Chicken Run: Value Manager's Dream?

By Vitaliy Katsenelson, CFA

March 20th, 2006 - The Motley Fool On the surface, chicken stocks like Sanderson Farms(Nasdaq: SAFM), Gold Kist(Nasdaq: GKIS), and Pilgrim's Pride(NYSE: PPC) are a value manager's dream. Most of them are not very leveraged, they generate a decent return on capital, and best of all, they trade at single-digit P/E based on last year's earnings. So, are chicken stocks the value manager's dream, or are they a value trap in the making? I think the answer is a little bit of both, depending on an investor's time horizon. A bird's-eye view Although it appears that chicken stocks are inexpensive, their cheapness is measured against last year's earnings when poultry prices were through the roof. The forward earnings have been sharply revised down, but even based on revised earnings guidance, chicken stocks appear to be relatively inexpensive. When analyzing companies that sell commodities, it's important to look at commodity prices. All right, industrial commodities are scarce, as it takes millions of years for them to form, whereas it takes six to eight weeks to raise a chicken. And yes, chicken does taste better than the usual industrial commodities. But chicken is chicken, and price is the most important differentiating factor. The cost of raising chickens is fairly fixed with the exception of feed prices (accounting for roughly 30%-40% of cost of goods sold), which may fluctuate. Thus, the market chicken price separates profitability from loss. The poultry prices trade at the historical average in nominal terms, or slightly below average in real terms. Although chicken leg prices declined by almost half over the past several months, a very large portion of chicken legs produced in the United States are exported, and legs are a relatively small (lower commodity price per pound) market compared to the white meat. Interestingly, only 15% of the chicken produced in the U.S. is exported, and 75% of these exports go to Russia. And Russia is one of the largest consumers of the dark meat. None, zero, zilch of American chicken exports go to Europe, as our American chicken doesn't meet European standards. (Another interesting factoid: Chicken legs imported from the United States are called Bush legs in Russia, after George H.W. Bush, on whose watch Russia started importing chicken legs from the United States.) Avian flu worries If an investor has a long-term horizon (let's say five years) and has a very strong stomach to see chicken stocks get halved or quartered on avian flu scare, today is as good a time as any to buy chicken stocks. However, at today's prices, chicken stocks don't fully discount the avian flu coming to the United States. If the avian flu does come to the U.S., which is a very high probability scenario, we'll get a chance to buy these stocks at much lower prices. I put very little value on forward Street earnings estimates, because avian flu could change these forecasts on a dime. According to the Department of Homeland Security, the migration of birds is likely to bring avian flu to the United States -- it's just a matter of time. And when avian flu comes to America, chicken stocks will share the fate of the chickens -- they'll get slaughtered, as their profitability will dissipate overnight. Demand for chickens will likely drop off disproportionately to the actual threat, similar to what happened in European countries when they got their first cases of avian flu. However, the drop will not be permanent. Once the real threat passes, consumers will get tired of steak, pork, and Tofurky, and they'll want real white-meat chicken. So far, that's how avian flu has played out in Europe: an immediate decline in demand followed by gradual recovery. If the infected birds flying from Asia take a different route and spare the United States from the avian flu, the chicken prices and stocks may rebound from today's lows very rapidly because they're heavily shorted. Surprisingly, Sanderson Farms -- the only one of the bunch that pays a meaningful dividend -- appears to be the most shorted one, with 23% of it float shorted, which is at least twice the short interest of other chicken producers. Importance of a strong balance sheet The avian flu will pass, but financial strength will be extremely crucial for chicken stocks, as it will provide staying power. Chicken producers will be losing money for some time. Thus, their balance sheets will be their life sources. Chicken producers are in very good financial shape: Gold Kist has $145 million of cash and approximately as much debt. However, the bulk of debt will not mature until 2014. Pilgrim's Pride has $500 million of debt (about 20% of its assets), and close to 40% of its debt is due within a couple of years. It does have $170 million of cash and reserves to get it through the tough times. Both Pilgrim's Pride and Gold Kist have more than a $100 million line of credit available to them. Sanderson Farms -- the smallest of the bunch -- has very little debt, but it has little cash. However, it does have access to a $200 million line of credit, which is plenty of liquidity to guide it through these trying times. One important caveat on credit lines -- banks love to provide them when companies don't need them and may withdraw them if a company starts losing money. However, Sanderson Farms' bank covenants are dependent on the balance sheet, not profitability. The covenants restrict the debt-to-assets ratio from exceeding 55%. It's currently around 4% today. Foolish bottom line Sanderson Farms and Gold Kist both had respectable return on assets over the years, higher than Pilgrims Pride's, which has been moving to more stable and lower return on asset business of prepared foods. However, I favor Sanderson Farms over other chicken stocks for the following reasons: * Leveraged to chicken prices. Sanderson doesn't focus on the fast-food (small chicken) market, where most of the agreements are cost-plus type of arrangements. Therefore, its sales will be more sensitive to market prices. If you believe that in the long run, chicken prices will go up (after the initial decline), then Sanderson Farms is a way to go, since higher prices will generate a better return on assets. * Lack of debt. Sanderson Farms has chosen the higher volatility of cash flow and higher return on assets route. Thus, a conservative balance sheet offsets the risk inherent in more volatile operating cash flows. * Dividend yield of 2.2%. Yes, this stock can go up or down by more than 2.2% in a given day. However, the commitment to a dividend is an indication of management creating shareholder value. * High short interest. On a sliver of any good news, short sellers will have to start buying back the stock to cover their short positions. That means that Sanderson Farms will bounce back at a faster pace than the rest of the flock. Of course, there's Tyson Foods(NYSE: TSN) as well. However, Tyson is not a pure play on chicken, as it's diversified into pork and beef. I've been asked many times whether there are any non-chicken plays on avian flu. Yes, in fact, there are. Aside from vaccine stocks such as Chiron(Nasdaq: CHIR), Baxtor International, and Invitrogen, there's also pork play Hormel(NYSE: HRL), which is one of the biggest producers of the other white meat. Of course, there's also Clorox(NYSE: CLX) -- maker of disinfecting products. Avian flu is passed through uncooked chicken, so Clorox wipes and the rest of the disinfecting arsenal will come in handy to fight the flu on the kitchen front. Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates. He teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He also writes for The Financial Times and Minyanville.com. He and his company have no positions in the companies mentioned. The Motley Fool has a disclosure policy. Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Lloyds: Prime for Takeover

