Don’t buy the hype; SAFM is a defensively positioned value trap

I had to chuckle this weekend a bit as I read some some market news reports. The market has dropped far enough that in the latter part of the week, I think investors were starting to look for reasons to start buying. Friday looked set to mark the first time in weeks the market managed two straight positive days, but late in the day investors started selling again, driving the the S&P 500 Index below an important technical support level at around 2,350.

Yesterday, investors had reason to get even more pessimistic as word came down that Republicans and Democrats in Congress couldn’t manage enough compromise to complete the next phase of the federal government’s highly anticipated stimulus package. The word today, of course is that they’re still working on it, but the apparent re-emergence of bipartisan bickering at a time when states like California, New York and Illinois are imposing sweeping bans on traffic and commerce and issuing “shelter-in-place” orders.

Coronavirus frenzy is still dominating the airwaves, and its increasing presence in U.S. communities seems to make it hard to find any kind of good news to hang onto right now. In previous posts, I’ve written about how a smart investor tries to find places to put investing capital when the markets are in decline that might offer some kind of safe haven, or that might even be able to benefit from the decline. One of those areas right now is the Food Products industry. The public’s frenzy has included ransacking grocery stores across the country for basic goods, including toilet paper, bottled water, and other items that make up the “staples” you and I will find in anybody’s cupboard, refrigerator and freezer.

An interesting pocket of this industry is protein. People have to eat, of course, and so it isn’t too surprising to see that demand for protein products like chicken, beef and pork – fresh or prepackaged, including frozen – is pretty high. The really interesting part, and what I think represents a silver lining in the cloud of chaos right now, is the fact that China has begun increasing imports of U.S. poultry products. The swine flu outbreak in that country decimated their pork production capacity, which certainly played a role in Chinese officials finally removing a five-year ban on U.S. poultry imports last year. Now, as China slowly begins to come back to regular-ish activity from the draconian (but now, admittedly proving to have been necessary) measures to slow the spread of COVID-19, analysts and economists are predicting that protein imports to the second-largest economy in the world from the U.S. will begin to increase.

That’s good news for U.S. protein producers, including Tyson Foods Inc. (TSN) and Sanderson Farms, Inc. (SAFM). SAFM is the third-largest chicken producer in the United States. The news I just mentioned is one of the reasons over the last few days that these stocks have been rebounding off of their own big drops from previous highs. For its part, SAFM peaked in December at nearly $180 per share. It’s decline from that point is a little over -30%. Is this a stock that is well-positioned now to withstand current market volatility and offer investors both a good defensive alternative, along with terrific value? I’m not so sure. Let’s dive in.

Fundamental and Value Profile

Sanderson Farms, Inc. is a poultry processing company. The Company is engaged in the production, processing, marketing and distribution of fresh and frozen chicken, and also preparation, processing, marketing and distribution of processed and minimally prepared chicken. It sells ice pack, chill pack, bulk pack and frozen chicken, in whole, cut-up and boneless form, under the Sanderson Farms brand name to retailers, distributors, casual dining operators, customers reselling frozen chicken into export markets. The Company, through its subsidiaries, Sanderson Farms, Inc. (Production Division) and Sanderson Farms, Inc. (Processing Division), conducts its chicken operations. Sanderson Farms, Inc. (Production Division) is engaged in the production of chickens to the broiler-stage. Sanderson Farms, Inc. (Foods Division) is engaged in the processing, sale and distribution of chickens. The Company, through Sanderson Farms, Inc. (Foods Division), conducts its prepared chicken business. SAFM has a current market cap of about $2.9 billion.

Earnings and Sales Growth: Over the last twelve months, earnings declined by almost -115%, while revenues improved by about 10.7%. In the last quarter, earnings dropped by -85%, with revenues also down -92.%. SAFM is a company that, like many stocks in the Food Products industry, operates with a very narrow margin profile; however in this case there are signs that even their narrow margins are deteriorating; in the last twelve months, Net Income was 0.92% of Revenues, but declined to -4.68% in the last quarter.

Free Cash Flow: SAFM’s free cash flow is negative, at -$74.4 million. This is actually an ongoing pattern; the last time the company reported positive free cash flow was in the first quarter of 2017.

Dividend: SAFM’s annual divided is $1.28 per share and translates to a yield of 1% at the stock’s current price.

Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but I like to work with a combination of Price/Book and Price/Cash Flow analysis. Together, these measurements provide a long-term, fair value target around $185 per share – just a little above the stock’s multiyear high. That offers a big-time discount from its current price, with 48% potential, long-term upside. That is, admittedly, very tempting under current market conditions.

Technical Profile

Here’s a look at the stock’s latest technical chart.

Current Price Action/Trends and Pivots: The red diagonal line measures the length of the stock’s longer-term upward trend; it also informs the Fibonacci trend retracement lines shown on the right side of the chart. After reaching a peak near $180 in December of last year, the stock began an extended drop into a downward trend that only recently appears to have found a bottom at around $102 per share. The stock has rallied strongly from that point on the view that protein producers are one of the isolated areas of the economy that is seeing an increase in demand. Immediate resistance is at the 38.2% Fibonacci retracement line, near to $132 per share, with current support around $120. A break above $132 should give the stock momentum to rise to about $141 in the near term, while a push below $120 could see if drop to anywhere between $102 and $108 per share.

Near-term Keys: SAFM’s deteriorating fundamentals work in direct contrast to the value proposition its valuation metrics might tempt you to believe; that makes this stock the perfect definition of a value trap. That doesn’t mean it won’t increase in price in the long term, but it does mean that if it does, it will be based strictly off of the market’s continued emotional reaction to news and events as they happen. In that case, expect to continue seeing a lot of volatility from the stock; however, a push above $132 could offer and interesting, bullish short-term trade, with upside to about $141 that would be great for a short-term buy of the stock or a call option trade. A drop below $120, on the other hand should be taken as a signal to consider shorting the stock or working with put options, using $108 as a likely, useful target price for a bearish trade.

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