CALM - Cal-Maine Foods: CALM Down There Is Little Upside Left

Summary

• Cal-Maine Foods, Inc. is involved in the production, grading, packaging, and distribution of shell eggs. They are the largest producer in the US.
• The business has grown revenue and profits considerably since 2022, driven by inflation and supply-side issues.
• Our outlook on the coming 12 months is softening prices for eggs, as companies are able to build up inventory. This said, Bird flu will continue to pose a risk.
• Financial performance prior to these supply-side issues was extremely volatile and so a return to these levels could be value destroying for investors.
• With a potential upside of 10%, we do not believe the current risk investors face is adequately covered by the reward, thus consider the stock a sell.

Company Overview:

Cal-Maine Foods, Inc. ( CALM ) is involved in the production, grading, packaging, and distribution of shell eggs. The company offers a variety of specialty eggs, including nutritionally enhanced, cage-free, organic, and brown eggs, under well-known brands.

The company primarily sells its products to grocery store chains, supermarkets, food service distributors, and egg product consumers in various regions across the U.S.

CALM is the largest egg producer in the US, with 46 million layer flock.

Share price:

In 2022, CALM stock experienced an unexpected resurgence due to a rise in egg prices driven by inflationary pressures and supply issues. This drove superb financial results. CALM was not only able to pass on greater costs but significantly improve its margins in the process. The UK, for example, experienced a shortage of eggs and required them to be rationed for a short amount of time .

With an impressive dividend yield and improving financials, investors are likely to consider this investment in 2023, as we are still suffering from heightened inflation. Within this paper, our objective is to assess if the business is currently attractive at its price, or if current investors are too late and are better off looking elsewhere.

Economic consideration:

The finances of consumers are being squeezed due to heightened grocery prices and increasing borrowing costs, with many businesses also feeling the strain. CALM is one of the few to be enjoying the current conditions, with economic conditions providing it with a once-in-a-lifetime windfall. As the following graph illustrates, inflationary pressures have wreaked havoc in the food industry, especially in the eggs segment.

The current economic environment is characterized by elevated interest rates and inflation levels. With consumer finances squeezed, they have prioritized their essential expenses, resulting in a reduction in disposable spending. The key driver of inflation is supply-chain issues stemming from various sources.

CALM has been able to benefit from such circumstances as the demand for eggs is inelastic. Consumers are not going to stop purchasing eggs because their price has increased. This is for two reasons. Firstly, eggs are cheap relative to income and so the impact on financials is minimal. Secondly, eggs are required for so many cuisines that the food is far too important to society to forego.

Our economic outlook is uncertain as although inflation looks to have peaked in 2022, it is inconclusive if rates will need to increase further in order to bring inflation down to a sustainable level. Recent CPI results show inflation has fallen less than forecast . Our view would be that rates rise one final time, with inflation coming under control from Q4-23 to Q1-24.

The key for CALM will be to carefully manage its costs and ensure they remain competitive in the market with pricing. With this in mind, we still see scope for elevated egg prices, but they may not reach the peak we have seen in recent months. This point aside, our view is that with a May year-end, 2023 will likely be their peak.

Avian influenza outbreaks:

Outbreaks of avian influenza (Bird flu) can have a significant impact on the production of eggs as the disease easily spreads through poultry and leads to the culling of infected hens. As the following graph illustrates, the inventory levels held have gradually declined throughout the year . ERS has found that inventory began to rise in the final week of 2022, with the expectation that egg-laying flocks will again increase, contributing to a decline in prices.

Shift towards cage-free and organic eggs:

In recent years, consumers have sought to purchase cage-free and organic eggs at a greater level, driven by concerns for the welfare of animals and a desire for more natural food options. This poses a problem for both consumers and CALM, as the current supply-side issues will lead to a greater number of caged hens. WATT Poultry survey has found that half of the egg-laying hens in the US will continue to be caged in 2025. This will likely allow CALM to sustain greater prices for these eggs but will also contribute to their costs increasing as fewer scale economies are available.

