We thought we would take a look back at the thesis in that article, now that the period for short term capital gains tax has passed and examine how the issues performed against one another, but also against the benchmark S & P 500 (Alpha).
The original article was written during a period of great pessimism surrounding the industry and contained the following points in summary:
1. Tariffs on chicken exports to China would be offset by relaxed restrictions from Russia (at least as large of a market) taking place at the same time - we commented:This lead us to the conviction that the whole affair was presenting some very real buying opportunities in this particular industry. As we wrote on September 30th, 2010:
"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..."
2. The particular parts of the chicken exported to China were only of peripheral importance to Revenue recognition in the US.
3. Corn futures would affect producers more or less equally in the long term – thus could not be considered an advantage to anyone producer.
4. Food, in particular a low cost protein source such as chicken would be a good hedge if you believed that inflation was going to be a problem. We wrote:
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.
Turns out, Inflation has been a problem.
5. However, upon examining the China tariffs more closely, they did indeed turn out to be an advantage to the larger producers, yet the industry as a whole moved lower in tandem, with apparent disregard to both this distinction, as well as radical difference in the quality of the financial statements of the various providers:
"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..."
"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."We decided to look at two of the largest concerns Sanderson Farms and Pilgrims Pride, here was our cursory opinion of these two leading companies:
"Examining the financial condition of a company can be done from 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..."Yet oddly, PPC continued to be a poplar issue to invest in because it was more profitable than SAFM (at that moment in time). However, we called into question weather or not this profitability could be maintained. Here was our reasoning:
Figures as of Sept. 28th, 2010 here
"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.We further pointed out that over a slightly longer horizon there was really no comparison:
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 hasgrown 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.We also felt at the time the way intangibles were being handled were important to an accurate assessment of the true value of the two firms:
Not all management teams are created equal. In the case of SAFM, the efficiency is clear..."
Figures as of Sept. 28th, 2010 here
"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."
"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.Our conclusion regarding PPC was as follows:
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."
"...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"Indeed, in Q1 and Q2 of 2011 PPC booked a combined loss of some 249 mln., thus further eroding shareholder equity. We had a very different view of SAFM:
"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."Further to these comments, the market was not willing to pay the premium today that they were willing to pay one year ago, but nonetheless, the article appears to have been quite accurate in the assessment that:
a) Sentiment would improve in a yearWe continue to believe that the stock's real value is closer to (~$52) than today's price (~$46). With regards to inflation the Georgia dock price at the time the original article was written was 86.73 cents per pound. As of the end of August 2011 (last date that figures are available) the price was 88.14 cents per pound; or about 2% higher (may have been yet higher if the September data was taken into account). However, the official CPI figures have "Food at home" gaining 6 pts. in the last 12 months.
b) There would be at least modest inflation
c) The price could be much higher in one year
Either way, it suffices to say that inflation has been at least "modest", it is important to note that these comments were made at a time when virtually everyone was still discussing "deflation" and not inflation.
Here is the price performance of the two issues:
|SAFM||9/28/2010||$ 41.19||9/27/2011||$ 46.20||12.2%||12.0||12.2%|
|S & P 500||9/28/2010||1147.7||9/27/2011||1185.72||3.3%||12.0||3.3%|
|PPC||9/28/2010||$ 5.66||9/27/2011||$ 3.96||-30.0%||12.0||-30.1%|
|S & P 500||9/28/2010||1147.7||9/27/2011||1185.72||3.3%||12.0||3.3%|
As the figures indicate, SAFM returned 12.2% to investors in the last year or ~14% w/ dividends. PPC on the other hand, which pays no dividend, lost 30% of it's shareholders value. Despite an unparalleled run-up in corn futures, which lead to losses in Q1-Q3 (due to their unhedged position in corn feed), SAFM still outperformed PPC by some ~44%, and even the broader S & P 500 by about 9%. Although it took another year, our friends at Goldman Sachs finally came around to seeing things our way when theyadded SAFM to their "conviction buy" list, today September 27th, 2011, citing a $55 price target (not far off our own). Of course a buyer acting on Goldman's advice of today would pay 14% more than a buyer acting on our advice 1 year ago.
On October 21st, 2010 a friend asked for advice on a stock that was still "actionable". We have included the contents of our email response (which includes more of our thinking on SAFM) in the following post here. In the correspondence, we pointed out that SAFM would return at least 15% within one year – and that the stock the our friend was interested in (CREE), should be avoided. After just over 11 months SAFM returned 14% (still 3 weeks to make up the remaining 1%). A purchase of CREE on the same day would have resulted in a loss of ~39% as of today (or an annualized loss of some ~42%)
More on our reasoning a year ago and the correspondence here
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