Saturday, January 1, 2011

Cal Maine Foods Playing its Very Own Cyclical Game







Cal Maine Foods CALM gave Q2 results over the festive season and, I confess I found them intriguing. Cal Maine is the largest single US producer and distributor of eggs (about 16% of US market) which suggests they are an easy company to analyse. However, performing equity research analysis on a stock like Cal Maine is actually more difficult than it superficially appears. It would be easy to look at rising feed costs and immediately conclude that margins are about to get crushed, but it is a lot more subtle than that. High feed costs are usually good news for Cal Maine!
 It is an attractive stock to buy because its profit drivers are diversified from the mainstream economy. Therefore, its profit and share price drivers should not be correlated with the S & P 500, which means it should work well in giving portfolio diversification. It seems to operate in an isolated industry cycle.  Indeed a quick look at its share price demonstrates this. Note how well it does in 2008...


source: bigcharts.com

What Drives the Cal Maine Foods Share Price?
I will list them in bullet form below and then articulate these points in turn
  • Egg pricing is highly sensitive to small shifts in production and demand as it is a price inelastic good
  • High Food Prices do not necessarily mean Cal Maine’s margins will fall, on the contrary, they are usually good news for Cal Main
  • Production is cyclical and follows end demand and feed prices
  • Demand can be guided by dietary fads and health concerns, but the marginal demand is guided by the economy (people eating out etc)
  • Cal Maine pays a third of its net income in dividend within the quarter, so it is a dividend play
  • Speciality egg sales (health/ethical) are less cyclical, higher margin and are growing quickly as a portion of total sales
  • Cal Maine tends to be highly cash generative
  • They are a consolidator in the industry
  • They have had some near term weakness due to product recalls, which could be creating a buying opportunity

Cal Maine Gross Margins and Pricing Power
Firstly, looking at long term gross margins and feed costs I see that it is a cyclical business with some interesting aspects to it

2004
2005
2006
2007
2008
2009
2010
H1 2011
Gross Margins
30.69%
9.44%
13.03%
19.83%
32.60%
22.04%
21.39%
18.34%
Feed Costs (cents)
23.4
22.5
20.2
25.2
33.4
39.1
34.9
36.1
Source: Cal Maine Foods (feed costs are per dozen)

I think that as feed costs rise, their gross margins tend to do so too! This shouldn’t make sense in a competitive and commoditised business such as egg production. It does appear that high feed costs are passed onto the customer via higher prices.

2004200520062007200820092010H1 2011
Price (cents)91.462.575.193137.7120.9112101.2
Feed Costs (cents)23.422.520.225.233.439.134.936.1
Source: Cal Maine Foods, price and feed costs are per dozen

However, I do not think this is the key profit driver. On the contrary, it is the marginal shift in production that guides the business cycle of the egg industry. For example, in 2004 revenues expanded rapidly as low carbohydrate diets reached their nadir of popularity. The industry geared up for growth and the resulting fall in demand hurt pricing, as the producers had too much supply coming on tap. Here is the relationship between supply and margins. I have used Cal Maine’s gross margins and compared them with industry wide supply numbers...

20032004200520062007200820092010H1 2011
Gross Margins30.69%9.44%13.03%19.83%32.60%22.04%21.39%18.34%
Total Supply734674277586763676437609758476417674
growth1.10%2.14%0.66%0.09%-0.44%-0.33%0.75%1.04%
Source: USDA (shell egg equivalent, million dozen), Cal Maine foods (cost per dozen), Earnings View

I have adjusted the yearly numbers too equate with Cal Maine’s year end of May. Similarly, the H1 2011 numbers are adjusted.
There is a clear pattern to these numbers. High margins attract high industry growth rates, which then lead to lower margins, then low production followed by higher margins. So high feed prices are not necessarily bad for Cal Maine but strong growth in industry production is. The company itself sees long term egg consumption has trending with population growth, in other words its volumes should grow long term at around 1%

Specialty Eggs: Egg-Land’s Best, Farmhouse and 4-Grain

Cal Maine producers and markets a range of specialty eggs. Egg-Land’s Best are believed not to increase serum cholesterol levels, whilst Farmhouse layers are non-caged and fed solely on natural grains. 4-Grain eggs range includes natural, cage-free, vegetarian and omega-3 options. Specialty eggs tend to be higher margin and less cyclical, therefore their percentage contribution to total sales (dollar) will go up in bad times. Furthermore, their volume percentage contribution is also going up because of their strong growth. This is very positive for Cal Maine and will reduce cyclicality in future
 
2007200820092010
Specialty Eggs Sold59,48680,997107,025116,083
growth36.16%32.13%8.46%
Specialty Eggs % volume8.68%11.94%13.76%14.41%
Source: Cal Maine Foods

At the recent H1 2011 interims the percentage volume of sales coming from specialty eggs rose to 15.2% and in dollar sales terms it was at 24.1%

Cal Maine Free Cash Flow Generation
As you would expect, this follows the cyclicality of its earnings. In particular working capital requirements fluctuate with higher feed costs. Capital expenditure requirements are relatively light.


2004200520062007200820092010
FCF74,465-2,3638,55936,252126,73085,17095,882
FCF % rev13.01%-0.63%1.79%6.06%13.84%9.17%10.53%
Source: Cal Maine, Earnings View
I will use these numbers in the concluding remarks and try to 'guesstimate' some value scenarios for Cal Maine.

A Stock to Buy?
The short answer is not right now, but perhaps later this year.
The key thing I am looking at is the United States Department of Agriculture numbers of egg supply. As indicated above, Industry production rates do tend to guide Cal Maine’s margins. This could create an interesting scenario whereby the stock gets sold off due to high feed cost fears. I think this would be a misguided approach. The key is industry production. I would like to wait and see when/if high feed costs start to hurt the smaller industry players, who should then cut back on production. I haven’t seen evidence of this yet.
Moreover, if I go by Cal Maine’s gross margins, then they could still be seen as attractive to producers to increase supply. Indeed as Cal Maine notes in the recent results


We continue to monitor the national chick hatch, which has been trending higher, and will affect future supply. Feed costs also remain a concern for fiscal 2011. For the second quarter, feed cost per dozen produced increased by four cents compared with the same quarter last year.
In evaluation terms, if you take a ‘trough to peak’ approach to their free cash flow (ex 2005-2008) you get an average of $42.23m or around 5.6% free cash flow yield across one cycle. The current share price is $31.53 giving a market cap of $753m.


Mitigating Factors

That approach is ok, but I think there are positive and negative mitigating factors here. Firstly, the low carbohydrate Atkins diet boom is unluckily to disturb the supply/demand imbalance in future, as much as it did in 2004-2006. This is positive. However, it is unlikely that the financial turmoil of 2008-2009 will be replicated any time soon. I suspect the smaller producers couldn’t expand production then –even if they wanted to- because of lack of funding. This was a good scenario for Cal Maine but I think it is unlikely to return.
Long Term Buy?
I like the longer term trend of reducing cyclicality by increasing specialty egg sales and, the company is an impressive industry consolidator. However, my hunch is that analyzing long term fundamentals such DCF evaluation, is not the way to trade this stock. I think you want to be in this stock as industry production starts to slow below 1% and then sell it as it goes above. This is not a definitive trading heuristic but rather, a primer for looking at it in more detail.
In addition, in 2011 there could be rising feed costs matched with continuing rising production and this could hurt the company prospects. However, if industry production decreases and feed costs stay high, this will be a net positive. I will monitor and wait for evidence of the latter. The data in table 3 indicates that it is probably too early just yet. The key to this stock is the supply/demand balance and not necessarily its feed costs.