The Elephant Fund

Have poultry shares hit bottom or is this merely the calm before the storm?

Unfortunately, I don't know; but, I think these shares are attractive now and could become even more attractive with a little patience. In particular, I think CGL-A, GKIS, IBA, PPC, and SAFM merit a closer look.

They’re businesses that I understand

The companies mentioned above are a sampling of the leading US poultry disassemblers. To varying degrees, they essentially all do the same thing: raise, slaughter, and package fresh and frozen chicken. The primary players and their respective market shares are as follows:

IBA operates exclusively in Mexico and consequently doesn't report US production.

They have favorable long-term prospects (kind of)

As far as I can tell, most people like chicken and will most likely continue consuming into the future. If you don't believe me, both the American and Mexican governments track domestic chicken consumption relative to other proteins. They've concluded the following:

• Since 1980, US Chicken consumption has increased at a 2.4% CAGR while Beef and Pork have declined slightly and Turkey has increased 1.7%.
• In Mexico, since 1977, chicken consumption has grown at a 5.3% CAGR and is projected to increase at a heady clip of 6.5% through 2010.

Don't get me wrong, this is not a growth story. However, the sky isn't falling either. I would be foolish to ignore the short-term prospects given the threat of a worldwide avian flu pandemic. However, if you're still reading, I'm sure you've drawn your own conclusions on the avian flu threat/pandemic/burlesque...

I think poultry investors are very scared of the uncertainty that lies ahead. I see an opportunity. Warren Buffet once said:

"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."

Here is what I see in the poultry market:

Like Warren, private equity players often get greedy when others are fearful. I think that an investment in one of these companies could be an interesting PE idea:

• Invest in the trough
• Wait for the multiple expansion
• Pay down some of the debt
• Grow EBITDA
• Sell after the rebound

Later, I’ll walk through my intrinsic value estimate: a LBO valuation of these firms. In fact, the key driver in this investment decision is the valuation. The industry isn’t particularly attractive. Nonetheless, I'd like to comment on the competitive position of these companies as it might affect which horse we pick.

In a commodity business (like this one), relative cost position is key. Given that processors have less influence on the end-product pricing, competitive advantage (and the ability to generate higher returns) comes in the form of being the lowest-cost producer. Contrary to intuition, protein disassembly is not a scale industry. The highest operating margin is held by one of the smallest players (in order from biggest to smallest):

SAFM is the low-cost producer both on an operating margin basis as well as cost / lb.:

I trust the management

Walking through SEC filings as well as Investor Relations postings, you’ll see that this industry has some of the highest levels of disclosure around. In addition, Insiders (mostly founders) remain heavily invested in their companies (TSN, SAFM, PPC, CGL-A). I think transparent filings and high insider ownership suggest that management and investor incentives are aligned.

Did I mention the valuations were a steal?

CGL-A

CGL-A opened today at $6.75, implying a capitalization of $32M. Okay, it’s small; BUT, at that valuation, it’s trading at .66x net asset value (Assets – Liabilities). Even PPC paid BV when it bought CAG’s operations for a song.

IBA

Again, a net asset value comparison suggests that IBA is trading at .75x NAV ($876M / $1,175M). BTW, $300M of that is cash in the bank. In other words, Mkt. Cap / EV = 1.5x.

With both companies, I believe the gap below net asset value + intangibles which aren’t recorded on the balance sheet (supplier relations, customer lists and relationships, brand equity, etc.) creates a sufficient margin of safety. However, for both companies, there isn’t much liquidity and given their unique statuses (micro-cap and a Mexican company, respectively), a catalyst to realizing intrinsic value might appear later than sooner.

SAFM

This one is a little tricky. Using current valuations and earnings as a starting point doesn't make a lot of sense since everything is likely to look decidedly negative. After reviewing SAFM’s historical 10K’s, I propose taking FY2005 as the basis for our valuation (2004 was exceptionally strong and a lot has changed since 2003).

