Tuesday, July 31, 2012

Cal-Maine Foods, A Great Stock to Play Rising Protein Prices

One of the market's favored investment themes is the long term uptrend in soft commodity prices. The central thesis being that, as the numbers of the middle class expand within emerging markets, they will tend to eat more protein. In general, it takes 7-8 times as much feed (wheat/soya/corn/barley etc) in order to produce a protein meal, as it would to give the same meal made out of the feed ingredients.

Such long term considerations are seen as putting upward pressure on food prices. So what is the best way to play the sector?

I want to focus on an overlooked company that I think could give good exposure to corn prices.

Cal-Maine Food $CALM is the largest single US producer and distributor of eggs (about 18% of domestic US consumption) and the only listed company. It also claims to be the lowest cost producer in the industry.  Eggs are a cheap and rich form of protein and demand is relatively inelastic. It actually tends to improve in downturns. So how does this fit in with the commodity thesis?
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 can be good news for Cal-Maine! Essentially, what happens is that as feed prices rise, smaller producers cut back on production because they have relatively higher costs than Cal Maine. So, as production is scaled back, egg prices rise. Egg demand is relatively price inelastic because as protein prices rise elsewhere, eggs will still be relatively cheaper.

A similar argument could be applied to Smithfield Foods $SFD which offers exposure to the attraction of pork as a cheap protein. However, pork meat is likely to be far more price elastic than eggs would be. And, Smithfield is also exposed to the vagaries of Chinese pork production whilst Cal-Maine is much more of a US focused play.

Another option is Sanderson Farms $SAFM with poultry. Sanderson has significant exports and also has large exposure to the more cyclical food service sector. This is reflected in its earnings over the years. It is a similar situation with the traditional crop plays Syngenta $SYT and Monsanto $MON whose products stem across a whole range of crops. In a sense, this makes them attractive because corn and soybean are subsititue crops so, as long as prices stay high for one of the two, then land will be cultivated. However, if prices are low across the board, then Syngenta and Monsanto will be exposed. Arguably, they are more cyclica than Cal-Maine.

So What Drives the Cal Maine Foods Share Price?

Listed in bullet form below.
  • 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 can lead to expansion
  • 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 dividends within the quarter
  • 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
  • It is a consolidator in the industry
  • Typical with all foods, Eggs are susceptible to recalls and health scares
I’ll deal with some of these points in turn, but first, I want to hone in on my earlier claim about Cal Maine’s ability to raise margins even given high feed costs.

Note that in 2008, Cal Maine’s margins and profitability soared. This is probably because feed prices did too and, smaller producers would have had difficulty gaining funding in the midst of the financial crisis. However, as feed prices rise, this time around, we haven’t seen the same effect.
 At least not yet, but there is some evidence that high corn feed costs are starting to hurt the industry. Here is the latest data from the USDA regarding egg-type chicks hatched.

Note, how the number of egg-type chicks hatched starts to track weaker at the end of 2011. Indeed, the cumulative numbers finished up weaker than in 2010. Similarly, we appear to be tracking lower in 2012, as well. If this trend continues then, it is reasonable to believe that Cal-Maine’s margins could expand in the future as industry production is scaled back.
Moreover, the company is seen as a consolidator in the industry so the chance to make acquisitions will surely not be lost.

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

Cal-Maine producers and markets a range of specialty eggs and the recent news highlights the attraction of this division. 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.

It is not hard to see the attractions of the deal with Eggland’s Best and, Land O’Lakes. Specialty eggs are a key growth area that should reduce cyclical risk to Cal-Maine’s stock.

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, and the business is highly cash generative.

To put this into perspective, at the current price of $36.44, the stock trades on an Enterprise Value of $713.5m.  In other words, over the last nine years it has generated 74% of its EV in free cash flow. Despite the cyclicality, this stock does not look expensive.

What Next for Cal-Maine?

In the short term, I think the acreage planted this year for worldwide corn may well cause corn prices to go down. Counter intuitively this may not necessarily be good news for Cal-Maine; because it looks like industry wide production is currently being slowed by today’s corn price. And lower production by less cost efficient producers, usually means higher margins for Cal-Maine.

No matter, looking longer term, I do think the price pressure on the ‘softs’ will be for higher prices. This is an environment that the company can thrive in. In addition, the growing portion of revenues in specialty eggs is reducing cyclical exposure, which should mean that the stock attracts a higher rating. Egg demand remains price inelastic. Protein demand isn’t going away anytime soon.

The obvious concern is that margins and profits have been falling in recent years and a long term investor will need to be convinced that this is not part of a structural trend. I don’t think it is an inexorable trend and, if corn prices continue to move higher in the longer term, it is possible that industry production will be curtailed, with Cal-Maine being a key beneficiary.