Despite Softer Outlook, Pilgrim's Pride Is Attractively Valued

We have slightly lowered our fair value estimate for

Even though Pilgrim’s Pride is the second-largest poultry producer in the United States (68% of revenue) and Mexico (12%), with the remainder of sales from Europe following the 2017 deal for Moy Park, we don’t believe it has carved out an edge.

Proteins are generally on trend with consumers, but over 80% of Pilgrim’s products are undifferentiated and therefore have difficulty commanding a price premium and higher returns. Several factors outside the company’s control affect costs (weather, flock disease, global trade). Prices of the primary feed ingredients, corn and soybean meal, can be quite volatile. They surged in 2008 and led to Pilgrim’s bankruptcy. Since that time, the industry has moved to new pricing strategies, which are helping to protect the processors from revenue/cost mismatches. However, despite Pilgrim’s size, we do not believe this affords it a scale cost advantage.

Pilgrim’s aims to unlock significant value in its Moy Park acquisition, which we view as achievable. Poultry producers’ operating margins in Europe tend to be lower than other regions (midsingle digits versus high single digits in the U.S. and Mexico) because the balance of power swings in the favor of customers. Even so, Pilgrim’s thinks it can improve its European margins to the same level as its U.S. and Mexico operations in the next four years as it differentiates itself through reliable supply and consistent quality. While we think 8%-9% margins will prove elusive, we believe margins can improve from 3.9% in 2017 to 5.5% by 2020.

Pilgrim’s has implemented many changes since emerging from bankruptcy in 2009 to improve the level and stability of profits. It has cut costs, refocused resources on high-potential customers, improved customer contracts, and expanded its less commoditized prepared food lineup to 16% of revenue. However, most of the company’s revenue and profits are tied to commoditylike products that lack pricing power, and we’re not confident in Pilgrim’s ability to generate returns on invested capital in excess of its 8.2% cost of capital over time.

Lack of Competitive Advantages Means No Moat We do not believe that Pilgrim's Pride has an economic moat. The most likely sources would be brand intangible assets or a cost advantage, but we do not think the company has achieved a sustainable competitive advantage in either context.

In determining whether the company has a brand intangible asset, we look for evidence of pricing power. About 84% of its products are undifferentiated commodity-type offerings (whole birds, bird parts, and chicken byproducts), which Pilgrim’s categorizes as fresh products. The pricing for a large portion of these products is formulaic, tied to Pilgrim’s cost of raising the bird. Given the volatile price swings of the raw materials needed to raise poultry (primarily corn and soybean meal), the industry moved to cost-based pricing after huge spikes in feed costs led to operating losses for most poultry producers in 2008 and 2011. Therefore, the pricing for these products is largely based on cost, not brand strength. Furthermore, for products such as these with minimal differentiation across brands, consumers base their purchasing decision to a greater extent on price rather than brand. If a brand is priced higher than others, we would expect volume to suffer.

Pilgrim’s Just BARE brand has a portfolio of organic and natural products. These products are also classified as fresh. Although organic and natural products are obviously differentiated from nonorganic products (as evidenced by their price premium), we argue that one brand’s organic chicken breast is essentially undifferentiated from another brand’s organic chicken breast. This is supported by our price checks, which show that Just BARE typically sells at a similar price as Perdue Harvestland organic and natural products.

About 16% of the company’s products fall under the prepared category and are less commoditized (cooked, ready-to-cook, nuggets, patties, and so on). These products are sold under the Pilgrim’s and Country Pride brands. In general, the price points of the Pilgrim’s brand are comparable with those of other national brands, which fails to suggest it maintains much in the way of pricing power. Furthermore, the retailers that carry the Pilgrim’s brand tend to be low-price leaders such as Walmart, Aldi, Sam’s Club, and Meijer. These large, powerful retailers use their clout to ensure that product prices are held as low as possible.

We believe Pilgrim’s has not demonstrated a sustainable cost advantage. A cost advantage would be exhibited in either profit margins that are higher than competitors or dominant market share (a cost advantage would allow the company to offer lower prices to secure greater volume). However, neither of these datapoints is in evidence. The U.S. market is dominated by four large poultry producers: Tyson TSN (21% share), Pilgrim’s Pride (17%), Sanderson Farms SAFM (8%), and Perdue Foods (7%). While Pilgrim’s number-two market position is substantial, it is not high enough to demonstrate an economic moat via a superior cost advantage. In fact, even Tyson has not been able to demonstrate the existence of an economic moat through a scale cost advantage, in our opinion. Pilgrim’s normalized operating margin is 8%, compared with 8% for Tyson’s chicken segment and 10% for Sanderson Farms.

