Jubak's Journal
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5 stocks aided by a bountiful harvest
The nation's corn harvest is expected to be big this year, which could cut commodity prices and help profit margins at some companies.
By Jim Jubak
The news was all too typical for this earnings season: A 2-cents-a-share earnings miss, a profit-margin decline and a projection of slower growth. The stock plunged 7% the day of the news.
But help is on the way for Sysco (SYY, news, msgs) shares. No, not that Cisco (CSCO, news, msgs). The dominant maker of computer networking gear, Cisco Systems, did see its stock tumble 11% the day after forecasting slower-than-expected growth. But Cisco shares, like those of other technology companies, are going to have to wait for evidence that CEOs are spending on technology before they can begin any lasting rally.
For Sysco, however, the countrys dominant food service company, relief is just a harvest away. The Agriculture Department is projecting the worlds largest grain harvest ever this year. Thats likely to trigger lower prices for key food commodities (or at least moderating food commodity inflation), which would be good news for food companies like Sysco, Smithfield Foods (SFD, news, msgs) and Sanderson Farms (SAFM, news, msgs).
How big is this harvest? Sooo big!! Especially for corn. After its most recent survey of farmers fields, the agency raised its projections for the soon-to-be harvested corn crop to 10.7 million bushels, a 5% increase from last years harvest.
Overall, the Agriculture Department raised its projections for world grain production by about 1% from last months projection to 1,962 metric tons. That would be 7% above last years production and 4% higher than the historic peak in production in 1997.
Fighting the squeeze
Why is this so important to food companies? Because theyve been getting eaten alive by the rising prices of the commodities that they process and then sell to customers. In the current economy, its been just about impossible for a food company to pass along the full increase in commodity prices to consumers. Kraft Foods (KFT, news, msgs), for example, just predicted that higher commodity prices will cost it $600 million to $700 million by years end. Recognizing that it couldnt raise prices enough to recoup the full increase, the company has announced another round of job cuts in an effort to reduce costs.
This kind of food commodity inflation is exactly what bit Sysco in the most recent quarter. The company announced that total sales grew by 16.7% over the same quarter in 2003, but that only about half of that, 8.3 percentage points, was real growth. The rest, eight percentage points, resulted from inflation in the prices that Sysco charged customers. And those price increases were having an effect on company growth: Sequential sales were essentially flat from the previous quarter. Gross profit margins, meanwhile, fell 0.45 percentage points in the quarter. The worst cost pressure came in the meat and dairy segments.
A big harvest would certainly damp food commodity inflation. The Agriculture Department estimates that corn prices should fall by 6% from 2003 levels, wheat by 4% and soybeans by 20% if its harvest projections are correct.
Which companies are likely to get the biggest earnings bang out of any drop in grain prices? I picked three companies on Wednesday at 11:20 a.m. ET on CNBCs "Morning
Call."
Maximum leverage
Sysco. The company's huge economies of scale -- with annual sales of $28 billion the company is about equal in size to its 10 largest competitors combined in the highly fragmented food service business -- mean that it will be able to get maximum leverage out of any drop in food commodity prices. Syscos operating margins are already two to three times higher than its competitors' thanks to that leverage. Any drop in grain prices will be especially profitable to Syscos meat supply business. The company owns 10 of the country's 22 certified Angus beef suppliers. After the recent drop, the stock sells at 20 times the consensus earnings estimate for the fiscal year that ends in June 2005. Our StockScouter rated Sysco a 6 out of 10 on Aug. 18.
Smithfield Farms. The company processes 7% of the countrys beef but the big story is pigs. Smithfield is the dominant pork processor with a 27% market share and the biggest hog producer with a 17% share. Any drop in corn prices will give Smithfield a huge boost in operating margins since hog prices are likely to hold steady until lower corn prices gradually lead suppliers to increase pig production. The company will also see an improvement in its beef-processing business, which has been suffering from a shortage of cows to process, if lower grain prices increase cattle production.
The stock is down 16% since July 30, with the big killer an Aug. 4 warning that earnings for the quarter that closed Aug. 1 would come in at 45 cents to 50 cents instead of the 58 cents Wall Street had projected. The drop is due to losses on hog contracts that Smithfield used to hedge against a hog-price decline. As hog prices went up, the company lost money on the contracts and gave up some of the gains from higher hog prices. At recent prices the stock trades at 11 times projected earnings for the year that ends in April 2005. The company is scheduled to report earnings on Aug. 26. Our StockScouter rated Smithfield a 10 out of 10 on Aug. 18.
A major correction
Sanderson Farms. The company's stock is in a major correction. After climbing 47% from May 20 through June 24, it's down 22% through Aug. 17. Other than valuation, which started to look expensive to many investors, the catalyst for the sell-off seems to be reports of an unseasonable buildup in chicken supplies that showed up at the end of July in the Agriculture Departments survey of cold-storage supplies. Chicken prices are among the most volatile of animal proteins since chicken farmers can quickly ramp up supplies. That means prices drop steeply on signs of oversupply but that margins and production levels will also respond quickly to declines in the price of corn.
The stock trades at 11 times trailing earnings and eight times projected fiscal 2004 earnings. The company is scheduled to report earnings on Aug. 24. Our StockScouter rated Sanderson a 6 out of 10 on Aug. 18.
2 exclusive picks for CNBC.com on MSN
PepsiCo (PEP, news, msgs). So what do you think they make corn chips out of anyway? And does any consumer think that the price of a $2.49 bag of corn chips will come down if the price of corn dips? Can you say margin growth? PepsiCos Frito Lay division owns 60% of the U.S. salty snack food market. I think you see where Im going with this, right? PepsiCo has done a good job of international purchasing to keep its commodity costs as low as possible but any drop in food commodity prices will certainly make that job much easier. The stock trades at 22 times projected 2004 earnings per share. Our StockScouter rated PepsiCo a 7 out of 10 on Aug. 18.
Deere & Co. (DE, news, msgs). The long-term grain picture isnt nearly as rosy as the scenario for the next year. Yes, were probably looking at a historic peak grain harvest this year, but even that kind of production wont be enough to rebuild low global grain reserves because global demand is increasing at historic rates. To meet projected global grain demand in 2005, the worlds farmers will have to beat even this years record production by almost 1.5%. The likelihood that grain farmers will be able to produce a record harvest every year is small and the trend in food commodity prices over the next decade is up. This bodes well for farm income because record harvests plus high prices equals high income. And that means that the current cycle in farm equipment still has a long way to run. Deere, with its superb dealer network and better-than-its-peers financial strength, is my pick for riding that cycle. The stock has been in retreat lately and recently sold for 15 times trailing earnings and 13 times projected earnings. Our StockScouter rated Deere an 8 out of 10 on Aug. 18.
Its always a good idea to view projections, especially agricultural projections, with skepticism. This years harvest isnt in the bag and weather in the northern part of the U.S. grain belt has been cool enough to present a potential problem. But the corn crop has cleared its most weather-sensitive growth stage, so the corn numbers are reasonably solid. The soybean projections have more wiggle-room since the soybean crop isnt as far along and the final harvest level will depend on production in South America, where the harvest wont take place until the spring of 2005 and where we wont even know how many acres will be planted until October.
So do as the farmers do: Plant and watch the sky.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: PepsiCo. He does not own short positions in any stock mentioned in this column.
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