Let’s start with a picture of normalized earnings. In 2005, SAFM achieved a 11.3% EBIT margin on revenues of roughly $1B. For the sake of conservatism, let’s assume 10%.

An analyst at J. P. Morgan recently commented that SAFM has historically traded in a range of 3-7x EV/EBITDA, averaging around 5x. I estimate that a weighted average of that multiple (weighted by the amount of time trading at a specific multiple) over that time period is most likely in the 5.2-5.7x range.

Based on normalized earnings alone, SAFM might be worth:

Currently, SAFM trades at $23 (.74x normalized earnings): a 35% margin of safety.

Let’s look at it a different way. SAFM currently has a very conservative capital structure with minimal debt: D/E = .06x.

• What if SAFM were to re-organize its capital structure?
• Better yet, what if SAFM were taken private by a PE shop or otherwise?
• What would be the private market value?

First, we’ll re-capitalize SAFM assuming the use of typical LBO debt instruments:

Summing everything, SAFM total interest bearing debt becomes $511M, or D/E of 1.5x. I think an average of cost of debt of 9% would be acceptable, making annual interest payments of $46M or a normalized EBIT / interest coverage ratio of 2.2x. After interest and taxes, SAFM could then pay down some of its debt:

So, what is the maximum that a PE shop would pay today for SAFM while targeting a 30-40% IRR? I think that a PE shop would pay as much as $32 / share.

PE shops make money in three ways: using leverage, waiting for multiple expansion, and executing operational improvements. I’ve oversimplified the investment model, but here are three potential scenarios:

Erring on the side of conservatism, my intrinsic value estimate is $32.

To summarize:

• Everyone likes chicken and will continue consuming long after you and I pass on.
• High levels of insider ownership align management with investors.
• Valuations are attractive to both retail and PE buyers.
• Everybody wins.

Even though SAFM is attractive at current prices $22-23, I think it could become even more attractive with a little patience. Given current poultry prices, the current quarter is likely to be a disaster and could present an attractive buying opportunity as speculators run scared. In addition, if avian flu follows historical migratory patterns, it will most likely hit the US and these shares will tank. If that were to happen, I would then be more greedy than fearful.

I will consider a small position at the current price and then build my position if the price falls.

Good luck, RMA.

# posted by RMA @ 09:18 6 comments

It’s been some time since my last posting which unfortunately shows how hectic my schedule has been of late. In contrast to my ambitious start (3 postings in 5 days), I’ve realized that updating this blog with valued content will at best be a semi-monthly endeavor.

After waiting almost two months for a work visa, I’ve recently moved to Madrid to begin a new assignment that will take me through the end of September. So far, Madrid has been great (think: sangria, tapas, and mid-day siestas). I live on the northern side of the city (Nuevos Ministerios) which lacks the charm of Madrid’s more historic parte vieja, but I’m conveniently just a 5 minute walk from the office.

Pasamos a hablar de inversiones. Before my next analysis, I wanted to provide some context on my performance and portfolio theory. The latter is very much a work in process and I expect to do a significant amount of spring cleaning as I take on a more ‘focused’ approach.

The first quarter has come to a close and my actively managed portfolio is up 14.3% YTD.

Holdings as of 3/31/06, listed in no particular order:

I actively manage a little more than 2/3 of my investment portfolio while the balance is invested in a mix of cash and domestic & international equity index funds offered through my firm’s 401k plan. I haven’t invested enough time to determine the optimal allocation between active & passive as well as current & tax-deferred investments. Instinctually, I feel that diversifying my tax liability between traditional brokerage and tax-deferred investment accounts is the correct answer. Correspondingly, I actively manage the brokerage account and passively manage my 401k contributions.

I hold little cash and no debt or derivative securities. As to the benefits of an all equity investment plan, I recommend you pick up a copy of Jeremy Siegel’s Stocks for the Long Run. Jeremy is a Wharton finance professor who has completed extensive security research showing that stocks have historically outperformed all other asset classes given a long-term investment horizon (~20 years).

Hasta el próximo, RMA.

# posted by RMA @ 06:50 0 comments