February 1, 2006 - The Motley Fool

By Vitaliy Katsenelson, CFA

Lloyds TSB (NYSE: LYG) is up more than 5% at Wednesday's open, on the speculation that it will be bought out by Spanish bank BBVA. It's hard to tell whether this speculation has any substance, since rumors of a Lloyds takeover surface every couple months or so. However, Lloyds is a prime candidate for acquisition for several reasons:

• Lloyds provides a clean exposure to the U.K. market. It's a very well-managed company and provides quick entry into the European Union's best economy.
• The Lloyds brand is valuable. As one of the highest-rated banks in the world, Lloyds TSB carries a very old and well-respected brand. Wells Fargo (NYSE: WFC) is the only other non-government-sponsored bank rated AAA by Moody's.
• The acquirer will be able to leverage Lloyds' AAA-rated balance sheet. I've seen this happen before when Lincoln National (NYSE: LNC) bought Jefferson-Pilot (NYSE: JP). Lincoln Financial's debt rating was several notches below the very highly rated Jefferson Pilot's. By bringing Jefferson Pilot's debt rating to Lincoln Financial's level, it was able to extract several hundred million from Jefferson Pilot's equity, thus reducing the ultimate cost of the acquisition.
• Say goodbye to the high dividend. Lloyds has one of the highest dividend yields in its industry, 6.6%. The acquirer will be able to cut the dividend, bringing it to the industry's level and freeing up additional cash.
• Lloyds is still a bargain, trading at about 12 times 2006 estimates. Banks usually trade at lower P/Es to the market, due to the limited growth opportunities in this mature industry. Thus, at current valuation, Lloyds does not appear to be a bargain-basement stock. However, after leveraging Lloyds' balance sheet, the company may, in fact, be a bargain.

Despite its 80% dividend payout ratio, Lloyds is growing earnings by mid-to-high single digits. Since the company has plenty of room left for organic growth, it's not building a war chest to make acquisitions.

Foolish bottom lineI have to confess, I don't want Lloyds TSB to be acquired. Yes, I could make a couple more dollars in the short run, but I'm loath to part with Lloyds for several reasons. First, management showed that it is very shareholder-friendly by paying a superb dividend. Second, the company doesn't have any plans to do something foolish, like buy a minority interest in a risky foreign bank that will turn into a liability in a few years. (Remember Argentina?) Lastly, Lloyds doesn't have trading operations that help it meet quarterly earnings -- until it loses billions of dollars on a good trade gone bad. You can pass this stock along to your grandkids, secure in the knowledge that it'll still be around in 30 years.

