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Playing "Chicken" With the Market - Is It a Bright Idea?

(A Guest Commentary on Sanderson Farms - October 6, 2005)

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.

Okay, folks, I know you some of you have wanted this for a long time.  So far, virtually all my analyses have been on a macroeconomic scale - whether it revolves around a discussion on the financial markets, the commodity markets, or in various industries.  Analyzing individual stocks requires a different kind of focus - said focus which I have not spent too much time to work on at this point.

This is why I have brought back Bill Rempel - a former guest commentator who has previously written two guest commentaries for MarketThoughts.  As the financial markets become more liquid (made possible in no small part to the proliferation of the hedge fund industry) on a global basis, profit opportunities - especially for the individual investor - will inevitably be scarcer.  Going forward, there will be a continuing need to emphasize on individual stocks or individual commodities that are not as liquid - in order to make outsized profits and/or not eaten alive by the major hedge funds.  Bill is a true student of the markets, as well as individual companies - not just the financials but the stories behind each company as well.  It is with the utmost pleasure that I bring to you Bill's latest guest commentary on Sanderson Farms (which he had already sent me by Tuesday afternoon).  First of all, following is biography of Bill:

Bill Rempel (aka nodoodahs) is an active poster on the MarketThoughts forum as well as a few others around the web. Bill has previously been a guest commentator on our website on a couple of occasions (see "The Art of Value Investing" for his next-to-latest guest commentary). Bill graduated from Caddo Magnet High School (a high school for nerds) in back in 1985 and proceeded to learn the hard way when he drank his way out of a scholarship to Tulane later that year. After a few years of sweating for a living, he decided to go back to school, and graduated from LSU-Shreveport in 1995 with a Bachelors in Mathematics - all the while working the overnight shift stocking shelves in a grocery store.

Post-college, Bill has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife Millie are amateur investors with a variety of holdings, but they prefer to buy and hold value investments. Their current portfolio contains (in rough descending order of equity) real estate, individual value stocks, physical gold, a foreign-denominated bond fund, a bear fund, and a precious-metals mining fund. In typical "value" style, they live cheap, driving old cars and preferring to save or invest instead of buying fancy "stuff."

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.

Playing "chicken" with the market - is it a bright idea?

So the low-carb diet craze is now past its zenith and presumably closer to its nadir, and the price of chicken has been falling.  Similarly, the stock prices of some poultry companies have fallen significantly off of their 52-week highs.  The story is a simple one: fickle investors pick up on the latest diet craze, buy up all the stocks involved, and when the diet craze ends, they dump the stocks indiscriminately.  Did they throw out any babies in the bath water?  Are there any good companies selling at cheap prices in this broth?  Is this the time for a contrarian investor to buy a good company at a discount?  Should we play "chicken" with a falling poultry company stock? 

One stock in this segment that found its way onto my value investing radar recently is a small cap player in the meat products industry, Sanderson Farms, Inc. (SAFM  At Tuesday's close of $37.54, SAFM had TTM PE of 11.51 and FW PE of 8.71, as well as positive earnings and operating cash flow for the last several years.  Additionally, the operating cash flow exceeded the net income.  This is one screen setting I like to use, profitability from operations with low valuations.  As a bonus for those with long investing horizons, it's a small cap with a market capitalization of about $765 million, leaving it plenty of room to grow. shows fifteen stocks competing in the "consumer goods > meat products" industry, with SAFM being ninth in rank by market cap.  From a relative valuation, SAFM stacks up pretty darn nicely, as the table below shows.  About the only thing not to like here is the lack of Free Cash Flow on a TTM basis.  Otherwise, from looking at the numbers to the right of "market cap," you'd think that SAFM was an industry leader.

  Mkt Cap PE ROE DivYield LTDebt/E PB PrftMrg P/FCF
Industry: Meat Products 23.4B 13.20 14.00 0.95 0.01 2.58 2.90 26.20
Tyson Foods Inc. 6.5B 20.28 7.31 0.90 0.64 1.43 1.95 1032.58
Hormel Foods Corp. 4.5B 18.99 16.74 1.60 0.28 2.98 3.80 77.91
Smithfield Foods Inc. 3.3B 11.46 16.55 0.00 1.22 1.73 1.66 26.07
Pilgrim's Pride Corp. 2.5B 9.28 27.09 0.20 0.48 2.22 5.93 17.52
Seaboard Corp. 1.6B 6.81 33.80 0.20 0.36 1.96 8.49 37.74
Perdigao S.A. 1.6B 12.97 27.95 2.20 0.81 3.30 6.44 -14.19
Industrias Bachoco SA de CV 1.1B 6.75 15.80 2.00 0.01 1.01 17.48 23.76
Gold Kist Inc. 992.4M NA NA NA 0.47 2.23 7.42 5307.19
Sanderson Farms Inc. 768.8M 11.56 21.06 1.10 0.03 2.28 9.08 -59.76
Premium Standard Farms Inc. 482.5M 6.49 19.11 1.60 0.33 1.15 6.27 36.77
Bridgford Foods Corp. 72.4M 185.90 0.80 0.00 0.00 1.51 0.88 -625.66
Rica Foods Inc. 70.8M 33.95 10.20 NA 1.99 3.30 2.75 -214.17
Provena Foods Inc. 3.7M NA -10.32 0.00 1.16 0.46 -1.05 -0.72
Stronghold Technologies Inc. 0.7M NA 85.04 NA -0.69 NA -240.36 1.56
Cagle's Inc. NA NA 15.55 0.00 0.65 NA 2.34 NA

