Description

The African Swine Fever that threatens China the world’s largest pork producer is wreaking havoc on the world protien markets has sent stocks like Tyson (TSN), JBS, Sanderson Farms (SAFM) and Pilgrim's Pride (PPC) rocketing higher as there is speculation that the tightness in pork will bleed over into chicken and beef.  This may be true but there is a better play that is not widely recognized because it is not widely followed. Long Seaboard (SEB) is the best way to play the African Swine Fever epidemic in China with 75% upside and limited & defined downside. As a vertically integrated pork processor with 100% ractomine free product and existing relationships with Chinese buyers, SEB will deliver record earnings over the next few years and book value will appreciate meaningfully. This opportunity exists because SEB is an opaque situation with zero investor and sell-side following. See the chart below comparing SEB which is up a little over 30% YTD vs. all of the tangential beneficiaries mentioned above which have had much more substantial rallies.

Seaboard Corporation was founded in 1918 and is headquartered in Merriam, KS. Majority owned by the Bresky family and managed by third-generation CEO Steven Bresky, Seaboard is one of the largest vertically integrated pork processors in the world. Originally a domestic milling operation, Seaboard operates today as a conglomerate comprised of pork processing, commodity trading and milling, shipping, and sugar divisions. The company also owns a 50% stake in the country’s largest vertically integrated turkey processing operation, known as Butterball. While the business lines can be volatile and are certainly commodity driven, over the years the company has proven to be a good steward of capital, compounding its value multiple times over. Sporting a ~$4,000 stock price, no sell-side coverage and zero investor relations engagement, fundamental changes in the company’s business (such as the ASF impact) go mostly unnoticed by the market and create the opportunity to gain an informational edge. We currently view Seaboard as one of the best long opportunities in the market with limited downside. The company is uniquely positioned to benefit from the fallout of the African Swine Fever(ASF) outbreak in China, a black-swan event for global pork and protein markets. It is hard to overstate the impact of ASF, as we’ll detail later in this thesis. Suffice to say, we believe we are in the early innings of a world-wide pork shortage which will result in significantly higher pork prices. The recovery process from the ASF outbreak will take years, positioning Seaboard for an extended period of elevated earnings. SEB has $600M of net cash on the balance sheet, enough total cash ($1.5B as of 12/31/18) to repurchase the entire public float 1.5x over, and a management team that executed its first share repurchase in 4Q18 since a $100M tender in 2014. Management is willing to buy the stock <1.25x BV, which provides a floor at $3,658 given their cash balance and the limited liquidity. On the upside we expect a prolonged positive pork cycle which will drive record earnings and a substantial increase in book value. We believe the upside for SEB is $8,000 or ~75% upside.

Background

Started by Otto Bresky almost 100 years ago, Seaboard has evolved from a simple Kansas-based milling business into one of the largest agribusinesses in the world. From shrimp farming to sugar production, Seaboard has been in and out of almost every agricultural business imaginable; and while the company retains its roots in the milling business, current operations are dominated by protein processing. Historically perceived to be a volatile and low-return commodity business, Seaboard has produced an impressive track-record of value creation since going public, compounding its book value per share at a CAGR of 11.2% since 1991.

Despite Seaboard being principally engaged in commodity pork production, the company has vastly outperformed the S&P 500 for the last twenty years. As the chart below indicates, Seaboard has appreciated 10X compared to just 3.3X for the S&P 500 with dividends reinvested.  Seaboard’s performance is a testament to the talent of the Bresky family’s stewardship of the company over the last twenty years.

Seaboard reports its results within six segments: Pork, Commodity Trading and Milling, Marine, Sugar & Alcohol, Power and Other. While contributions can vary depending on the year, Pork Processing represents roughly 25% of revenue and 70% of operating income. Commodity Trading and Milling contributes about 50% of total revenue, but only 15%-20% of total operating income. Marine is the company’s third-largest segment, representing 15%-20% of revenue and 10%-15% of operating income. Sugar & Alcohol, Power and Other have historically been rounding errors, and haven’t contributed meaningfully to the consolidated results, although in 2018 Power accounted for 10% of operating income. It is important to keep in mind that Seaboard reports its interest/income from the Butterball JV below the operating income line, under “Income from Affiliates”. In an average year, protein processing winds up accounting for roughly 80% of Seaboard’s total net income, the majority of which comes from the pork segment.

