Chicken stocks...are we about to get plucked?

There is an excellent post this morning on Shai’s blog regarding chicken stocks. He links another insightful blog from Geoffrey Gannon on the chicken processing industry and Sanderson Farms (SAFM) in particular.

I have written up some of the fundamentals regarding SAFM in a previous post.

The cyclicality of the business should come as no surprise. To quote from the Sanderson 10-K:

“Profitability in the poultry industry is materially affected by the commodity prices of feed ingredients, chicken and alternative proteins, particularly beef. These prices are determined by supply and demand factors. As a result, the poultry industry is subject to wide fluctuations that are called cycles. Typically we do well when chicken and beef prices are high and feed prices are low. We do less well and sometimes have losses, when chicken and beef prices are low and feed prices are high. It is very difficult to predict when these cycles will occur. All we can safely predict is that they do and will occur.”

The Pilgrim’s Pride (PPC) recent shortfall was addressed by management. PPC explained that about half of its sales are in the form of prepared foods that are sold on fixed priced contracts. The other half is a function of whole bird prices and by leg quarter prices.

Leg quarter prices have plummeted from 49c per pound in early October to 29c in the last week of December according to Bloomberg. The average price during the December
quarter (according to Bloomberg) of 39c was down 17%.About 80% of chicken exports are leg quarters and according to PPC, export sales had weakened earlier in the quarter, lasting through mid-December. However, I suspect that lower prices became sufficiently enticing that demand picked up again in the last two weeks of the year and in early 2006.

Insiders at SAFM have sold some stock, notably the CEO, Joe Sanderson. However, through options exercise, he now actually has greater exposure to the company than he had a year ago with a total of 1,091,104 shares versus the prior year’s 954,854 shares.

Harkening back to the valuation, on an EV/EBITDA basis, based on TTM which is the last full fiscal year, the company is trading at 4.94 times EBIT. Long term debt to capital is below 2%. In fact cash of $35 million exceeds long-term debt of about $11 million.

ROIC has sunk to about 11% for the most recent quarter compared to about 21% for the full year. ROIC peaked at about 36% for FY 2004, but has been at 0% back in 2000.

In my view, the risk relates to the perception of avian flu. Consumption patterns for chicken have been very strong over the last dozen years, reaching an all-time high of 86.8 pounds per capita! Per capita consumption of beef has been flat recently but falling from levels of a decade ago.

Recognize that this is a highly cyclical industry that is currently being squeezed by higher input costs and weakening product prices. Momentum trends are clearly against us at the moment. However, for a reasonable horizon, the stock appears very cheap.