Description

SHORT.  It is time to be short the chicken cycle.

We currently maintain material short positions in the three largest US chicken producers: Pilgrim’s Pride Corporation (“Pilgrim’s” or “PPC”), Sanderson Farms, Inc. (“Sanderson” or “SAFM”), and Tyson Foods, Inc. (“Tyson” or “TSN”).  This write-up was written with a focus on SAFM, but due to recent share price movements it is our view that PPC is now the most compelling and overvalued short of the three.  We believe PPC is worth $15 (vs. $29+ today), that SAFM is worth $55 (vs. $81 today), and TSN is worth sub-$30 (vs. $39 today).

Importantly, all three stocks are liquid with lots of market cap and are borrowable at GC.  We believe the stocks will revert to fair value or below fair value over the next 2-4 quarters.

Summary

The chicken cycle is one of the investment world’s great short themes.  The opportunity to short the chicken cycle reappears every 2-3 years as the chicken industry follows a repeating supply-side driven cycle.  While pundits and the sell-side wax enthusiastic about growing chicken demand, high pork and beef prices relative to chicken, rising exports, falling corn prices, operating efficiencies, supply constraints, animal diseases, a changing industry structure, etc., this is all “white noise”.  The chicken cycle is about one thing and one thing only: how much chicken is produced in the United States.  Keep your eye on the ball and you will have a lucrative trade on your hands.

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 removed from 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.  Today, chicken producers are extremely profitable and we see clear signals that a large supply response is on its way that should lead to a massive oversupply of chicken by 2016 if not sooner.  It’s time to be short.

There are two ways to play this trade from the short side.

The first is to try and “call the top”.  We have been short the chicken names for a number of months now as we believe we came pretty close to nailing the peak of the trade.  This is difficult to do and involves higher risk and higher reward.

The second is to short the chicken cycle after the first crack.  One reason shorting the chicken names can be so remunerative is that you can “shoot them in the back” on the way down by aggressively pressing the short on bounces as the stocks revert to fair value.  Simple economics of supply and demand virtually mandate supply follow profitability – in an economically irrational industry like chicken, capacity is added when producers are profitable and it is removed when producers are unprofitable.  The only question is how long it takes the stocks to catch up.

We believe the first crack occurred on Thursday of last week.  On Thursday 10/16, Sanderson had its Investor Day in New Orleans.  Sanderson’s management team is outstanding – the best in the industry – and CEO Joe Sanderson, Jr. is as straight a shooter as they come.  The sell-side did everything but beg Joe and his team to say that the industry had changed, that a large supply response would not come this time, that buying back shares was an attractive use for SAFM’s rapidly-building cash reserves.

Joe shot them down every time – and in no uncertain terms.  It’s worth listening to a replay of the Investor Day here.  Though be warned: Joe has a voice like molasses and the SEC college football references are out-of-control.

Chicken company stocks fell sharply following the SAFM Investor Day – PPC was -18%, SAFM was -10%, TSN was -5%.  This was the crack we’ve been waiting for.  The sell-side defended the names and the bounce has been powerful with PPC +8% and then +5% on Friday and Monday; the chicken stocks are up slightly again today.  We think the bounce will prove ephemeral.  We have added to our shorts and – following the playbook – intend to press them as the stocks revert to fair value.

This write-up is divided into four sections.  We begin with an overview of the chicken cycle.  We then delve into the theory of cyclical industries and speak to rational industries vs. irrational industries and some of their characteristics.  The third section is a review of why this is not just a chicken cycle but a “chicken super-cycle”.  We conclude by laying out the investment thesis on the short side for PPC, SAFM, and TSN.

The Chicken Cycle

A supply-side protein cycle works as follows:

• Bottom of the Cycle.  An oversupply leads to low protein prices and unprofitable producers.

• Shift to Underproduction.  Marginal producers go bankrupt or shut production, reducing supply and causing protein prices to rise.  As protein prices increase, producers shift from loss-making to profitable.

• Top of the Cycle.  An undersupply leads to high protein prices and profitable producers.

• Shift to Overproduction.  Profitable producers add capacity, increasing supply and causing protein prices to fall.  As protein prices decline, producers shift from profitable to loss-making.

• Bottom of the Cycle.  An oversupply leads to low protein prices and unprofitable producers.

