From the top down, I'm looking for companies with stable, almost annuity-like, revenue during economic cycles combined with a large percentage of expenses from materials. An example in my portfolio is Kimberly-Clark (ticker KMB), a consumer staple company that sells products like Kleenex and has significant costs associated with wood due to its paper-based products.
Of course, this idea assumes commodity prices continue to fall. Based on my Sagflation theme of slow-to-negative growth combined with volatile prices, in which I believe the current direction of prices is moving towards deflation, commodities should continue to decline. Significant government intervention in the form of fiscal and monetary stimulus could change this outlook.
In this article I review my investment in Kimberly Clark (ticker KMB), analyze a few companies with similar margin improvement potential due to falling commodity prices, and conclude with a decision to make 2-4% investment in Tyson Foods, ticker TSN.
First, a look at some commodity prices and their change this year:
Oil (Light Crude)
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Copper
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Corn
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Wheat
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Cotton
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Live Cattle
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The charts above illustrate that the largest price drops over the past year have occurred in copper. Over the past six months there has also been a significant drop in oil and cotton prices with more moderate pullbacks in corn and wheat. Not included in the charts is lumber, which has also seen a modest pull back in prices over the past couple months. Cattle prices have actually rallied strongly over the past. While I expect commodity prices, in general, to continue their decline as deflationary pressures strengthen, for the purposes of the current analysis I shall focus on oil, copper and agricultural products, excluding livestock.
Kimberly-Clark (Ticker: KMB) Cost of Products Analysis
| 2Q11 | Y/Y | |
|---|---|---|
| Revenue ($mm) | $5,259 | + 8.3% |
| Gross Margin | 29.6% | - 4.2% |
| Op. Margin | 11.9% | - 2.7% |
| Dil. Op. EPS | $1.18 | - 1.7% |
Source: SEC Filings
In 2010 cost of products sold accounted for about 67% of revenue, highlighting the importance of raw material costs in the actual products and used during the manufacturing process. The primary raw materials in the company's products are recovered paper, synthetics, kraft pulp, cellulose pulp and recycled fiber. Natural gas, electricity, and petroleum-based products are key costs during the manufacturing process. Therefore pulp prices and oil prices can have a material impact on financials.
As seen in the charts above, oil prices have declined about 22% since the May peak. The Forestweb North American Pulp Index has dropped over 9% since the June peak. The gross margin for KMB dropped more than 400 basis points from 33.8% in 2Q10 to 29.6% in 2Q11, largely due to higher raw material costs, much of which the company does not hedge. Should oil and pulp prices continue to decline I expect to see the margins improve for the business, enabling above average EPS growth.
Looking over some other key metrics: annual dividend yield is a healthy 4%, the dividend increased 6% this year, TD/ EBITDA is a comfortable 1.5x, PE on '12 EPS is an okay 13.5x, and last month the consensus recommendation moved up to Overweight from Hold because one analyst upgraded. Five analysts have a Buy, ten have a Hold recommendation, and one Sell. I believe the stock is reasonably valued and the dividend yield combined with stable revenue should attract buyers in a weak market.
Sysco Corporation (Ticker: SYY) Cost of Sales Analysis
Sysco is a food distributor with significant fuel and food costs. Because of this position, I decided to look at the margin potential. For the purposes of this analysis, in which I am looking for potential margin expansion due to falling commodity prices, the key disclosure in the company's filing is the following, "we make a significant portion of our sales at prices that are based on the cost of products we sell plus a percentage markup." As a result, falling commodity prices are likely passed along to the customer in the form of lower prices, instead of retained by the company for margin improvement purposes.
Campbell Soup Company (Ticker: CPB) Cost of Products Sold Analysis
Campbell Soup is a food company whose significant costs include agriculture commodities like tomato paste. Therefore I looked at it as a candidate for margin improvements. The key disclosure in their SEC filings is the following, "The company also enters into commodity futures and options contracts to reduce the volatility of price fluctuations of diesel fuel, wheat, natural gas, soybean oil, aluminum, sugar, cocoa, and corn, which impact the cost of raw materials." Therefore there is likely not the upside to margins as commodity prices fall.
