Why Tyson Foods Is a Buy

By Ronald Thomas, CFA  OCT 12, 2012 3:35 PM

This stock has little downside risk and a large upside potential.


MINYANVILLE ORIGINAL)  I believe that  Tyson Foods (NYSE:TSN) is 30% undervalued and that, all things being equal, the stock price could gain back much of its undrevaluation by summer of 2013. At today's stock price low of $15.94 and the target price is $21-22 (analysis below). Tyson stock fell from near $21 in May to $15 in July as the market over-discounted the effect of the drought in the US corn belt, in my opinion.

Of course it could rise sooner on any of a variety of catalysts (including winter rain/snow that increases ground moisture at spring planting).

One thing that could push it lower would be higher feed pricing in turn would cause a margin squeeze since not all of the cost could be passed on to consumers who would then eat less beef, pork, and chicken, resulting in a decline in unit sales and  volume.

Meanwhile the biggest "risk" is that money in the stock is now "dead money" waiting for better weather and planting conditions. if the overall market rallies in the interum Tyson could underperform relative to the market.

In investment analysis (as well as in agri-business), the assumption is that there will be a return to normal. Therefore, Tyson should be bought, based on its normalized earnings potential and on the assumption that normality will return.

Regarding normalized earnings per share (EPS), I used the low end of Tyson’s estimate ranges of the normalizable operating income to sales ratios for beef (2.5%, 42% of total revenue), chicken (5%, 33% of revenue ), and pork (6%, 18% of revenue) which gave me a conservative estimate of $1.93 per share. (The high end would be $2.75, but that is pie in the sky for me.)

To value Tyson, I use a 3.8% risk free rate (present 30-year Treasury bond plus 1% to adjust for “QE whatever”) and a 7% risk discount (not for real risks to the business enterprise’s long term cash flows, but only for year-to-year earnings volatility, as other consumer staples are assigned nearer 4%).  I believe that earnings can grow at a 4% five-year growth rate for five years after that, based on more protein consumption worldwide by developing countries. So the stock -- about $16 now -- should then be worth $22, for 35% appreciation.  

Also, the current 7% risk discount assigned to the stock makes no sense, considering that other branded consumer staples companies are assigned a risk discount of around 4%.  I believe that the increasing inroads being made by private labels on their branded competitors, combined with Tyson’s growth in the developing world, will ultimately lead to a 6% discount for Tyson (worth $24.50 vs. $22.00) over maybe a five-year time horizon. That could help long-term holders, but I have not, and would not, predict that it will happen in the holding period required for this recommendation to work.  But readers should note that the top four US beef producers have 75% market share; the top four in pork have 57% market share; and the top five in chicken have 63% market share. So there is at least some mild pricing power to be developed in the next few years instead of a totally competitive market model.

Getting to my valuation is all about what could be a longer period of no earnings momentum to catalyze the stock, even with a very cheap valuation.

One of the first things I learned as a young analyst is that the US corn crop comes in well five out of six times, i.e., do not bet against it.  However, there have been three bad corn crops in a row now. Rain has not been great since July; unless there is a lot of snow this winter, there will be low soil moisture, even when the corn crop is planted in May. However, there have been three bad corn crops, a statistical outlier given the norm of five out of every six years being good for crops.

It would be extremely unlikely there would be a fourth year, akin to the Dust Bowl years of the 1930s, but it can't be discounted. So a good corn crop is not likely to be discounted in the stock until there is better weather news. The situation for corn is somewhat the same for US soybeans and dryness in US pasture land.  A bumper crop in the southern hemisphere would be unlikely to change things much.

Also working against the stock in the shorter term is the fear that the economically stressed US consumer will not be able to pay for higher-end "center of plate proteins," such as meat, poultry, and seafood. Chicken prices were already at historically high levels before the towel was thrown in on the US corn crop.  Pork and beef will both get more expensive. Now I have seen many consumer analysts say that this or that product will not have much demand elasticity because consumers are so attached to it, only to find out otherwise. But it is a safe bet that US consumers are not turning into vegans anytime soon, and that chicken demand will not be particularly elastic. (Pork demand is also not expected to be particularly elastic.)

Another thing working against the stock is the tendency of the chicken industry to over-produce and not adjust production to rising costs fast enough. Egg sets may not decrease fast enough, and Tyson said that it is not cutting them now. This may be a problem when it comes to achieving normal earnings. Producers may end up betting too heavily on the lack of demand elasticity noted earlier. Heifers are being slaughtered so the beef profitability will be pushed out, with normal profitability here possibly not coming until 2015.

So analysts' average earnings per share for FY September 2013 is at $1.55 (down from a $1.77 FY12 estimate), which looks very optimistic. I would not be surprised to see something below $1.00 for FY13 (the lowest sell-side estimate is $1.20).

If you're trying to outperform the market, big upside that remains unrealized can make your relative performance look bad.  But dead money is my favorite risk, easier to take than other risks out there that affect other stocks in other industries, at least in this environment.
Long Tyson

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