Description

I.               Pitch

We think Cal-Maine Foods (CALM), the largest North American egg producer, is a long offering ~50% upside in a normalized scenario, versus ~25% downside (to 1.0x book) if we enter oversupply akin to the post-2015 avian flu hangover (which we believe is unlikely). The market is overly focused on the short-term, with the stock trading below historical book multiple (~2x vs 2.5-3x avg) and high short interest (11% of float). Our research suggests a much less severe supply response than the 2015 cycle. We estimate CALM has a $0.15-25/dozen opex advantage vs peers, which we view as a sustainable EBIT floor in equilibrium (higher if peers actually want to earn a profit!) – assuming 14x NOPAT drives ~50% upside over 1.5 years. If AI recurs we see the stock doubling, and believe the stock will be an outperformer in a recession given its defensive characteristics (~MSD% IRR).

II.            Business Overview

i.            Egg Production Overview

Egg producers buy hen hatchlings from breeding houses (i.e. Hy-line) who own the genetics to highly productive and templated hens. Producers raise these hatchlings (called “pullets” while they’re not laying eggs) for ~20 weeks, after which they become “layers”. Layer hens lay for ~90 weeks, after which lay rates begin to deteriorate yielding poor economics given high decrementals.

There has been a slow and steady push (by consumers, retailers, and regulators) to produce eggs “cage-free” (CF). Since 2015, the industry has grown from 10% CF to ~40% today, however, retailers who were previously hoping to be 100% CF by 2025 are now pushing back targets. VAR has estimated eggs will be 60% CF by 2035, but this is a moving target based on prevailing social conditions, government priorities, etc.

ii.            Industry Overview

The NA egg industry has been slowly consolidating over time, though remains relatively fragmented. CALM is the largest producer with ~15% market share, and the next four largest producers have ~25%. Experts expect consolidation to continue, if not accelerate.

From 2005 to 2021, NA egg production and layer hen supply grew 1.4/0.8%/yr (lay rate improvement added 60 bps/yr).

In 2015, Highly Pathogenic Avian Influenza (HPAI, or AI) killed ~10% of the layer flock resulting in both record industry profits from spiking egg prices, and a subsequent overbuild of CF capacity as producers invested these profits. A longer outbreak of AI hit the industry in 2022, killing ~8% of the layer flock. The industry is currently building back hen supply (discussed later).

CALM’s market share dipped post-2015 for two reasons: (i) a co-packing contract w/ Wal-Mart ended (profits per dozen were effectively $0), and (ii) peers built greenfield capacity faster than CALM post-2015 AI. We believe both events were one-time, the latter due to the industry’s decision to convert capacity to cage-free in this cycle, versus build net-new greenfield capacity in the last.

III.          CALM’s Intrinsic Value

The buyside and sell side seem overly (almost exclusively!) focused on the short-term. We believe the more important question is what CALM is intrinsically worth (we discuss the near-term in the next section). In our view:

i.            Sustainable Earnings – Conventional Eggs

We use two approaches to estimate Conventional sustainable EBIT/doz: (i) cost spread vs peers, and (ii) inflation-adjusted historical earnings.

Method I: Cost Spread vs Peers

We think CALM has a $0.15-0.20 cost/doz advantage vs the marginal source of supply:

CALM’s EBIT bakes in ~$0.05/doz of payroll, taxes and benefits – we assume that this covers the small producer’s required salary to stay in business. We ignore capital costs as almost no producer is adding incremental Conventional capacity (all incremental capacity is CF). Therefore, we believe CALM’s sustainable Conventional EBIT/doz is simply its cost spread vs peers.

Method II: Inflation-Adjusted Historical Earnings

The period 2015-2020 was abnormally volatile given the first onset of AI, the subsequent oversupply, the knock-on surge post-AI birds aging out in sync, and then the pandemic, all combined with excessively volatile corn/grain prices. Therefore, these years are difficult to extrapolate from. However, CALM’s EBIT/doz pre-2015 was actually reasonably stable. Inflation adjusting (CPI +40%, 2012 to today) this historical base through today implies a sustainable EBIT/doz today of ~$0.12 to 0.23:

Note: the orange line above is what we use to calculate all usages of “normalized” earnings in the memo – for example, in our EV/Normalized NOPAT historical multiple chart in Section II.

ii.            Sustainable Earnings – Specialty Eggs

We think CALM has a similar operational cost advantage vs the marginal source of CF supply as they do in conventional production. However, CF is a growth market, and therefore producers require a return on capital to incentivize new capacity. We assume an 8% k_c which requires the marginal producer to earn an additional ~$0.16/doz to cover their capital costs. We then compute the market-clearing price of $1.34, where CALM should earn ~$0.33 of sustainable EBIT:

iii.            Totalco Value

We believe a 14x NOPAT multiple is justified based on: (i) a ~10% through-cycle earnings algo with defensive characteristics + 5% div yield, and (ii) CALM’s historical trading range. This implies ~2.8x EV/TIC (wtd case), which is reasonable/conservative relative to history:

iv.            Additional Sources of Upside

We believe CALM has additional through-cycle upside from perpetual AI recurrence. In the past two AI cycles, CALM generated ~$5-12/sh of excess cash ($8.50/sh avg). AI has occurred twice over the last ten years, but a sample size of two is difficult to extrapolate from. If we assume a 10%/yr likelihood, CALM will earn ~$8.50/10 per year through-cycle from excess AI cash. A DCF at an 8% k_c implies this is worth an extra ~$10/share today (~20% add’l upside). A 20%/yr probability implies ~$20/share (~40% add’l upside).

