Demand Spurs Pilgrim's Progress

We believe  Pilgrim’s Pride (PPC) allows investors to capitalize on strong protein and fresh food demand and rising meat consumption in Mexico. The no-moat firm is exposed to commodities, but we expect its balanced portfolio and growth in Mexico to act as a counterweight as inputs normalize. The shares are currently trading at an attractive discount to our $29 fair value estimate,

Even with ground beef prices falling, Pilgrim’s Pride should benefit from rising U.S. chicken consumption because of the meat’s price advantage and health perception. We see poultry taking share from beef in the long run, though short-term sales could be pressured as some consumers return to red meat and prices fall in step with beef.

Pilgrim’s has previously been hit by commodity swings, but we think it is now more insulated, given increased use of variable-price contracts, a buy/grow strategy that limits cut mismatches, and a broad portfolio that includes steady but lower-margin small birds and more volatile and lucrative large chickens. Industry discipline could fail if commodity prices stay low, but we expect large players to be better positioned than smaller producers, owing to contracting.

Despite cost savings, better contract terms, and a growing prepared foods lineup, Pilgrim’s fortunes are dictated more by commodity price dynamics than a competitive edge. The firm competes in a low-margin industry with hard-to-differentiate core products that carry little pricing power. While rising demand for higher protein foods and low feed costs are tailwinds, poultry production is competitive and economics can shift quickly.

We see Pilgrim’s diversified exposure to fresh chicken as a plus (fresh products constituted about 82% of 2015 sales). Pilgrim’s U.S. fresh chicken sales are equally exposed to big birds, tray pack, and small birds, different from Tyson’s (TSN) steadier small bird and tray pack focus and Sanderson Farms’ (SAFM) higher-margin but more volatile large bird orientation. We believe Pilgrim’s can also leverage plant investments to expand higher-margin prepared food revenue (18% of 2015 sales). With chicken prices and demand growth falling somewhat from recent highs and input costs showing signs of rising, the firm’s portfolio should perform relatively well, although we do not expect a return to the low teens operating margins of 2014-15 in a less attractive environment.

As Mexico’s second-largest chicken producer, Pilgrim’s should benefit as the economy develops and consumption rises (Mexico accounted for 14% of 2015 sales). The market is structurally different from its U.S. counterpart; live birds account for about 30% of Mexican poultry sales and cut and value-added chicken constitute less of the market. However, higher margins and Mexico’s affinity for dark meat versus its white-meat-centric northern counterpart should boost economics while reducing cut demand mismatches.

Though cost discipline has improved efficiency, much of what drives profitability is beyond Pilgrim’s control. Feed costs are influenced by factors as diverse as the weather and subsidy policy, and animal diseases can threaten flocks and Pilgrim’s access to foreign markets. As operating margins are thin (we expect them to average 10% over the next decade), Pilgrim’s has little room for error.

Lacking an Economic Moat
The most likely sources for a moat would have been brand intangible assets or a cost advantage; however, we do believe Pilgrim’s Pride has achieved a sustainable competitive advantage in either context. While recent returns on invested capital have been strong, averaging 32% from 2013 to 2015, we believe this is mostly due to industrywide demand and cost tailwinds as well as a favorable contracting environment, as opposed to superior competitive positioning. These conditions could easily reverse as the industry features commodity products, fragmentation, and modest scale benefits, and Pilgrim’s has posted losses in less favorable market conditions as recently as 2011. As grain is the primary input cost--approximately two pounds of feed is needed to produce a pound of chicken--the industry can find itself in circumstances where demand and cost conditions work against producers, magnifying downside risk (and upside potential, as currently low commodity costs and high demand have boosted returns of late).

While Pilgrim’s has done well to reduce costs and improve efficiency, many of the key drivers of profitability (chicken demand, grain costs, export opportunities, and flock health) are largely out of its control. An attractive input cost environment that has seen relatively low and stable feed prices has boosted returns industrywide since 2014, but one need only look to 2011 to see the impact of a high-cost environment: Pilgrim’s posted a negative gross margin on its way to a nearly $500 million net loss. Further, a high leverage position compounded an unattractive cost and demand environment in 2008, ultimately leading to Pilgrim’s bankruptcy and JBS’ purchase of a majority stake in the company. While many of the company’s cost-reduction initiatives should endure even if markets once again become unfavorable, we expect cost deleverage will still be significant in a downturn, with Pilgrim’s positioned similarly to peers but at a slight disadvantage relative to competitors like Tyson that feature an increased mix of differentiated, branded products.

The industry at large is still at the mercy of commodity markets. Furthermore, despite Pilgrim’s initiatives to promote flock health and the increasing regionalization of import bans, the company remains susceptible to export volatility that may be triggered by disease outbreaks inflamed by less cautious producers. Additionally, disease and food safety concerns can act as cover for diplomatically motivated trade actions that have little to do with the companies affected.

We concede that the recent industrywide shift away from longer-term, fixed-price contracting has reduced producers’ exposure to feed market volatility by tying agreed sale prices to prevailing commodity market conditions. However, we question whether market discipline will endure over the longer term, particularly as smaller participants in a fragmented market may see an opportunity to gain share by offering clients more advantageous terms.

