(By Ken Perkins) Grain prices skyrocketed in recent months amid droughtlike conditions in the Midwestern United States, which are expected to result in the lowest crop yields since 1995. In the near term, higher corn and soybean prices will challenge the cost structures of meat processors, as grains represent a disproportionately large percentage of their production costs. Despite these headwinds, we think long-term industry fundamentals are relatively unchanged. The market has punished the shares of meat processors like Tyson Foods (TSN
) over concerns about the drought's impact on short-term earnings. While there are still risks, we believe Tyson's current share price merits attention from investors.
Drought Conditions Are Real, but Margin Pressure on Meat Producers Should Abate
Since meat processors rely heavily on grains to feed animals and the drought sent grain prices to record highs, we expect meat processor margins to come under pressure over the coming quarters. Just when it looked like commodity inflation was easing, drought conditions across the Midwest sent average grain prices soaring more than 20% since May and nearly 3 times above their 50-year historical average. While the drought's full impact is difficult to estimate, it is clear that 2012 crop yields came in well below expectations set at the beginning of the planting season, and grain prices are likely to remain elevated over the near term. (The U.S. Department of Agriculture currently estimates that weighted average corn prices will be $7.10-$8.50 per bushel for the crop year ended August 2013.)
Although shares in meat processors have fallen because of concerns that profitability will be challenged in the short term, we believe the fundamental trends affecting total demand for proteins should lead to long-term upside. To put the near-term headwinds into perspective: Through the first nine months of 2012, the temperature index was the highest it has ever been, and only six years since 1900 have experienced a more severe drought. Also, although corn prices have doubled since 2007, there could be some relief on the horizon. Corn futures have come off August highs and, based upon the market's current expectations, prices could fall 15% and another 20% over the next one- and two-year periods, respectively. In addition, the USDA estimates that Brazil exported a record 3 million tons of corn in September and 19.0 million tons in 2011-12 (more than double exports in 2010-11), which could help to offset reduced U.S. production over the near term.
Tyson's Chicken Segment Will Be Hardest Hit Over the Near Term
The drought's impact will challenge each of Tyson's business segments, but the timing and magnitude of the impact will vary greatly by protein because the production cycles and grain requirements differ for chicken (34% of sales), beef (42%), and pork (17%). Tyson's chicken segment margins will be hardest hit by elevated grain prices over the near term, as the segment's vertical integration requires that Tyson directly purchase grains used to feed broilers (birds used for meat production). In addition, Tyson's spread pricing for beef and pork products limits the direct impact that elevated grain prices will have on beef and pork gross margins. Still, beef and pork segment operating margins could contract if consumers balk at higher prices, as lower volume would force Tyson to spread its fixed costs over fewer units.
Gauging the Timing and Magnitude of Elevated Grain Prices
Raising broilers typically takes about seven weeks, and when adding another week or so for processing and distribution, it is reasonable to expect higher input costs to hit the cost of goods sold about eight weeks after grain is purchased. The chicken production process can take up to 36 weeks. However, meat processors can adjust output much more quickly, as increasing or decreasing production is controlled via the number of eggs set in incubators and the number of chicks placed for output. Thus, when assessing the timing of the potential flow-through of higher input costs, the period from hatching to distribution is most critical to understand.
Hedging benefits would normally help to smooth the effects of input cost volatility on margins, but we believe Tyson had entered into fewer hedge positions than it normally would have before the drought. During its third-quarter conference call, management noted that it was only fully covered through the fourth quarter (ended October), as it was originally expecting a bountiful harvest in 2012 due to record plantings--which influenced the USDA's bullish outlook for 2012 crop yields. Although incremental hedges could have been applied since that call, we suspect that the drought's impact on chicken margins will be amplified over the first few quarters of fiscal 2013.
Given how quickly corn prices can change, as well as the relatively short lead time (eight weeks) between when grain is purchased and when it flows through COGS, the full-year impact of the drought on fiscal 2013 earnings is still highly uncertain. However, based on several factors and data gathered from the company, we peg Tyson's incremental annualized cost at just over $700 million.
Our basic assumptions include: Feed costs (the ratio of corn to soy needed is about 2:1 for chicken) account for just over 40% of the cost of raising a broiler to the appropriate slaughter weight. A $0.10 change in corn prices (per bushel) or a $10.00 change in the price of soybean meal (per ton) will generally result in a $0.0025 change in the cost per live-weight pound of chicken. The baselines of capacity, product, output, and costs are based on company reports.
Several moving parts could affect our initial $700 million cost increase estimate in the coming quarters. First, we used rounded grain futures prices, as corn and soybean meal prices were very volatile in in late July and early August. Second, chicken producers have been cutting back production (and could slaughter chickens at a lower-than-average live weight), which would bring this estimate down. Third, current corn and soybean futures are below August highs, and as the firm continues to purchase these inputs throughout the year, the weighted average cost would decline.
The following exhibit illustrates the potential impact that recent corn and soybean meal prices could have on the cost of producing one live-weight pound of chicken. All else equal, our $700 million cost headwind would result in a 200-basis-point contraction in consolidated gross margins, and we expect that the chicken segment would not report an operating profit.
Meat Processors Are Weighing Their Pricing Strategy and Potential Volume Impact
Chicken producers are likely to will seek additional price increases to partially offset higher feed costs, which could hurt near-term volume. We believe that coordinated decreases in industry supply would help to stabilize prices and potentially provide some buffer to falling margins. We believe that Tyson's (and other industry leaders') production cuts over the past few months should help the company take pricing over the near term. However, we expect cash-strapped U.S. consumers will continue to focus on maximizing limited income, resulting in a near-term decline in chicken volume. (Chicken volume declines may be more muted than declines in other proteins, primarily because chicken products are often perceived to offer good value relative to other proteins.)
Though it may be ambitious, we estimate that Tyson will need to take high-single-digit to low-double-digit pricing to completely cover elevated input costs, as average corn prices increased more than 20% between May and early August, and grain typically accounts for more than 40% of the cost of raising a bird to the appropriate slaughter weight. We think Tyson should be able to take most of this pricing as long as it and other industry participants are rational in reducing supply. We estimate that a 10% increase in prices would result in 1%-2% of volume reduction. However, Tyson is unable to control the actions of its competitors and could be affected whether or not these players cut supply.
We Still See Upside From Current Levels
As the market extrapolates lackluster earnings, we see an opportunity for patient fundamental investors. Concerns about the margin headwinds are real, but we believe a modestly improved outlook could spur a rebound in Tyson's profitability and push shares back toward our $20 fair value estimate. Moreover, we believe that weather is mean-reverting to a considerable degree, and the poor crop yield of 2012 could be followed by a bountiful harvest in 2013. An improved outlook could bring about a rebound in Tyson's profitability (we believe $2.00 is a reasonable estimate for normalized earnings), and using a conservative 10 times multiple, we think its shares could jump to $20 as they did when corn prices began retreating in early 2012 after the USDA announced expectations for record plantings.
Our $20 fair value estimate implies a fiscal 2013 forward price/earnings ratio of 13 times, enterprise value/EBITDA of about 6 times, and a free cash flow yield above 5%. Our annual average revenue growth estimate of more than 3% over the next 10 years is driven almost entirely by price/mix, as we assume flattish volume in aggregate for Tyson. We forecast normalized gross margins of approximately 6%-7% over the next decade, though we recognize that margins are volatile and subject to swings in commodity prices. We project fairly stable selling, general, and administrative expenses from year to year, which leads to normalized operating margins of approximately 4%.