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Sanderson Farms Does OK This Quarter, But Long-Term Value May Be Elusive (SAFM, PPC, TSN, HRL)

Stephen D. Simpson, CFA

Protein production is a tough, low-margin business. Like most other tough, low margin businesses, it's also difficult to build real economic moats and create long-term shareholder value. So while Sanderson Farms (Nasdaq:SAFM) deserves credit for a decent quarter during challenging times, investors would likely do well to regard this name as more of a trading opportunity than a long-term core holding.

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Mixed Results Across the Board
As other protein producers like Tyson (NYSE:TSN), Smithfield (NYSE:SFD) and Pilgrim's Pride (NYSE:PPC) have announced before them, this was a quarter with a lot of noise and moving parts for Sanderson - much of it basically out of management's control.

Revenue rose about 16% for the fiscal fourth quarter. With Georgia dock (a common measure for chicken prices) prices up just under 8%, there was definitely some ongoing volume growth here.

Profitability was a different story. Gross margin improved on the year-ago loss, but fell about seven points sequentially (to just 4%) on higher feed costs. Likewise, operating income reversed a year-ago loss, but fell significantly (nearly 70%) on a sequential basis. With operating margin of just 2.4%, it doesn't seem hard to argue that this was a case of profitless prosperity for Sanderson Farms in the fourth quarter.

Go Big or Go Home?
I believe a significant aspect to the Sanderson Farms story is the company's ability to continue to profitably add scale to its operations. Although the fourth-largest producer of chicken in the United States (Pilgrim's Pride is No.1, Tyson is No.2), Sanderson Farms is well behind those two in terms of market share and operating scale. In a market where even a just a penny per pound of operating leverage matters, that's a sizable operating disadvantage. It's also worth noting that Sanderson Farms has yet to add the branded/packaged food business that has offered some stability and upside to Tyson and built better returns on capital for Hormel (NYSE:HRL).

I do wonder, though, if the company recaptures some of this disadvantage by focusing on larger birds in its product mix - it would stand to reason that if you can't compete on scale, focus on higher-value products. In any case, whatever advantage that may offer, there's also the sizable export business to consider - while protein exports to countries like Russia, Japan and China have been a growth opportunity for many companies, the international protein business is even more cutthroat and volatile than the domestic business, making the benefits of Sanderson Farms' export leverage something of a mixed blessing.

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Whither Costs and Volume in 2013?
It would seem that the biggest (and most important) unknowns for 2013 center around production costs and production volumes. Given that feed costs can range from 20 to 50% of the cost of raising a bird (and corn is about 60% of that), the higher corn and soy meal costs in 2013 are going to continue to hit margins. At the same time, though, the high prices going into 2013 are likely to lead to record-high plantings, so it will be interesting to see what the company may be able to do in terms of hedging.

Production volumes are another major unknown. Recent eggs set reports haven't shown the declines that many analysts and investors seem to have expected, so even though cold storage levels are relatively low on a 10-year basis, it may take a while yet for producers to scale down their production. In the meantime, that could introduce some downside risk to prices (not to mention volatility).

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The Bottom Line
Sanderson Farms is, on balance, usually a profitable company. Returns on capital have been very erratic though, and while the company's weak history of free cash flow production can be explained in part by its growth, it's hard to say that the company has added a large amount of value. While it can be a misleading number, it is also worth noting that the company's shareholder equity growth has been relatively solid.

As is so often the case with protein producers, cash flow-based valuation is not particularly useful with Sanderson Farms (though the stock doesn't seem overpriced on that basis). Given that these shares have rebounded strongly from a steep summer plunge and have struggled to stay above $50 over the past five years, I'd be inclined to be careful with long positions, but this is likely going to continue to be a stock that gives investors multiple trading opportunities.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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