From a simplified DCF analysis, it seems the current price is somewhere between "fair" and "a real bargain" depending on your assumptions.  The idea behind the Discounted Cash Flow analysis (DCF) is that companies are worth the sum of their future earnings, discounted for a desired return.  Alas, the devil is in the details.  I like to use some benchmark numbers and do this on a "quick and dirty" basis, just as a check to see if the valuation makes sense.  The historic return of the S&P 500 is 11.5% annually, and the historic growth in earnings for S&P 500 companies has been 6%.  If we use those in a "perpetual growth" version of the DCF, the required PE is 1/(Return - Earnings Growth) = 1/(0.115 - 0.06) = 1/0.055 = 18.18, meaning that SAFM would be trading at a deep discount if its growth matched that of the S&P 500.   Of course, one could play with various assumptions to come up with a "target" PE for the S&P 500, as noted in this post to the forum. forum/viewtopic.php?t=815  With a more conservative discount rate of 15% (derived from the historic M3 inflation rate and the historic return on the 10-year Treasury bond), the required PE is 11.11, meaning that SAFM would be trading at a fair value if its growth matched that of the S&P 500. Unfortunately (fortunately?), SAFM is not followed by a gaggle (or is that google?) of analysts, and there is no "consensus" five-year estimate of future earnings growth.  At this point, perhaps we leave the DCF now, with the above caveats.  Any meaningful growth in earnings would place this stock as significantly undervalued - we just need to decide for ourselves, without the assistance of the vaunted Wall Street analysts, if we think that growth is likely.

The table below summarizes why the stock has tumbled, the decline in growth and income this year.  It certainly does gel with the "end of the lo-carb craze" story, doesn't it?  The last column compares the year ending July 1 2005 to the year ending October 1 2004.  The question that begs answering - is this just a temporary decline, or is this something more permanent?  Is there anything in the history of this company to suggest they can recover from this decline?

Growth Measurements Oct '02 Oct '03 Oct '04 Jul '05
Revenue Growth 5.3% 17.3% 20.6% -3.4%
Net Income Growth 3.6% 87.8% 68.9% -28.2%
Total Assets Growth -2.9% 6.6% 25.5% 14.0%
Total Liabilities Growth -13.8% -18.3% -6.0% -5.2%
Net Worth Growth 8.0% 26.4% 41.7% 20.7%

Perhaps a longer-term look will provide perspective.  As we see below, this is a company that shows a consistent pattern of growth in revenue, has only two unprofitable years in the last nine, and has managed to reduce the long-term debt significantly without diluting the shares outstanding.

Income Statement - 10 Year Summary (in Millions)
  Sales EBIT Deprec Total NI EPS
Oct-04 1052.3 150.8 26.3 91.4 4.57
Oct-03 872.2 90.6 24.5 54.1 2.75
Oct-02 743.7 50.2 24.7 28.8 1.43
Oct-01 706.0 51.6 25.7 27.8 1.36
Oct-00 605.9 -0.3 26.4 -5.3 -0.26
Oct-99 559.0 23.3 24.7 10.5 0.50
Oct-98 521.4 32.1 23.2 15.3 0.71
Oct-97 481.8 7.6 21.4 0.6 0.03
Oct-96 455.1 1.2 19.7 -2.4 -0.12

Balance Sheet - 10 Year Summary (in Millions)
  Curr Asst Curr Liab LT Debt Shares
Oct-04 216.4 65.8 10.9 20.0 Mil
Oct-03 143.2 60.9 21.6 19.5 Mil
Oct-02 123.5 55.0 50.0 19.6 Mil
Oct-01 126.2 49.2 77.2 20.3 Mil
Oct-00 108.0 36.7 107.5 20.4 Mil
Oct-99 99.2 31.9 104.7 20.9 Mil
Oct-98 85.2 26.6 95.7 21.6 Mil
Oct-97 84.3 18.3 118.8 21.5 Mil
Oct-96 78.4 17.5 90.1 21.5 Mil

SAFM is also a company whose recent earnings quality metrics seem strong to me.  There's no untoward buildup of inventories, and the company has absolutely no problems generating cash flow or earnings from operations, and no reliance on financing cash flow to generate income.

