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Counting chickens - Sanderson Farms

December 10, 2010 | About:
Third Avenue and David Dreman are long SAFM. http://www.thirdavenuefunds.com/ta/documents/sl/TAF%204Q%202010%20Shareholder%20Letters.pdf

Sanderson Farms, the fourth-largest poultry processor in the US, owns 7 hatcheries, 6 feed mills and 8 processing plants. It has contracts with 550 grow-out farms and 160 breeder farms to house its flock.

The company just spent 125m to build new facilities to process 1.25m birds a week in Lenoir County, North Carolina. The complex will require 130 contract growers. http://www.sandersonfarms.com/kinston/

Once Kinston is on line, the company will be processing a total of 9.5 million birds per week. 4.5m birds in the big-bird deboning segment serving foodservice customers and export markets and 5m birds per week for retailers.




Investment thesis
Sanderson farms is by far the lowest cost producer of chicken meat; the company sells at a reasonable price.


The opportunity exists because
* Earnings are understated due to high growth capex.
* The current outlook for poultry farms is bleak due to expected higher corn prices.
* This is perceived to be a fragmented commodity business with no chance of long-term value creation.


Quantitative analysis
I use round numbers; most of the input is from the latest 10-k and 10-q. http://www.sec.gov/Archives/edgar/data/812128/000095012310079755/g24426e10vq.htm

Earnings power
We start by assuming earnings power is correlated to capacity.

In 10 years:
* SAFM earned 475m starting out with a capacity of 5.5m chickens weekly.
* PPC earned -100m; add back the "nonrecurring" loss in 2009 to get +800m starting out with a capacity of 12m chickens weekly
* TSN earned 1500m starting out with a capacity of 45m chickens weekly.

In 2000 SAFM was the 7th largest producer. It's now the fourth. On top of that, PPC and TSN have significant international operations, SAFM does not.

This is one of many ways to prove SAFM is the low cost producer. You can compare gross margin and/or growth of book value (rock hard hard book value !). TSN is not a bad company and currently runs at > 90% capacity. SAFM is running at < 75% current capacity. SAFM spent heavily on growth and still outearned TSN; and I'm not even factoring in the fact that TSN diluted shareholders as it grew.

My conservative estimate of the earnings power at the current capacity of 9.5m chickens is 90m.

Replacement value
Sanderson spent 125m to add capacity of 1.25m birds per week at Kinston …. Total current capacity is 9.5m birds a week so replacement value of 950m => $45 a share.

Pilgrims Pride bought Gold Kist for 1.3B (including debt). This company processed some 14m birds a week. At the time PPC argued that company was priced at a discount to replacement value => 830m for 9.5m birds => $35

I conclude the assets of SAFM trade at or near replacement value. However, an analysis of the earnings power of SAFM proves these assets are worth much more as a going concern simply because SAFM consistently earns returns well in excess of higher cost producers. Other chicken processors provide an umbrella under which SAFM makes money.

SAFM is the WMT of chicken meat..... with a better balance sheet and a 6% market share.

Having said that, I could have reached the same conclusion in 2001 looking back to 1995..... would the results have been satisfactory ?


Qualitative aspects

* Corn (feed) is by far the greatest cost factor to breed chickens and chickens are the most effective way of transforming corn into meat. You may have noticed chicken meat is cheap relative to other forms of meat. The US has for a long time been the low cost producer of corn on this planet. The country has the highest yield per acre and is blessed with many acres to begin with.

http://www.nationmaster.com/graph/agr_yie_cor-agriculture-yield-corn

http://fatknowledge.blogspot.com/2009/03/corn-yield-growth.html

In short, if you are the low cost producer of chicken meat in the US, you are the worlds cheapest source of meat. This is why the USA exports chicken meat to China. It’s that simple.


* China knows this and slaps a tariff on chicken meat imported from the US. Sanderson typically has a lower tariff than PPC and/or TSN.

http://www.marketwatch.com/story/now-profitable-us-chicken-makers-face-china-2010-02-05

http://www.bloomberg.com/news/2010-09-27/tyson-foods-seeks-to-reverse-chinese-anti-dumping-tariffs-on-u-s-chicken.html

http://finance.yahoo.com/news/Ahead-of-the-Bell-China-apf-1182577565.html?x=0&.v=1


The reason Sanderson dominates this industry is because it locates its farms where the cheapest corn on the planet can be found. Also, its operations and finances are superbly managed. This post is too short. http://www.sandersonfarms.com/static/newsletters/Summer_2010.pdf http://www.freeman.tulane.edu/burkenroad/pdf/SANDERSON_FARMS_10.pdf


Specific Risk

* Timing; This is a highy cyclical business. For all I know, the industry may be poised for some bad years. This of course is good news for the low cost producer with the best balance sheet. More often than not, mr. Market doesn’t care and shares may drop 75% from here.

* Illness; Some wicked illness may wipe out all the chickens in the US. This of course is…..

Any and all comments and questions welcome as usual.

About the author:

batbeer2
I define intrinsic value as the price I would gladly pay to own the business outright. With current management in place. For most stocks, that value is 0. As of September 2012, I'm the author of the monthly Buffett-Munger Best Bargains Newsletter. I can be reached at fvandenbroek AT gurufocus DOT com

Visit batbeer2's Website


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