Volatility in feed costs:

One of the largest costs for CALM is feed for its hens, and so fluctuations in feed costs can have a significant impact on profitability. Feed prices themselves are influenced by the availability of grain and oilseed crops, as well as weather patterns, which can affect the cost of ingredients and transportation. As the following graph illustrates, costs have substantially increased in 2022.

Thus far, there has been little cause for concern as prices have been able to increase in excess of costs. CALM's GPM has increased from 19% in FY22 to 32.5% in the LTM period, illustrating that although this is a problem, it has not caused an issue thus far. What is more concerning is that if costs remain sticky, falling prices could contribute to a sharp tightening of margins in the coming 12 months.

Financials:

CALM's financial performance over the last decade can only be described as unusually volatile.

Revenue has grown at a CAGR of 7%, but if we exclude the prior two periods, revenue has remained essentially flat across the historical period. The reason for this is that the business is fundamentally tied to the market price for eggs. As an example, FY17 was substantially below the year prior due to a 42% decline in prices (Source: 2017 Annual account). This poses a serious risk for investors as the business lacks the ability to hedge/mitigate the risk of price swings. Further, this displays that prices can be volatile and so although we are predicting a gradual decline in prices, the reality is that they can substantially contract.

S&A expenses have gently increased over the historical period, driven by an increase in the size of CALM's operations. In FY14, 884M shell eggs were sold, v. 663M were produced. In comparison, 1,084 were sold in FY22, with 1,022 produced.

One counterargument for growth is that the business will be able to conduct further M&A activity to drive accretive gains by capturing synergies. So far, 23 transactions have been made, with several deals in the past few years. Although this will help mitigate some of the risks, the business does still face the risk of a material change in egg prices.

Objectively, however, the financial performance has been fantastic in 2023 so far. The business has managed to run incredibly efficiently with only a marginal uptick in costs, resulting in an impressive FCF conversion of 14%.

Although the market as a whole suggests prices may begin to decline, CALM is still running hot. As inventory turnover shows, the business is selling inventory at a faster rate than in FY22. This is usually a great indicator of slowing demand and so we will be very curious to see how the next quarter shapes up.

With the business being highly susceptible to changing prices, it is positive to see that the business is currently debt-free. This reduces any substantial downside risk to investors.

Peer group comparison:

In order to assess CALM's performance, we have utilized Seeking Alpha's rating, which compares CALM to other companies in its sector. With the current wave lifting all boats, our expectation is that most businesses are currently operating at inflated levels, thus it is still possible to compare the businesses.

CALM performs extremely well compared to its peers, with far superior growth. Given the company's significant production capacity, the business was well positioned to benefit from the current prices.

Further, this translates directly into profitability, with the business outperforming by a large margin once we consider the bottom line.

Again, this is likely driven by scale as on a GPM level, the business is only marginally better.

For this reason, investors looking for exposure to this industry can genuinely consider CALM to be the premier choice.

Valuation:

With large variability in prior trading, it is extremely difficult to use historical performance as a baseline for a valuation. The only somewhat stable metric is EV/Rev, which across CALM's history averages 1.05x. This is compared to 0.95x now, which suggests an upside of 10%.

One thing that is often forgotten, however, is that the denominator can also change. With our outlook that revenue will fall, investors will be banking on the share price remaining resilient in order for the 10% to be realized. Our view is that this is a large risk to undertake.

Final thoughts:

Investors face getting eggs on their faces with this investment. While some investors may have benefited from CALM's recent rise, there is a risk of negative returns due to a change in market price trends. The current outlook suggests that egg prices may decline, which would have a negative impact on the business should it materialize. The company's financial performance in FY17 serves as a cautionary tale of the impact of changing market prices.

With a moderately attractive upside based on the stock's current valuation, we do not believe this rewards investors for the risk they would be undertaking. For this reason, we consider the stock a sell.

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