2023-11-03 08:17:41 ET
Summary
- Tyson has been performing poorly for the past 18 months and is below its pre-pandemic price.
- The company faces challenges such as slim margins, growing competition, and vulnerability to climate change.
- Despite these challenges, Tyson has strong long-term prospects and maybe a protective pick in a tightening economic environment.
Tyson( TSN ) has been trending down for the past 18 months, and it is currently below its pre-pandemic price. It has slim margins, a growing competitive environment, is highly vulnerable to climate change, faces tight margins for the near future, and might risk a reduced growth in its dividends. Despite all that, it is an excellent pick for tightening economic conditions with substantial long-term prospects and a low downside.
The article will examine the top three headwinds for the stock, disruption of the supply chain, shift in consumer spending, and labor shortages, and why the macroeconomic conditions may lessen Tysons' problems while providing tailwinds.
Headwinds
The disruption of the supply chain is affecting Tyson on two sides: the market and the Manufacturing side. In the market, many of Tyson's products are sensitive to supply chain disruptions. If the products spend more time in transit, capital expenditure is required to transport and store them, as well as costly operational inefficiencies that result in reduced gross margins.
Unfortunately, it seems that supply chain issues that rose during the pandemic will continue in the short and mid-term, and this is reflected in the valuation.
The other side is manufacturing and automation impact. While measures to control reduced volumes and shifts in consumer spending have been implemented surprisingly quickly, like the closure of six chicken facilities during the year, automation of labor-intensive tasks has lagged due to longer lead times in machinery. This is causing Tyson to be unable to implement financially viable automation solutions quickly enough. The upside is that the efficiencies generated by the company's increased capital expenditure might not yet be fully reflected. This lag could reflect improving gross margins in the next 12-24 months.
This enabled us to announce today that we plan to close four additional chicken facilities bringing the total announced closures to six this year.
Donnie King - President, CEO - Q3 2023 Earnings Call
Labor shortages have reduced gross margins and have been worsened by this effect. While there is a long-term boundary on how much the average wage for manual tasks can be before automation becomes financially attractive, the lengthy implementation and concern for the long-term sustainability of labor shortages have pushed current labor costs beyond this boundary.
Finally, the shift in consumer spending impacted Tyson in two ways: loss of revenue to competitors with new plant-based products or premium food consumption and the shift in its portfolio mix, increasing costs of shifting manufacturing and forecasting errors. These issues will continue, but their impact will diminish as plant-based products will likely move from exponential growth to more stable growth.
The Macro Play
Two of the three most crucial issues for Tyson might crumble with shifting macroeconomic conditions: The shift in consumer spending and labor shortages.
We are currently in one of the worst macroeconomic conditions for the stock. Unemployment is below the long-term average, intensifying labor shortage, high interest rates, and longer lead times for machinery make automation less financially attractive and require more extended implementation times, and loose fiscal policy is increasing disposable income, shifting spending from essential consumables to premium ones.
However, these conditions are unlikely to be sustained, and this meta-stable economic condition will likely end up in harsher economic conditions, which would trigger a flight to safety and improve the conditions for Tyson.
The Fed's decision to sustain interest rates will play into Tyson's strengths. High-interest rate environments disproportionately affect companies with higher levels of debt and beta. The perfect example of this is Beyond Meat ( BYND ), which has a high level of debt, a high beta, and its products have been eating Tyson's growth for the last few years. In comparison, Tyson has a beta of around 0,7 and a strong balance sheet with little debt, making its cost of capital very low. This has not been fully reflected as the economy is growing at a higher pace than expected, but if this were to change, the full effect of higher interest rates would be a catalyst for the stock's upside potential.
Unemployment is not sustainable below its long-term average. We are beginning to see a contraction in manufacturing activity, which may signal the beginning of the end for current unemployment levels. This will ease the burden of labor shortage and improve margins. This will likely cascade into GDP growth and disposable income.
