.3, + projected CY 2008 cash earnings of $4.7 for $15.  Implies a pre-tax ROC at 10%, EBIT margin 5%

3)     Competitors: Tyson Foods and Pilgrim’s Pride both trade at 1.3x BV.  While Pilgrim’s raises all types of poultry, including egg layers, the broiler industry is more concentrated – the top 4 firms have 59% of the market, vs. 20% for eggs. 

4)     EV/Egg Layer: Cal-Maine at $39EV/hen.  Paid $11 per hen for Hillandale in 2005, and paid from $2 to $8 in for the six companies bought in the 1990s.

5)     Replacement cost: Brand-new facilities would cost $400M - $450M, or ~$18/share.  Most of Cal-Maine’s capacity was built before the early 1990s.

 

 

 

 

 

Catalyst