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Sanderson Farms Inc. (SAFM) - SOLD

This past week I sold SAFM from my personal account and also on my StokBlogs account.  Both at losses --  34% roughly. Talk about negative wealth creation.  I broke the first and second rules of Warren Buffett -- never lose money. Everyone has their bad calls, Warren Buffett with Berkshire Hathaway textile, Wallace Weitz with Adelphia. Part of life is bad beats. Since I paid the tuition cost, what’s the lesson learned?

 
I got interested in Sanderson Farms because several newsletters and blogs mentioned it as a value play.  It's a poultry processor similiar to Perdue, Pilgram's Pride, Gold Kist's, etc. The business isn't glamourous, but it's profitable. 

 
Return on equity: 16.68%

Return on capital 12.78%

P/E ~8 (generating an earnings yield of 12%)

Current ratio: 2.3

Total debt to equity: 0.062.

 
These numbers alone – high return on capital, low debt, near 52-week low – totally unloved by analysts. My kind of stock!

 
I never imagined a poultry business could generate double digit gross margins (15.01%) and operating margins of 8.34%. Its competitors --  Gold Kist and Pilgram's Pride post gross margins of 13% and 12%, respectively. Gold Kist and Pilgrams' operating margins fell in line at 8.29% and 6.93%.  In Sanderson, I thought I found the lowest cost producer in the industry -- and I still believe I did.  Also, I found the management to be candid and trustworthy. Always building the business and being very conscious of creating shareholder value.  I thought it was a bargain at $32 coming down from a 52-week high of $49.19 on Avian Flu fears. I thought it was overblown. Mad cow came and went and bird flu will play out similarly. Sanderson has a track record of navigating out of these "crises" profitably. Gaining market share and investing in facilities when blood was in the streets. So, why did I give up?
 
Pricing Power/Brand recognition

 
This past quarter every poultry producer warned and produced negative earnings. Even Sanderson Farm, normally, I would consider this a blip on the map for a long term investor and it is. But, it got me thinking. Is this the industry I wanted to be in? As the lowest cost producer in the industry, how wide is its moat? It's wider than most of its competitors, but it didn’t equate to pricing power? Like Warren Buffett said, does it agonize over raising prices? I realized it's a commodity business -- most people don't really care if their chicken is Sanderson Chicken or Perdue Chicken? It's just chicken.

 
Part of pricing power is brand-recognition. You never hear KFC chicken grown on Sanderson's Farms! Or McDonald’s nuggets made with Sanderson Farm chicken! It just doesn’t happen.

 
Black mailed by weaker competitors

 
Because of the bird flu, many competitors are running at losses to keep their farms/processing centers running. So, it's like the airline industry where irrational competitors dictate the prices -- whether it's  good long-term of not. It forces everyone to suffer. It's great for the consumers, but bad for all producers. Being the lowest cost producer, it'll ride this out and the industry will go back to equilibrium when bird flu stops being a headline risk and also, when the irrational producers run out of money. But, long term, the pricing power isn't resolved – everything will be dictated by supply capacity.


Can this be a good investment? Of course, it’s predicated on your buy price. But, in terms of long term value creation, commodity businesses aren’t the type of industries that great investors invest in.

By schin at 2006-03-12 11:58 | Stocks | SAFM | schin's blog


Poultry Supply/Demand

schin,

Your last paragraph got me thinking the most:

Can this be a good investment? Of course, it’s predicated on your buy price. But, in terms of long term value creation, commodity businesses aren’t the type of industries that great investors invest in.

The stock is definitely undervalued.  Their fundamentals are great as well.  But, like you said, Sanderson Farms (SAFM) is not a Buffett-type business like American Express (AXP) where the stock will recover once the bad news blows over.  SAFM will have its day again, but I think that will be dictated by supply and demand.

Think about oil.  Most people really don’t care whether their gas comes from ExxonMobil (XOM) or not.  Sure there are some loyal reward-program fanatics, but the majority of people will flock to any pump that sells gas 10 cents less than everyone else.  This is classic commodity business.

But oil companies are making record profits and their stocks are at record highs.  What’s the difference?  Supply and demand.  The world is running out of oil, yet demand for energy is growing rapidly.  This has made oil and the entire energy sector terrific investments over the past few years.

So what does the supply/demand chart look like for poultry?  Frankly, I have no idea.  I spent the past hour scouring the Internet and was not able to find a thing.  If anybody has the answer to this question, please post a comment!

