Recommending Seaboard

Seaboard is a ‘long term compounder’, albeit one with non-linear earnings growth and year to year volatility in results. The idea has been written up twice on VIC as a short, with the 2005 write-up likely coming a little too early, but the 2007 call being well timed. It is a business/stock that from time to time over-earns and over-inflates. I don’t view that to currently be the case, particularly relative to the broader food group. Shares currently trade at a reasonable entry price, and at a substantial discount to the broader market.

Seaboard’s largest businesses are the production of branded and bulk pork products (Prairie Fresh, Daily’s) and turkey (Butterball, 50% stake). The company is also a global grain miller and bulk shipper in the Americas. Smaller operations include Argentine sugar production and a Dominican Republic power generator.  

Despite deriving its earnings from commodity based businesses, Seaboard has generated excellent long term returns. Over the last thirteen years, the company has achieved an average return on equity of 13.7%, despite roughly 20% of its equity held in cash over that time period. Book value per share has doubled since 2010 and increased five-fold over the last thirteen years, rates well ahead of the S&P 500. The company has intelligently bought back shares, expanded capacity, invested in its brands and value added products, and opportunistically partnered.

I believe there is more good news ahead. The company is set for a major expansion of its hog processing count in 2017, as well as an expansion of its Daily’s brand bacon production capacity. I expect these two moves to increase annual earnings by about 10%, beginning in late 2017. In addition, the company, in conjunction with partner Maxwell, has made major improvements in the Butterball brand and product mix, which I believe will result in higher earnings and less seasonality for that business in the years ahead. The company’s shipping business is under-earning given industry overcapacity, but could have substantially improved earnings as a low industry order book translates into tighter industry conditions in the years ahead. Finally, earnings from the company’s milling business have likely been obscured recently weakness in one region (Brazil). As those problems are remediated, earnings for that division should improve.

The company also has more than $600 million of net cash on hand and total liquidity in excess of one billion. Management commentary in the annual letter indicates they hope to make a shipping acquisition to complement their existing bulk cargo business. Absent a major acquisition, Seaboard would hold roughly a third of its market cap in cash in two years.

On valuation, Seaboard trades about in line with its historical price to book at 1.3x. I currently model earnings per share of $226 for this year, putting 2016 PE at 14x. Current year EV/EBITDA is 8x, slightly above the less diversified Pilgrim’s Pride and at a two point discount to Tyson.

I think earnings can grow substantially next year and even more in 2018, based on recent capacity expansion in its pork division combined with improvements in shipping and milling.

Butterball (35% of 2016 estimated operating income)

One factor in my optimism around Seaboard’s prospects involves its well timed purchase of a 50% stake in Butterball. Butterball provides Seaboard with a stake in a leading brand with broad retail distribution. Butterball sales represent roughly twenty five percent of US processed turkey sales, and that share is growing. In its 2015 annual letter, CEO Gresky indicated that 70% of Butterball’s sales are now value added. Examples include sliced turkey cold cuts, ground turkey, and turkey bacon. Whole turkey sales peak around the Thanksgiving holiday. In 2015 the split of earnings was 60% of earnings to the fourth quarter, 40% to rest of year

Seaboard’s timely purchase of the Butterball stake is an example of the company’s above average capital allocation. The 49% stake was previously owned by Smithfield foods, alongside 51% owner Maxwell Farms, Inc., who continue to own the majority stake. Smithfield triggered a put/call option in late 2010 with a bid of $170 million for the purchase or sale of the remaining stake, a value representing roughly book value.

The Maxwell group chose to acquire the asset at Smithfield’s price, and then sold the stake plus 1% (50% stake) to Seaboard for $178 million. In addition Seaboard provided an additional $100 million of subordinated debt, payable at 15% (5% cash interest, 10% PIK). Seaboard also received warrants, which allow it to increase its stake by a non-voting 5%. The warrants can be exercised at any time before December 2020, but can also be repurchased at fair market value by Butterball. Seaboard also arranged for the refinance of Butterball’s debt, and received a $5 million placement fee for that assistance.