While JBS’ ownership of 79% of Pilgrim’s stock affords some benefits, such as shared headquarters space and marginal procurement and distribution leverage, we do not believe these synergies are significant enough to warrant a sustainable competitive cost advantage.

According to Watt Global Media, a major provider of data on the poultry and feed industries, Industrias Bachoco is the number-one poultry producer in Mexico, followed by Pilgrim’s. Bachoco is substantially larger, with Mexico revenue of $2.0 billion in calendar 2017, compared with just $1.3 billion for Pilgrim’s (representing a low-double-digit percentage of the company’s consolidated sales base). Given the size difference, we cannot conclude that Pilgrim’s has a scale cost advantage over Bachoco in Mexico. Over the past three years, both companies have generated similar operating margins, averaging around 10%.

In Europe, Pilgrim’s is not listed in the top five European poultry producers according to Watt Global Media; therefore we deem it as too small to warrant a scale-driven cost advantage. Pilgrim’s average adjusted operating margin between 2015 and 2017 was 3.6% compared with 4.7% for number-one L.D.C. and 3.8% for number-two Plukon Food Group. This further supports our contention that size does little to drive a cost advantage moat source.

While Pilgrim’s returns on invested capital were quite high in the past two years (averaging 23.8%) and are generally expected to outpace our 8.2% weighted average cost of capital over the next decade, there has been a significant amount of volatility in its historical performance. Even after the improvement in operations since emerging from bankruptcy in 2009, high feed costs led to an operating loss in 2011, with the company reporting an adjusted operating margin of negative 4.6%. As such, while we forecast 13.0% ROICs on average annually over the next five years, the actual results reported will probably be more volatile. Given the unpredictable timing and magnitude of cycles, we forecast earnings at normalized midcycle profitability. Therefore, we lack confidence in the company’s ability to generate economic profits over the next 10 years, hence our no-moat rating.

Risks Include Commodity Volatility, Disease, and Tariffs The most pressing risks for Pilgrim's are volatility in commodity prices, the potential for flock disease, and trade disruption. These risks, coupled with thin operating margins, can quickly lead to profit losses.

Commodity prices (primarily corn and soybean meal) are significant cost inputs for Pilgrim’s. These prices can be volatile and are affected by factors outside the company’s control, such as weather, which can affect growing conditions. This risk has been reduced with the new pricing structures, but the new contracts do not directly pass costs through and the company still experiences margin volatility.

Another potential risk is flock disease. In 2015, an outbreak of avian flu in the U.S. resulted in many large trading partners banning imports of U.S. chicken. Despite the outbreak, Pilgrim’s was able to report a very healthy operating margin in its U.S. business that year, given a sharp drop in corn and soybean meal prices, although we don’t expect these events to always occur in tandem.

The most recent fiscal year is a great example of how trade disruptions can depress margins, even when tariffs do not directly target chicken. The U.S. beef and pork markets were hit with tariffs from China and Mexico in 2018, which were essentially shared by all supply chain participants. The price of live cattle and hogs fell, which resulted in U.S. consumption shifting from chicken to beef and pork. Chicken prices have now also fallen, and we’re starting to see consumption shift back to chicken, but only after 2018 profitability was sharply impaired. There has been potential progress with trade negotiations of late, but we think issues like this could resurface from time to time.

We view Pilgrim’s financial health as solid; we don’t see any issues to suggest the company will be unable to meet its financial obligations. While Pilgrim’s generates healthy cash flow (approximating a mid-single-digit percentage of sales annually) and has a manageable debt load, the business is inherently cyclical with many factors outside management’s control. We applaud changes that have improved the predictability of earnings. Chicken pricing contracts now link costs and prices. In addition, Pilgrim’s now maintains diversified exposure to fresh chicken, which we see as a plus (fresh products constitute about 84% of U.S. sales). Its U.S. chicken sales are equally exposed to big birds, tray pack, and small birds, unlike Tyson’s steadier small-bird and tray-pack focus and Sanderson Farms’ higher-margin but more volatile larger-bird skew.

For the first few years of our explicit forecast, we do not expect Pilgrim’s to pay any dividends, as it will be paying down debt issued for the Moy Park acquisition. We model dividends beginning at $1.24 in 2020 and gradually increasing to $2.24 throughout our explicit forecast.