Value Play: Sanderson Farms (Nasdaq: SAFM)

“The chicken guys have never had it so good.”

— Meat industry analyst

Emerging markets are one of the strongest growth drivers for U.S. meat producers because countries such as China, Brazil, Mexico, and South Korea are developing affluent middle classes that can afford to eat meat for the first time. Emerging markets account for more than half of U.S. pork exports and around 40 percent of U.S. poultry exports. Since 1990, meat exports to emerging markets have exploded by 1,300 percent and poultry exports in particular have been the biggest beneficiary of all, rising by an even faster 2,050 percent.

The recent economic slowdown in China has affected the export and construction industries much more than domestic food consumption (people need to eat). In 2013, Chinese beef imports quadrupled. In any event, recent signs that China’s economy is recovering are good news for U.S. meat producers. Emerging stock markets have rallied strongly so far in 2014 after a rough start to the year, thanks to stabilizing foreign currencies that are benefiting both from stronger global economic growth, as well as from inflows of foreign investment capital seeking alternatives to the persistently-low interest rates in the developed markets of North America, Europe, and Japan.

The Developing World is Hungry!

The biggest beneficiary of economic revival in the emerging markets will be commodities. Analysts at HSBC expect agricultural commodities to experience a “boom” of demand much larger than for energy or metal commodities:

It may, in fact, be the case that food prices have the potential to outperform relative to metals and energy prices in the coming years, as growing middle class incomes continue to boost demand.

Agriculture product prices have risen by far less than metals and energy prices over the past decade, but could be the next big story, it said. As incomes rise and the middle classes expand in the emerging economies, populations are expected to demand more and better quality food.

There is likely to be a continued shift in the type of food that is in demand. Our estimates suggest that an additional 1.3 billion people are expected to attain at least middle-income levels by 2030 – a number that is equivalent to four times the current population of the US. Another 2.6 billion people are expected to obtain middle income status by 2050.

Takeover Fever in the Meat Industry

The emerging markets are not satisfied with importing the meat that they need; they are also intent on buying the companies that produce the meat. For example, last year Chinese pork processor WH Group (then called Shuanghui) acquired U.S. pork producer Smithfield Foods for $4.72 billion and this year Brazilian meat producer JBS bid $6.4 billion (through its Pilgrim’s Pride poultry subsidiary) in an unsuccessful attempt to acquire luncheon-meat and sausage manufacturer Hillshire Brands (Tyson Foods won the bidding war with a purchase price of $8.55 billion). In fact, in the five-year period between June 2008 and June 2013, Chinese and Brazilian buyers accounted for $21.9 billion of the $24 billion (91 percent) worth of meat-industry acquisitions worldwide.   

With JBS having lost out on both Smithfield and Hillshire, there is speculation that it is interested in buying one of the last remaining independent U.S. meat producers. A prominent acquisition candidate often mentioned is this month’s Value Front Runner: Sanderson Farms. 

Sanderson Farms (SAFM)

Sanderson Farms is the third-largest poultry producer in the United States (Behind Tyson and Pilgrim’s Pride), processing 9.4 million chickens per week, generating $2.7 billion in annual sales, and holding a 7.4 percent market share (slide no. 4) in the ready-to-cook (RTC) chicken segment.

Family Run

The company was founded in 1947 by D.R. Sanderson and his two sons, Dewey and Joe Frank. Current CEO Joe Frank Sanderson Jr. is the son of co-founder Joe Frank Sanderson Sr., so the company remains in the hands of the founding family, which is a positive for stock outperformance because founders care about preserving a long-term legacy of achievement. In 1992, the current CEO’s father even wrote a 20-page booklet on the family business entitled Family Matters: The Story of Sanderson Farms. Insiders collectively own a 5.5 percent stake page 4) in the company, so their interests are financially aligned with the averages shareholder.