Thus far the Butterball purchase has been extremely profitable, returning a mid teens ROI. In the four years the stake was owned by Smithfield Farms, the Smithfield stake lost $47 million. In the roughly six years since Seaboard purchased the stake, Seaboard’s share of profit is just over $200 million, not including roughly $60 million in interest income. Seaboard’s Butterball stake earned $100 million in 2015 and appears on track to earn a similar amount this year.

As far as what changed in Butterball’s business, part of the story is grain prices fell, which improved the profit dynamics for all poultry raisers. That doesn’t tell the whole story however, as Butterball was under-earning under Smithfield even during periods of relatively low grain prices, like 2010, when Smithfield lost $20 million on its share of the venture. 2010 was not a bad year for most poultry producers – Sanderson Farms for example earned pretax profit of $134 million for the twelve months ending October 2010.

My belief is that Seaboard and Maxwell have combined to better leverage the Butterball brand beyond whole turkey sales, and have also boosted Thanksgiving sales. Smithfield may have been reluctant to allocate significant capital to the venture as a minority holder. In contrast, Seaboard has provided substantial funding and it appears to be yielding very favorable results. This included the 2012 purchase of additional processing assets from Gusto Packing Company. While terms weren’t disclosed, Seaboard provided an $80 million loan to finance the purchase. Comments by Seaboard’s CEO Gresky in the 2013-Annual Letter reflect the ongoing commitment to expand this asset:

“Although the Butterball brand is closely tied to the Thanksgiving holiday and the seasonal whole bird business, we believe that the brand has significant untapped potential in the value-added markets. With the acquisition of the further processing facility, Butterball has strengthened its position to continue the development of its product lines and further leverage the brand. The continued development of our value-added business and focus on being a low cost producer are key factors in managing underlying commodity risks going forward, and we feel very good about the business model that is in place and our position as the markets return to normal in the upcoming year. Despite the challenges of the past year, our focus is the vast opportunities that lie ahead and therefore we remain confident in and committed to the future success of this investment”.

Pork (45% of estimated 2016 operating income)

Seaboard is a vertically integrated pork producer, and sells pork to further processors, and to retail under the Prarie Fresh and Daily’s brands. Seaboard is a 50% owner of Daily’s in partnership with Triumph Foods.

The company’s pork businesses is fundamentally a spread business, earning the difference between feed costs and meat prices. That said, over a cycle they have earned good returns, with pork operating margin averaging just-under 10% over the last fifteen years, albeit with significant year to year variability. I would expect 2017 to be a fairly good year, given high grain inventories, supporting continued low feed costs. One risk to my forecasts is pork prices, which could trend down from current levels depending on supply trends. As of the June 2016 USDA count, US inventory of hogs was up 2% year over year, which was small enough to support improved pricing from earlier in the year. Rapid expansion of hog inventories, which would depress pricing, is a risk to my thesis. My current expectation is that over time, Seaboard will continue to earn respectable returns in this business, and will grow the business through expansion of its branded production and its commodity hog production.

In mid-2017, Seaboard will complete a new hog processing facility in Sioux City, Iowa with the capacity to process three million hogs annually per shift, or six million hogs assuming two shifts. Seaboard acquired hog inventory to supply the new plant in February 2016 for $148 million.

I assume 70% 2018 utilization for this new plant, suggesting 2 million processed hogs for Seaboard’s proportionate share (with room for growth in 2019).

I estimate the incremental earnings from this expansion as follows:

Two million fully processed hogs at estimated value of $202 per processed hog. (I calculate $202 as Seaboard’s current realized dollar per hog at its existing Guyman, OK plant, which has 7.5 million hogs full year capacity. I assume 88% utilization, based on Tyson’s pork processing utilization.)