The length of each protein cycle varies by commodity and is largely dependent on animal biology.

The longest of the protein cycles is the beef cycle, which generally lasts 5-7 years.  The pork cycle is twice as quick, lasting only 2-3 years.  The fastest is the chicken cycle, which can last as little as one year.  Additional detail on each of the cycles is included here, but a short review of each animal’s biology makes plain why the speed of a supply response can vary from protein to protein:

The chicken cycle is a fascinating topic to study.  Historical data on the cycle is rich and readily available: the USDA provides a treasure-trove of chicken industry statistics going back more than five decades; our financial model of Sanderson Farms includes twenty-five years of financial statements.  Careful analysis of the data yields two important conclusions: (i) from peak-to-trough (or vice-versa) the chicken cycle lasts between one and three years, and (ii) the key driver of the chicken cycle is supply – other factors such as exports, demand, the price of competing proteins, etc., play a tangential role but are overwhelmed by simple supply-side economics.

From an investment perspective, it is critical to understand how the investment community reacts to each cyclical peak and trough.  When analyzing cyclical industries, we value companies via a two-step process.  First, we determine the company’s current production capacity.  Second, we assume a “normalized” level of profitability on that production by averaging-out historical peaks and valleys in profit margins.  By taking this two-step approach, we avoid falling into the trap of valuing the business on “peak earnings” or “trough earnings” and instead focus on the company’s “through-the-cycle” earnings power.  Our objective is to understand the go-forward profitability of the company through a complete industry cycle.

But that’s not how the market tends to treat cyclical industries.  Most investors (i) invest with a short-term time horizon and (ii) extrapolate current trends into the future.  When chicken producers do well, investors assume the good times will continue.  Conversely, when chicken producers do poorly, the investment community’s pessimism can be overwhelming.  Investors frequently value chicken producers at peak valuation multiples on peak earnings at the top of the cycle and at trough valuation multiples on trough earnings at the bottom.

And therein lies the opportunity.  By carefully weighing the data – and by maintaining a clear view of each company’s through-the-cycle earnings power – it is possible to purchase cyclical commodity businesses at a substantial discount when things are going poorly and to short them at a substantial premium when things are going well.  As valuation multiples and earnings concurrently expand (in an up-cycle) or contract (in a down-cycle), the double-effect can magnify investment returns in either direction of the cycle.

The Worst Hand in Poker

What is the worst hand in poker?

Ask any competent no-limit hold ‘em player and the response is automatic: “two-seven off.”  Examples of this hand include a two-of-hearts and seven-of-spades or a two-of-clubs and seven-of-diamonds.  This is the hand with the lowest high-card – the seven – that also (i) minimizes the odds of a flush (as the cards are “off” – i.e., of two different suits) and (ii) minimizes the odds of a straight (as the cards are five numbers apart).

Though this answer is technically correct, it is not actually the worst hand in poker.  The worst hand in poker is the second-best hand.  This is the hand that incentivizes the player to bet heavily without the odds in his or her favor.  It is the poker hand that offers the player the greatest risk of loss.  Competent players know to fold a two-seven off.  Gifted players know to fold the second-best hand.

A similar framework applies when thinking about industry structure in cyclical, commodity businesses.  The most profitable industry structure is a “rational” structure that has been consolidated to one or a few participants who together control pricing either explicitly (via a monopoly or cartel) or implicitly (by widely broadcasting pricing decisions such that the small number of industry participants can act in concert without directly coordinating their decisions).  A consolidated, rational industry structure allows up-cycles to last longer and down-cycles to be shortened.  Through-the-cycle profitability for each participant is meaningfully enhanced.

The next-best industry structure is a fragmented industry.  A fragmented structure is characterized by its many smaller, marginal participants.  In up-cycles, these marginal players often lack the capital to rapidly invest in additional capacity.  In down-cycles, these same marginal players lack the balance sheet strength to endure protracted downturns and so are relatively quick to shut capacity.  A fragmented industry is therefore marked by slightly longer up-cycles and demonstrably shorter (and shallower) down-cycles.

The worst industry structure is the second-best structure – an industry that is “almost-consolidated” with fewer participants, but not so few that pricing has become rational.  This structure leads to more violent cycles with (i) protracted downturns characterized by many well-funded large players each battling to outlast one another, followed by (ii) shorter, more-powerful upswings that are rapidly cut off as survivors rebuild financial strength and add capacity.  Through-the-cycle profitability is diminished as the industry consolidates toward rationality.

