Description

Seaboard is a highly cyclical commodity company that has recently experienced extraordinarily favorable conditions and unsustainable profitability. The company’s key businesses are hog production / processing, container shipping, and grain milling. The stock is somewhat thinly traded, management refuses to communicate with investors, and there is no research coverage, so the recent blockbuster results have lead to “momentum trading” that has carried the stock up nearly 8-fold, and to a valuation well beyond any justifiable or historic level.

With the peak in earnings now at hand, it is likely only a short time before this stock heads back down. Seaboard has traded below book value in each and every of the last 20 years, except yet in 2005. The stock currently trades at 2.8X book value. This is a very volatile set of businesses, and SEB has experienced 7 earnings downturns in the past 18 years (on average, every 2.5 years). Each time the stock has declined at least 30%, and on average 45%. Looking at price/book and EV/revenue, the stock currently trades more than 50% above the HIGHEST levels preceding previous downturns. I think there is a high probability this stock will be cut by 50% within a year as earnings once again come under significant, but typical, cyclical pressure.

SEB reminds me of the recent experience of another volatile commodity company, Cal-Maine (CALM), the leading egg producer. About 18 months ago the egg industry achieved unprecedented profitability as constrained supply encountered an Atkins-induced demand pop. CALM’s earnings went through the roof and its stock went up 10-fold in wild trading. Like SEB, CALM was a thin stock with high inside ownership, no management guidance, and no research coverage. Of course, egg supply responded to the high prices, CALM is now losing money, and its stock has declined about 70%.

SEB stock is not heavily shorted and should be relatively easy to borrow.

OVERVIEW

2001 2002 2003 2004

Revs 1805 1829 1981 2684
% of total
Pork 43% 35% 37% 36%
Shipping 21% 21% 21% 19%
Grains 26% 36% 34% 40%
Other 10% 7% 9% 6%

2001 2002 2003 2004

EBIT 118 51 72 253
% of total
Pork 58% -27% 31% 57%
Shipping 20% 33% 8% 24%
Grains 11% 36% 22% 11%
Other 11% 58% 39% 8%

SEB has three main businesses: pork production and processing (57% of ’04 EBIT), marine cargo shipping (24%), and wheat trading and milling (11%). They are also involved in citrus and sugar production in Argentina, energy production in the Dominican Republic, and processing jalapeno peppers in Honduras, but these businesses are immaterial to the results.

Operations are principally located in the Midwest, Miami, Central and South America and Africa, but executive offices are in Boston, where 79 year-old Chairman & CEO Harry Bresky resides. Bresky and family, through wholly owned Seaboard Flour, control 71% of the 1.26M shares outstanding, a stake worth $1.5 billion. Even though the company had over $2.5 billion in sales last year and sports a market cap of $2.15 billion, SEB works very hard to stay below the public radar.

Recent profit growth has been extraordinary due to simultaneously strong pork margins and shipping rates. Hog and pork prices grew on the order of 15-25% in both ’03 and ’04, reaching record levels, and in 2H04 grain costs came down sharply. Over the past year SEB’s shipping rates have been up strongly, likely in excess of 20%. The combined pork and shipping EBIT increased from $28MM in 2003 to $206MM in 2004, and $70MM in 1Q05.

However, both of these cycles are peaking. The string of 5 sequentially up earnings quarters will likely end when SEB reports 2Q05 in a week or so, and more significant earnings declines are likely in 2H05 and 2006.

PORK SEGMENT

2000 2001 2002 2003 2004 Q105
Pork Revs 725 772 646 736 962 242
Pork EBIT 63 69 -14 22 144 50
Margin 9% 9% -2% 3% 15% 21%

SEB is vertically integrated with its hog production business supplying live hogs to its processing operation. The hog growing industry is highly fragmented with the top 30 producers accounting for 50% of supply. SEB is the #3 producer in the U.S., raising 3.8M hogs, nearly 4% of the 103MM market. Smithfield (SFD) is #1 with 15% market share and Premium Standard Farms (PORK) is #2 with 4%.

Processing of pork is more consolidated as the top 3 processors control 56% of the market (SFD 27%, Tyson (TSN) 18%, and Swift 11%). SEB is #7 in processing with 16,000 hogs per day, about 4% of the 410,000 hogs per day market.

SEB’s processing business mostly turns out primal cuts like pork bellies and loins. Lacking much further processing, SEB supplies fresh meat to other processors and retail. This makes its margins more volatile than companies like SFD and TSN. The most direct public comparable is Premium Standard Farms (PORK), which came public in June.

Typically, the big swing in margins comes from production, as this business is very profitable when hog prices are up and feed costs are down and can easily lose money if conditions reverse, with a cycle typically about every 4 years. Processing operations have more stable margins as finished product prices generally track live hog prices. In the past year hog prices hit record highs while feed prices were depressed, so SEB’s consolidated pork margin exceeded 20%.

SEB does not separate its production from processing profits, but SFD and PORK do. In the last 4 years, hog production margins at SFD were +21%, -10%, +9% and +23%, respectively, and PORK’s were +14%, -18%, -1% and +20%. Meanwhile, processing margins at SFD were +3%, +4%, +4% and +2%, and PORK’s were +4%, +7%, +6% and +4%.