Earnings Quality Measurements Oct '01 Oct '02 Oct '03 Oct '04 Jul '05
Inventory as Percent of Sales 0.074 0.078 0.071 0.072 0.078
Reliance on Financing Cash [should be negative] -0.120 -0.158 -0.134 -0.053 -0.038
Earnings Quality [should exceed 1.00] 1.715 1.395 1.239 1.074 1.310
Cash Generating Power [should exceed 1.00] 2.157 11.571 2.123 1.239 1.197

In keeping with the long-term balance sheet table shown above, the company also has fine solvency metrics, and a pattern of improving, not worsening, their financial position as time goes on.

Solvency Measurements Oct '01 Oct '02 Oct '03 Oct '04 Jul '05
Total Liabilities / OCF 2.235 2.564 1.343 0.933 0.916
Current Liabilities / OCF 0.760 1.132 0.803 0.641 0.673
Interest / [OCF + Interest] 0.095 0.071 0.032 0.015 0.007

Back to one thing that concerned me earlier, the lack of Free Cash Flow: the table below shows that this is a recent phenomenon and not a recurring one.  It also shows a pattern of increasing dividends, which is a positive sign in my opinion.

Per Share Measurements Oct '01 Oct '02 Oct '03 Oct '04 Jul '05
Earnings Per (Diluted) Share 1.37 1.49 2.80 4.62 3.24
Book Value Per (Diluted) Share 7.11 8.07 10.22 14.12 16.62
Free Cash Flow Per (Diluted) Share 2.47 1.23 2.09 2.95 -1.26
Operating Cash Flow Per (Diluted) Share 3.19 2.51 3.93 5.19 4.88
Dividends Paid Per (Diluted) Share 0.00 0.27 0.62 0.84 0.89

Those who read my posts know that I'm not a technician or a trader, so I'll let the chart speak for itself.,m100,b&a=v,r14&c=

Sanderson Farms Inc.

Insiders have been selling, and the volume has been high, at least in terms of shares or dollars.  However, the selling amounts to a divestiture of only 2.9% of total shares owned by insiders.  The biggest seller has been Bill Sanderson himself, selling about 1/3 of his stake over the last year.  Interestingly, all of his sales have been when the stock was trading over $40, with most being when the stock was trading over $44.  Even with the selling over the past year, insiders still have a commanding 33% of the stock, so we know where their bread is buttered.  Or should I say where their chicken is basted?  The company still has significant family ownership - is this just a diversification sale on Bill's part?

One statistic that positively jumps off the page is the amount of short selling associated with this stock.  As of September 12 2005, 2.47 million shares (7.2 times the average daily volume) were short!  This is 15% of the float, fairly impressive.  It stands to reason this may be why the price is depressed.  Next question: are the shorts right, or is there a squeeze ahead?  Even without a squeeze, massive short selling is a self-fulfilling price action, and as it unwinds, will the price rise?

There are intangibles to be considered, as well.  The company is a specialist in chicken.  Their fresh chicken is exactly that, chicken, without added salt, phosphates, or broth.  Additionally, they sell over 100 prepared food items that range from soups to frozen foods to restaurant supply.  Their geographical reach is limited, but not so limited as to pigeonhole them as a one-state wonder.  They have a small export market, but even without export, they have zero presence in the U.S. northeast, which gives the company plenty of room to grow.  And they're spending the money to grow!  Capital expenditure as a percent of revenue is increasing.

  Oct '01 Oct '02 Oct '03 Oct '04 Jul '05
Capital Expenditures / Revenues 0.021 0.026 0.027 0.026 0.105

One can probably expect the FCF deficit to continue while the company funds its expansion, which, according to their annual report, will be funded by cash on hand, internally generated working capital and cash flows from operations.  These expenditures include a new office complex and an expansion of facilities in Georgia.

In summation, the picture I see is a small, growing company that is poised for long-term success, whose stock is currently trading at a significant discount.  Some of the short-term negatives include the insider selling, the high short ratio, the possibility that the quarter ending October 1 2005 will disappoint, and the drag that current capital expenditures might create on the coming year's earnings.  I will soon be considering freeing some of my own capital for entry into this stock.

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