Description

Thesis Summary

â–  SAFM is over-earning due to unsustainably high processing margins

â–  There is some evidence that supply is growing enough to drive down margins

â–  Fair value on mid-cycle earnings is approximately 45% below current levels.  The stock appears slightly over-valued even in a realistic best-case scenario

Business Overview

Sanderson Farms is the third largest poultry processor in the US with current capacity of approximately 11.9mm heads per week (about 8.3% market share). The company’s assets include 11 processing plants, 10 hatcheries and 8 feed mills.  SAFM hatches eggs which are then grown on third-party farms to which SAFM provides animal feed. The company then processes grown chickens into a variety of fresh, frozen and processed chicken products. Chicken feed (mostly corn and soy) accounts for about 45% of total costs. As such, by far the most important determinate of SAFM’s margins is the spread between feed grains and chicken prices.

The Chicken Cycle

This is a business with truly no barriers to entry. As such, when profitability is high producers increase supply in order to profit from favorable conditions. Increased supply in turn causes lower prices and lower profitability. As a result, there is a long history of margins for chicken producers being low and volatile.  This relationship between profitability and supply growth is not only intuitive, it can also be proven statistically.  Using high-quality industry data available from the USDA a regression analysis on the last 14 years yields a highly statistically significant relationship between profitability and supply growth with an R-squared of 0.80.

Figure 1: Regression Output of Profitability to Supply Increase

Sanderson Farms is Over-Earning

Current chicken processing margins are near all-time highs. There are several reasons for this including disruptions in the cattle and pork markets (a drought in 2011 and 2012 forced liquidation of America’s cattle herd to 60-year lows and a 2014 outbreak of Porcine Epidemic Diarrhea virus impacted pork supply) which raised prices for competing proteins. These elevated prices increase demand for lower-priced chicken.  Concurrently, grain prices have fallen to multi year lows leading to significantly lower feed costs. This combination of robust demand and lower costs have produced elevated margins for chicken producers like SAFM. 

Figure 2: Factors Contributing to Elevated Margins

In-line with the overall chicken cycle, SAFM’s margins are highly variable. This fiscal year, SAFM’s gross margin per pound is expected to be $0.162 which is less than $0.01 below the all-time in 2014.

Figure 3: SAFM Historical Gross Margin Per Pound

Supply Growth Appears to Be Accelerating

Given the elevated industry-wide margins, one might expect to see significant supply growth.  As shown in Figure 4 below, at current margins the after-tax ROI for new capacity exceeds 20% vs. approximately 8.6% with margins at mid-cycle levels.

Figure 4: New Project Economics at Current and Normalized Processing Margins

Recent supply growth however has not been as robust as might be expected.  Much of the reason for this lack of supply growth can be traced back to a fertility issue with the primary type of breeder hen (the animal that lays the eggs that are raised for meat). In 2014 hens shipped by Avigen (the largest supplier of breeder hens) suffered a genetic defect which caused decreased fertility. This in turn lead producers to increase the production period for available hens resulting in an aged breeder flock. It took several quarters to remedy this issue, but recently the breeder flock has expanded to multi-year highs and the average age is down to a normal level. As shown in Figure 5 below, this larger breeder flock appears to be resulting in increased egg production. Breeder flock size is the best predictor of supply (both statistically and intuitively) and most forecasts now call for greater supply growth than the last couple years.  Of course, things are never that simple and can always change quickly, but given the nature of this industry and the strong incentives to increase supply it would appear that some level of increased supply growth is inevitable.

Figure 5: Breeder Flock Growth Should Lead to Supply Growth

Fair Value is Approximately 45% Below the Current Price

In the 15 years from 2002 to 2016 SAFM’s gross margin per pound averaged 8.6 cents. Given that there do not appear to be any fundamental changes in the industry it seems reasonable to assume normalized margins of $0.09/lb. Since this is an industry with no barriers to entry, economic theory would predict that over-time returns on capital would equal the cost of capital. As shown in Figure 4 above, at margins of $0.09/lb new capacity expansion would earn a return of approximately 8.6% which seems about equal to SAFM’s cost of capital providing further evidence that $0.09/lb is a reasonable estimate of mid-cycle margins. Gross margins of $0.09/lb translate to earnings of about $5.63 per share. Using a “no growth” multiple of 14x (significantly above the company’s historical trading multiple of 12x – chart in Appendix B) and adding back the excess cash less near-term capex needs of about $7.50/ share yields a fair value of $86 per share or 48% below the current price.

Even if you assume normalized margins are $0.12/lb which is 33% above the long-term average and a level that was exceeded only once in the 12 years from 2002-2013 this would imply a fair value of approximately $146/share or 12% below the current price. As such, SAFM shares do not appear cheap even in a realistic best case.

Figure 6: Valuation

Risks

The primary risk here is that there has been (or will be) some change in the structure of this industry that will allow margins to remain at elevated levels.  Some investors believe that the industry has become more rational than it was in the past and will thus be hesitant to add supply even with margins near all-time highs.   Recent history might seem to support this view as over the last few year supply growth has not been as robust has may have been expected and margins have been well above historical levels. However, given that this is a highly fragmented industry with nearly 50% of supply controlled by smaller producers, it would be highly unusual to observe industry-wide coordinated rational behavior. In reality. the primary reason for the lack of supply growth is the temporary issues with the breeder flock fertility.  These issues have now been resolved and supply growth appears imminent.   

SAFM is also a full tax payer. If corporate taxes rates fall significantly this will hurt the short. 

Catalyst

Lower future earnings