Cash market pork prices are currently well off their highs with hogs down around 10% from Q1 peak, and pork bellies off more than 20% YOY. It appears these declines are in response to growing supply (larger avg. litters and higher avg. weights), demand moderating, and flattening export growth (which has been very strong recently). Signs point to further production increases as sow slaughter rates are off 7% year-over-year (more sows equal more future breeding). Futures contracts through year end project hog prices will drop another 10-15% and pork bellies will stabilize at down 20-25% year-over-year.

Feed costs, primarily corn and soymeal, are still lower than a year ago, but they bottomed in the spring and have since rallied about 15%. The futures market indicates the prices of both feeds will increase further in 2H05, and by year end be about 15% above year earlier levels.

So the drivers that resulted in the recent unprecedented pork segment profitability have reversed – prices are coming down and costs are rising. I expect while SEB’s pork profit was still up year-over-year in 2Q, it was down sequentially and is likely to fall much further in the next few quarters. This is no surprise to industry participants. SFD management recently cautioned, “Based on the current market for hog futures and projected raising costs given current grain market futures and hedged positions, it is expected that hog production profitability will be lower in the first half of fiscal 2006 compared to the first half of fiscal 2005.” Sell-side analysts are forecasting SFD’s hog production profit to be down 20-50% over the next four quarters.

PORK management also recently warned investors, “[Most recent] FY results reflected historically high pork and hog prices, which have declined somewhat in recent months. We believe it is unlikely that the current favorable price environment will be sustained. Consequently, we believe that our net sales and net income for this fiscal year [ending March ‘06] will be substantially lower.” Sell-side analysts project PORK’s earnings will decline 25% over the next year, and more than 50% over the next two years. It’s no wonder that PORK trades at only 6.5X trailing EPS. SEB trades at 10.3X.

Also note – in May SEB acquired 2 bacon processing plants from Daily Foods, a legacy customer of the processing division. This should help shift some processing mix away from fresh primal cuts, although the estimated $300-350M revs should be mostly intercompany to the pork division instead of incremental. SEB paid $120M in cash and stock.

SEB also has a marketing arrangement with Triumph Foods to market its processed product beginning later this year. Triumph is a co-op of hog producers building a large new processing facility that at full capacity will add 2% to the U.S. market. There is little detail on this arrangement, but my guestimate is that SEB could at best make 1-2% on $500M in sales once the plant is at full capacity in 2007. Possibly a more important point I think is that Triumph’s 2% incremental processing volume should add to supply pressure over the next two years.

SHIPPING SEGMENT
2000 2001 2002 2003 2004 Q105
Ship Revs 365 385 383 409 499 148
Ship EBIT 15 24 17 6 62 20
Margin 4% 6% 4% 1% 12% 14%

SEB’s shipping operation consists of 7 owned and 23 chartered containerized cargo vessels, carrying 17,000 twenty-foot-equivalent units (TEU), serving trade routes between the U.S., the Caribbean and Central and South America, primarily out of Miami and Houston. They carry dry, refrigerated and specialized containers and provide intermodal transport service to and from the ports of call. Profitability has been driven by higher rates due to supply pressure and improved volumes. Management attributes supply tightness to ships being diverted to strong Asian routes. SEB’s improved volumes are due to geopolitical recovery in South American markets, hurricane recovery and improving tourism in the Caribbean, and additional routes.

Container shipping accounts for about 15% of the world’s seaborne trade. It is a fragmented, intensely competitive industry with the top 15 shippers accounting for 55% of the global market. Seaboard is a small regional player operating relatively small boats and commanding well less than 1% of the global market. The container shipping industry has enjoyed a heck of a run, reporting average freight rates up on the order of 25-100% in ’03 and ’04. This strength has been driven by global trade boosting container throughput 13-15% annually, well higher than capacity growth during that time. The increase in demand is skewed towards Asia, but the supply constraints have flowed through to nearly all trade routes.

However, this highly cyclical industry is now facing huge capacity growth. The ship orderbook through ’07 equals 50%+ of current capacity. Virtually all industry analysts are warning of impending large rate declines. Drewry Shipping Consultants and Clarkson forecast capacity growth of 12-18% in ’05-’07 versus 6-12% demand growth. Leading consultant Howe Robinson direly predicts: “Even by the standards of an industry well rehearsed in over-ordering, the task of absorbing [such capacity] sets up one of the biggest challenges since the introduction of the container. Even if demand stays strong, charter rates are likely to fall 15-20%, but should demand growth slip to 9%, its long term average (vs. 10-12% recently), freight rates would be devastated and charter rates would probably halve during the year.”

Although SEB’s routes are not the prime target for the new capacity, just as they have benefited from the supply constraints caused by Asian trade growth, they will feel pressure as a glut of new supply into those markets forces capacity into other regions.

