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April's Stock Red Flags

Three stocks we think investors should be wary of.

Morningstar Analysts, 04/25/2006

This article originally appeared in Morningstar StockInvestor.

In tables, click Star Rating, Business Risk, and Size of Moat to see definitions of these terms. Definitions are hosted on Morningstar.com.

We calculate the Risk-Adj. Ret by taking a stock's fair value and assume it will grow at the company's cost of equity over the next five years. This is the stock's fair value in five years. We then subtract out the "risk" of the stock--defined as its cost of equity plus a margin of safety. All data below are as of March 31, 2006.

In addition to death-care provider Stewart Enterprises, this month we're highlighting a pair of firms that are very similar to each other: Tyson Foods and Pilgrim's Pride.

Meat processing is a difficult industry that is characterized by its dismal returns on invested capital. And thanks to bloated inventories and fears over avian flu and mad cow disease, we are forecasting a rough year for the industry.
Here's what analyst Greggory Warren recently wrote in a stock analyst note:

"We continue to express extreme caution on the meat processors, given the stark increase in chicken supplies over the past six months and the likelihood that beef and pork supplies could head upward as well. Our greatest concern rests with the poultry processors, such as Tyson Foods and Pilgrim's Pride, which have seen export markets for chicken products decline dramatically as the avian flu virus has spread from Asia to the Middle East, Europe, and Africa."

This is the second time we've highlighted Pilgrim's Pride in Red Flags. Unfortunately, it was another warning that we were early on. After it was profiled in November 2004, the stock rose from about $27 to almost $40 in March 2005. However, over the past several months, the stock has been on a serious slide and is now trading around $20.

We believe Tyson and Pilgrim's Pride will eventually make it through the industry downturn and overcome fears of avian flu and mad cow disease. That said, there are plenty of firms that are less risky, more shareholder friendly, and generate stronger and more stable returns than either of these companies provide. The tough industry conditions these companies face are just one more reason to stay away.

Stewart Enterprises STEIE

Star Rating Business Risk Fair Value Current Price Size of Moat
None $6.50 $5.71 None
Consider Buy Consider Sell 1-Yr. High 1-Yr. Low P/E
$4.10 $7.80 $7.71 $4.43 63.4

Stewart Enterprises is by far the most efficient operator in the death-care industry. However, its less-than-stellar stewardship concerns us.

The firm's $515 million in annual revenue may be less than one third that of market leader Service Corporation SCI, but Stewart commands several other important categories. Revenue per cemetery and revenue per funeral home, key metrics in the death-care industry, are 21% and 20% higher at Stewart. In addition, Stewart's average operating margins on these facilities are substantially higher than competitors'.

But management is a major concern. In January, Stewart announced that the release of its financial statements would once again be delayed. Stewart outlined three main causes for its persistent difficulty in filing statements on time: noncompletion of the deferred revenue project, disruption caused by Hurricane Katrina, and management's assessment of internal financial reporting controls. In our opinion, the deferred revenue project and insufficient internal controls are the fundamental issues, and Hurricane Katrina simply exacerbated those problems.
Chairman emeritus Frank Stewart owns every Class B share, which when combined with his 7% Class A share ownership, gives Stewart 30% of the voting power and effective control of the company. After Stewart, share ownership by executive officers and directors as a group is only 2%--hardly enough to align their interests with shareholders', in our opinion. Stewart's executives average 28 years of death-care industry experience and 15 years with the firm. Tenure often indicates expertise, but in light of Stewart's largely self-induced turbulent past, we think
this is a negative. PAGEBREAK

Tyson Foods TSN 

Star Rating Business Risk Fair Value Current Price Size of Moat
+Avg $15.00 $13.74 None
Consider Buy Consider Sell 1-Yr. High 1-Yr. Low P/E
$9.60 $18.10 $19.91 $12.57 14.3

Tyson has considerable scale in beef, chicken, and pork processing. It is the leading domestic producer of beef products and chicken processing, as well as one of the largest domestic producers of pork products. Tyson's well-recognized brand name also provides some advertising leverage, as the firm uses its name across all three business lines.

Unfortunately, the large economies of scale that Tyson possesses in meat packaging have done little to protect it from the vagaries of the commodity markets. Tyson has also had a difficult time navigating many of the shocks that have affected the domestic meat industry over the past few years--like mad cow disease and the avian flu virus.

The firm's attempt to drive higher sales and margins through the branding of fresh-cut and packaged meats has also come under pressure as other meat processors have adopted similar strategies. This is bad news for Tyson, which has struggled to generate operating margins in excess of 3% per year over the past five years and has posted returns on invested capital in just the 6%-7% range during the same time frame.

If that wasn't enough to keep investors away from this low-return business, the company has also had a long history of poor corporate governance. The Tyson family controls 80% of the company's voting shares and has shown a propensity for running the corporation like a family business--enriching the majority owners at the expense of minority shareholders and, at times, running into trouble with the law. The company has also had a colorful past when it comes to labor issues, environmental concerns, patent infringements, and accusations of bribery and collusion.

Pilgrim's Pride PPC

Star Rating Business Risk Fair Value Current Price Size of Moat
+Avg $23.00 $21.67 None
Consider Buy Consider Sell 1-Yr. High 1-Yr. Low P/E
$14.70 $27.70 $40.23 $20.95 6

Pilgrim's Pride is one of the largest chicken producers in the United States. Its 16% share is second only to Tyson, which has 23% share of the domestic market. The economies of scale that come from having large, vertically integrated operations do very little, though, to protect Pilgrim's Pride from the vagaries of the commodity markets.

Poultry processing is ultimately a low-margin business in which very few companies generate above-average returns. Pilgrim's Pride has struggled to earn returns on invested capital in excess of our estimate of its cost of capital--a classic sign of a no-moat company. While this is the norm for the industry, the situation is made worse for investors, in our opinion, by the poor corporate governance that exists at the firm.

Pilgrim's Pride is a poster child for poor corporate governance. Through a network of family trusts and limited partnerships, the current chairman and original cofounder of the firm, Lonnie "Bo" Pilgrim, controls 60% of the outstanding shares of the company. As the dominant shareholder, he has shown a propensity for running the corporation like a family business, rather than acting in the best interest of all of its shareholders.

While the company does hold annual elections for its directors, the results are generally dictated by the family. The chairman and his son, Lonnie Ken Pilgrim, sit on the company's compensation committee, and several additional members of the Pilgrim family are also employees of the firm. Beyond several related-party transactions with the chairman, the company also has chicken-grower contracts with several other officers and directors.

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