Over the last decade, the chicken industry has morphed from “fragmented” to “almost-consolidated.”  The top-3 players today have 45% market share; the top-10 have 79% share.  While these numbers are concentrated, we believe they are not concentrated enough to lead to rational pricing behavior.  As a result, the amplitude of the chicken cycle has dramatically increased.  In the thirteen years from 1993 to 2005, SAFM had negative operating profit only once (2000) and negative net income only twice (1996 and 2000).  In the eight years since, SAFM has already had negative operating and net income three times – with a fourth, we believe, on the way in 2016.

The Chicken Super-Cycle

In the last twenty-plus years, the chicken industry reached cyclical peaks in 1993, 1998, 2001, 2004, 2007, 2010, and 2014.  These peaks can be identified two ways.  First, they can be seen in chicken producer gross profit margins (either on a percentage-of-revenues basis or on a gross profit dollars per pound basis), which are high at cyclical peaks and low at cyclical troughs.  Second, they can be seen in broiler egg set data (broilers are chickens raised for consumption) – a good proxy for real-time industry profitability and a leading indicator of future supply.  Broiler egg sets are high at cyclical peaks and low at cyclical troughs.

Of the seven identified peaks, two can be described not just as chicken cycles but as chicken super-cycles.  The first of these extraordinary cycles occurred in 2004.  The second is happening today.

The story of the current chicken super-cycle begins in 2010 when the chicken cycle last reached a cyclical peak.  Sanderson set a company record that year with $130M in after-tax profits.  The company’s gross profit margin reached 15% versus a “normalized” gross profit margin of about 9%.  With chicken companies highly profitable, supply increased and broiler egg sets reached a cyclical peak of 212 million per week in mid-2010.  The writing was on the wall that as this supply reached the market, 2011 would be a down year for the chicken industry.

And so it was.  In 2011, Sanderson’s profitability flipped to an after-tax loss of $127M as the company’s gross profit margin plunged to -6%.  Chicken producer profitability reached cyclical lows and the industry – per usual – responded with capacity reductions.  Broiler egg sets bottomed out at 179 million per week in late-2011.

The 2011 capacity reductions set the stage for a renewed up-cycle.  As the calendar moved into 2012, a trend could be seen towards improving industry profitability.  2012 looked to be a good year for the chicken industry.

Then disaster struck.

Corn represents the single largest input cost for the chicken industry; for every one pound of chicken produced, two pounds of corn are required as feed.  In mid-2012, a drought hit the Midwestern US.  Typical corn yields in the US are 155-160 bushels per acre.  In 2012, the US average was 123.  Corn prices responded by doubling to more than $7 per bushel.

The surge in corn prices took a sledgehammer to chicken industry profitability.  Instead of a good year, 2012 proved a second poor year in a row for the industry – a “double-bottom” of the chicken cycle.  By the fall of 2012, weekly broiler egg sets had fallen back to 179 million, almost exactly where they had been one year earlier.

The double-bottom to the chicken cycle acted as a loaded spring, propelling the industry to fantastic results in 2013 and 2014.  The double-bottom removed substantially more marginal industry capacity than a typical cyclical bottom and pushed many chicken producer balance sheets into unusually weak financial positions.  With producers unable to quickly bring on additional capacity due to a lack of financial strength, chicken production was slow to rebound.  The industry benefited by reaping supernormal profits in an extended chicken up-cycle.

Three factors accentuated the up-cycle to create an unusually prosperous period for chicken producers:

• Corn Prices in 2014.  Growing conditions in the current crop year have been ideal.  We project average US yields of 174 bushels per acre in 2014, which would set an all-time record and blow away the current record of 164.7 bushels per acre (2009).  Corn prices have fallen to less than $3.50 per bushel.

• High Pork/Beef Prices.  Pork and beef prices have recently reached record highs.  The hog industry is currently wrestling with porcine epidemic diarrhea virus (“PEDv”) which has killed nearly 8 million piglets in the last twelve months.  Cattle prices are also reaching never-before-seen levels as calves that would normally be slaughtered are held back to increase herd sizes.

