Description

Recommendation:

I recommend shorting Bachoco (ticker BACHOCOB.MX; there is also an ADR with the ticker IBA), the #1 chicken producer in Mexico.  The thesis here is essentially the same one fiverocks19 laid out in his/her excellent PPC write-up from October of last year: “At a high level, trading the chicken cycle is simple.  Go long the chicken names when there is oversupply, chicken companies are losing money, and capacity is beginning to be added to the industry.  Go short the chicken names when there is undersupply, chicken companies are raking in profits, and capacity is beginning to be added to the industry.”

Fiverocks19’s thesis is playing out, and the US chicken names have been good shorts so far in 2015.  While I still think there is meat on the bone (pun intended) for the PPC and SAFM shorts, Bachoco is my preferred way to play this theme right now.  I believe Bachoco is subject to the same cyclical dynamics as PPC and SAFM, but Bachoco has seen less of a correction so far, its multiples have farther to contract, and it is a cheaper/less crowded borrow (although in fairness, Bachoco is less liquid than PPC and SAFM, making it more appropriate for smaller funds).  Note that the statistics and ticker in the heading above are for the ADR and are in USD, although the Company reports in Mexican pesos.

Company Description:

Bachoco is the #1 chicken producer in Mexico with 35% share.  They also have operations in the U.S. (U.S. is ~25% of Bachoco revenue) where they have 2% share.

Accelerating supply growth is driving a turn in the North American chicken cycle:

I believe US chicken supply production (already up 4.6% in the first half of 2015) is on pace to exceed 5% YoY growth over the next few quarters.  Why focus on US chicken production figures when Bachoco is primarily a Mexican producer, you might ask.  The simple answer is that we have much more data on US chicken production than we do on Mexican production.  That said, the Mexican chicken market historically tracks very closely with the US chicken market, so I think any conclusions we make about the US chicken cycle are likely to be valid for the Mexican cycle as well:

Okay, but why then do I expect US chicken production to exceed 5% over the next few quarters?  I arrive at this estimate based on the following:

• Through the first half of 2015, pullet placements (leading indicator of hatching egg volume) are up about 6% YoY
• Through the first half of 2015, the percent of US hatching eggs that are exported (most of which are bound for Mexico) is running around 7%, up about 3 percentage points from the 4% levels of the first half of 2014.  This suggests that the number of broilers produced for domestic consumption might be 300 bps lower than YoY pullet placement growth suggests:
• Through the first half of 2015, broiler weights are up about 2% YoY, suggesting that total meat production will be 200 bps higher than the increase in head count.
• After factoring in the countervailing impacts of increasing hatching egg exports and increasing broiler weights, I think the stats are pointing to 5%+ supply growth in the US chicken market over the coming quarters.  The supply growth may be even higher in Mexico given the increase in hatching eggs being sent to that market.

5% supply growth in the chicken market is a big deal.  Below is a graph of Bachoco’s LTM EBITDA margins and US broiler production growth.  Over the last decade, there have been two instances where US broiler production growth exceeded 5%.  In both cases, Bachoco’s EBITDA margins fell below 5% in the year following the period of 5%+ supply growth:

A return to historical average multiples implies ~25-40% downside:

I expect Bachoco to trade back down to historical average levels or lower in terms of P/B and EV/Sales when the cycle turns:

At 1.0x P/B, Bachoco would trade around 45 pesos per share, 42% below the current price.  At 0.5x EV/sales (assuming sales of 45 billion pesos, net cash of 12 billion pesos and 600 million shares), Bachoco would trade around 58 pesos per share, 25% below the current price.

Bachoco is a much less crowded short than SAFM and PPC:

*Note that IBA figures above are for Bachoco’s ADR.  Although I don’t have short interest data for BACHOCOB.MX, I believe the days-to-cover for the Mexican-listed shares is much lower than it is for the ADR.

The fact that Bachoco is a less crowded short provides two advantages.  First, the risk of a short squeeze is reduced.  Second, Bachoco is cheaper to borrow.  Currently at my prime broker, the cost to borrow PPC or SAFM is 3.6%, while the cost to borrow Bachoco (either the ADR or the Mexican-listed shares) is less than 0.6%.  While the cost to borrow Bachoco has been steady in my experience, I’ve seen higher figures for PPC and SAFM in recent months.

Risks:

• Mexican chicken market, due to increased consolidation, is more rational with supply increases than US market, resulting in only a modest down-cycle for Bachoco.
• “Everybody” knows the chicken cycle is turning, meaning stock won’t react negatively even if our fundamental thesis plays out.
• Bachoco, with 12 billion pesos of net cash on hand, pursues acquisitions that diversify the company away from chicken.

Catalyst

• Chicken price decreases.
• Future earnings releases showing margin compression.