Sunday, October 9

Week 275 - Food Processors With Improving Fundamentals

Situation: Grain prices are low, which means equipment and seed vendors find that few farmers are eager to buy. But grain processors benefit when prices are low. 

Mission: Look for improvements in cash flow and revenue among the largest food processors, and assess the benefits and risks of investing in those companies. Look for Brand Value and clean Balance Sheets in addition to calculating Net Present Value.

Execution: see Table.

Administration: We’ve found 12 food processing companies that rank higher on the 2016 Barron’s 500 List than they did on the 2015 List. Those companies had a better overall score based on 3 criteria: A) Cash flow-based ROIC, B) 2015 ROIC vs. the 3-yr median, and C) sales growth in 2015 vs. 2014. All 12 companies have a 16+ year trading history that has been analyzed quantitatively by using the BMW Method; see Columns K-M in the Table

With respect to broad indications of quality (i.e., S&P bond and stock ratings at Columns P and Q in the Table), only 6 companies meet our standards. Our measures include a bond rating of BBB+ or better and a stock rating of B+/M or better. The 6 stocks are: Hershey (HSY), General Mills (GIS), Hormel Foods (HRL), Coca-Cola (KO), Campbell Soup (CPB), Archer Daniels Midland (ADM). Only 4 of those stocks are Dividend Achievers (annual dividend increases for 10+ yrs): GIS, HRL, KO, ADM

With respect to Net Present Value (see Column V in the Table), the top 4 companies are Ingredion (INGR), Hormel Foods (HRL), JM Smucker (SJM), Tyson Foods (TSN).

Hormel Foods (HRL) is the only company with a clean Balance Sheet. We have a problem when evaluating Balance Sheets for food processors (see Columns Y-AB). Those companies are able to be somewhat unconcerned about bankruptcy, since food prices tend to be inelastic (i.e., food is an “essential good”). This allows company managers to spend more on advertising than on growing Tangible Book Value. In the aggregate, these 12 companies carry too much debt. Their total debt is 160% of equity whereas 100% is the upper limit for a clean Balance Sheet. Long-term debt is 29% of total assets, which is barely acceptable. Tangible Book Value is 1% of each share’s price, which is barely acceptable. In the first half of 2016, two of the Dividend Achievers, Coca-Cola (KO) and Archer Daniels Midland (ADM), had insufficient free cash flow (FCF) to pay dividends. That means they either had to borrow the necessary funds or sell a non-strategic asset. 

With respect to brand value, Best Global Brands ranks the top 500 brand names annually. Three of the companies in our Table are among the top 500 for 2016. Those 3 are: Coca-Cola (KO), Kellogg (K), Tyson Foods (TSN). Two additional Coca-Cola brands appear on the list, Sprite and Fanta. Coca-Cola ranks #17 (down from #12), Kellogg ranks #183 (down from #181), Tyson ranks #307 (up from #353), Sprite ranks #411 (down from #391), and Fanta ranks #488 (unchanged). Interestingly, Hershey (HSY) is not a top 500 global brand.

Bottom Line: The “take-home message” is that stocks whose prices vary with the weather and global crop yields are speculative. The investment that farmers make in equipment, software, irrigation systems, seeds and chemicals will determine their crop yields, given favorable weather. Over the past 3 yrs of good weather (El Nino), those investments have paid off in all the countries of the Northern Hemisphere that have a strong agriculture sector. That means the prices that food processors pay for wheat, soybeans, rice, corn and meat have fallen. The other key fact that drives those growing profits is the addition of some 20 million people a year to the middle class, meaning they can finally afford to eat a 60 gm protein diet every day.

Risk Rating: 7 (where 10-Yr US Treasury Notes = 1 and gold = 10).

Full Disclosure: I own shares of HRL, KO and ADM but recently sold shares of GIS. I thought GIS shares had become overpriced but the current NPV calculation suggests that GIS shares continue to have considerable value (see Line 3 in the Table, at Column V).

NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 21 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256. Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = moving average for stock price over past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 10-Yr CAGR found at Column H. Price Growth Rate is the 16-Yr CAGR found at Column K. Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% is based on returns from a stock index of similar risk to owning a small portfolio of large-cap stocks, i.e., the S&P MidCap 400 Index at Line 26. The investment vehicle for that index is the SPDR S&P MidCap 400 ETF: MDY at Line 20. The NPV calculation for MDY (at Column V and Line 20) includes transaction costs of 2.5% on purchase and 2.5% on sale.

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