By Theo at Sun, 2006-03-12 22:50 | login or register to post comments

The difference as I see it

You're right about oil stocks. They are a supply and demand play. But, it's a little bit different from the commodity business which Sanderson is in. They're fewer alternatives for oil.  We have to drive our SUVs and all the earth moving equipment that India and China uses are predictated on oil.  Even with hybrid cars, there's not enough of a peneration to stop our dependence on Middle East oil.  We can't just stop driving our cars to work.  Plus, our energy policy is focused on oil -- sending our delivery trucks to stores, making our Dupont chemicals, etc. We could switch if we would.. but, we can't.. and it'll be that way for some time until we can replace old equipment with more efficient equipment (possibly predicated less oil or some other tech -- solar, wind?, nuclear)  

Also, one of the bottlenecks is refinery capacity. If you look at the link below, you see a bulk goes to refining and state taxes.  The Arabs are making money, but the US refineries and the states are too.  Eventhough, we have plans to build new refineries -- it takes years to build it, much less get the permissions from local governments. Who really wants a refinery in their backyard? So, that's why refiners are good buys for longer term trades. Sorry for the degression -- but, this example shows how certain parts of a commodity businesses could be decent investments.

Even in 1995, when oil was at $16 a barrel, XOM was making money.. not a lot, but they were in the black. The problem is oil is so capital intensive. Even with $16 dollars a barrel, XOM has to keep up with their fixed cost - cap. expenditures. So, that's why it's not a great industry. It's cyclical and extremely cap intensive. They have to keep up with the Jones. But, I'll take low profits in bad years over Sanderson Farm and others which are bleeding red in down years.

I'm assured chicken will come back in favor. But, chicken (food) has so many alternatives.. I don't want chicken, I'll take beef.. or pork.. or salad (vegs)... or seafood. There's no pricing power there. Some people -- my friends are loyal to oil companies.. they must have Shell Oil or Exxon.. because it's what their car needs... Okay, I admit it.. they're disillusional, but they're out there.
By schin at Sun, 2006-03-12 23:50 | login or register to post comments

RE: Foods

That's a good point about food alternatives like beef, pork, or salad.  I will remember that.

Correct me if I'm wrong here.  Basically, what you're saying is that demand is not high enough for chicken.   Either Sanderson would have to be the last chicken farm on Earth, or mad cow, mad pork, and mad fish would need to be rampant before you would consider Sanderson a decent investment.  Because right now, people can just as easily eat beef if chicken prices got too high while they wait for other farms to come online to drive prices down.  Which, of course, would not take very long.

Whereas any commodity business that is capital- and time-intensive, such as those that need exploration, drilling, refining, processing, etc., would have the ability to exploit the situation with high prices if supply/demand went out of whack. 
By Theo at Mon, 2006-03-13 21:48 | login or register to post comments

RE: Food

Yup, you got it.  I wouldn't say Sanderson has to be the last farm standing, but it's a very volatile industry with irrational competitors. Eventually, the irrational competitors will go away and the bird flu, Sanderson will make a profit again.. but, the fat margins will attractive different irrational competitors -- building a chicken farm and we'll go through this again.. so, it's like taking 4 steps forward and then 3 back.. but, this time, we're taking 6 steps back.. and hopefully, we'll gain 7 on the upside or 5. As an investment, you could buy now.. since some else has already paid the "steps" back.. and catch all forward movement, but, who knows if this "advantage" will be washed away when the next run happens. I'm all for "lumpy returns".. but, I'm not comfortable with the low switching costs in the food business.. versus the oil business which has higher switching/substitute costs.

By schin at Tue, 2006-03-14 17:44 | login or register to post comments

Chicken Run

Fool.com released an article today about the chicken industry and Sanderson Farms in particular.  The article discusses the costs of raising chickens, poultry commodity prices, U.S. chicken exports, the Avian Flu, the financial positions of chicken stocks, and general what-ifs.  Here's the intro:

On the surface, chicken stocks like Sanderson Farms (Nasdaq: SAFM), Gold Kist (Nasdaq: GKIS), and Pilgrim's Pride (NYSE: PPC) are a value manager's dream. Most of them are not very leveraged, they generate a decent return on capital, and best of all, they trade at single-digit P/E based on last year's earnings.

So, are chicken stocks the value manager's dream, or are they a value trap in the making? I think the answer is a little bit of both, depending on an investor's time horizon.
By Theo at Mon, 2006-03-20 20:55 | login or register to post comments

re: Chicken Run

I keep having this nagging feeling that I am going to miss out on a good thing by NOT investing in one of these. 

I am considering buying a "good weather" block at current prices, and then doubling-up if the storms (bird flu) arrive and the stock values tank. 

I'll blog my thoughts and ultimately the results if I do.  At the moment, I am not convinced enough to move on it.

Greg
By Greg at Tue, 2006-03-21 05:43 | login or register to post comments