Seaboard entered the pork processing business in 1990 when it acquired a pork processing plant in Albert Lea, Minnesota. Shortly thereafter, in 1992, the company began construction on a greenfield plant in Guymon, Oklahoma. In 1995 the company shuttered the Minnesota plant and brought Guymon online. Today the revenue generated by the pork division is derived from two shifts that run at the Guymon plant, as well as its 50% interest in the Seaboard Triumph JV which is reported using the equity method. Seaboard is vertically integrated with feed mills and hog farms across the southern Midwest that support the company’s processing capabilities. Given this vertical integration Seaboard is highly leveraged to the price of the pork cutout, which is the total value of all the different cuts of pork from one pig, and benefits from lower input costs of corn and soybean. Additionally Seaboard’s pork is ractopamine free, a growth hormone banned in China. The company exports 25% of its production, with China, Mexico and Japan being the three largest export customers. Seaboard has existing relationships with three Chinese buyers/distributors, with COFCO being the largest of the three.

The Pork Market

111 million metric tons of pork are produced annually across the globe. China accounts for ~50% (55.5mm MT) of this production, with the EU contributing 21% (23.3mm MT) and the US 11% (12.2mm MT). China is also the largest importer of pork in the world, a market that in totality represents 7.9mm MT annually. Of this amount China represents a 21% (1.66mm MT) share, Japan 19%, Mexico 14%, followed by South Korea at 8%. Global consumption of pork has increased by 2.1% per year over the past 30 years, driven by the growth of the middle-class in Asia and an increased appetite for the meat in Mexico. Mexico represents the fastest growing country in the top 10 consuming nations, growing at a 4.6% CAGR over the past 10 years.

China is the most important factor relative to global pork fundamentals. Small changes in the country’s production or consumption patterns can have a significant impact on the global supply/demand balance.

African Swine Fever

African Swine Fever (ASF) is a highly contagious viral disease which affects pigs. The disease is transmitted in a variety of methods: by live or dead pigs, through processed pork products, via contaminated feed, processing facilities, and transportation devices. There is no cure or vaccine for ASF. While the disease has a near 100% mortality rate for infected pigs, it poses no threat to humans via contact or consumption.

ASF Outbreak in China

The first report of ASF in China occurred in early August of 2018. At the time we were short SEB based on a domestic over-supply of pork production that had come online at the same time the Chinese/US trade war was heating up and Mexico imposed a 25% tariff on US pork exports. More reports of ASF began to come through during the month of August. Then on September 6th China reported finding ASF on four farms in a single day. We covered our short and began paying extremely close attention to the outbreak, which seemed to be intensifying by the day. By early November there had been 59 cases throughout 20 Chinese provinces.

The current numbers coming out of China are staggering. In March, the Chinese government announced that its hog herd was 19% lower y/y, and its sow population was down 21% y/y. These figures are likely severely under-reported. Reports surfaced during March that the herd population was down in excess of 30% y/y. On March 28th the Shandong Province reported its sow population was down 41% y/y. In 2017 the Shandong Province produced 47M hogs, representing ~7% of total Chinese production. The newest figures are pegging the current loss at 150M-200M. This is a loss of monumental proportion, and it will take years to restock the population.

As we noted earlier, it’s hard to overstate the scale of the ASF outbreak. China’s annual pork production is ~55.5mm MT. That figure is likely to be down in excess of 30% in 2019, representing a deficit of ~16.6mm MT. This amount is more than double the entire annual global export market of 7.9mm MT. There is simply not enough pork in the world to supplement this deficit. There is no easy fix for the problem, which continues to expand in scope. The 41% drop in sow inventory will create a production issue for many years, as it typically takes two years to raise a fully performing sow. Moreover, the disease is now spreading quickly through neighboring Vietnam. In mid-February

Vietnam reported its first case of ASF, and by late March 23 Vietnamese provinces were reporting ASF cases. Vietnam produces 35mm hogs annually, a figure which will be reduced in 2019 and beyond. The bottom line in that China will be required to significantly increase its pork imports in order to satisfy its appetite for pork. This was evidenced in April when China purchased 77,000 MT of US pork, the largest weekly Chinese purchase of US pork on record.

Below is the timeline of the ASF outbreak in China.

