Much fuss was made this week over China’s proposed tariffs on American Chicken. At first glance, the situation is grave; 50-100% premium on imports of chicken from the US. However, upon closer examination there are two other important data points to consider:a) the Chinese have a particular interest in parts of the chicken that we typically discard (namely the feet and the wings) and are virtually worthless in the US market and b) Russia announced that they would be allowing exports of chicken from the United States into Russia after a nearly one year ban.
Additionally much speculation has been had as to the negative impact of corn prices on chicken feed, and the commensurate impact to earnings, but since corn futures are largely a global phenomenon, they neither help, nor hurt any one nation, let alone particular producers in those nations. So, unless one is worried about the eventual abolition of the chicken producer industry as a whole, this information should be disregarded as affecting all companies equally. Incidentally, Russia appears to be at least as large of an export market as China. When the data regarding Russian exports is taken into consideration we see that the industry as a whole is still far better off now, that it was only one year ago. The Russian market, valued at 752 mln. In 2009, came back online, while the Chinese market, worth approximately the same value, merely has the prospect of slowing down – in aggregate, it’s still a major gain for US producers, over last year. Yet, the market has completely overlooked the news from Russia, which pre-empted the news from China by a mere two weeks.
Chicken is generally healthier than red meat, and less expensive. In a world of rising food prices, it’s hard to imagine a scenario where chicken doesn’t play a major role in the diets of people of the world. Food seems like a safe bet if you think inflation is going to be a problem – there’s always demand. It seems like we frequently use examples taken from food, when we refer to the “good old days” when prices were lower.
To that end, the “China Drama” over chicken has led to a rather sudden downturn in the general sentiment about the industry. Sanderson Farms (SAFM) and Pilgrim’s Pride (PPC) are examples of two companies of about the same size, but with radically different financial characteristics. The tariffs affect producers at two major levels; a) The 35 major producers in the ~ 50% tariff range (includes our examples below), and b) Everyone else who will face 105.4% tariff. In this sense, the tariffs are actually a competitive advantage to the 35 producers given preferential treatment over the rest. This gives rise to the thought that consolidation is likely in a world, where a great many producers can no longer compete for reasons outside US law.
However within the preferential group there exists yet additional more subtle advantages. Tyson foods, for example received the lowest tariff of 50.3%, in the case of our two companies, SAFM received a lower tariff by some 3% over its larger rival PPC.
So in general terms an import duty which affects all produces can be consider neither a benefit nor a handicap, in light of competitive advantages of one producer over another, unless it is applied unevenly, in which case, it certainly is an advantage to some, and a bane to others, but the investor has to look beyond the headlines to see this. If one's approach is value oriented, then industry wide negative sentiment can create buying opportunities for great companies. The general premise of the value investor is that asset prices can drop below their real value, if owners over-react and sell when perhaps they shouldn’t. The real question of course is determining real, and presumable, future value, that’s more of an art than a science, and by no means provides complete accuracy. However, if reason triumphs over emotion, then thorough analysis can provide a very sound framework that allows the investor to act. In other words, even if China launched a missile at the US tomorrow, we're not convinced the people of America, or Russia for that matter, or anywhere else, will stop eating chicken as a result. That having been said, buying a company that produces chicken, at a significant "missile launching" discount seems like a good idea. It’s likely to be an even better idea if no missiles are launched.
To that end the following are key measures for Sanderson Farms and Pilgrim’s Pride as of September 29th 2010. We excluded “Tyson” as generally not profitable enough for consideration and in a different revenue category altogether.
|Current Assets||$ 1,296,000,000.00||$ 340,000,000.00|
|Current Liabilities||$ 642,000,000.00||$ 89,000,000.00|
|Total Assets||$ 2,927,000,000.00||$ 770,000,000.00|
|Total Debt||$ 1,950,000,000.00||$ 176,000,000.00|
|Net Current Assets||$ (654,000,000.00)||$ 164,000,000.00|
|debt to equity||2.00||0.32|
Examining the financial condition of a company can be done from a many different perspectives. For some, a weak balance sheet, laden with debt is acceptable because the growth “prospects” (as usually outlined by the investment banks selling the stock) are so convincing. However, we have to confess, we’re big fans of the “sleep well at night” balance sheet club, of which SAFM is a member. While PPC is 37% larger than SAFM by market cap., it took a whopping 1100% more debt to get them there. In addition, when growth isn’t the spirit of the times, as appears to be the case for chicken right now, you start ask other questions, like who will survive if things worsen. Sometimes surviving is a competitive advantage – just ask Allan Mulally at Ford.
Both companies current ratio is sufficient to cover current debt, but SAFM can do it nearly four times over, an impressive measure for any company. As of the September 29th, 2010 SAFM had $7.80 or 19% of its share price in net current assets alone (NCA = Current assets - All liabilities), PPC by the same measure ran a deficit 654 mln (or $-3.05 per share), large though the current assets are. Why is a consideration of “net current assets” important? Because it’s the quickest way to look at a company’s ability to endure the inevitable storms of business, and answer one basic question; “could this company operate without additional financing?” If you think this is an extreme question to ask, you only have to look back to the fall of 2008. This brings us to the earnings picture, or the engine that drives owner’s equity (assuming owner’s equity is efficiently managed in both examples), and that will ultimately permit a company to function without additional long term financing, if necessary.
|EPS as % of current share price||41.08%||13.74%|
|MRQ annualized (available to common)||$168,000,000.00||$140,832,000.00|
|% of current market cap||14.1%||16.3%|
|MRQ EPS (annualized)||$0.80||$6.20|
|MRQ EPS (annualized) / current share price||14.4%||15.1%|
At first glance, Pilgrims appears to have the better earnings engine, with a full 41% of their current share price attributable to earnings in the trailing twelve months. Sanderson on the other hand, has a respectable 13.74% of their share price attributable to net earnings available to the common, a mere fraction of that of PPC. Both have modest Price to Earnings ratios well below 10.