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He and his company own shares of Lloyds TSB. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Expect the Unexpected

February 23rd, 2006 - The Motley Fool

By Vitaliy Katsenelson, CFA

After reading Jeremy Siegel's book Stocks for the Long Run, one gets a strong sense of security about investing in the stock market. Over long periods, the market overcame catastrophes like a global influenza pandemic, the Great Depression, the Cold War, two Gulf wars, two world wars, terrorist attacks, natural disasters, and much more. All of those events look like small potholes on the long road to prosperity when you put it into historical perspective.

I use Siegel's excellent book in my graduate investment class because it provides a very good historical overview of financial markets. However, students often ask me after looking at the well-defined upward slope of the stock market line on a 200-year chart, "Why bother tinkering with stock picking? Just buy an index fund and forget about all your worries."

Should investors buy an index fund in any market environment, regardless of the market's valuation? Does market valuation matter? After all, over the long term, stocks have produced a very respectable rate of return.

Unexpected Returns, the very insightful book by Crestmont Research's Ed Easterling, provides an answer to that and many other questions.

"Soar into space, and the earth loses its distinctive features: the Himalayas flatten; the Grand Canyon appears no deeper than a ditch ... but it gives few, if any, clues to the harsh geographical and financial realities that you should face walking across the earth's surface. ... If you take a long-term view on the stock market, perhaps fifty or seventy-five years, it becomes a beautiful blue chip market. But the long-term rise in the market obscures the realities that affect almost every investor."

What does Easterling mean by that, exactly? Here are a few of his key points:

Market valuation matters When buying an individual stock, investors must make the distinction between a good company and a good stock -- they're not always the same thing. For example, Wal-Mart(NYSE: WMT) is arguably a great company. It has a great balance sheet, a respectable return on capital, and a solid moat around its business. But the investor who purchased the stock in 1999 at 39 times earnings received no returns from the stock, with the exception of collecting a skimpy dividend. Although Wal-Mart has grown earnings more than 15% since, its excessive valuation has deterred the stock from rising (the valuation has since dropped to 17 times earnings). The same is true for other blue chips like Johnson & Johnson(NYSE: JNJ), First Data(NYSE: FDC), Microsoft(NYSE: MSFT), and Coca-Cola(NYSE: KO), to name a few.

This distinction often fails to translate when investors are talking about the stock market. Even when the stock market approaches a very high valuation, a buy-and-hold strategy is encouraged and investors expect to receive "average" returns. But average returns rarely happen. Returns that investors receive are a function, to a large degree, of a starting P/E. That makes a lot of intuitive sense. Returns from stocks are comprised of stock appreciation and dividends. Stock appreciation consists of P/E expansion and earning growth.

"Periods that start with above-average P/Es produce below-average returns, and periods that start with below-average P/Es produce above-average returns." Easterling proves this point time and again with numerous tables and charts.

The market is expensive Today's valuation is still above average as we're coming out of one of the biggest bull markets of 20th century. The S&P 500 is trading at 17 times trailing earnings, compared with the historical average of around 15.

Still, some would argue that the S&P's forward P/E of 15 is about average. The problem with this argument is that the historical averages are calculated based on trailing, not forward, earnings. Thus, the forward P/E is not useful for gauging today's market valuation because we're comparing apples to oranges.

Also, the current dividend yield of 1.7% is far below the historical 100-year average of 4.4% -- another confirmation of relatively high market valuation. Easterling argues that dividend yield is arguably a better yardstick of market valuation than P/E. P/E can be distorted during recessions (and economic booms), when dividends are more stable and unaffected by earnings adjustments.

Easterling makes another very interesting observation. Investors often associate bear markets with subpar or declining earnings growth and associate bull markets with above-average earnings growth. Nothing could be further from the truth. During the bear markets that took place in the 20th century (with the exception of the Great Depression), when stocks declined 4.3% on average per year, nominal GDP grew 6.9% -- in fact exceeding the nominal GDP growth of 6.3% experienced during the bull markets, when stocks rose 14.6% a year on average.

