EUR 850.00 For Business Accounts Only

Morningstar | A Mixed Quarter Leaves our Long-Term Thesis Intact for No-Moat Tyson; Shares a Touch Undervalued

We don’t expect to make a material change to our $67 fair value estimate for no-moat Tyson. First-quarter results (essentially flat revenue and 100 basis points of margin degradation to 8.3%) were largely in line with our expectations, despite some modest disparities at the segment level.

In the chicken segment, management cited pricing pressure in the tray pack business, which along with higher feed and labor costs, resulted in a 5.6% adjusted segment margin, below our 7.8% estimate for the year. Weak tray pack pricing is more than offsetting the higher contract prices going into effect during the first half. Given the severity of this pressure, we expect to lower our profit forecast for this segment for fiscal 2019 but expect supply to be reduced, bringing the market back into balance thereafter. Pricing and profitability in protein businesses can be volatile and beyond the firm’s control, which is the basis of our no-moat rating.

However, ample cattle supply and strong export demand drove beef margins of 7.8%, above our 6.2% estimate for the year. We expect to adjust our beef margin forecast slightly higher for the year to reflect the strong first quarter.

Beyond the quarterly performance, Tyson also disclosed its intentions to acquire the Thai and European operations of BRF S.A. for $340 million, less than 10 times EBITDA, which seems reasonable as it is in line with similar deals. From our vantage point, this supports their strategy to leverage the Asian footprint of the recent Keystone acquisition. This business (prepared chicken for the Asian and European retail and foodservice channels) allows Tyson to leverage the foodservice business while gaining exposure to the retail channel. Although we’ve believed integrating the sizable Keystone business will require a significant amount of management’s focus, we don’t think the addition of the BRF business will be overly burdensome, either operationally or on the balance sheet.

The prepared foods segment continues to reliably deliver revenue growth (up 1.9% excluding divestitures) and healthy 12.5% margins, slightly above our 11.3% estimate for the year, which we plan to maintain. We applaud management’s efforts to grow the size of this business, both organically and through acquisitions, as it helps to stabilize pricing and profitability of the company’s consolidated results. However, as this business is still a minority of profits (about 30%) and the brands within the segment have not demonstrated consistent pricing power relative to competitors, we believe this unit has not earned the company a moat.

Pork operating margins of 8.1% were higher than our 6.3% estimate, which we expected to be depressed due to the ongoing pricing pressure from tariffs. However, we do not plan to revise our projections until there is more clarity regarding China trade negotiations. If a trade deal is not reached between the U.S. and China by March 1, U.S. tariffs on Chinese imports are schedule to increase. China may respond with additional retaliatory tariffs. However, even if a deal is not inked, we are not inclined to believe that Chinese tariffs on imports of U.S. pork will be increased from the current 71% level. China is trying to control an outbreak of African swine flu among its hog population, and media reports indicate that the illness is continuing to spread. China could be forced to slaughter a significant number of its hogs to control the disease, which would depress its hog supply and provide an incentive to leave U.S. pork imports out of the broader trade dispute.

The strong margins reported in the beef segment echo the bull case scenario we laid out in December. We had posited that strong export demand for U.S. beef (from China and South Korea in particular) could represent a longer-term benefit, leading to higher margins than the 2% to 3% this segment has reported historically. We expect export demand to remain strong for the next few years, and as such, we are forecasting above-average margins over the next three years in our base case scenario. Thereafter, we expect a gradual return to normalized profitability as numerous factors could occur to restrict supply (drought, disease) or impair demand (economic weakness, trade disputes). Management indicated that strong export growth could last longer than the three years we are expecting. They highlighted export demand as a structural/secular change, along with the company’s efforts to shift beef products from commoditized to more differentiated fare. They announced their intention to analyze and quantify these two factors in order to better predict the enhanced margin structure that their beef segment could realize in the coming years. While we think the strong secular demand for U.S. beef is a great opportunity for Tyson, we think the unpredictable nature of the factors that impact the profitability of these businesses make it difficult to expect economic profits with conviction beyond a few years, thus our no-moat rating.