However, reviewing the income statement for several years tells a slightly different story. Pilgrims has had a very volatile earnings picture over the last five years, with a net loss in three out of the last five years between 2005 and 2009, and a very modest profit in 2007, a year of relatively good general economic conditions. While it is true that In 2008 Pilgrims took a large impairment on assets of 546 mln., even had this impairment not been booked, the company would still have recorded a net loss of some 96 mln. or a full $1.39 per share. In sum, the last five years of operations for Pilgrims has amounted to an aggregate loss of some $5.81 per share or 422 mln. dollars. This is grounds for serious circumspection on whether or not the current earnings picture is sustainable, particularly in light of the overall decline in Pilgrims revenue in 2009.
Sanderson on the other hand with its relatively modest earnings picture over the last twelve months has grown revenues and market share every year between 2005 and 2009. Sanderson, like Pilgrims also recorded a loss in two out of the last five years, but both years were a relatively modest loss indeed, with the largest loss in 2008 attributed to special onetime items. In aggregate, including losses recorded in 2008 (also a year of difficult economic conditions), Sanderson’s still earned $10.44 per share between 2005 and 2009, or about 25% of its entire market cap. as of September 29th, 2010. The picture becomes even more interesting, when the special items are excluded from the 2008 earnings pictures. If the 52 mln. (apparently related to legal expense and settlement) is excluded from the 2008 operating expenses, net earnings for the firm would have been about 30 mln.
Not all management teams are created equal. In the case of SAFM, the efficiency is clear. When you annualize the MRQ EPS for Sanderson’s, they are returning nearly 24% to their owners in the form of enlarged equity.
|Net Working Capital per Share||-$3.05||$7.89|
|NWC as % of Share Price||-55%||19%|
|Net Tangible Assets||$925,258,000.00||$593,879,000.00|
|Book Value Per Share||$4.32||$28.24|
|Current Price to Book||1.29||1.46|
As price is concerned, Sanderson sells for about a 46% premium over its (tangible) equity, which is larger at first glance than Pilgrims by some 24%. However, Pilgrims has booked 52 mln to intangibles, which may or may not be a fair assessment of the asset. However, when intangibles are stripped away, and the price is considered in terms of tangible assets alone, Pilgrims is actually selling at a 29% premium over book, or a mere 17% less than Sanderson’s premium to book. This is a pittance in our opinion given the different condition of both the revenue figures and net earnings over the last five years, not to mention the consistent growth in Sanderson’s owners’ equity.
The relationship between capital structures, efficient equity management and growth requires a good deal of investigation. The initial numbers for Owners equity for our two companies is no exception.
|**2010 through Q3||$977,000,000.00||547%||$629,000,000.00||46%|
|twelve month forecast||$579,216,925.97||$752,557,779.75|
|Avg (ex 2010 PPC dilution):||-41%||20%|
|Avg. w/ dividend:||-41%||21%|
|forecast BV per share (1 yr.)||$2.70||$35.78|
|1 yr. price at today's premium over book||$3.47||$52.20|
Between 2007 and 2009 Pilgrims suffered an average annual loss in owners’ equity of about 41% while Sanderson gained an average of 11% in the same period. However, in 2010 paid in capital increased owners’ equity by 540% over the previous year, this may sound good at first but it was at the expense of the issuance of an additional 140 mln. shares, or 289% increase in the share float and dilution of existing owners. Sanderson also diluted their existing owners in 2010; they issued 11% more shares, or roughly 154 mln. in additional paid in capital, on top of accumulated retained earnings of 452 mln. through the same period. That compares to an accumulated deficit of $448 mln. for Pilgrims.
Sanderson Farms has generated almost 1 billion more in retained earnings through the second quarter of 2010, despite having less than half the gross revenues, and about a tenth the debt. The disparity in earnings is nearly enough to purchase the entire operation of Pilgrims at the September 29th market price.
Any intelligent attempt to determine the future value of a common stock would have to take into consideration the growth in owners’ equity over at least five years of performance. In our case, we have to conclude that no intelligent evaluation of Pilgrims future equity value can be determined due to the massive dilution of existing owners, upon which there can be no assurance of a future re-occurrence, particularly given the company's remarkably consistent loss in owners’ equity leading up to the most recent offering.
However, we feel confident that a sound assessment can be made for Sanderson. If the 2009 growth in equity is considered (46%), the average over the last five years is about 20% (excluding dividend payments). At that rate, the book value per share in one year would be $35.78, and that is just net asset values, since Sanderson has no entry for good will or other intangibles, which presumably are very important in the food industry. However, if the market price of the stock were consider in light of the 46% premium the market was willing to pay for the stock (over tangible assets) on September 29th, 2010 a day when sentiment was particularly negative in light of the China tariff news, the value would actually be $52.20 – or 26.7% higher than the quoted price on September 29th, 2010. We won’t mention estimates for the realities of good will in the food industry, but we think it’s very significant. Add to that the likelihood that sentiment will improve in a year, and even modest inflation, and the price certainly could be much higher by this time next year. It will be interesting to see.
In the meantime Pilgrims Pride looks about as good as куриные ноги! (“Chicken feet”)
**The above is not an endorsement to either buy or sell an interest in either security, but is intended rather, as a review of the quantitative factors of the concerns. The approach is “value” oriented and intended for readers with intermediate to advanced experience with securities analysis. Qualitative factors are undoubtedly important in any consideration of value, but are beyond the scope of this article, that having been said, the financial statements of a company is one of the best ways of measuring quality within the organization.