Impact on US pork market

The ASF outbreak in China will be a boon for US pork producers, especially those which are vertically integrated, i.e. Seaboard. Pork prices were initially muted during the very early stages of the ASF outbreak through February, but this was due to an over-supply of pork at retail due to the mass culling of infected herds. Although ASF is deadly to pigs, it poses no threat to humans even when consumed. However, in early March this inventory began to get worked through and the price of the pork cutout began to rise rapidly, bucking the typical seasonal decline during lent.

We expect this is just the beginning with respect to elevated pork prices.

Another tailwind for Seaboard and other US pork producers should be lower soybean prices. In 2018 China consumed 4.2 billion bushels of soybeans, roughly one-third of the global soybean production. Of the 4.2B bushels consumed, 1.2 billion were imported from the US. China’s need to import US soybeans will likely drop given China’s hog production is likely to be down 30%+. This should create excess soybean supply in the US, which lower domestic soybean prices.

According to Arlan Suderman of INTL FCStone, an agricultural financial services firm, there will be a 22mm MT reduction in soybean demand due to the ASF outbreak. 22mm MT on soybeans translates to ~733mm bushels. To put that amount of soybeans in perspective, the US produces ~4.4B bushels of soybeans annually. This will exacerbate a domestic over-supply situation which is already pressuring prices, as evidenced by the March USDA grain stocks report:

“Soybeans stored in all positions on March 1, 2019 totaled 2.72 billion bushels, up 29 percent from March 1, 2018. Soybean stocks stored on farms are estimated at 1.27 billion bushels, up 49 percent from a year ago. Off-farm stocks, at 1.45 billion bushels, are up 15 percent from last March. Indicated disappearance for the December 2018 - February 2019 quarter totaled 1.03 billion bushels, down 2 percent from the same period a year earlier.” – USDA quarterly grain stock report for March 1, 2019.

The combination of lower input prices and surging pork prices have already begun to manifest themselves in the Urner Barry Pork Packer Margin Index (for Vertically Integrated plants), with the index sitting at the highest seasonal level since the 2014 PEDv outbreak. This margin expansion will translate to Seaboard’s results in 2Q18 at the earliest, as pork prices were artificially depressed in January and February due to the temporary over-supply at retail.

Seaboard Specifics

Seaboard is the only publicly traded pure-play vertically integrated US pork producer. Pork processing operations are primarily run at the Guymon, OK plant, and the recently (2017 & 2018) ramped production at its new Seaboard Triumph JV in Sioux City, IA, which is a ractopamine-free facility (key to Chinese import approval). The company is upgrading and expanding its Guymon facility in 2019.

Seaboard’s pork processing margins are correlated to price of the pork cutout, as the company is vertically integrated, i.e. it internally raises the hogs for production. The company also sells pigs to third parties, thus benefitting from a rise in live hog prices. We look at the 2014 PEDv outbreak in an attempt to quantify the impact of ASF on Seaboard’s pork processing segment. In 2014 6M-8M pigs in the US were destroyed due to PEDv. The ASF outbreak in China is 10x-20x the scale. The value of the pork cutout rose significantly throughout 2014, hovering between $1.00-$1.30 per pound between March and October. Seaboard benefitted significantly from the rise, and margin performance was the best in the past 20 years, this margin performance was despite significantly higher soybean prices in 2014.

Given our projection for both elevated pork prices and lower soybean costs we expect a similar, if not greater, outcome over the next 12-24 months (outside of 1Q19, as noted above). In 2014 Seaboard’s pork segment produced operating income of $349M.

The primary difference between the current situation and 2014 is Seaboard’s 50/50 JV with Triumph, which effectively increased Seaboard’s pork processing capabilities by 50%. The STP plant has an equivalent two-shift capacity as the Guymon facility, but Seaboard splits the profits 50/50 with its partner. Assuming similar market dynamics Seaboard could reap an additional $175M operating profit, which translates to an incremental $117 earnings per share. Accounting for the lower current corporate tax rate and one-time gains in 2014, this translates to a total of ~$400 in EPS for Seaboard, implying a ~10x multiple. Seaboard has historically traded at an average P/E multiple of 15x.

Seaboard has a clean balance sheet, with $1.53 billion in cash & equivalents and $926 million in debt. The public float represents 24% of the shares outstanding, with the balance owned by the Bresky family. During the fourth quarter of 2018 Seaboard executed its first public share repurchase since the $100M tender in 2014. That tender was announced with the stock trading at 1.17x book value and was executed at 1.40x book value. In 4Q18 the company used $5M to repurchase stock at an average price of $3,658 (1.26x book value). In December alone Seaboard repurchased 1,191 shares out of total of 11,471 traded, accounting for more than 10% of the total volume. We spoke with Mr. Bresky and book value is indeed the metric he focuses on relative to buybacks, with <1.25x being “too cheap”. This buyback provides ample support for the stock given the low liquidity and management’s apparent willingness to participate at that level.

