Top Performing Fund Goes Short On Sanderson Farms, Inc. (SAFM)

Wolf Hill Capital is bearish on Sanderson Farms, Inc. (NASDAQ:SAFM), the third-largest domestic poultry producer in the United States. The top-performing fund believes that SAFM and other chicken processors are “over-earning based on unsustainably high processing margins that are poised to mean-revert over the course of the next two years as industry capacity ramps up.” According to Wolf Hill, the fair value for the company’s stock is $72 per share. SAFM is currently trading at around $126 and has a consensus average rating of Underweight from analysts polled by FactSet. In its Q4 investor letter, Wolf Hill discussed SAFM and other companies – we have already covered Archrock Partners and Constellium. In this article, we’ll take a look at comments made by the fund about Sanderson Farms in the letter.

During the quarter we established a sizeable short position in Sanderson Farms, the third largest domestic poultry processor with approximately an 8% U.S. market share. We believe that SAFM and other domestic chicken processors are currently over-earning based on unsustainably high processing margins that are poised to mean-revert over the course of the next two years as industry capacity ramps up. We believe that fair value for SAFM is about $72/share, based on 12x mid-cycle earnings of $6.00/share, or 56% lower than the price at which we initiated our position.

Chicken production is a highly volatile, low-margin, commodity business with virtually no barriers to entry. The profitability of a chicken producer is primarily a function of two variables: the price of fresh, frozen, and processed chicken products, and the spread between feed costs (corn and soy) which account for 45% of total costs. Over the course of the past few years, SAFM has benefited from a perfect storm type scenario of elevated chicken prices due to a temporary curtailment in supply, and low feed costs. Over the past 6 years, SAFM has averaged $8.17/share in EPS, versus $12.30 in 2017. 2017’s record earnings were driven by gross margins/pound of $.16 versus a 15year average gross margin/pound of $.09. As is often the case in highly cyclical industries, when industry conditions tighten considerably, producers add capacity to take advantage of this favorable, often fleeting dynamic.

New capacity takes time to ramp up and often comes on-line just as industry conditions are beginning to roll over. Protein Industry analysts are currently forecasting supply growth of over 4% per year over the course of the next several years based on already announced capacity additions as many previously announced expansion projects come on-line. We anticipate this supply growth to continue to put downward pressure on chicken prices. Even if feed costs do not continue their recent upward trajectory, SAFM’s 2018 earnings will likely fall substantially below current consensus earnings estimates.

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Sanderson Farms, Inc. (NASDAQ:SAFM) is a $2.87-billion market cap poultry processing company that produces and distributes fresh, frozen, and prepared chicken products in the United States. It does business with retailers, distributors, and food operators in the Southeastern, Southwestern, Northeastern, and Western United States.

Sanderson Farms had a positive year in 2017, with the share price surging more than 47%. However, the stock is down nearly 10% so far this year as the company reported weaker-than-expected profit for its fiscal fourth quarter of 2017. Shares started declining in mid-December after investors reacted to the chicken giant’s earnings report. The company had net income of $72.9 million, or $3.20 a share, versus $76.0 million, or $3.36 per share, in the fourth quarter of 2016.

Meanwhile, Sanderson Farms was in 19 hedge funds’ portfolios at the end of September. The company has seen an increase in support from the world’s most elite money managers recently. There were 15 funds in our database with positions in the poultry producer at the end of June, including Sprott Asset Management, and Breton Hill Capital.

Disclosure: none