Looking at the business of Cal-Maine Foods

I’m going to have to spend some time over the next few weeks evaluating stocks that I don’t own in my portfolio covered by this blog.  These are companies of a few portfolios that I am taking on the responsibility of managing.  Many of these companies I am not terribly familiar with, and so I am going to have to learn what they do and whether they are businesses worth holding onto.

One of the larger positions that I am inheriting is Cal-Maine Foods. In this post I am going to focus on Cal-Maine’s business.  In a subsequent post I will look at the effect of the European legislation that is causing egg prices to increase substantially in Europe, and try to draw a conclusion on whether I will hold onto or sell the stock.

What they do

Cal-Maine was founded in 1957 in Jackson Mississippi.  The company came on to the national scene when they bought out Ralston Purina in 1972.  Since that time they have completed 16 more acquisitions of other egg producers.

Cal-Maine is the largest egg producer in the United States.  They sell shell eggs in 29 states, primarily in the southwestern, southeastern, mid-western and mid-Atlantic regions of the United States.

Cal-Maine distinguishes between eggs.  They sell regular eggs, and they sell specialty eggs.  A specialty shell egg is one of either a nutritionally enhanced, cage free and organic egg.  In fiscal 2011, specialty shell eggs represented approximately 25% of our shell egg dollar sales, as compared to to 21% in 2010 and 19% for fiscal 2009.  Retail prices for specialty eggs are less cyclical than non-specialty shell egg prices and are generally higher due to consumer willingness to pay for the increased benefits from those products.

Is the company growing?

Cal-Maine says that the shell egg business grows about 1% a year.  So this isn’t exactly Facebook.  In the last fiscal year (ended May 30th 2011) Cal-maine sold 820,000 dozen eggs.  Egg sales have been growing consistently over the past few years at a rate that is higher than the industry growth rate, though this growth rate has been still only been in the low to mid single digits.

Below is the growth in eggs sold since 2007.  The 2012 number has been pro-rated to 12 months and I wasn’t sure how much to adjust for seasonality so I might be a bit on the high side here.

Costs and Margins

The cost of producing a dozen eggs have been increasing for Cal-maine.  The main input cost is the cost of feeding the chicken.  Feed for chickens are corn and soybean meal and so the costs of these inputs are directly related to the cost of corn and the cost of soybeans.  Both commodities tend to fluctuate quite a bit, and because of the growth of demand for corn from the developing world, as well as the ethanol subsidies, feed costs have been on what seems to be a secular uptrend over the past few years.

This is what feed costs look like over the past 5 years.

Cal-Maine doesn’t take any forward pricing positions to hedge feed cost.  So you can basically look at the price of corn, and to a lesser extent the price of soybeans, and that is what the costs are going to be for that quarter.

Apart from the feed cost, other costs associated with producing eggs consist of the cost of operations, labour, electricity, the usual.  There are also processing and packaging costs.  The total costs of doing business, and the margins, are illustrated in the table below for the past 5 years as well as thus far in 2012:

Again, its clear that the cost pressures are primarily on the feed side.  Processing costs and non-feed farm costs have risen slightly over the past 5 years, but not enough to warrant any concern.

Earnings, ROE, and ROA

Earnings fluctuate pretty significantly depending on feed costs and egg prices:

But even with the cyclicality, its not a bad business.  Profitability has been consistent, even through the recession.  Return on Equity has consistently been above 15%.  Return on Assets has consistently been above 10%.

Two ways to grow the business

Cal-Maine highlights a 4 pronged growth strategy but I am going to focus on the two of those prongs that I think are most promising.

1. Acquisitions
2. Specialty Egg Business

Acquisitions

Pretty much all the competitors to Cal-Maine are family owned businesses.  At the JP Morgan conference the CEO, Fred Adams, pointed out that there is always generational turnover in these businesses and that turnover represents opportunities for acquisition.  What that means in english is that the younger generation isn’t always interested in running a boring egg business and without anyone to take over when the parents are ready to retire, Cal-Maine can buy them out.

I stole the chart below from the Cal-Maine presentation at the conference.  As you can see, none of the companies below are publically traded and most of them are family owned.

Obviously the advantage that Cal-Maine has is that it can take over these companies and quickly integrate them into their much larger operation.  Presumably there are cost efficiencies to be had.

In response to a question about acquisitions this is what Cal-Maine’s CFO Tim Dawson said about the company’s appraisal process:

When we talk about industry valuations we want to talk about the model we use.  We aren’t able to predict egg prices.   When you talk about an EBITDA model at the end of the day you are really basing that off of egg prices.  And we admit that we can’t predict egg prices.  So what we do is we send in a team of internal appraisers, and we do a depreciated replacement cost appraisal of the assets.   And then make an adjustment based on how good or bad the market that they service might be.

So basically an acquisition is going to be done based on the equipment, machinery and labour value of the operation.   Basically, how much would it cost to build this operation from scratch?   By looking at the acquisition target this way, they don’t have to make cash flow predictions that would of course be tied to egg prices.

The CEO, Fred Adams had this to add:

If someone wants to sell their business we are usually the first one they call because we have a good track record.  And if someone wants to sell their business its really just putting a value on the land, buildings and on the equipment.  Everything else is dollar for dollar whether it is receivables or inventories.  We’ve been very successful in the past, we’ve missed one or two but we’ve been told we were probably over-paying.

The company is well positioned to take on more assets at the moment.  They have an extremely clean balance sheet and net cash per share of $158M (about $6 per share).

You will also note that shareholder equity is $453M.  Total shares outstanding are a little under 24 million.  That puts the book value of the company at $18.88.  The company has consistently been growing book value at $40M to $50M a year for the past 5 years.

Specialty Eggs

Specialty eggs represent the second growth potential for the company.  Cal-Maine produces specialty eggs through the Egg-Land’s Bestä, 4-Grain, and Farmhouse eggs brand names.  Retail prices for specialty eggs are less volatile than prices for regular shell eggs.  They get a higher, more stable price for specialty eggs.  What is not clear from the 10-K and from the presentations I have listened to is whether the specialty egg business is actually a higher margin business.  Given the company’s desire to expand further into the business I would assume it is, but I can’t find informaiton anywhere that states the margins of the specialty business versus the regular shell egg business.

The company is growing the Specialty egg business at a brisk rate.  In 2011 it grew at a 14% clip and so far in 2012 its growing at a 9% clip.

Europe and the egg crisis

The third potential growth opportunity for Cal-Maine comes in the way of an unexpected egg shortage that is occuring in Europe, brought on by changes to legislation that have resulted in the loss of a large chunk of the egg producing chickens.    This is the topic that I am going to focus on in my next post.

What to make of the valuation

On a first glance at Cal-Maine, here is what I see.  I see a company that is running a decent business, a business that is profitable and bringing in cash, and they are reasonably priced.  At $36 they are trading at 12.5x last years earnings and 10.9x the average earnings over the past 5 years.  This excludes the $6.60 of net cash that they have on their balance sheet.

I think though that the key to the stock in the near term is whether the situation in Europe is going to spill over into the United States.   Right now I’m not sure of that, so I am going back to my hole to do some more research and figure out whether Europe can have a positive impact on a company for a change.