Idea of the Week – Does the Drought Spell Opportunity?
The way you approach investing in food processing stocks should be tempered by your long-term view of climate change – are we due for a series of summertime droughts? – as well as by your risk tolerance.
If you have been paying attention to the headlines or watching the news, you’ll know that the heat and lack of rainfall in the U.S. Midwest has triggered one of the worst droughts seen in North America in more than six decades, wreaking havoc on corn and soybean crops. It’s grim news for farmers: even as prices for their harvests soar, the amount they’ll be able to take to market diminishes almost daily, with the U.S. Department of Agriculture reporting that in Iowa alone, only 16% of crops can be rated as being in either “good” or “very good” condition. Livestock farmers worried about feeding their animals on today’s deteriorating pasturelands and inadequate corn supplies through the winter are sending their beasts to slaughter in droves.
The drought also is taking a toll on many food-processing firms. Whether you see the slump in their share prices as an opportunity to snap up some bargains, however, depends a lot on how you see this summer’s drought playing out. Is it a one-season weather crisis that will abate once autumn comes and brings cooler weather? Or is it a harbinger of hotter, drier conditions – if not as acutely so – in coming summers? Your answer to that question will determine which companies you want to add to your portfolio – if any. Cyclical or secular? Keep reading, and we’ll give you some suggestions.
The map above displays – in vivid color – the impact of the drought; with the darkest shades of red highlighting the worst hit regions. For now, it is the corn crop that has borne the brunt of the crisis; it is weeks ahead of its normal growing schedule but rather than growing steadily it has rushed to maturity without adequate rainfall – with predictable consequences. The yield per acre may hit its lowest level since 1995, the USDA projected late last week. Soybeans, harvested later in the year, aren’t yet in as dire shape, although without adequate rainfall soon, that crop could be hurt even more severely.
Droughts end – eventually. In this case, however, that may take a while to happen, according to longer-term forecasts from the National Oceanic and Atmospheric Administration (NOAA), which predicts the drought will continue over the next few months, impacting the soybean crop as well as corn. Since the US Midwest produces 75% of the corn and soybeans used for food, livestock feed and biofuels such as ethanol, this smaller harvest will translate into higher food prices.
When the drought finally breaks, that’s the moment that investors will want to begin viewing food processing companies as potential investments – although their timing will be crucial. There is a risk that if you begin to buy before the flow of bad weather news weighing on share prices begins to taper off, you may find lower or even negative returns. Timing and keen attention to the way that different weather scenarios will affect different parts of the food processing industry will be critical in capturing a solid return. (For more insight into this, please check out the video version of “Idea of the Week.”)
Year-to-date returns for this group vary, with Dean Foods leading the pack, up 48%, followed by giant Kraft Foods (KFT.N), whose stock is about 11% higher. That’s where much of the good news ends. Kellogg (K.N) is ahead by 3%, and just a few other companies in the industry whose stock prices vary from being flat to as much as 12% lower so far in 2012. The latest earnings report and outlook from Tyson Foods (TSN.N), a midcap industry participant, sent the company’s shares sharply lower; it now trades down 24% so far in 2012. Also languishing in negative territory are smaller cap stocks such as Pilgrim’s Pride (PPC.N), down 19% year to date, Sanderson Farms (SAFM.O), which is 20% lower so far this year, as well Smithfield Foods (SFD.N), which has fallen 22% over the course of 2012.
Over the last five years, as the DataStream chart above demonstrates, investors owning Kraft Foods (whose total return of 44% is plotted in yellow) and General Mills (GIS.N) (with a 58% total return, represented in green) would have fared better than those owning a group of the smaller food processors, such as Archer Daniels Midland (ADM.N) and Conagra (CAG.N), whose total return as a group of -2% is plotted in blue on the chart. In addition to these firms’ higher relative operating margins and their general financial strength, this also may be due, at least in part, to the ability of the larger firms in the industry to hedge some of the risks associated with big raw material price shocks such as the one taking shape in the Midwest today. That kind of scale and skill in hedging could mean that these are the firms best able to ride out a protracted drought and preserve their margins. But that doesn’t mean that you should overlook the opportunity for good trades in some of the smaller food processing companies, which may generate outsized returns if you own the right stocks at the right time as the selling tapers off.
The DataStream chart, below, shows just what is happening to corn prices, which now are topping $8 a bushel. For livestock farmers and meat processing companies, that’s a giant corporate migraine: they need corn to feed their chickens and cows, and what they really don’t need is a feed bill that is double what it was only a few years ago. If they put hedges in place to protect themselves at the beginning of this season, all well and good. But nobody can hedge indefinitely: to the extent that the hot, dry weather conditions that led to the drought appear likely to continue into 2013, hedging costs, too, will skyrocket.
We looked at Tyson Foods (TSN.N), 90% of whose revenues come from processing beef, chicken and pork, to see how past spikes in corn prices affected these companies. Tyson’s fiscal third-quarter earnings fell short of expectations, pushing the stock price down another 8%, hard on the heels of the 20% decline it had already suffered as the Midwest drought began damaging food processing company share prices as well as crops. That selloff, however, turned into an opportunity for some investors to find a relatively cheap entry point into the stock, of the kind highlighted in the chart below.
We indexed the total return of corn and of Tyson’s shares, in yellow and blue, respectively. Except during the 2008 financial crisis, every spike upward in the price of corn in the last five years gave investors the opportunity to jump into Tyson’s common stock a few months later, and to pay lower prices each time – and generating healthy gains each time. In each instance, a key ingredient was a recovery in the grain markets.
