How to wing it when the feathers fly

Financial figures in the next six to 12 months may be tough to digest

The local poultry sector is no place for the lily-livered investor. Higher feeds costs have pecked away at once fat margins, cheap imports (now aided by a stronger rand) are scratching away at market share and consumer demand is on the ebb. Some industry players have pointed out that chicken is now often sold at prices well below what it costs to produce a bird.

That situation can’t continue for too long — not without there being a culling of the more inefficient poultry producers.

However, lest we forget, the cycle always turns, and poultry producers provide an affordable protein source for SA’s growing households and also have lucrative contracts to supply the multitude of fast food outlets that are feeding into the burgeoning middle class.

Whether the worst is over for the local poultry producers is difficult to say.

However, one thing is certain: financial figures in the next six to 12 months will probably be tough to digest, and some companies’ bottom line may even be coated in red ink.

This rather unpleasant scenario offers investors some interesting food for thought. The JSE’s “big bird” Astral Foods has clawed its way back from a January low of R90 to about R135 at the time of writing. The share is still well off its R190 annual high, but the slow recovery has been sustained despite a dismal operating update issued recently. In short, Astral indicated that factors to the detriment of the local poultry market had turned out more severe than expected.

Feed costs continued to escalate, following the impact of the drought on the local maize crop, and there were also record levels of poultry imports, adding to the existing surplus of poultry stock. Astral has consequently warned of instituting marked production cut-backs.

Smaller Uitenhage-based competitor Sovereign Food Investments, on the other hand, seems to be flying above the dire trading conditions, its shares trading at close to a 12-month high. The share price, though, is tied to a 900c/share buyout offer tabled by unlisted rival Country Bird Holdings (CBH).

CBH has already accumulated a 25% stake in Sovereign by buying shares from groups of smaller shareholders.

The hitch, of course, is that, at this delicate juncture, it seems highly unlikely that CBH will succeed in its buyout pitch. Sovereign’s largest shareholders — Prudential, Sanlam, Old Mutual and RECM & Calibre — have to date backed the company’s management, and also its promising initiatives in supplying value-added chicken to Spar’s supermarkets.

It seems a reasonable bet that come mid-September, when the buyout offer expires, CBH will not be holding much more than its current stake in the company.

If the buyout offer falls away (removing the pricing peg) and there has not been a miraculous recovery in the poultry sector’s prospects, it might be possible to knock down Sovereign’s share price with a feather. That might well suit CBH, with its negative control stake, though that’s a story for another time.

But Sovereign’s second half of the financial year to end-February did show operational strain, with the sprightly earnings gains made in the first half pushed back in the latter months.

There’s no doubt that Sovereign, by virtue of its size and value-adding initiatives, will fly when the sector turns. CBH must know this too; why else would it covet Sovereign’s assets?

But in the short term, IM thinks Sovereign’s margins will be squeezed and profit growth staunched. We would opt for a short on the share.

While Astral is clearly also going to endure a lean period, the company has the balance sheet and strategic wherewithal to profit in the longer term from poultry industry carnage.

Astral has already warned that a number of mid- to large-sized independent poultry producers are in “severe financial distress and are either currently in the process of closing down their businesses, or are going into business rescue”.

The company may well pick up choice pieces in the distressed poultry sector, buying only the bits where value can be enhanced easily without legacy liabilities being inherited.

Sentiment might well fluff up for Astral as investors see the company as the default bet on a recovery in the poultry sector and take an early position for generous dividend flows over the longer term.

IM choice would be to go long on the “big bird”.