• Rooster Infertility.  The world’s largest chicken breeder, Aviagen Group, has experienced issues with the genetics of its standard Ross male rooster.  A recent genetic modification led to a 2% decrease in successful hatches of fertilized eggs.  The standard Ross male is sire to roughly 25% of US broilers.

Though each of these factors has contributed to the chicken up-cycle, we believe none outweighs the importance of chicken production numbers in what remains a supply-side commodity cycle.   That said, we do believe the impact of all three factors is set to reverse.  The rooster genetic issues have been identified and resolved.  New cases of PEDv are in rapid decline as the hog industry gets its arms around the disease – we expect a substantial supply response in the pork market in 2015/2016.  The long, slow process of rebuilding cattle herds is now underway.  And changes to feed prices tend to impact the industry in the short-run but not have a long tail.  The crux of the cycle remains the supply of chicken.

The Best Cure for High Prices is High Prices

The closest analogy I can draw to the current chicken super-cycle is the wheat shock of 2008-09.

In the 2006-07 and 2007-08 production years, the global wheat market experienced concurrent weak harvests in Canada, Australia, Europe, and the United States.  The poor harvests led to a serious supply-demand mismatch and a one-third drawdown in wheat ending stocks.  The price of wheat, which had historically traded between $5-6 per bushel, skyrocketed to a peak of $12.50 per bushel in February of 2008.  Certain strains of high-quality spring wheat quadrupled to nearly $25 per bushel.  Consumers panicked and speculators piled in.

In early-2008, I spearheaded the research at the fund I previously worked for on the wheat market.  My conclusion was that the record-high wheat prices were incentivizing an unprecedented supply response.  Farmers across the globe switched from planting barley or potatoes or corn or sugar beets to planting wheat.  Extra fields were put in use for the first time in years.  In Europe, 15-year-old cultivation limits were scrapped to boost potential planted acreage by millions of acres.  Wheat was planted fence-to-fence across the globe.

My view was that the world was about to produce the largest wheat crop in human history – and that’s exactly what happened.  In 2008-09, global wheat production surged to 682 million metric tons.  The prior record was 625 million.  The price of wheat promptly collapsed.  Wheat today trades for $5.50 per bushel.

We think a similar supply response is in store today for the US chicken industry.  The industry-benchmark Georgia Dock chicken price recently hit an all-time high of $1.13 per pound.  Before this up-cycle, the price had never reached $1.00 per pound.  Two-plus years of strong profitability have rebuilt producer balance sheets.  And now, we believe, the supply response will soon arrive.  The record for weekly broiler egg sets is 222 million (during the 2007 cyclical peak).  Current USDA data shows broiler egg set numbers have passed 200 million per week and recently reached 207 million per week.  We think the record of 222 million will fall in 2015 as chicken producers scramble to add capacity.  A veritable tidal wave of chicken is on its way.

The best cure for high prices, after all, is high prices.

Investment Thesis

Our investment philosophy on the short side is “valuation plus a catalyst.”

From a valuation perspective, chicken producers currently trade for well above intrinsic value and at peak valuation multiples on peak earnings.  As a highly-cyclical commodity producer, we believe Sanderson should trade for 10-12x “normalized” earnings (in-line with SAFM’s historical valuations).  The company has also tended to trade for 2x book value.  We value SAFM at $55, which represents 11x our estimate of through-the-cycle earnings plus the company’s estimated $5-6 per share of net cash as of year-end 2014.

The catalyst is the imminent supply response that we believe will plunge the chicken industry into unprofitability by 2016.  Markets tend to revalue highly cyclical commodity companies such as Sanderson at the first sign of a substantial supply response in the industry data.  We believe this will occur within months.

Importantly, we believe we can already see signs of an imminent supply response in the data.

A female egg-laying chicken is a “hen” or a “layer”; when she is young and has not yet laid eggs, she is a “pullet.”  Industry data on pullets “placed” into production is therefore a double-leading indicator of supply growth – more pullets placed today imply more broilers tomorrow.  Year-to-date in 2014, pullet placements have grown at nearly 3% year-on-year, the quickest pace since the 1990’s.  The data can be choppy month-to-month, but our sense is that with chicken producers earning cyclically-high gross profit margins and cyclically-high gross profit dollars per pound, that this trend of rising pullet placements will continue.

