Description

Summary

Short Cal-Maine Foods (CALM). CALM has recently benefited from record shell egg pricing amid high priced substitutes, a dislocation due to the anticipated effects of new California regulations, and strong export demand. However, these factors are likely to be transitory, and the benefits to CALM should reverse as the egg ranchers respond in a manner consist with a commodity industry and previous cycles. CALM should trade down to $23-$28 as the market looks past a blowout fiscal 2015 (ending 5/31/2015) with a more sober assessment for fiscal 2016.

Note: CALM was much higher when I started working on this, and the market got ahead of me. Please accept my apologies. I believe there is still considerable downside left as CALM's assets and market power cannot support this valuation.

Charts and figures may be accessed here

Industry Overview

The shell egg industry is highly competitive and regionally fragmented. However, the industry has been steadily consolidating as larger producers invest in advanced operational systems (in-line production) to reduce some production costs. Egg production facilities are spread throughout the country, but are concentrated in Iowa, Ohio, Indiana, and Pennsylvania. Facilities are often built on unproductive land, but close to agricultural areas to keep feed costs low.

Shell egg consumption is fairly steady with per capita consumption generally growing or shrinking 1% each year since 1993. Fluctuations great than +/- 1% have usually been related to diet fads (e.g. Atkins, concerns about cholesterol, etc…) or price swings. Per capita consumption peaked in the 1940s at just fewer than 400, and is projected to be 259 for 2014, which is the same level as 2006. Despite these unfavorable long term trends, the industry has expanded its egg offerings by designing facilities that produce specialty eggs to satisfy the demand of a variety of constituencies. These specialty eggs include cage free, organic, free range, in-shell pasteurized, and many other varieties. These eggs are more expensive owing to higher fixed investment costs, such as bigger housing facilities, and higher variable costs related to feed requirements.

Egg prices are currently at or near all-time highs. The reasons for the rally in shell egg prices are similar to the appreciation of other protein rich commodities: higher feed cost trends, higher prices for protein substitutes, and export demand growth. Shell egg prices follow a predictable cycle common to other commodity industries; variable costs drive pricing and high profits attract competitors. The barriers to entry are very low for building an egg ranch, and the short life cycle of a laying hen (less than two years) promotes boom-bust cycles. Two recent cycles occurred in 2004 and 2007. There is very little that individual producers can do to arrest the momentum of a boom-bust cycle because of the fragmented quality of the industry. However, producers have tried to overcome this coordination problem by colluding with each other. Over the past five years, egg producers, including CALM, have settled price fixing charges with the Department of Justice and other parties. Given the recent anti-trust review, it is unlikely, but not inconceivable, that egg producers would once again conspire to keep their flocks at an optimal size.

As economic logic would predict, flock sizes are indeed at all-time highs. Hatchery and pullet projections also point to continued record flock sizes into mid-2015. The most recent USDA report shows pullet placements are running +4% compared to last year. Shell egg prices should fall as these pullets mature in the spring and early summer. Additional supply should be available to the US market as new supply agreements reflect the appreciation of the dollar.

Business Overview

CALM markets approximately 25% of domestic shell eggs and sells through the Egg-Land’s Best, Land O’Lakes, Farmhouse, and 4-Grain brands. CALM’s ultimate customers are the national grocery chains, including Walmart, which accounts for approximately 30% of CALM’s revenue. Pricing is determined by supply and demand and regional benchmarks given the type of shell egg. CALM’s actual egg production is approximately 75% of its total egg sales (per dozen). It buys eggs from other producers at market prices if customers are too far from production locations or if CALM’s internal production capabilities cannot satisfy customer supply agreements.

Consistent with the overall industry dynamic, CALM’s historical margin profile does not show returns to scale. Changes in gross margins are almost wholly explained by changes in external factors: shell egg prices and feed costs. Despite total layers growing from 23 million in 2007 to 32.4 million in 2014, SG&A costs have remained constant. The additional expenses related to specialty egg marketing have offset any gains from scale. These specialty egg costs are expected to rise as CALM continues to shift towards this niche. Corn prices have fallen significantly from last summer, but have stabilized. This provided a short term boost to CALM’s 1H2015 gross margins.

Figure 1: Cal-Maine Foods Margin History

It is worth noting that there isn’t a futures market for eggs and customer purchase agreements are short, so CALM cannot hedge out price volatility.

