Chicken Run: Value Manager’s Dream?

On the surface, chicken stocks like Sanderson Farms(Nasdaq: SAFM), Gold Kist(Nasdaq: GKIS), and Pilgrim’s Pride(NYSE: PPC) are a value manager’s dream. Most of them are not very leveraged, they generate a decent return on capital, and best of all, they trade at single-digit P/E based on last year’s earnings. So, are chicken stocks the value manager’s dream, or are they a value trap in the making? I think the answer is a little bit of both, depending on an investor’s time horizon. 

A bird’s-eye view 

Although it appears that chicken stocks are inexpensive, their cheapness is measured against last year’s earnings when poultry prices were through the roof. The forward earnings have been sharply revised down, but even based on revised earnings guidance, chicken stocks appear to be relatively inexpensive. When analyzing companies that sell commodities, it’s important to look at commodity prices. All right, industrial commodities are scarce, as it takes millions of years for them to form, whereas it takes six to eight weeks to raise a chicken. And yes, chicken does taste better than the usual industrial commodities. But chicken is chicken, and price is the most important differentiating factor. 

The cost of raising chickens is fairly fixed with the exception of feed prices (accounting for roughly 30%-40% of cost of goods sold), which may fluctuate. Thus, the market chicken price separates profitability from loss. The poultry prices trade at the historical average in nominal terms, or slightly below average in real terms. Although chicken leg prices declined by almost half over the past several months, a very large portion of chicken legs produced in the United States are exported, and legs are a relatively small (lower commodity price per pound) market compared to the white meat. Interestingly, only 15% of the chicken produced in the U.S. is exported, and 75% of these exports go to Russia. And Russia is one of the largest consumers of the dark meat. None, zero, zilch of American chicken exports go to Europe, as our American chicken doesn’t meet European standards. (Another interesting factoid: Chicken legs imported from the United States are called Bush legs in Russia, after George H.W. Bush, on whose watch Russia started importing chicken legs from the United States.) 

Avian flu worries 

If an investor has a long-term horizon (let’s say five years) and has a very strong stomach to see chicken stocks get halved or quartered on avian flu scare, today is as good a time as any to buy chicken stocks. However, at today’s prices, chicken stocks don’t fully discount the avian flu coming to the United States. If the avian flu does come to the U.S., which is a very high probability scenario, we’ll get a chance to buy these stocks at much lower prices. I put very little value on forward Street earnings estimates, because avian flu could change these forecasts on a dime. According to the Department of Homeland Security, the migration of birds is likely to bring avian flu to the United States — it’s just a matter of time. And when avian flu comes to America, chicken stocks will share the fate of the chickens — they’ll get slaughtered, as their profitability will dissipate overnight. 

Demand for chickens will likely drop off disproportionately to the actual threat, similar to what happened in European countries when they got their first cases of avian flu. However, the drop will not be permanent. Once the real threat passes, consumers will get tired of steak, pork, and Tofurky, and they’ll want real white-meat chicken. So far, that’s how avian flu has played out in Europe: an immediate decline in demand followed by gradual recovery. If the infected birds flying from Asia take a different route and spare the United States from the avian flu, the chicken prices and stocks may rebound from today’s lows very rapidly because they’re heavily shorted. Surprisingly, Sanderson Farms — the only one of the bunch that pays a meaningful dividend — appears to be the most shorted one, with 23% of it float shorted, which is at least twice the short interest of other chicken producers. 

Importance of a strong balance sheet 

The avian flu will pass, but financial strength will be extremely crucial for chicken stocks, as it will provide staying power. Chicken producers will be losing money for some time. Thus, their balance sheets will be their life sources. Chicken producers are in very good financial shape: Gold Kist has $145 million of cash and approximately as much debt. However, the bulk of debt will not mature until 2014. Pilgrim’s Pride has $500 million of debt (about 20% of its assets), and close to 40% of its debt is due within a couple of years. It does have $170 million of cash and reserves to get it through the tough times. 

Both Pilgrim’s Pride and Gold Kist have more than a $100 million line of credit available to them. Sanderson Farms — the smallest of the bunch — has very little debt, but it has little cash. However, it does have access to a $200 million line of credit, which is plenty of liquidity to guide it through these trying times. One important caveat on credit lines — banks love to provide them when companies don’t need them and may withdraw them if a company starts losing money. However, Sanderson Farms’ bank covenants are dependent on the balance sheet, not profitability. The covenants restrict the debt-to-assets ratio from exceeding 55%. It’s currently around 4% today. 

Foolish bottom line Sanderson Farms and Gold Kist both had respectable return on assets over the years, higher than Pilgrims Pride’s, which has been moving to more stable and lower return on asset business of prepared foods. However, I favor Sanderson Farms over other chicken stocks for the following reasons:

1. Leveraged to chicken prices. Sanderson doesn’t focus on the fast-food (small chicken) market, where most of the agreements are cost-plus type of arrangements. Therefore, its sales will be more sensitive to market prices. If you believe that in the long run, chicken prices will go up (after the initial decline), then Sanderson Farms is a way to go, since higher prices will generate a better return on assets. 
2. Lack of debt. Sanderson Farms has chosen the higher volatility of cash flow and higher return on assets route. Thus, a conservative balance sheet offsets the risk inherent in more volatile operating cash flows.
3. Dividend yield of 2.2%. Yes, this stock can go up or down by more than 2.2% in a given day. However, the commitment to a dividend is an indication of management creating shareholder value.
4. High short interest. On a sliver of any good news, short sellers will have to start buying back the stock to cover their short positions. That means that Sanderson Farms will bounce back at a faster pace than the rest of the flock.

Of course, there’s Tyson Foods(NYSE: TSN) as well. However, Tyson is not a pure play on chicken, as it’s diversified into pork and beef. I’ve been asked many times whether there are any non-chicken plays on avian flu. Yes, in fact, there are. Aside from vaccine stocks such as Chiron(Nasdaq: CHIR), Baxtor International, and Invitrogen, there’s also pork play Hormel(NYSE: HRL), which is one of the biggest producers of the other white meat. Of course, there’s also Clorox(NYSE: CLX) — maker of disinfecting products. Avian flu is passed through uncooked chicken, so Clorox wipes and the rest of the disinfecting arsenal will come in handy to fight the flu on the kitchen front.