CALM - Egg Industry Uncertainties Loom Large As Cal-Maine Foods Reaps The Benefits

Summary

• Highly pathogenic avian influenza has caused devastating losses to the U.S. table egg layer flock as confirmed cases increase.
• The egg industry is experiencing rising operating costs and is facing a significant long-term investment in its transition to cage-free egg production.
• As the U.S. largest producer of eggs, Cal-Maine Foods has thrived in periods of uncertainty.

Uncertainty weighs heavy on egg producers when contemplating an addition to their flock and in turn expanding the U.S. table egg layer flock. Cal-Maine Foods ( CALM ) and the egg industry might enjoy better egg supply and egg demand balance in the coming few years, as industry uncertainties could provide producers with a measure of restraint when adding to the U.S. table egg layer flock.

In 2016, I wrote an article titled " The Egg Industry After A Decade Of Plenty ." What followed were five mostly lean years in which CALM reported overall lackluster earnings.

HPAI Uncertainty

CALM's biosecurity measures, mostly southern U.S. locations, and plain luck have contributed to zero HPAI confirmations in 2022 or 2015. Egg industry HPAI losses for 2022 were larger and more widespread compared to the 2015 HPAI outbreak. Summer heat has not had the same effect on the current virus as cases continued into the fall. Total HPAI confirmations in all commercial and backyard flocks were ~ 57.8 million in 2022 compared to ~ 50.4 million for 2015. The majority of these losses have been in the table egg laying industry.

The egg industry has earned efficiency gains by placing large flocks (often 1 million plus hens) in one location. A recent Urner Barry's Reporter article titled " Is Culling Birds A Sustainable Answer To Avian Influenza? " questions the practice of culling an entire flock when HPAI is detected. The article also discusses the use of vaccines and the impact they may have on trade.

If the industry does not find good solutions to mitigate HPAI loss, producers may need to consider smaller flocks with a central processing plant in more diversified locations. It may be determined that parts of the U.S. have a reduced risk due to wild bird migration patterns or higher temperatures for example. The broiler industry generally has smaller flocks with a higher concentration in southern states and have experienced fewer losses to HPAI.

As of Jan. 1, 2023, table egg-type layers were numbered at ~306.3 million compared to ~326 million for the prior year. With high egg prices, producers are motivated to replenish hens lost to HPAI as quickly as possible.

Global HPAI losses have been significant this year as well. According to the ECDC , HPAI cases have affected 37 European countries and ~50 million birds were culled between November 2021 and September 2022.

In 2015, egg purchasers were able to import a significant number of eggs to replace a portion of U.S. supply lost to HPAI. For 2022 global HPAI losses have resulted in fewer eggs available for import. In addition, higher priced grain has hampered production in some countries further reducing global supply.

In addition to the use of egg imports to supplement lost U.S. supply in 2015, some food processors were able to substitute lower priced vegetable oils for high priced eggs in their recipes. In 2022, prices for many vegetable oils have increased along with eggs.

Egg prices have dropped from holiday baking season highs and may continue to drop as layers lost to HPAI in 2022 are replenished. However, CALM appears to be earning more during this 2022 - 2023 HPAI cycle compared to 2015 and it appears this HPAI cycle may last longer. December of 2022 (first month of Q3 FYE 2023) may have been CALM's best earnings month ever, given the extraordinary peak egg prices.

Cost of Production Uncertainty

FYE 2023 costs have increased compared to the previous five years and not by just a little. Grain costs have increased due in part to ethanol demand, climate and reduced Ukraine exports. Rising energy and transportation costs are a part of most all CALM costs, including delivery expense under selling, general and administrative (SG&A). The volume growth in specialty eggs since 2015 has also contributed to higher costs as those hens require more expenditure per dozen than non-specialty.

A return to pre-HPAI "normalized" egg prices with these higher 2022 costs may result in losses which is of concern to investors. A contrarian view is that higher costs lead to a higher egg quote and greater gains on a cents per dozen basis.

Producers may be more willing to cull late cycle lower producing hens if the farm price for eggs does not exceed the farm production costs for an older flock. This may lead to longer periods between flock replacements, a reduction in egg supply, and potentially stable or higher egg prices. Also, these higher farm production costs may change the cost benefit scenarios when producers consider additions to their flock numbers.

The following are scatter charts of CALM average feed costs compared to both average selling price and EPS for the last twenty years plus the first half of FYE 2023. I believe there is a moderate to high positive correlation between feed costs and egg prices. However, the correlation with feed and earnings is less significant at low positive.

While feed is the most variable of CALM costs, I believe other costs have a low positive affect on earnings as well. This "higher costs are OK" theory may be put to the test again over the next decade as producers continue to make tremendous long-term investment in cage-free egg production, while current production costs are on the rise.