One could argue that this 20-40% “through-cycle AI upside” should be reflected in the multiple. Our 14x EV/NOPAT does not factor in any of this upside – if we did, we’d be modeling 15-18x (low/high), or 18-22x using base case multiples, which is roughly where it’s traded since the first outbreak.

IV.          Near-Term Dynamics and Potential Oversupply

CALM has 11% short interest because bears believe we are about to enter (or have already entered) a period of oversupply, driven by the AI-driven surge in producer profits. We’ve spoken to a handful of shorts and believe their perspective is more muscle memory from the last cycle rather than observation-based. We believe we are still below pre-AI layer hen levels, and will return to pre-AI levels by mid-2024. We discuss our reasons for why we don’t expect a 2016 repeat below, but more importantly, we can project with reasonable confidence what the future layer hen population will look like based on the current pullet population (the birds that will mature into layers in 0-20 weeks), combined with the lay rate curve as the hens age. This is well below where we are at the same point in the cycle in 2015/16.

We believe we are not seeing a burst of supply akin to the 2015 cycle for a handful of reasons:

1. Cage-free conversions, not greenfields. Our research indicates the majority (75%+) of new CF capacity is replacing existing caged capacity. We believe the cage-free builds in the 2015 cycle were closer to 75% greenfields (and only 25% conversions). A CF replacement actually reduces like-like hen supply by ~20%, as CF bird facilities produce less eggs.
2. Interest rates. Contacts called out higher interest rates as a deterrent to building new capacity, given the highly capital-intensive nature of conversions and the reliance of small producers on financing.
3. Inflation. Our conversations revealed that producers are more cautious bringing on new capacity in the face of high (and uncertain) inflation.
4. Lesson learned. VAR suggested the years of losses post-2015 AI has tempered producers’ appetite to aggressively build. We always take “this time is different” with a grain of salt, but don’t think this argument is unreasonable (see below).

Our investigative journalist’s calls with a smattering of small producers suggest a similar message:

“I can’t say for sure, but given the state of the economy, I think egg producers might be more cautious this time around. Plus, it’s more expensive to borrow for farm expansions than it was even last year.” – WATT Poultry USA

“[why less oversupply vs 2016] Some of it was caused by simple biologic cycles. In 2015, HPAI wiped out 40mm birds in our area. Almost all of it happened during a 60-day period… This time, HPAI was different, it was a slow burn, playing out over 12 months and in different regions. The 2024 flock will have a better mix of layers, not all of which will be high producing.” – Farm Credit Services of America

“[why less oversupply vs 2016] producers responded by building new CF houses [greenfield], but they still had their old houses available, and they filled them. This time, a lot fewer farmers have old housing available to refill to capitalize on the market.… The other big factor is commodity costs. Corn and [soy] bean prices in 2015-2016 were quite low. In the first part of this post-HPAI cycle, you had the lingering effects of COVID and Ukraine … I think anyone putting in new birds will be more tentative because of those economics.” – Hy-Line

How much cash will CALM burn?

In the 2015 down cycle, CALM burned $144M of cash over 5 quarters (or ~$0.11/doz). If we assumed the same duration and loss/doz this cycle, CALM would burn $160M, ~25% of their cash or ~7% of their market cap. As discussed earlier, we don’t expect this cycle to be as severe as the last. The higher interest earned on cash improves the burn by ~$6M per quarter – we assume a ~$3M smaller burn/quarter given the less severe supply response, implying $92M of total burn this cycle (over 4 quarters).

V.             Risks

• Sustained oversupply. For every additional quarter of oversupply and negative earnings, CALM will burn ~$23M in cash (<1% of PT). Of course, the real risk is M2M related where we’d expect ~30% downside assuming the stock trades down to 1x book value.
• AI vaccine. We believe an AI vaccine would have a negative M2M impact on the stock, but believe an adoption of a vaccine is extremely unlikely in the US. This is because the broiler hen market exports 30-40% of its birds, and importing countries will not buy birds from a country that vaccinates. Why? HPAI kills birds within a few days – a non-vaccinating country’s birds are virtually guaranteed to be non-infected (if they were infected, they’d be dead). Vaccinated birds can carry the virus – countries are hesitant to buy from vaccinating countries to avoid bringing in diseased birds unwittingly. In addition, 100% vaccination rates are very hard to ensure – you could test every bird, but that is extremely expensive and unrealistic.
• Secular demand threats. Some have argued that eggs are at risk of being replaced in our diets. In the 2015 AI cycle, ingredient buyers of eggs switched their formulas due to high egg prices. Customers reacted poorly leading the buyers to change the formulas back. The ingredient buyers held formulas the same in the latest round of AI, and egg consumption, though volatile year-to-year, has grown at or above population growth for decades.

Disclosure:

We and our affiliates are long Cal-Maine (CALM US) and may buy additional shares or sell some or all of our securities, at any time. We have no obligation to inform anybody of any changes in our views of CALM. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

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