Our chicken thesis applies to the entire chicken industry, but there are pro’s and con’s to shorting each of the three large publicly-listed chicken producers.

Tyson Foods, Inc.

Tyson is the #1 chicken producer in the US with 3x Sanderson’s market share.  That said, chicken sales represent only 35% of trailing TSN revenues.  We believe TSN is still an attractive short candidate as its chicken profitability fluctuates significantly with the chicken cycle and the company recently overpaid for an acquisition as it tried to further diversify away from chicken at a cyclical peak.  In 2013, chicken represented 47% of TSN’s operating profit.  In 2016, we believe chicken will be a negative contributor.  We use a sum-of-the-parts analysis to value TSN, separating its branded processed foods businesses from its commodity protein businesses, and arrive at a fair value between $25 and $30 per share.  We view TSN as an attractive short but the least attractive of the three listed in this write-up.

Pilgrim’s Pride Corporation

PPC is the #2 chicken producer in the US and is the largest pure-play chicken producer operating at more than twice the size of Sanderson.  Pilgrim’s went bust in late-2008 and was acquired out of bankruptcy by the Brazilian conglomerate JBS SA (BOVESPA: JBSS3) which assumed control of the company in 2009.  Since then, PPC has made substantial strides operationally and now is a top-quartile operator where five years ago it was in the bottom-quartile.  We believe the go-forward gains that can be achieved from operational improvements are slim relative to what they were 2-3 years ago.  PPC is a “pure-play” on the chicken cycle with normalized earnings power between $1.00 and $1.50 per share.

Sanderson Farms, Inc.

Sanderson is the best-run public chicken company with outstanding management and excellent corporate governance.  In 1997, the company made a strategic decision to shift its production from small birds (5-6 pounds) to big birds (8 pounds) which are more cost-effective to process; SAFM’s average live chicken weight is 7.6 pounds per chicken versus TSN and PPC at 5.6 pounds each.  As a result, Sanderson maintains a structural margin advantage over other producers with little room for improvement.  We view a SAFM short as a pure-play bet on the chicken cycle.

We believe fair value for TSN is sub-$30 per share (TSN shares trade near $40 per share).  We believe fair value for PPC is $15 per share (PPC shares trade close to $30 per share).  We believe fair value for SAFM is $55 per share.  We expect shares in all three companies to trade to below fair value in the 2016 chicken down-cycle.

Risks

The most important risk to our short thesis is the duration of the cycle.  Every quarter that the current cycle extends is an extra quarter of profitability for the companies we are short.  As a result, should the chicken cycle be prolonged beyond our expectations, the intrinsic value of each company may rise above our forecasts.

A second risk to our thesis is M&A activity.  We do not believe the companies we are short are likely acquisition candidates due to their cyclically high valuations.  However, TSN recently raised $2B in capital by issuing (in our opinion, overvalued) shares to help finance its acquisition of The Hillshire Brands Company (NYSE: HSH).  We think it possible that PPC will attempt to diversify into branded food products – and perhaps in the process combine with JBS SA’s US subsidiary (“JBS USA”) which controls pork and beef processing businesses.  Should PPC diversify away from chicken or merge with JBS USA’s units, the company may no longer be as attractive a short candidate.  We do not believe Sanderson is a likely acquirer as the company prefers to grow organically.

A third risk to our thesis is that we are wrong on the cycle and the industry has consolidated to the point where rational pricing is sustainable.  It is our strong view that the chicken cycle is alive and well and that the industry has not yet consolidated to the point of rationality.  If we are wrong, our short thesis may prove incorrect.

Finally, the most difficult aspect of the chicken short thesis is timing.  We believe a downward turn in the chicken cycle is inevitable – and that investors will sell shares in SAFM, PPC, and TSN at the first convincing sign of an industry supply response.  When that moment occurs is hard to predict, but we believe it is a near-term event.  Our investment portfolio is poised to benefit from any such change in investor sentiment.

Disclaimer

The author of this posting and related persons or entities (“Author”) currently holds a short position in this security.  Author may sell additional shares, or cover some or all of Author’s shares, at any time.  Author has no obligation to inform anyone of any changes to Author’s view of PPC US.  Please consult your financial, legal, and/or tax advisors before making any investment decisions.  While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in PPC US.  READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE.  As with all investments, caveat emptor.

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