Foolish bottom line Unexpected Returns raises many very important questions. It doesn't-- nor does it claim to -- provide specific investment solutions. However, it does provide important investment insights. Easterling makes a very compelling case for active, more "hands-on" investment strategies in today's investment environment. The sense of security about stocks the book fosters goes away pretty quickly after putting it down. Yes, buying an index fund and forgetting may work if one's investment horizon is 50 years or longer, but that's not the case for the rest of us. As economist John Maynard Keynes said, "In the long run, we are all dead."

It would be just plain wrong to leave the reader on this less-than-optimistic note. In future articles and in my upcoming book, I'll discuss an investment strategy that will work in today's market environment.

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He and his company own shares of First Data. His company also owns Johnson & Johnson. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Copyright The Motley Fool

The Profit Margin Paradigm?

March 1st, 2006 - The Motley Fool

By Vitaliy Katsenelson, CFA

"Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly." -- Jeremy Grantham

Many investors (including the author) were caught off guard by the economy's surprising earnings growth over the last several years. Earnings of S&P 500 companies have grown more than 20% during the last two years, and they are expected to climb another 8% in 2006. This astonishing growth has exceeded the Gross Domestic Product (GDP), which topped out at 4.6% in 2004 and has grown at a slower rate since. Contrary to common perceptions, corporate earnings growth historically stays in line with GDP growth.

The source of this earnings growth was profit margin expansion (here we define profit margins as corporate profits / GDP), from 7.0% at the end of the third quarter 2001 to a whopping 10.3% in the latest quarter. As profit margins rise, corporations get to keep more of their sales, leading to improved profitability. To put things in perspective, the average profit margin for corporate America over last 25 years was approximately 8.3%, 200 basis points less than today.

The question comes to mind: Are the billions of dollars dedicated to productivity enhancements over last decade finally paying off? Did the new era of technology-induced corporate efficiency descend upon us? Are we in a "new"-economy, higher-profit margin paradigm? (OK, three questions). The answer is no, no, and definitely no.

Fallacy of composition Corporate America's enormous investment in technology did not go to waste. It made companies more efficient, helping them to produce more with less -- the definition of productivity. That's the good news. The bad news is that technology improvements were available to everyone. Oracle(Nasdaq: ORCL) will sell its software to any company that can spell "Oracle" on a multi-million dollar check. This is where the economic concept fallacy of composition (what is true for part may not be true for the whole) kicks into high gear. Though technological investment may help the first adapter to cut costs and get a leg up on the competition, competitors won't watch their economic pie being eaten by a more efficient company. Those who do sit still will be driven out of business. The others will adapt by writing a big fat check to Oracle, SAP(NYSE: SAP), or Microsoft(Nasdaq: MSFT), eventually catching up and competing the higher margins away. Thus, what was true for one company is not true for the industry.

As much as we would love to believe that productivity improvements brought to us by technological innovations will transform into corporate profitability, historically that has not been the case. Wal-Mart(NYSE: WMT) has changed the retail landscape by installing the most (at the time) revolutionary inventory management and distribution systems, passing the cost savings to the consumer, and driving less efficient competitors out of business.

However, Wal-Mart-like technology is available off the shelf to any retailer aspiring to coexist in today's competitive landscape. Even companies like Dollar General(NYSE: DG), with stores the size of several Wal-Mart bathrooms put together, wrote sizable checks to Manhattan Associates(Nasdaq: MANH) and installed perpetual inventory and automatic reordering systems. This investment will keep Dollar General in the game by helping it survive in the new competitive environment, but is unlikely to send its margins much higher from today's level.

Should all-time high corporate margins worry investors? Today's stock market valuation is higher than it may appear. As margins revert to the historical average (and they always do), corporate earnings growth will either decelerate -- disappointing Wall Street expectations of 8% earnings growth (according to First Call) for the S&P 500 over next five years -- or decline, driving earnings, the "E" in the P/E equation, down. The broad market index fund investor may be in a pickle when a cheap market suddenly becomes more expensive. If today's corporate profitability reverts to the mean profit margins observed over the last 25 years, corporate profits would decline almost 19%.

Putting macro-shmacro stuff aside, why does this all matter to investors holding individual stocks? Companies that don't have a sustainable competitive advantage (a metaphorical moat around their business) will not get to keep the benefits from the increased productivity. These benefits will get competed away, and their margins will decline. Do you own one of those companies? I strongly recommend you take a look at the companies whose margins are hitting an all-time high, and examine their competitive landscape and their business for sustainable competitive advantage.

Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. His firm own shares of Oracle and Microsoft. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Copyright fool.com