Cracker Barrel (Ticker: CBRL) Cost of Goods Sold Analysis
Cracker Barrel is a family-dining restaurant plus retail chain that are typically located next to highways. While not immune to economic slowdowns, their relative low average check, locations near highways, and established brand name can provide healthy revenue trends when gas prices fall, encouraging more people to drive. Thus the company is fairly unique in that falling gas prices can actually drive revenue. The concern is that the company's niche is largely in the lower-to-middle class income segment, which may be hurt proportionally more during an economic slowdown.
| F4Q11 | Y/Y | |
|---|---|---|
| Revenue ($mm) | $613 | 0% |
| Gross Margin | 68.4% | - 1.7% |
| Op. Margin | 6.2% | - 1.2% |
| Dil. Op. EPS | $0.25 | + 14% |
Source: SEC Filings
Gross profit was 68% in the fiscal fourth quarter (FYE July), down 170 basis points from the previous year. The primary cause of the higher cost of goods sold was a 2.9% increase in food commodity prices for the fiscal year. Looks promising so far. Dairy, including eggs, accounted for 13% of food purchasing expense in fiscal 2011. Beef, poultry, and pork each accounted for 11% of food purchasing expense. Together, these four segments accounted for 46% of food costs. The company raised menu prices 2% last year to offset the rising costs but the traffic declined about 2%, which may be due to the higher menu prices, weak economic environment, and also higher gas prices.
The key issue, in my mind, concerns the following disclosure about the fiscal 2012 outlook, "we presently expect the rate of commodity inflation to approximately double in 2012 as compared to 2011. We expect to offset the effects of food commodity inflation through a combination of menu price increases, supply contracts and other cost reduction initiatives." On the one hand, expectations are already set for higher commodity prices, providing room for upside should food prices actually fall. The problem is that beef prices are rising due to the droughts around Texas. On the chicken side you would think poultry prices would decline with lower corn prices. However, producers have been getting squeezed due to higher corn prices and thus have cut back production, suggesting poultry prices may remain firmer. Pork belly prices have declined about 5% since peaking in May, so this segment may offer some upside.
My conclusion is that food prices impacting Cracker Barrel may not go down as much, offering less upside to margins. Couple this with the uncertain impact of a weaker economy and I have decided to put this idea on the shelf.
Tyson Foods (Ticker: TSN) Cost of Sales Analysis
Tyson Foods, Inc. is a meat protein and food production company. It produces, distributes and markets chicken, beef, pork, prepared foods and related allied products. Its operations are conducted in four segments: Chicken, Beef, Pork and Prepared Foods. The largest revenue segment is beef, followed closely by chicken, which together account for almost three-quarters of revenue. Revenue is typically fairly stable during economic cycles, although can fluctuate due to prices for beef, chicken and pork.
| F3Q11 | Y/Y | |
|---|---|---|
| Revenue ($mm) | $8,247 | 11% |
| Gross Margin | 6.4% | - 3.7% |
| Op. Margin | 3.8% | - 3.0% |
| Dil. Op. EPS | $0.46 | - 31% |
After looking at Cracker Barrel, and trends in poultry prices, I found the chart below interesting. Basically, it summarizes the ratio between broiler prices (chicken) versus feed. The higher the ratio the better the margins for a chicken producer. The chart's labels are horrible, but basically the time line is from 2007 to the end of September 2011. I love this chart because it illustrates an unsustainable state in the market. Chicken producers are actively cutting back production because their margins are under pressure, suggesting broiler prices should remain at least stable in a weak economy. Additionally, I believe with corn and wheat prices declining the feed prices should decline, enabling the ratio to recover back above 1.0x.
Because of the rising feed costs associated with corn and wheat prices, Tyson saw its gross margin decline 370 basis points in the quarter ended July 2. The company does actively enter into derivative and longer-term contracts in order to manage the volatility of prices like corn, live cattle, lean hogs, and natural gas. Thus how well they manage these positions likely impacts the margin potential, in my view.
A couple additional key metrics: The PE on C2011 is an attractive 8.5x. The consensus recommendation is Overweight, which has been stable for the past quarter. The company has met or exceeded EPS estimates each quarter during the past two years. The consensus EPS estimate for the September quarter is $0.31, a drop of over 50% from the previous year. Dividends have been stable over the past two years and the current annual dividend yield is about 1%. The company's debt has been upgraded twice by both Moody's and S&P over the past two years. TD-to- TTM EBITDA is just over a healthy 1x and the company plans to repurchase debt outstanding with cash on-hand. As of July 2, the company was authorized to repurchase over 18 million shares.
In conclusion, I plan to establish a 2-4% position in Tyson Foods based on what I believe is an outlook of stable protein commodity prices and falling feed costs, offering upside potential to estimates through margin improvements. In addition, I believe the valuation builds in a cushion for higher expected feed costs and worries about a demand slowdown.
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