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We do not believe a cost advantage extends to the production or procurement side of the business. Pilgrim’s Pride is the second-largest U.S. chicken producer, with a market share in the mid- to high teens (Tyson’s is around 20%), with the top four producers accounting for roughly half of production. While profitability depends on capacity utilization to leverage costs, we believe regional and local independent producers can largely replicate industry leaders’ cost structure by copying best practices and managing to target high relative production volume in the context of a smaller infrastructure. Similarly, feed prices are transparent and dictated by market dynamics; we expect procurement in scale carries minimal pricing benefits.

Because of the limited benefits of increased scale, we do not expect a significant wave of consolidation behind industry leaders, leaving fragmentation intact. This dynamic could lead to a breakdown in the industry’s fledgling and tenuous pricing rationality, with a return to longer-term fixed-price contracts by smaller participants looking to capture market share, imperiling Pilgrim’s ability to pass feed costs through to customers.

From a brand standpoint, we believe Pilgrim’s core products are difficult to differentiate and in many cases are essentially commodities. This leaves the company with little pricing power and confines the role of the firm’s labels to a signal of reliable distribution for retail and food-service partners. We do not believe this advantage constitutes a sustainable edge, because the perishable and commodity-priced nature of the core product allows local and regional participants to achieve sufficient client access.

We suspect similar cost and branding dynamics are at play in Mexico, which constituted 14% of 2015 sales but should rise to around 16% in 2016 due to a full year of ownership of Tyson’s Mexican assets. The Mexican chicken market is less developed than its northern counterpart; per capita chicken consumption is approximately 35% lower south of the Rio Grande. While Pilgrim’s size and reputation are an advantage with retailers, we don’t believe they translate into significant pricing power. Although Pilgrim’s has been better equipped to handle the avian influenza storm than local participants due to its ability to leverage its U.S. assets, we expect competition to intensify as flocks rebuild.

While JBS’ ownership of about 77% of Pilgrim’s outstanding common stock affords some benefits, such as shared headquarters space and marginal procurement and distribution leverage, the synergies with the Brazilian beef producer are not sufficient to affect our estimation of Pilgrim’s competitive standing. Though we expect the stake offers another source of capital for a company that has had recent financial struggles, JBS is subject to similar input cost volatility and may be imperiled by increased political risks in the event of a downturn.

Commodities Costs, Disease, and Trade Are Biggest Risks
About 30%-40% of Pilgrim’s cost of goods is feed; corn (46% of 2015 feed costs) and soy (35% of 2015 feed costs) constitute most of its birds’ diet. Many of the factors that influence input prices, such as drought, disease, and trade and subsidy policies, can raise Pilgrim’s costs independent of demand and without much recourse for the firm. As Pilgrim’s depends on high plant utilization for optimal efficiency, its cost profile changes with market dynamics. Also, a reversal in recent industry moves away from fixed-price contracts could greatly increase risk by reducing Pilgrim’s ability to pass feed costs on to customers.

Poultry diseases, especially avian influenza, are an ongoing threat, and despite preventative measures, disease can still decimate flocks. Euthanization of infected birds can lead to losses as retailers form new relationships with unaffected producers to replace supply. Pilgrim’s recent move to convert a plant to organic chicken production adds risk as the firm has less experience with raising birds under that subcategory’s restrictions. Also, since regulatory edicts target production by county or state, Pilgrim’s can be at the mercy of other less cautious producers located near its farms. However, regulators have recently taken a more focused containment approach, targeting affected regions rather than the blanket restrictions of the past. More broadly, food safety constitutes a significant risk as pathogens and contaminants that pose human health risks can lead to litigation and reputational damage.

The firm is exposed to capricious global trade dynamics that can severely restrict Pilgrim’s access to foreign markets. Disease and food safety concerns often act as cover for diplomatically motivated trade actions, which can lead to returns at multinational food processors being sacrificed at the altar of political expedience.

Pilgrim’s has a conservative balance sheet, with net debt at less than 0.5 times adjusted EBITDA as of 2015. Long term, we expect the company to maintain a prudent 0.5 times net debt/adjusted EBITDA ratio, holding indebtedness down as a result of painful lessons learned from its 2008 bankruptcy, an event triggered by high input costs and slow demand amid a high-leverage capital structure. We expect Pilgrim’s to eventually transition from periodic special dividends to a regular payout to investors.

JBS’ ownership of about 77% of Pilgrim’s outstanding stock gives Pilgrim’s an additional source of capital in the event of distress. We do not expect JBS to materially expand its stake for the foreseeable future. However, we believe Pilgrim’s will continue to consider acquisitions as a use of cash. A purchase within the U.S. poultry segment could provide some synergy benefits, though we believe scale has quickly diminishing returns in poultry production. We would be more intrigued by acquisitions to build Pilgrim’s international presence or its branded, differentiated product portfolio. Rather than speculate on the timing and nature of potential acquisitions, our analysis assumes excess funds are used to fund dividends and share buybacks, the likely outcomes if attractive M&A opportunities do not materialize.