Very Profitable

Approximately 89.4% of Sanderson’s poultry sales occur in the U.S., but a sizeable and growing 10.6% of sales are exports to foreign countries, with Mexico the number-one destination market. Selling chickens is a simple business, but a very profitable one. Sanderson’s return on equity is sky-high at 29.5% and not manipulated higher by debt because Sanderson is almost debt-free (1% debt-to-equity ratio). The company suffered a loss in 2011 on record-high corn prices (chicken feed is made of corn), but that was temporary and profits quickly returned with a reversal in corn prices.

Annual earnings per share in 2014 are expected to hit $8.58, which would be a record high. The company’s second-quarter financial report was very strong, with earnings more than doubling on revenue growth of 6.4 percent – both numbers beat analyst estimates.

Positive Catalysts

Sanderson Farms is benefiting from a couple of tailwinds:

1. Beef prices are skyrocketing, which is causing consumers to buy more chicken as a lower-cost substitute meat. “There’s typically a lag of at least 18 months between the decision to breed calves and their readiness for slaughter. That means that as the market prepares for the third quarter, there could be an even slimmer supply of beef available.”
   
   
2. Corn prices are falling (slide nos. 24-25), which is a primary feed ingredient for chickens. Lower input costs increase profit margins since chicken prices have remained stable. Soybean meal is another chicken feed and it has risen in price until recently, but soy prices are set to fall because farmers are planting more acres of soybeans, which will increase supply and lower prices. In fact, corn prices are at a five-month low and soybean futures prices are at almost a three-year low (since Dec. 2011) and a commodity analysts stated:

Sanderson Farms’ stock price reflects the company’s good fortunes, having risen 172 percent over the past two years. I could have selected Sanderson for the Momentum portfolio, but the amazing thing is that the stock also qualifies as a value stock.

The Stock is Cheap

Even after the strong price run-up over the past two years, the stock still trades at an EV-to-EBITDA ratio of only 5.9. Other value metrics are similarly cheap, including price-to-earnings (11.4), price-to-sales (0.8) and PEG ratio (0.9). The investment risk is that Sanderson Farms is a cyclical stock and 2014 represents peak earnings at the top of the cycle, which would make the stock’s seemingly low valuation a value trap. The short interest-to-float ratio is elevated at 17%, reflecting some investor skepticism both that corn and soybean prices will remain low and that beef prices will remain so high, but I’m a believer that the good times will continue thanks to growing foreign exports and the real possibility of a takeover.

More Growth is on the Way

Right now, foreign exports constitute less than 11% of total sales, so the runway for export growth is huge. Sanderson Farms is building a new poultry processing facility in Palestine, Texas that is expected to open in February 2015 and churn out 1.25 million birds per week – increasing the company’s total production by 13.3%. More chickens sold, more profit!

Takeover Candidate

Although Sanderson Farms is family run, which arguably makes a takeover less likely because the family wants to hold on to its legacy, family ownership is not large enough to veto a takeover. Sanderson has a single class of stock and insider ownership is less than 10 percent. Other family-run companies with dual share classes where insiders own the share class with super voting rights (e.g., 10 votes per share instead of one vote) are virtually invulnerable to a hostile takeover, but Sanderson isn’t one of them. On the other hand, the company’s 10-K filing states on page 18 that:

Anti-takeover provisions in our charter and by-laws, as well as certain provisions of Mississippi law, may make it difficult for anyone to acquire us without approval of our board of directors.

Even if approval by the Sanderson family is needed for a takeover, such approval may be forthcoming because “there is no obvious family successor” to CEO Joe Sanderson Jr.

Lastly, Sanderson Farms is a value stock with price momentum, which bodes well for future stock-price appreciation because Sanderson Farms fits the profile of James O’Shaughnessy’s “Tiny Titans” stock screen that has outperformed the market by almost double.

Sanderson Farms is a buy up to $108.50; I’m also adding the stock to my Value Portfolio.

Sell Alert

To make room for Sanderson Farms, Roadrunner is selling:

• Fresh Del Monte Produce (FDP)

The stock of this fruit grower has rebounded nicely above $30 and our investment has made a double-digit profit. In listening to the past few quarterly conference calls, however, I’ve lost confidence in management.  Back in 2002, the company was acquired  under suspicious circumstances. Although what happened 12 years ago is arguably irrelevant today, it may help explain why management isn’t the best. You can get a sense for my frustration by reading the October 30, 2013 portfolio update.