An interesting factor relative to the company’s book value is the impact of movements in the debt and equity markets on the company’s investments.  As detailed by the company in its 2018 annual report:

        “Unfortunately, 2018 also resulted in our first pre-tax loss since 2002. This was caused primarily by mark to market unrealized losses in our short-term investment portfolio. For the last three years, we have carried a large position in equities, fixed income and cash and with the significant decline in the stock market in December, we recorded a $110 million unrealized loss for 2018. As a comparison, in 2017 and 2016 our pre-tax income included unrealized gains of $146 million and $49 million, respectively. There is no guarantee that those 2018 unrealized losses won’t turn into future realized losses, but we continue to manage our investment positions closely as we seek deployment of our liquid positions into fixed investments.

Equity and debt securities have risen significantly during the first quarter of 2019, and we expect Seaboard has benefitted from these gains. We expect a $150M+ increase in book value from the return on these assets in the first quarter.

We view the risk/reward on this trade as very attractive. Management has shown a willingness to repurchase shares at 1.26x-1.40x book value, which currently translates to $3,576-$3,972 per share. With $1.5B in cash on the balance sheet, and given the relatively illiquid nature of the stock, we believe there to be strong support for the stock at that range, equating to 13%-21% downside from current prices. On the upside we believe that Seaboard’s book value will increase substantially over the next two years as a result of its elevated earnings. We believe book value will approach the $4,000/share level in ~24 months. Historically the stock has traded as high as 1.75x-2.0x book value, which would translate to upside of 52%-75%. As such we assess the reward/risk ratio of this trade to be ~3.5:1, with the probability of success being much higher than the probability of a loss.

Risk Factors

1) African Swine Fever in the US. If ASF cases were to appear in the US, other countries could impose a ban on US pork exports. This would likely cause a significant over-supply of pork domestically, as the US exports 25% of its production on an annual basis. That said, this was not the result during the PEDv crisis, when pork prices rose significantly due to the outbreak. The outcome is uncertain, but we would prefer to not see ASF cases in the US.

2) Trade. There are both potential trade risks and opportunities. Risks would include any disruption of trade between Mexico and the US. Mexico is the largest importer of US pork, and any disruption would be detrimental to the US pork industry. On the opportunity side, China current imposes a 65% tariff on US pork. Should there be a positive outcome from the US/Chinese trade standoff, this could be a significant benefit for US pork producers.

3) New domestic capacity. Over the past 3-4 years there has been a significant increase in pork processing capacity in the US. This incremental supply finally overwhelmed demand in 2018, due in part to trade spats with Mexico and China, pressuring prices to decade lows and causing SEB to report an EPS loss. While there is much less planned capacity schedule to come online in the foreseeable future, the supply/demand balance situation can be precarious.

4) Black Box Factor. Seaboard’s smaller segments, including the Commodity Trading and Milling segment, are volatile and difficult to predict. We are not able to predict the outcomes of the segments with a high degree of certainty, and results from these segments can swing quarterly results dramatically. Mark to market gains and losses, as noted above, can also have a large impact on reported results.

5) Negative press/investigation. Seaboard was the target of an unflattering Wall Street Journal article in November of 2016. The article detailed a potential investigation by the US government into whether or not Seaboard illegally sold flour to an African business that is tied to a black-listed family. Seaboard denied the claims. In addition, Seaboard agreed to pay more than $1M in a settlement with the US government regarding an investigation into alleged employment of unauthorized workers from 2007-2012 at the Guymon plant. Seaboard cooperated fully with the investigation, and the settlement acknowledges that Seaboard denies each and every allegation of wrongdoing and explicitly reflects that the settlement is not an admission of liability by Seaboard.

6) Investor relations. Or rather lack-there-of. Seaboard does not communicate with outsiders, other than at the annual meeting (which we attended). This creates a higher degree of opacity regarding the business operations and the stock. We believe this works in our favor, as Seaboard is not widely followed, has no formal sell-side coverage, and does not appeal to retail investor given the nominally high price of the stock.

Catalyst

* Higher pork prices lead to increased proffits