Description

Opportunity here is to short CALM, which is a cylical over-earner with a burning platform. The market is broadly aware of the former, which is why the SI at c.15%, but is unaware of the latter. My analysis of both these effects points to a valuation in the $17-$20 dollar range, down from a near all-time high of c.$58 today. This value should be realised in the next 18M as the US egg-laying flock recovers from highly pathogenic avian influenza-linked excess mortality. In addition to this, I believe that the necessary transition to cage-free, demanded by the US consumers and numerous state legislatures, should cause the market to revise CALM's book value downwards in the coming years. Including dividends of c.$3.3 over the next 18M, this opportunity should yield an IRR of c.46% (downside 60%). The risks to the short (7.5 days to cover, borrow is cheap) are capital return from management, productive capital allocation (unlikely given record, M&A is concentrated in caged assets which now need to be converted), and unprecedented pressure from HPAI on laying flocks (could go endemic). The first two risks are mitigated by CapEx needed to transition production capacity to cage-free. Management has indicated that that will be the focus for capital allocation.

Figure 1: CALM is both a cyclical over-earner and a burning platform. The market exaggerates the company’s ability to sustain exceedingly high cash flows (8x normal on Q basis) and over-states book value by ignoring the burning platform.

Source: Capital IQ, USDA, United Egg Producers, own estimates.

Business Description

Cal-Maine Foods, Inc. (NasdaqGS:CALM), founded in 1957 in Ridgeland MS, is the world’s largest fresh egg producer with over 40MM laying hens and c.$1,777MM FY2022 (end. May ‘22) revenue. The company’s core business is to supply white eggs (i.e. conventional or battery-farmed, 60% revenue). Since 2008, the company has diversified into specialty eggs (brown, cage-free, organic,..) to satisfy more animal welfare-conscious customer preferences; now c.36% of revenue. The balance is made up of “egg products” – broken shell eggs sold in liquid, dried, or frozen form. CALM is the only public player in a consolidated market, where the Top 20 layers produce >70% of eggs. Customer base is consolidated in retail, with Walmart at c.30% of group sales. The company has a net debt of c.-$280MM.

Note: for a more ample discussion of business operations, market structure, M&A history, and for a case study of the 2015 situation (which is a good comp) please consult ideas by tdylan409 (05/29/2015) and Kyothe (01/06/2015), which provide plenty of detail.

Context

1 - HPAI: Just like in 2015, there has been a severe pandemic of highly pathogenic avian influenza in North America this year. According to the USDA, c.40MM laying hens were culled (infected birds are destroyed to avoid virus propagation), or 9% of the total US flock. This has caused the price of conventional eggs (quoted on Urner Barry) to rocket from c.$0.8/doz. to c.$2.5/doz. The price of specialty eggs (i.e. cage-free) has remained stable at around c.$2/doz. This sharp increase in the price of eggs has caused CALM to over-earn spectacularly. LTM EPS is at c.$5.7, whereas FY2021 (ending May 2021) EPS was at c.$0.04. CALM's financials are ordinarily very cyclical and management has no control over economics (takes price for eggs and major inputs). There is no consensus as to when the pandemic will clear up, and it has already matched 2015 mortality rate (c.10% of flock) and outlasted it (2015 pandemic died in the fall, virus has never survived winter). The last major outbreak was over Thanksgiving weekend, so 3 weeks ago from today (12/12). These can be monitored here: https://www.aphis.usda.gov/aphis/ourfocus/animalhealth/animal-disease-information/avian/avian-influenza/hpai-2022/2022-hpai-commercial-backyard-flocks.

2- Feed prices: At the same time that it is over-earning from high egg prices, CALM is facing strong cost headwinds from high feed prices. Chicken feed is c.75% yellow corn and c.25% soybean meal. Corn prices have shot up from c.$4/bu. to around $6.5/bu. because of the crisis in the Ukraine (S/D is very tight for corn, so small drop in production creates large impact) and poor weather in US. My VAR with corn experts and academics suggests that if Ukraine cannot plant a full crop by April (corn planted in spring, harvested in Autumn), prices will remain high through CY2023 and into CY2024. Stocks are low in the US (11/22 ending stocks at c.30MMt, LT avge 50MMt), so need time to replenish them for price to recover fully. Soybean meal prices also shot up, c.$350/tonne to c.$500/tonne, due to poor weather in US midwest. This should normalise. These effects, combined with high enery and labor prices, means that CALM is facing COGS of c.$1.6/doz.. LT avge is c.$1.1-$1.2

Thesis

1 - Normalisation of egg prices by end 2023, but high COGS!

The street assumes little normalisation over next 18M, with prices >$1.5 (or 2x LT avge) through period. In contrast, I have more pessimistic expectations. Even assuming 10MM more deaths (which would be all-time record), a simple cohort analysis suggests that flocks will recover by October 2022 (which is also what some sell side analysts have been saying).

Figure 2: Flock to reach normal supply by year-end 2023, and overshoot after that. Note: The over-supply is likely to normalise within a year as hatch-type chickens are not replaced (rather than edging up)

Source: NASS data, own estimates.