Seaboard’s revenue share: 2*202: $404 million

Operating income, assuming 11% operating margin: $44 million. Note that 2016 year to date pork operating margin is 11% and historic margins have ranged from mid-digits to high teens, depending on the spread between grain/feed prices and hog prices. This is a spread business, with substantial volatility over time. However the industry is increasingly concentrated among large producers, which should encourage rational pricing, and Seaboard also continues to grow the value added portion of the business (branded bacon, ham, cold cuts) which is higher margin.

In addition, the Daily’s JV will complete a new bacon facility in St. Joseph Missouri, capable of producing 60 million pounds per year of raw bacon. Daily’s has historically been a premium priced bacon product, with somewhat limited distribution. A five pound package on line of Daily’s center cut bacon sells for $28 online, or $5.60 / pound.

I assume the JV achieves just over 80% utilization in 2018, producing 50 million pounds of bacon saleable at $4.00/pound. That implies total JV sales in 2018 of $200 million, or $100 million to Seaboard. I assume higher operating margins for this part of Seaboard’s pork business of 12%, slightly above the overall average for this division. That implies another $10 million in profit to Seaboard.

2018 additional operating earnings from expansions:

Processed pork JV: $44 million

Bacon JV: $12 million

Total incremental operating income: $56 million

Incremental EPS, assuming 35% tax rate: $28/share, roughly 13% growth over my 2016 EPS estimate of $226/share (this incremental earnings will be divided between 2017 and 2018, with the majority in 2018).

Marine (7% of estimated 2016 income)

Anyone watching the containership market knows this market is oversupplied and hated by investors. Public companies in the space like Diana Shipping, DryShips, Safe Bulkers and Navios Maritime are trading near all-time lows. The silver lining of these conditions are they make it nearly impossible for these leveraged names to finance new builds, and this is an industry where three to five percent of capacity is scrapped annually. Scraps, some demand growth, and a declining number new builds, should lead to a tightening of the market in over the next several years. The current new build order book stands at roughly 15% of the existing fleet, a fifteen year low, and is likely to shrink further in 2017, given industry conditions.

Seaboard has a slightly different focus than the public bulk shippers, as it is focused on moving grains, resins, and other bulk cargo in the Americas. As such, it is not exposed to China, iron ore or coal. The company maintains terminals and warehouses at the port of Miami (PortMiami) and port of Houston. Seaboard is the largest shipper as measured by volume in PortMiami.

Despite the terrible market conditions, Seaboard is operating this business profitably due to an efficient fleet, good labor contracts, and adequate volumes to cover fixed costs. It is also an opportune time for the company to expand its fleet. In the 2015 annual letter, CEO Bresky comments, “At Seaboard Marine, we will continue to look for opportunities to expand our route structure without jeopardizing our current network and should an accretive investment opportunity present itself, we would be keen to expand our country and customer base.” Given the depressed state of the bulk cargo ship market, and the company’s substantial liquidity, I believe the company could make very accretive acquisitions in this area.

Commodity Milling, Trading (8% of estimated 2016 operating income)

Seaboard has a significant amount of capital invested in its grain milling business, which crushes grain for flour and also supplies and brokers grains globally. The company reports a $1 billion asset investment in this business (Seaboard doesn’t break out equity investments by business). The grain business has historically been a low single digit margin and ROA business, but even by those standards has significantly underperformed over the last year. The annual letter suggests a large part of the underperformance was due to operating issues in Brazil, although it does not quantify what earnings would have been absent those issues. I would expect substantial improvement in this division in the next two years, likely increasing EPS by at least $20 or so a share (about 10%).

Other Businesses (power, sugar) (5% of estimated 2016 operating income)

Seaboard’s Argentina based sugar business and its Dominican Republic based power business are both marginal contributors to company profits. It is conceivable with political reforms in Argentina the sugar business could become more important over time.

One last note - Seaboard does not hold conference calls, and at least in my experience the company primarily communicates with shareholders through its SEC filings. The company holds an annual meeting in Newton, MA, which I have attended in the past, and where I have found management relatively responsive and open to discussing the various businesses.