Cage-Free Transition Uncertainty

The U.S. table egg layer industry currently houses ~ 106 million hens in cage-free conditions or better compared to ~38 million in December 2016. At the end of 2015 and into 2016, a plethora of grocers and egg purchasers pledged to transition to cage-free egg sales exclusively, mostly with target dates around 2026.

In 2015 the industry was meeting California mandated space per hen guidelines which led to investment in new hen housing construction and equipment. In 2018 California Proposition 12 was signed into law upgrading its animal welfare standards to cage-free conditions or better by 2022.

At least seven additional states have adopted similar rules with varying target dates between now and 2026. In the Burkenroad Reports Investment Conference April 29, 2022, slide 22 with citations, CALM highlights :

Meet retailer commitments: ~70% flock may require cage-free housing by 2026; average capital cost ~$45 per bird.

Legislative actions: ~27-32% households expected to reside in mandated cage-free states in 2026.

Exiting the 2015 HPAI cycle, state animal welfare actions and customer pledges indicated more cage-free production would be required. Producers responded with new construction and table egg-type layers ballooned to near 340 million hens as of Dec. 1, 2019, increasing egg supply.

Exiting this 2022 HPAI cycle, producers may be reluctant to construct new conventional housing considering the eventual transition to cage-free. Yet, many shoppers, especially food insecure shoppers, continue to choose lower priced conventional eggs when available. Producers may also be reluctant to construct new cage-free housing considering two retailers have recently adjusted their cage-free transition targets and backed away from a 100% transition. The cage-free transition now seems to have gone from a sprint to a marathon as it appears the "~70% U.S. cage-free flock by 2026" may not be reasonable and eggs from conventionally housed hens may be available for long while, possibly into the 2040s, according to a WATT Poultry article .

CALM management is following a Supreme Court case that challenges the constitutionality of California Proposition 12, which seeks to ban the sale of pork from hogs that don't meet the state's production standards even if the pork is produced outside the state. The egg related provisions of Prop 12 are not before the court, but the ruling may potentially have ramifications for the egg and other industries in the future.

The average cost of transitioning to cage-free housing varies depending if it's new construction or refurbishing existing facilities. With an ~$45 per bird investment in cage-free facilities, producers do not want to get ahead of cage-free demand as excess higher cost cage-free eggs may be priced with conventional eggs or nest run breakers. From CALM's most recent 10-K :

Our customers typically do not commit to long-term purchases of specific quantities or types of eggs with us, and as a result, it is difficult to accurately predict customer requirements for cage-free eggs.

Valuation and Growth

Book value, egg dozens produced and net income per egg dozen produced can be helpful measures in analyzing CALM for investment. CALM's book value at Q2 FYE 2023 was ~$27 and can be expected to increase this quarter if analysts are on target with their estimates.

CALM has increased its dozens produced (not the same as dozens sold) from ~535 million in FYE 2008 to ~1.02 billion in FYE 2022. CALM table egg layers have increased from ~22 million in FYE 2008 to ~43.7 million in Q2 FYE 2023. Factors that have contributed to this growth include acquisitions, U.S. population, per capita egg consumption, reduced reliance on outside egg purchases, and taking market share with new customers.

Net income per dozen produced can be meaningful when looking at a trailing 10 or 15-year period. Over the 15-year period ended FYE 2022 for example, CALM has averaged net income of ~11.5 cents per dozen produced. If CALM produces 1.02 billion dozen with 11.5 cents net income per dozen produced and has 48.84 million shares outstanding, CALM might expect average earnings per share of ~$2.40 going forward.

Expectations for net income per dozen and number of dozens produced may be adjusted up or down for various industry changes, including the following:

• HPAI: CALM's trailing earnings would be less without periods of HPAI included.
• Industry transition to cage-free egg sales: CALM has enjoyed a significant pricing premium for their specialty eggs over the last few years. Expansion or contraction of the cage-free market may affect earnings per dozen produced.
• Industry consolidation: CALM is the largest table egg type producer in the U.S.; however, their hens represent less than 15% of the U.S. table egg type layers. Industry concentration into fewer but stronger hands might lead to less cyclicality and a more stable egg quote.
• Continued increases in per capita egg consumption: Eggs are nutritious and generally a good value when compared to protein rich meats like beef. A dozen large eggs are about 24 ounces in weight, so it is easy to determine price per pound for comparison with meats. In addition, both chickens and table egg laying hens convert feed into product more efficiently than beef and use less water per pound produced. If our land and water resources become scarcer, chicken and table eggs may continue to enjoy a production cost advantage compared to beef and gains in per capita consumption.

Conclusion

I am comfortable holding CALM shares near ~2x book value or ~$60 per layer hen. CALM has significant cash and short-term investments available for an acquisition or to take market share with continued investment in cage-free housing.

With its size and strong customer relationships, CALM might navigate industry challenges more profitably than other producers. I view CALM as a good long-term investment for patient investors with a tolerance for egg industry related bumps along the way.

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