2015 comp.: HPAI started in June 2015 (FQ1 2016), 30MM birds were culled, and flocks recovered to full force by March/April 2016 (FQ4 2016). Price of CALM conv. egg spiked at $2.16/doz in FQ1 from $1.2-$1.3 range in the lead up, and then normalized to <$1 by FQ4 2016. Essentially, as soon as the flock recovered, price tanked because of oversupply. Then price hovered at around $1 for years.

If the comparison holds, we can expect prices to normalise by the end of next calendar year (FQ2 2024). The S/D balance is at 320MM egg-type laying hens (balance of layers make pulles, not eggs..). Current pullet (immature chickens) production is above LT avge to bridge capacity. We can expect over-capacity and strong price normalisation.

Figure 3: Price normalisation should follow rapidly after capacity is reached. Historical price movements have been sharp! Note: price predictions are imprecise and indicative, meant only to show sharp nature of normalisation. Please consider with care.

Source: NASS data, Stephens (sell side estimates), own estimates.

Valuation impact: The delta of today's EV vs FY2021 EV suggests that c.$820MM of EV was created in the past 18M. Minus cash of c.$282MM, that's c.$538MM of value that the market has assigned to CALM from its over-earning. That's around 7.4 quarters of over-earning at c.$70MM (FQ1 2023 FCF). Normal FCF gen is c.$30MM per annum. I see it normalising to that by FQ1 2024, or 4 quarters earlier. On thesis 1 alone, that's a decent margin of safety to price-implied expectations.

2 - Burning platform due to cage-free transition

Major retailers such as Walmart (30% CALM sales) and Kroger (10%) have made commitments to transition to cage-free production after consumer-led pressure to improve animal welfare standards. Until this year, both retailers had "100% by 2025" cage-free targets, but have walked back on these commitments due to high cage-free egg prices and mis-matched consumer demand. Kroger now has a target of c.54% by 2025 and c.70% by 2030, which is consistent with the progress of state legislation to ban battery egg production (I estimate legal pipeline to take 48% of population in cage-free states by 2025). 

Figure 4: Both Walmart and Kroger (together 40% of CALM sales) have changed their commitments towards cage-free production (blaming prices and S/D), but major US states are pushing for change.

Source: Walmart, Kroger.

The USDA (and CALM in its 10-K) assume conversion cost to cage-free of c.$45 per head. At that price, converting to 70% cage-free (LT target) would cost CALM c.$660MM (= (41MM total birds *54% - 14MM cage-free existing) * $45).

Valuation impact: CALM has a net tangible book value of c.$23 per share. The cost of conversion (to 70%, which is a reasonable terminal adjustment to book) is of c.13.5$ per share. The adjusted NTVB is of c.$9.5 per share. At a LT multiple of 2.3x, this values the shares at c.$22. That's a c.62% downside to current price. The market is clearly not pricing this in, and believes that today's book value is "clean". Investors should value CALM like a melting ice cube.

3 - Unit economics of specialty eggs means CALM is no better off!

Prof. Maro Ibarburu (Iowa State) made a great presentation on cage-free egg economics in 2019. The key points, confirmed by my VAR, are that labor costs go up 3x (1.9 cents/doz to 7.5 cents/doz., need men to walk around open aviary and pick up eggs, debris, and birds dead or alive). Pullets (immature chickens) that supply cage-free systems also have to be cage-free, so they cost 50% more. Energy costs also increase because barns are larger in cage-free. These effects, combined with licensing costs that CALM pays to brand cage-free eggs 21 cents/doz. means that the unit economics are essentially the same for caged and cage-free systems (in CALM's context of course!). In short, the transition to cage-free should have no positive return for CALM, it just serves to maintain revenue.

Figure 5: Even if the price looks good (for now!), a drastic cost increase means CALM is no better off in FY2025.

Source: M. Ibarburu: The cost of cage-free transition and proposition 12 to producers and consumers (2019), own estimates.

Valuation

Use LTM EV/NOPAT method on FY2024 NOPAT of c.$55, for price target of $19.3 per share. Adding $3.3 in dividends, the cumulative downside of c.60% (IRR of c.46% over next 18 months). This valuation is backed up by the NTBV analysis above (LT valuation) and a DCF with 14x TEV/EBITDA and a WACC of 8%, which comes out at $17 (including conversion CapEx in TV). This convergence of price targets gives me comfort on valuation. Bull case (on unadjusted NTBV) is at 20% upside, which is manageable.

Figure 6: Base case valuation on the right, ties in well with an adjusted BV approach on the left, and DCF below.

Source: Capital IQ, own estimates.

Signposts

Figure 7: ​Could go wrong if HPAI intensity keeps up, or capital allocation improves

Source: own views.

Figure 8: CALM is a perennially-shorted stock because of cyclical nature and constant price/cost volatility. SI was 17%-20% at last peak of c.$60 in 2015.

Source: Bloomberg, Capital IQ, own estimates.

Catalyst

Short-term: Normalisation of egg-laying flock to c.320MM by year-end 2023 and concurrent normalisation of price of eggs from c.$2.5/doz. to c.$0.8/doz.

Long-term: Conversion to cage-free production to revise NTBV down to c.$9.5 (from current $23). Catalyst would be clarification of announcements on cage-free as egg prices / inflation subsides.