CP Ships’ (TEU) Latin American segment, similar in revenues to SEB and serving some of the same Central and South American ports, has shown 35% year-over-year rate increases over the last 3 quarters. In its most recent conference call management mentioned “concern about increased capacity in the U.S. East Coast-South American trade and what impact that might have.” I have not been able to get more detail from TEU (quiet period and takeover speculation), but this does not bode well for SEB.

Look at any long term chart of shipping rates compared to either net capacity growth or orderbook as a percent of total fleet, and you will see what this business is facing. Shipping bulls will argue a new paradigm, but the likelihood of a meaningful rate decline appears very high. Dry bulk and tanker rates have recently fallen 35-40% and 70%, respectively, from peaks reached early in ’05.

GRAIN TRADING & MILLING

SEB’s other main segment is grain trading and milling, which accounted for 40% of 2004 revenues, but only 11% of profits because of typically razor-thin margins. Although this division reported an unusually strong EBIT of $20MM in 1Q05, $9MM was do to a one-time derivative gain. EBIT historically has been very volatile, averaging around $6MM per quarter. The company recently announced the sale of its $630 million revenue third party commodity trading operations (60% of segment revenue), which will leave only its grain milling business in this segment. The sum received for this transaction was not disclosed, but was certainly a fraction of revenue given the low-margin. The remaining business will be fairly immaterial from a contribution standpoint.

VALUATION

SEB currently has a market cap of $2.15B, debt of $324MM, and cash of $221MM (before recent transactions, which are probably close to a wash), for an EV of $2.25B. Trailing revenue (adjusted for recent transactions) is approximately $2.3B, and EBITDA is around $370MM. So EV is 1.0X revenues and 6.1X EBITDA. The stock is 2.8X book value and 10.3 times trailing EPS. These multiples of revenue and book are far above historic ranges and comparables. The multiples of EBITDA and EPS are in-line with historical averages, except one must consider that profitability is vastly above sustainable levels.

As mentioned earlier, PORK is a close comparable to SEB’s pork segment, and it trades at 6.4X trailing EPS, .67X revenue, and 3.4X EBITDA, 30% to 50% discounts to SEB.

Shipping stocks are typically valued on book and EBITDA, but more so on book at cycle peaks. The global container shipping group (all outside the U.S.) currently trades at 1.3X book. The dry bulk and tanker shipping stocks trade around 1.8X book.

It’s no wonder that SEB has consistently traded below book value over the past 20 years. It’s a mini-conglomerate of commodity businesses, lacks adequate disclosure, has lost money about 1/3 of the time, and its average ROE has only been around 8%. SEB has always been, and remains today, concentrated in highly cyclical, marginally profitable businesses. I generously model normalized forward EPS to be in the area of $60. Assuming a normalized P/E of 10-12X (consistent with historical), then the “fair value” is well less than half the current quote. Of course, cyclical stocks often overshoot fair value in both directions. Remember, this stock never traded above $600 until within the past year, and not much has changed in terms of its intrinsic value in the time since.

The strong free cash flow from the recent earnings surge has been used to pay down debt and build up cash. Management has not shown interest in repurchasing stock, except a few years ago when it bought $47 million worth of Bresky’s own holdings.

MANAGEMENT

It’s hard to say much about management since they are so reclusive. We know for certain that they have absolutely no interest in speaking with investors. There is minimal inside ownership other than Bresky. There is a long history of “related party” dealings with limited disclosures. Their press releases are typically terse and financial filings lack helpful data. No conference calls, no public appearances. It is difficult to find relevant articles or other information, although I did find this Time magazine article interesting:

http://www.cnn.com/ALLPOLITICS/time/1998/11/23/pigs.html

Of course, the hog business is pretty nasty, and almost anybody could write a negative expose on such an operation. What struck me the most in this article was management’s underhanded dealings and complete disregard for the minority shareholders (Kahn Brothers sued SEB/Bresky for self-dealing and forced him to pay back $10 million in ill-gotten gains. The testimony in the case is pretty shocking).

CATALYSTS
- Decline in pork margins – beginning in the soon-to-be-reported 2Q05 and poised to get worse.
- Forthcoming surge in container shipping capacity will crush rates in 2006.
- Not likely to repeat $9MM 1Q05 derivative gain in grain unit.
- Earnings reversal will begin shaking out momentum holders. We have found numerous technical/momentum/quant strategies recommending SEB. These will reverse.
- Current valuation is at a significant premium to peers and past experience.

RISKS
- Lack of detail and investor interaction leaves a lot of unknowns about strategy and outlook.
- Avian flu in Asia becomes a continental problem instead of a regional problem, reaccelerating export demand.
- Domestic mad cow scare or avian flu bolsters U.S. pork demand.
- Sudden favorable turn in grain supply leading to sharply lower grain prices.
- Jobs Creation Act changes the tax of offshore shipping income. SEB is still accruing 35% income tax on these earnings, but they could ultimately be deemed non-taxable, reducing tax rate on one-quarter of earnings base.
- Low float stock and erratic trading. Soon-to-be-reported EPS will be up over last year, giving the appearance of continued momentum, so may be another quarter before holders bail out.

Catalyst

Earnings downturn pricks the outlier valuation.