Wednesday, September 12, 2012

Investing in Protein Stocks

My favorite type of modern music is minimalism. You know that sort of insistently repetitive series of ambient noises that guys like Brian Eno or Steve Reich specialize in. In response to its seemingly infinite army of detractors I always point out that although the music does sound the same, it is in fact subtly changing so the end result is significantly different.  Ok, so what does this pretentious twaddle have to do with Cal-Maine Foods? $CALM. I think that in a similar way this company’s results and prospects need to be appreciated as subtly changing but seemingly the same.

Superficially, these results were not that great and it appears to be the same old story of slowly growing egg sales accompanied by an increase in feed costs, which ate into gross margins. However, just as with minimalism there are some interesting things slowly developing here.

What Happened with these Results?

Eggs sold went up nearly 11% whilst prices rose 2.4% to $1.152 per dozen. This led to a 13.6% rise in revenues but unfortunately feed costs rose 7.4% so gross margins declined by 200 basis points. The result was that gross profits were flat for the quarter. This is part of a declining gross margin trend that is largely being caused by rising feed costs and easier financing terms for Cal-Maine’s competitors.

Frankly, I would usually avoid business with declining gross margins but I think there are some interesting underlying developments here.

Specialty Egg Sales Rising

Firstly the share of revenues coming from specialty eggs appears to be rising. Cal-Maine produces 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 also explains why it went into a joint venture recently with Eggland’s Best Inc., and Land O’Lakes in order to expand sales of specialty eggs.

Feed Costs Rising

Feed costs are rising again. I confess that earlier in the year I had thought that the high levels of corn acreage planted this year would cause an oversupply and feed prices would start to drop. Alas the weather had other ideas and the company warned that feed costs are likely to rise in the near term.

This is a significant concern because – although egg demand is relatively price inelastic -- the egg market is competitive.

This is a significant benefit because – although egg demand is relatively price inelastic -- the egg market is competitive.

See what I mean about me and minimalism?

There is a serious point to this journalistic self-indulgence. In the near term high feed costs will hurt margins at Cal-Maine, but in the long term, high feed costs will cause the weaker players to drop out or create acquisition opportunities for Cal-Maine. This is good news because ultimately egg prices are very sensitive to shifts in production. The latter scenario happened in 2008 and Cal-Maine actually came out of that year in pretty good shape.

Rising feed costs are not necessarily a problem for the company. On the contrary they could be a good thing. Aside from the opportunity to acquire and consolidate in the industry, higher protein prices overall will add to the "substitute value" of eggs as being a cheap protein option.

Hedging High Feed Costs and Other Options

Incidentally, a similar argument applies 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. I also quite like Sanderson Farms $SAFM with poultry. Sanderson has significant exports and also has large exposure to the more cyclical food service sector. In addition I think Cal-Maine's competitive positioning and ability to act as a consolidator in its industry make it more attractive.

Investors worried about higher feed costs could do worse than look at 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 substitute crops so as long as prices stay high for one of the two, then land will be cultivated either way and they should benefit. Another alternative is just to go and buy a focused agricultural play like Deere & Co., although Deere comes with a lot more global exposure, which makes it a bit weaker to be used as a hedge for what is going on in the US. In addition Deere, Syngenta and Monsanto are a much more cyclically sensitive then Cal-Maine is.

Where Next for Cal-Maine?

Going forward I would expect further gross margin declines because feed prices are rising. As for the dividend, the company tends to pay a fixed portion of its earnings in dividends so dividend hunters need not get too excited about the dividend if earnings decline. Cal-Maine needs to continue its strategy of expanding specialty egg sales and making acquisitions in order to consolidate the industry. These actions would help reduce the cyclical nature of its earnings and margins. As a long-term holding it makes sense but investors will have to put up with the same story repeating itself as the underlying changes migrate the business toward a less cyclical business.

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