A diminishing disposable income in the population and high inflation suggest a shift in consumer spending from "premium" foods to necessities. This shift, paired with a higher cost of debt, will reduce competition and likely bring more revenue growth back to Tyson.
Valuation
The valuation for Tyson's business is relatively simple to model. However, appropriately reflecting the stock's risks proved challenging. We will see three approaches: FCFE, Dividends, and Residual income. In general terms, the high scenario reflects a smooth return to pre-pandemic conditions provided by the favorable macroeconomic conditions for the stock described above. In contrast, the low scenario reflects a slow and partial recovery of margins and revenue growth, leaving outside of its scope only extreme tail events and black swans.
The gross margin is projected to stabilize by 2025. The high scenario reflects the pre-pandemic level, while the mid and low scenarios reflect a considerable margin deterioration, reflecting the increased competitive environment of meat alternatives and lower pricing power.
However, the profit margin stabilizes as the scalability of SG&A costs does not affect the valuation significantly, and the low Debt to Equity ratio allows the company to shift its capital structure to react to worsening conditions. The mid and low scenarios also benefit from reducing depreciation and amortization expenses, as capex expenditure is reduced by lower revenue growth.
With these estimates, a free cash flow to equity valuation puts the low range of the fair price of the company at around $80, which is almost a 50% upside from current prices in the "pessimistic" scenario. Because of this extreme value, the FCFE valuation assesses whether the stock might be undervalued or overvalued.
One of the issues with this valuation is that FCFE considers cash inflows from debt and, in this case, may create noise in the valuation because of the low leverage of the company. This "flaw" is also present in the Gordon Growth model but to a lesser extent.
The flaw in the Gordon Growth model is that if the company has enough cash and flexibility with its capital structure to sustain dividends from its FCFE, it may provide overly optimistic valuations in the low range. In this case, it is especially noticeable as a reduction in revenue growth in the low scenario also reduces capital expenditures and results in higher cash.
The valuation considers a capital structure within the 1.1 and 0.7 range, yielding a significant dividend disbursement of around 30% of FCFE. Considering these assumptions, the stock could be overvalued by about 18% in the low scenario, fairly valued in the mid-scenario, and highly undervalued at around 50% of its fair price in the high scenario.
The mid and high scenarios make sense; the middle has the company fairly priced, and the high scenario considers the substantial upside in the possibility that the company returns to its pre-pandemic conditions. On the other hand, the low scenario is more likely to present the "flaw" of being overly optimistic about the dividends the company could afford. To test that theory, I used the Residual Income valuation.
The residual income valuation assumes the fair value as the current book value plus the present value of the future residual income of the company. The residual income is the excess return above the cost of equity that the company can deliver.
The residual income valuation returned a higher fair value estimate for the low scenario than the GGM. Easing the worries that the valuation on the downside could be substantially overstated.
Conclusion
Tyson is likely undervalued, has a relatively low downside potential, and could deliver a substantial upside if economic conditions deteriorate. This results in a rare risk proposition that may not only serve as a hedge against debilitating economic conditions, but may even flourish with them.
Relating to the tortoise and cat portfolios, both portfolios would include the stock differently and for different reasons.
For the tortoise portfolio , it would be a significant asset. It has the desired low downside, which is the portfolio's top concern. It also has dividends, which might grow in the mid to long term, providing growing long-term income. It is ESG-friendly and not only serves as a temporary hedge but also could have a long-term place in the portfolio.
For the cat portfolio , the stock has enough upside to justify an allocation and may be able to protect the portfolio in the present macro conditions. While it may not be a long-term holding for the portfolio, it has enough short-term upside to justify an underperformance of the market in absolute terms with its beta below 1.
As for my portfolio , I am including Tyson. It plays into two of the seven most important trends of the XXI century, the shift in demographics and sustainability, while also being an excellent hedge to macroeconomic pressures, which risk-adjusted should improve the portfolio performance even if the high side does not materialize.
For further details see:
Tyson Foods: A Shield For Choppy Waters, Unveiling Substantial Upside