Bottom line: as I wrote in What is a Roadrunner Stock Part 2, corporate communications is key and I don’t get the sense that the CEO knows what he’s doing. Furthermore, the company’s  future growth prospects are estimated to be only 7% per year, the EV-to-EBITDA ratio of 10 is not cheap, and insider selling has picked up, so let’s cash out our profit and move on! Fresh Del Monte Produce is being sold from the Value Portfolio.

Four Momentum Buys:

1. ANI Pharmaceuticals (Nasdaq: ANIP)

ANI Pharmaceuticals is a biotechnology company that both develops its own proprietary drugs (e.g., female sexual dysfunction) and provides contract manufacturing services to other drug companies. The company merged with BioSante Pharmaceuticals in 2012.

• Price gain between 12 months ago and 3 months ago = 470.14% (100 percentile)
• Price gain over the past 2 months = 14.66%
• Price gain over the past month = 17.62%
• Roadrunner Momentum Rating: 470.14 – (14.66) – (3*17.62) = 402.72

ANI Pharmaceuticals is a buy up to $45; I’m also adding the stock to my Momentum Portfolio.

2. Emerge Energy Services LP (NYSE: EMES)

Emerge Energy Services is a diversified MLP that operates in two divisions: (1) sand proppant for frac drilling; and (2) processing and distribution of fuel “transmix” from other companies’ pipelines. No incentive distribution rights paid to general partner, so 100% of cash flow goes to the limited partners.

• Price gain between 12 months ago and 3 months ago = 270.81% (100 percentile)
• Price gain over the past 2 months = 42.13%
• Price gain over the past month = 7.66%
• Roadrunner Momentum Rating: 270.81 – (42.13) – (3*7.66) = 205.69

Emerge Energy Services is a buy up to $120; I’m also adding the stock to my Momentum Portfolio.

3. Clayton Williams Energy (NYSE: CWEI)

Clayton Williams Energy is is an independent oil and gas company engaged in exploration and production of oil and natural gas primarily in Texas, New Mexico and Louisiana. Proven reserves are 82% oil and natural gas liquids, with the remaining 18% natural gas. An analyst at Wunderlich recently reiterated a buy recommendation, stating:

“We believe that the inventory of drillable locations could be larger than the company’s current estimate. We reiterate our Buy rating on this Permian first mover and are raising our NAV and price target to $162.”

• Price gain between 12 months ago and 3 months ago =218.39% (100 percentile)
• Price gain over the past 2 months = -2.21%
• Price gain over the past month = 15.07%
• Roadrunner Momentum Rating: 218.39 – (-2.21) – (3*15.07) = 175.38

Clayton Williams Energy is a buy up to $150; I’m also adding the stock to my Momentum Portfolio. 

4. AerCap Holdings N.V. (NYSE: AER)

AerCap Holdings N.V.   is a global leader in aircraft leasing and aviation finance with 1,300 aircraft and $45 billion in assets. Recent acquisition of AIG’s International Lease Finance Corporation (ILFC) was “transformational” and catapulted AerCap into a market-leading position. Purchase price was a bargain and the value of ILFC is not fully reflective in AerCap’s stock price.

• Price gain between 12 months ago and 3 months ago = 150.60% (99 percentile)
• Price gain over the past 2 months = 4.95%
• Price gain over the past month = -2.48%
• Roadrunner Momentum Rating: 150.60 – (4.95) – (3*-2.48) = 153.09

AerCap Holdings N.V. is a buy up to $53; I’m also adding the stock to my Momentum Portfolio.

Momentum Sell Alerts

To make room for these four new momentum stocks, Roadrunner will be selling four price laggards:

• HomeAway (AWAY)

• Solarwinds (SWI)
  
  
• Valmont Industries (VMI)
  
  
• Western Refining (WNR)