Description

SHORT. It is time to be short the chicken cycle .

We currently maintain material short positions in the three largest US chicken producers: Pilgrims Pride Corporation (Pilgrims or PPC), Sanderson Farms, Inc. (Sanderson or SAFM), and Tyson Foods, Inc. (Tyson or TSN). This write-up was written with a focus on SAFM, but due to recent share price movements it is our view that PPC is now the most compelling and overvalued short of the three. We believe PPC is worth $15 (vs. $29+ today), that SAFM is worth $55 (vs. $81 today), and TSN is worth sub-$30 (vs. $39 today) .

Importantly, all three stocks are liquid with lots of market cap and are borrowable at GC. We believe the stocks will revert to fair value or below fair value over the next 2-4 quarters.

The chicken cycle is one of the investment worlds great short themes. The opportunity to short the chicken cycle reappears every 2-3 years as the chicken industry follows a repeating supply-side driven cycle. While pundits and the sell-side wax enthusiastic about growing chicken demand, high pork and beef prices relative to chicken, rising exports, falling corn prices, operating efficiencies, supply constraints, animal diseases, a changing industry structure, etc. this is all white noise. The chicken cycle is about one thing and one thing only: how much chicken is produced in the United States. Keep your eye on the ball and you will have a lucrative trade on your hands.

At a high level, trading the chicken cycle is simple. Go long the chicken names when there is oversupply, chicken companies are losing money, and capacity is beginning to be removed from the industry. Go short the chicken names when there is undersupply, chicken companies are raking in profits, and capacity is beginning to be added to the industry. Today, chicken producers are extremely profitable and we see clear signals that a large supply response is on its way that should lead to a massive oversupply of chicken by 2016 if not sooner. Its time to be short .

There are two ways to play this trade from the short side.

The first is to try and call the top. We have been short the chicken names for a number of months now as we believe we came pretty close to nailing the peak of the trade. This is difficult to do and involves higher risk and higher reward.

The second is to short the chicken cycle after the first crack. One reason shorting the chicken names can be so remunerative is that you can shoot them in the back on the way down by aggressively pressing the short on bounces as the stocks revert to fair value. Simple economics of supply and demand virtually mandate supply follow profitability in an economically irrational industry like chicken, capacity is added when producers are profitable and it is removed when producers are unprofitable. The only question is how long it takes the stocks to catch up.

We believe the first crack occurred on Thursday of last week. On Thursday 10/16, Sanderson had its Investor Day in New Orleans. Sandersons management team is outstanding the best in the industry and CEO Joe Sanderson, Jr. is as straight a shooter as they come. The sell-side did everything but beg Joe and his team to say that the industry had changed, that a large supply response would not come this time, that buying back shares was an attractive use for SAFMs rapidly-building cash reserves.

Joe shot them down every time and in no uncertain terms. Its worth listening to a replay of the Investor Day here. Though be warned: Joe has a voice like molasses and the SEC college football references are out-of-control.

Chicken company stocks fell sharply following the SAFM Investor Day PPC was -18%, SAFM was -10%, TSN was -5%. This was the crack weve been waiting for. The sell-side defended the names and the bounce has been powerful with PPC +8% and then +5% on Friday and Monday; the chicken stocks are up slightly again today. We think the bounce will prove ephemeral. We have added to our shorts and following the playbook intend to press them as the stocks revert to fair value.

This write-up is divided into four sections. We begin with an overview of the chicken cycle. We then delve into the theory of cyclical industries and speak to rational industries vs. irrational industries and some of their characteristics. The third section is a review of why this is not just a chicken cycle but a chicken super-cycle. We conclude by laying out the investment thesis on the short side for PPC, SAFM, and TSN.

The Chicken Cycle

A supply-side protein cycle works as follows:

• Bottom of the Cycle. An oversupply leads to low protein prices and unprofitable producers.

• Shift to Underproduction. Marginal producers go bankrupt or shut production, reducing supply and causing protein prices to rise. As protein prices increase, producers shift from loss-making to profitable.

• Top of the Cycle. An undersupply leads to high protein prices and profitable producers.

• Shift to Overproduction. Profitable producers add capacity, increasing supply and causing protein prices to fall. As protein prices decline, producers shift from profitable to loss-making.

• Bottom of the Cycle. An oversupply leads to low protein prices and unprofitable producers.

The length of each protein cycle varies by commodity and is largely dependent on animal biology.

The longest of the protein cycles is the beef cycle. which generally lasts 5-7 years. The pork cycle is twice as quick, lasting only 2-3 years. The fastest is the chicken cycle. which can last as little as one year. Additional detail on each of the cycles is included here. but a short review of each animals biology makes plain why the speed of a supply response can vary from protein to protein: