March 16, 2012

Chicken wings won’t be enough to help Sanderson Farms earnings fly higher

by Sridharan Raman

March Madness is upon us, and as the college basketball season enters its final stretch, fast food restaurants will see a spike in orders for that perennial favorite: chicken wings. In fact, the first quarter of the year is traditionally the busiest for chicken producers, given that the NFL Super Bowl also causes a spike in demand. March is important to chicken producers for another reason: that’s when the US Department of Agriculture’s National Agricultural Statistics releases the first report for 2012 that details how much corn farmers expect to plant and harvest later this year. That in turn determines how much will be available to chicken farmers as they start calculating their costs for the coming year. Unfortunately, the outlook for Sanderson Farms (SAFM.O) appears fairly bleak, despite the apparently insatiable appetite of sports fans for chicken wings, the company has a StarMine Earnings Quality (EQ) score of only 10, indicating that its earnings may not be sustainable in the future.

StarMine uses computer-driven models to analyze the financial statements of companies in the United States and around the world, and then calculates proprietary StarMine Earnings Quality (EQ) scores for each security. Those companies with low StarMine EQ scores as calculated by this model are likely to have difficulty in sustaining past earnings. (For a more detailed explanation of this model, please refer to the recent AlphaNow discussion of American Express.) This look at Sanderson Farms is the next installment in our series of articles examining companies across North America that rank either especially high or particularly low in terms of earnings quality, as measured quantitatively by the EQ model.

In the past four quarters, the company has been generating losses rather than earnings. In the chart below, the red bars indicate the amount by which the net income lagged free cash flow (FCF). Not only has the company reported losses, but the outflow of FCF has been even more notable. Although earnings were “less bad” in the last reported quarter, the losses still amounted to $8 million, while the FCF came was actually an outflow, of $22 million. Earnings that aren’t supported by strong cash flows are often unsustainable, so whenever FCF has been as consistently negative it has at Sanderson Farms in each of the past five quarters, it’s important to dig more deeply into the company’s financial results.

Source: Thomson ONE / StarMine

What that deeper dig into Sanderson Farm’s fundamentals showed is that higher corn prices have contributed, not surprisingly, to erosion in profit margins. More worrying, however, is the drastic rate at which these margins have fallen. To make matters worse, the key margin measures are far below the industry median, which means that the rest of the industry hasn’t been hit as hard as has Sanderson Farms. The chart below displays the key margin measures: the gross margin (represented by the red line), operating margin (the green line) and the net margin (the blue line). Since October 2010, all three measures have plummeted. In fact the operating margin for Sanderson Farms was 10.9% in October 2010, above the industry median of 9.3%. (Sanderson Farm’s rivals, such as Tyson Foods (TSN.N), Smithfield Foods (SFD.N) and privately held Perdue Farms all have profit margins that are stuck at single-digit levels,) Since then, operating margins have fallen and are currently negative, to the tune of 7.1%, far below the industry median of 8.9%. When margins for a company fall so precipitously, while those of the rest of the industry, however meager, hold up so much better, it is reasonable question the company’s operating efficiency.

Source: Thomson ONE / StarMine

Further, the company’s long-term debt has ballooned to $289 million from $62 million just a year ago. Management may be taking on debt to finance operations that are bleeding cash. The combination of that high level of debt, poor margins and negative cash flows has forced management to delay the construction of a second plant in North Carolina.

During the company’s quarterly earnings conference call on February 28, 2012, listeners could sense the urgency in the statement made by Joe Sanderson, its CEO and chairman. ” We need a good crop,” he said. “Even if we get adequate acres in the March 31 planting intentions report, that crop needs to get into the ground, and there’s little margin of error with weather as we head through the growing season.” Two years running during which crop yields fell below normal led to higher prices, which in turn put heavy pressure on the company’s margins and profits. (You can access the full transcript of this call on Thomson Reuters StreetEvents.) While the management may be counting on the heavens to deliver a bumper crop of corn, the company’s poor EQ score of 10 shows that it may well take more than that to turn Sanderson Farms into an appetizing stock for many investors.

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