Monday, April 8, 2013

Is Cal-Maine Still Good Value?

Cal-Maine Foods $CALM gave results recently, and I felt it was time to reassess its prospects. The stock is unusual in that it has a number of profit drivers which can come together positively to give the prospect of generating non market correlated returns. This is interesting in itself, but investors should understand the underlying dynamics before buying. And it is not as simple as it appears.

Cal-Maine A Recession Resistant Stock

As the world demands ever more protein consumption, it stands to reason that cheap protein options like eggs will see demand increase. Moreover, egg demand does tend to be price inelastic because as its input cost prices go up (pushing egg prices up) so will the prices for other proteins. Consumers will then be pushed into buying cheaper options like eggs. The downside is that gross margins will be affected.

Indeed, this was exactly the case with its recent results where revenues and profits went up (partly due to contributions from acquisitions), but gross margins declined thanks to higher feed costs. The longer term picture can be seen here.

The relationship is clear. As feed costs go up, so does the average selling price and gross margins fall. The relationship holds the other way too. So is Cal-Maine just a play on feed costs?

Cal-Maine Equity Research

2008-09 did some funny things to certain industries. Cal-Maine is the largest single egg producer in the US, and when the recession hit it became very hard for its much smaller competitors to get financing, particularly as soft commodity prices were going through the roof. A combination of these issues negatively affected industry hatch numbers, and Cal-Maine found itself in a fortunate position.

The paragraph above hints at what I think is the key to understanding the company. While egg demand is price inelastic, the key factor deciding margins for its normal eggs will be egg supply. As financial conditions are slowly getting better, I wouldn’t expect a ‘2008’ effect any time soon unless corn prices really go through the roof.

Cal-Maine Specialty Eggs

If market dynamics are reducing Cal-Maine into being a kind of black swan play for cautious investors (although there is nothing wrong with that) then what are the other potential upside drivers?

There are two obvious reasons to be optimistic. The first is that its specialty egg sales are rising as a proportion of the total and that it has long term consolidation prospects.

Alas specialty eggs don’t refer to chocolate Easter eggs but rather a range of eggs that offer consumers some added benefits. The range includes eggs that are believed to lower serum cholesterol levels, or hatched from naturally reared layers fed on natural grains or even omega-3 rich eggs. The benefits of expanding specialty egg sales is that they tend to be higher margin and less cyclical. A nice way to de-risk the stock.

The plan appears to be working, but as the first graph demonstrates it hasn’t offset the threat of margin contraction given rising feed costs.

Industry consolidation also offers long term prospects, and the company does tend to be highly cash generative (even after paying a third of net income in dividends), so we should expect more acquisitions going forward. Indeed, rising feed costs could create conditions where smaller producers are more willing to sell up. Cal-Maine’s scale gives it the opportunity to produce at a lower cost and obtain financing easy.

Smithfield, Sanderson Farms and Cal-Maine

I class the company as a protein play. In that vein Smithfield Foods SFD is worth looking at. It is a major pork producer, a relatively cheap meat option which has the attraction of long term demand increases from the emerging Chinese middle class. While this presents good growth prospects, it also exposes it to the variance of internal Chinese pork production. In other words, you will not escape cyclicality with this stock. For example, export demand of pork carcasses was stronger overall this year but substantially weaker in China. This isn't a stock that you buy purely on a macro view.

Sanderson Farms $SAFM offers exposure to the poultry market, however (a bit like Smithfield) it is reliant on export markets. Rather like Cal-Maine it is subject to the vagaries of feed input prices, but unlike the egg producer its poultry is not as price inelastic. Furthermore Sanderson’s heavy exposure to the food service market (which is still weak according to the company) means that it has more need of a return to dining out by consumers.

Where Next for Cal-Maine?

As discussed above, it represents an attractive proposition, especially compared to its peers. The US focus and ability to grow end demand in a weak environment means it should command a premium in its sector. The problem is in calculating what that premium should be and where the cycle is going.

CALM EV / Revenues TTM data by YCharts

If you accept that its earnings and margins are cyclical then price/sales might a better way to look at the company, and on that basis the stock looks like decent value but not special enough to pile in just yet. However, black swan (or should that be black chicken) worriers might want to buy some.