Cal-Maine Foods: Profit Opportunity in the Egg Business

In the current investment climate, rich in concerns that the market is overpriced and due for a correction, it is still possible to find bargains. Cal-Maine Foods (CALM) offers a strong balance sheet loaded with excess cash and short-term securities, and an attractive level of free cash flow. Based on 2010's results the company offers a free cash flow yield of approximately 16% once the excess cash is taken into account.

Cal-Maine is one of the largest egg producers in the United States, producing 18% of all the shell eggs in the United States in 2010. The company is of the opinion that the egg business is cyclical, but I think "highly sensitive to supply" would be more accurate; in 2006 there was a glut of eggs on the market owing to the declining popularity of the high-protein diet (Atkins and so forth). However, the excess capacity seems to have been absorbed since 2006 and Cal-Maine's profit margins seem to have stabilized, after an excellent year in 2008 owing to the high price of eggs. The company has also been attempting to increase its sales of specialty eggs, which are organic, cage-free and/or nutritionally enhanced. Prices for such eggs are both higher and less volatile than ordinary eggs. Specialty eggs represented 23.9% of total sales and 16% of total shell eggs sold during the first three quarters of fiscal year 2011, up from 21% and 14.1% respectively over the same period last year. Cal-Maine has also been consolidating smaller egg producers, having engaged in sixteen acquisitions since 1989.

Obviously, the company's chicken feed, which contains corn and soybean meal as major components, represents a large portion of Cal-Maine's expenses -- more than half of its total cost of sales, in fact. It is still an open question to what extent Cal-Maine can pass on increased feed costs to its customers, but the company has actually found historically that its profit margin increases as feed costs increase. At any rate, eggs are a fairly inexpensive form of protein, and are likely to benefit in terms of market share if feed price inflation puts the squeeze on sources of animal protein generally.

Turning now to the figures, I mentioned earlier the excess cash position. A common measure of a company's excess cash is total cash and receivables minus the extent to which current liabilities exceed noncash current assets. Cal-Maine has has $81 million in cash and $133 million in short-term securities, and noncash current assets of $65 million in receivables and $103 million in inventory, producing a total of $168 million. Current liabilities are $124, meaning that current liabilities are covered by noncash current assets and all the cash and securities may be considered excess. When this amount is removed from the market cap of $675 million, this produces a value of $461 million for the price of Cal-Maine's capital assets, which serves as the denominator of a free cash flow yield calculation.

As for free cash flow, in 2010 sales were $910 million, reported operating income was $103 million, other income was $8 million, excess depreciation was $11 million, producing operating cash flow of $122 million. (As I have removed the excess cash and short-term investments from the market cap, I have also removed the interest income produced by these assets when calculating earnings power). Interest expense was $8 million, producing $104 million in pre-tax cash flow, or $74 million after applying a 35% tax rate. This produces a free cash flow argin of 8.5%. 2010's results were a marginal improvement over 2009's results, presumably as a result of an increased emphasis on specialty eggs.

	2010	2009	2008	2007	2006
Sales	910	929	916	598	478
Reported operating income	103	121	224	58	5
Excess depreciation & other	19	8	6	1	-2
Operating cash flow	122	130	230	59	3
Interest expense	(8)	(7)	(8)	(7)	(8)
Pretax free cash flow	114	123	222	53	-5
After-tax cash flow (35% rate)	74	80	144	35	-3
Free cash flow margin	8.1%	8.6%	15.7%	5.8%	-0.6%

In 2006, as I stated above, the company did not produce a profit owing to the oversupply of eggs on the market, a situation that seems to have been brought under control. Further complicating the situation is the fact that Cal-Maine is a major driver in the consolidation of the egg industry, having made seven acquisitions in the last five years, hence the greatly increased sales. At any rate, the average free cash flow margin for the last five years has been 7.5%.

As of this writing we have 3 quarters of data from fiscal year 2011, as the fiscal year ends at the end of May, and we are seeing a similar pace of marginal improvements. Sales are up 1.5% over last year, operating earnings are essentially flat owing to higher general and administrative expenses, and owing to higher excess depreciation and "other" income, mostly income from partnerships, Cal-Maine has produced improvements in operating cash flow. Free cash flow for the first three quarters of 2011 is $55 million as compared to $51 million for the same period in the previous year. As eggs are a seasonal business it would be unwise to base a full year's projection on these results, but things at Cal-Maine seem to be going well.

	YTD 2011	Same period 2010
Sales	700	688
Reported Operating Income	70	70
Excess Depreciation & Other	19	13
Operating cash flow	89	83
Interest expense	5	5
Pretax free cash flow	84	78
After-tax cash flow (35% rate)	55	51

So, taking out $213 in cash and securities from the current market cap leaves $461 million for the market value of Cal-Maine's capital assets. Based on 2010's free cash flow of $74 million, we have a a free cash flow yield on capital assets of 16%. If instead we use the average 7.5% free cash flow yield calculated above, and apply it to 2011's projected sales of 920 million in 2011, the free cash flow yield would be 15%.

I would describe this situation as an attractive investment opportunity, as the oversupply situation seems to have breen brought under control and Cal-Maine is continuing its push in the specialty egg market, where prices are believed to be less volatile. The company has a policy of paying out 1/3 of its GAAP earnings as a dividend each quarter, which is unusual for many companies but Cal-Maine's management believes it is a reasonable compromise between the potential volatility of the company's earnings and the desire of its shareholders for a dividend.

As a result, I would say that Cal-Maine offers an attractive free cash flow situation and offers a strong possibility that the price of chicken feed inflation can be passed on to consumers. Therefore, I can recommend this company as a candidate for portfolio inclusion.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.