CALM has expanded through 18 acquisitions over the past 25 years. These acquisitions have been the primary method for the company to expand its laying hen and pullet capacity. Recent acquisitions have been used to build out CALM’s specialty egg vertical, which contributes 25% of CALM’s revenue. These acquisitions also provide an opportunity to show how differently CALM and the stock market value laying hens. CALM currently trades at $50 EV/Layer. CALM paid $21 EV/Layer for Delta Egg in March 2014, $18.50 EV/Layer for Maxim in November 2012, and $13.50 EV/Layer for Pilgrim’s Pride facility in August 2012. All of these facilities sell unbranded eggs, so there isn’t anything unique about a CALM egg versus these other outfits. CALM is expensive.

Value of a Laying Hen

Before delving into different valuation estimates, it is worth discussing the value of a laying hen. The value of a laying hen is critical to understanding the value of the business since CALM hardly earns a profit from its outside egg purchases. The key components of a laying hen’s value are:

• Laying span: The pullet phase lasts 18-20 weeks and hens can lay eggs for up to a year before a two week moult. Output declines as hens age, and 75% of a pullet cohort typically stops laying eggs after 70-72 weeks. Another way to back into the laying span is to divide the flock by the pullet population to estimate the replacement rate

• Layer rate: According to the USDA, laying hens are currently producing a quality egg about 80% of the time. Moulting and production issues could affect this input

• Egg prices: Prices are subject to seasonal supply and demand and are specific to the type of egg shell

• Farm production costs: Feed costs have ranged from 63-66% of costs, with other production costs holding between $0.22-$0.25/dozen

Figure 2: Cal-Maine Food Farm Production Costs

• Processing and packaging costs: These have recently been $0.18-$0.22/dozen

• Pullet costs: Approximately $3

• Taxes: Assume 35%

Except for its flock size, CALM has very little control over these value factors and is a price taker. This does not bode well for CALM’s valuation.

Valuation

CALM should have an exceptional FY2015 due to record shell egg prices and lower feed costs. CALM does not have significant analyst coverage and earnings estimates vary. It’s difficult to model record prices because it is an exercise in extrapolation, but I think CALM could earn as much as $203mm or $4.18/share. Although less elegant than my model, using the back of the envelope math described above, I get a similar estimate of $215mm. Since the market is forward looking, FY2015 is not very important, and the market is currently re-pricing to reflect FY2016 estimates. My FY2016 estimate ranges from $100-$112mm.

Figure 3: Cal-Maine Foods Peak Earnings Example

Figure 4: Cal-Maine Foods Normalized Earnings Example

There are many ways to value CALM, but using book value and forward earnings, I get the following estimates:

P/E: An 8-10x P/E is probably the right range for a commodity business coming off peak earnings. This would peg the stock price between $23 and $29. Using these prices and CALM’s dividend payout formula of 1/3 net income, the dividend yield would be 3.4-4.2%. The EV/Layer range with these valuations is $30-$38/hen.

P/B: As a commodity industry, CALM should trade as a reasonable multiple of book value. A multiple of 1.3x would reflect some growth, mostly owing to its specialty egg business. Book value is currently $637mm, which implies a market cap of $830mm or a $17 share price. The corresponding EV/Layer value would be $20.50/hen, which is consistent with recent transactions.

Other Potential Catalysts

Any event which would cause feed costs to fall amid a record flock size would have a cascading effect on shell egg prices. One such catalyst would be changes to the Renewable Fuel Standards (RFS), which governs how much ethanol should be blended with conventional gasoline. Corn is the main feedstock for ethanol. Although beyond the scope of this write-up, the RFS has been a disastrous blunder for the unholy trinity of central planning, cronyism, and environmental advocacy. There seems to be growing frustration with the law itself and the implementation (or lack of) by the EPA, and there is speculation that the RFS will be relaxed or abolished. Any changes to the RFS should lead to lower corn and feed prices.

Data Sources to Follow

To keep in touch with the egg market, I recommend reading the USDA’s daily reports or subscribing to Urner Barry. A cheaper way to get commentary from Urner Barry is to follow them on Twitter @UBegg.

Risks

Disease, weak dollar, price fixing, higher feed costs

Addendum re California Proposition 2

California Proposition 2 was enacted on January 1, 2015. Prop 2 and subsequent laws required Californian egg ranchers and any egg ranchers who sells eggs in California to keep hens in larger housing systems. Predictably, the number of layers in California has fallen 20% ahead of Prop 2’s enactment, while most of the country has added layers. Prices increased heading into 2015, but early reports indicate that some of the dire warnings might have been overstated. However, Prop 2 has bifurcated the market. This division should persist as long as the affected consumers (California) remains small relative to total supply (rest of US). In its most recent 10-Q, CALM said that its California egg sales are not material. This is an issue to monitor.

Chart 1: Effect of Proposition 2 on Shell Egg Spreads

Source: USDA

Catalyst

Commodity cycle to remain intact with large pullet supply to flood market; strong USD; Prop 2 to cause oversupply of non-Californian markets