One possible reason for the uneven returns from Tyson’s stock, as depicted above, may be that food processors tend to generate smaller operating margins than behemoths like Kraft, General Mills or Kellogg. While the latter typically have operating margins in the teens, at a firm like Tyson or smaller, margins have ranged from highs in the low single digits to slightly negative levels. That means that for Tyson and firms like it, any price shock rapidly becomes a margin shock as well, at least in the short term. During past periods of drought accompanied by soaring commodity prices, companies with tenuous balance sheets teetered on the brink of bankruptcy, with some — like Pilgrim’s Pride – falling over it and filing for Chapter 11 bankruptcy protection. So if you think this drought has staying power, companies that have signs of compressed margins and other hallmarks of a weak balance sheet or other credit issues should be avoided.
USDA Secretary Tom Vilsack has commented that energy prices have a greater impact on the cost of food to consumers than will the drought and its impact on corn and soybean prices. Nonetheless, the latest USDA food price forecast estimates that consumers will need to brace themselves for above-average increases of 3% to 4% for groceries, 4% in milk, bread and cereals, and 5% for beef, as premature slaughter of herds that may well produce a glut of cheap beef in the short term, becomes a scarcity next year and beyond. Eating out? Well, you can expect those costs to rise 2.5% to 3.5%, the USDA projects.
As companies pass their higher costs – of corn, soybeans, pork or beef – onto their customers, historically we have seen investors who bought their shares on earlier price weakness reap a healthy return. As we discussed previously, smaller food processing companies whose returns (represented by the blue line in the chart below) are tied in some way to the price of grain are likely to disappoint investors who simply buy them and hold them, when measured against their larger peers like General Mills (represented by the green line).
But investors looking for a shorter-term play, or who believe that the drought is a transitory phenomenon and that another bout of hot, dry weather is unlikely to stress both crops and the balance sheets of some of the smallest food processing companies, like Smithfield Foods and Sanderson Farms, may want to take a look at some of these companies. True, they already score poorly on StarMine models designed to detect sources of credit risk: these are high-risk investments that do offer the potential for higher-than-average rewards, for those investors willing to bet that their outlook for weather conditions is on target.
Let’s delve more deeply into four of these high-risk/high-reward companies: Dean Foods, Smithfield, Pilgrim’s Pride and Sanderson. All four of these companies, when ranked on one of three distinct StarMine credit models, generate scores that rank its balance sheet as characteristic of a company whose credit falls below investment grade, as seen in the chart below.
Pilgrim’s Pride is an all-too-familiar name; that’s the company that went bankrupt in 2009 in the wake of soaring feed prices, collapsing under the weight of its debt burden. Today’s company, having emerged from bankruptcy protection, still scores in the bottom 10% of all companies in the United States according to all three models, StarMine Structural Credit Risk model, the StarMine SmartRatios Credit Risk model, the and the StarMine Text Mining Credit Risk model. Dean Foods scores in the bottom decile on two of these three models, even though the company’s shares are up almost 50% so far this year, which could be a concern for the more cautious investor. Should investors sell a stock that has done so well? Leaving aside the company’s credit issues, the StarMine SmartEstimate still shows that top-rated analysts expect earnings to be above consensus as far into the future as 2013. For investors comfortable with taking the kind of credit risk the company offers alongside those forecasts, and the uncertainty created by the drought, owning Dean might still be an appealing prospect.
Indeed, for many investors with a keen awareness of the risks involved and the risk/return tradeoff, trading some of these smaller food processing companies’ shares may turn out to be a profitable venture. Two standout opportunities among this group have been Ingredion (INGR.N) (formerly known as Corn Products International), whose total return of 24% is portrayed in red, below, and Hormel, whose 80% total return is represented by the purple line. Both stocks have trounced the S&P 500 over the last five years, while Hormel’s total return topped even that of industry heavyweight Kraft. (So far this year, Hormel has lost 2%, Ingredion is flat, while the S&P 500 is ahead 13%.) Their secret? Both firms have operating margins that are in the high single digits or low double digits, within shouting distance of those boasted by their largest peers. A little extra margin, it seems, can go a long way in helping to generate returns. It isn’t just a matter of performance, however. Those slightly higher operating margins also may be contributing to the fact that both Ingredion and Hormel rate fairly well on the three key StarMine credit models cited above.
For less intrepid investors, however, the wisest course of action may be to trade up in market cap and quality, and tilt your portfolio in favor of some of the largest stocks in this sector, especially if the drought shows signs of lasting into the new year.
Given the already-discussed USDA forecast of higher prices for milk, bread and cereals, the three largest market capitalization firms (Kraft, General Mills and Kellogg) already may be preparing their customers for future price hikes and modifying their expectations. These three companies have StarMine credit model scores that put them in the top half of all U.S.-based companies, giving them the strongest credit profiles from among the ranks of the food processors — although Kellogg scores only 14 out of a possible 100 on StarMine’s Credit SmartRatios model.
So depending on whether you are thinking of investing in food processing companies in hopes of beating the market, or whether you are looking for situational opportunities in other names (of the kind we have identified here in the shape of Tyson Foods) this sometimes-boring, sometimes-high risk industry can sometimes be very rewarding in deed. Meanwhile, as the drought continues and its ramifications become more far-reaching, we here at AlphaNow will be providing ongoing coverage of the companies and sectors suffering or benefitting, as well as discussion about the potential economic impact, this week and in the weeks to come.