Why I Sold Cal-Maine Foods

(Source: Pixabay)

If you are wondering why this article is starting with some sad and grumpy-looking eggs, this is describing my feelings when thinking about my investment in eggs, or to be more particular, my investment in Cal-Maine Foods (CALM). I bought Cal-Maine Foods about two and a half years ago - on April 4, 2017 - and as you probably presumed correctly after reading the title, I sold the position on July 1, 2019.

You might point out that I am a bit late for suggesting to sell Cal-Maine Foods, but my intention is not to give buying or selling advice but rather describe an investment philosophy and what kind of companies I like to invest for the long term and why Cal-Maine Foods does not belong in this category.

Why Did I Invest?

It is a fair question to ask why I did invest in Cal-Maine Foods in the first place. My bull case was built on several aspects. First of all, Cal-Maine Foods seemed to be really cheap at the time when many other stocks were rallying and appeared rather expensive. In my first two articles about Cal-Maine Foods, “Story Of A Few Risks And Many Opportunities" in November 2016 and “At A Nice Entry Point” in April 2017, I presented some of the arguments why the stock seemed like a good investment. Egg prices were far below the long-term trend line at that point, and I assumed that the oversupply of eggs would resolve itself (which it did in some ways). I also assumed that Cal-Maine will be able to grow due to acquisitions (and I still think it has a very reasonable acquisition policy and has acquired some companies in the meantime). My bull case was also built on a growing percentage of specialty eggs, which would generate a higher amount of revenue for the company.

But so far, the stock didn’t perform as hoped - although it traded as high as $50 in the meantime - and in July I sold my position. Over that time frame, Cal-Maine Foods increased 13.7%, while the S&P 500 (SPY) increased 25.6% in the same time. For quite some time, Cal-Maine Foods had outperformed the S&P 500, but in the end the index outperformed the company.

Data by YCharts

Missing Consistency, Missing Stability

Of course, I knew that Cal-Maine Foods is a cyclical company when I invested. But back then, my main focus was on the valuation aspect, and I rather looked for companies that are cheap, and aspects like stability and consistency were only secondary. As it is typical for a commodity business, we see huge fluctuations when looking at the company’s revenue, earnings per share or free cash flow. While we see an uptrend for revenue and EPS until 2016, the numbers are now widely fluctuating, and in 2017, earnings per share and free cash flow were even negative.

(Source: Own work based on numbers from Morningstar)

But we are not only seeing revenue and earnings per share fluctuations. The company’s margins also show huge swings in both directions. Gross margin as well as operating margin could improve between 2013 and 2016, but in the last few years, they rather moved in a zig-zag-pattern. Another metric I pay close attention to is the return on invested capital, and when looking at the average RoIC during the last decade, 14.2% is a pretty solid number. However, that number by itself is not enough to get a good and stable business (and investment).

(Source: Own work based on numbers from Morningstar)

To underline more clearly how stability and consistency could look like, we can compare Cal-Maine Foods to other companies like 3M Company (MMM) or the two major credit card companies Mastercard (MA) and Visa (V). These three companies demonstrate much more stability in all the above-mentioned numbers, and the reason for the consistency can be found in the business model of these companies. Cal-Maine Foods might see better times again than the last three years, but as long-term investor I search for businesses I can hold for a decade or longer without having to reassess the business every few quarters. Cal-Maine Foods’ business will continue to fluctuate, and I see this as problematic for any long-term investment, as I would be forced to check on the company and the business every few months to see where we are standing and where we might go.

Commodity and Cyclicality

The reason why the different numbers like revenue or earnings per share are fluctuating so heavily is quite simple: Cal-Maine Foods is selling a commodity - eggs - and it is very difficult for an individual company to set a price for a commodity. Prices for commodities like gold, salt, corn or eggs are mostly determined by many different market participants - buyers as well as sellers - and a single company selling the product has very little influence on the price and mostly has to accept the price determined by the market. Cal-Maine Foods is

missing pricing power

, which companies like the above mentioned - 3M Company, Visa or Mastercard - have.

(Source: CALM Investor Relations)

The reason why it is so difficult for companies to charge a higher price for a commodity is the missing product and service differentiation. There are certainly differences in the taste or quality of eggs, but for most customers it doesn’t make a difference who is the producer of the eggs. I don’t know where the eggs I eat come from, and I don’t care. And I assume nobody will pay extra to get eggs from Cal-Maine Foods, and hence, the company is missing pricing power. Egg is egg, like gold is gold or oil is oil - customers don’t differentiate between the different vendors and care only about the price.

Cal-Maine Foods is trying some form of product differentiation by selling specialty eggs, for which the company can not only charge a higher price but for which the price fluctuations are also lower. Over the past few years, it was one of Cal-Maine Foods’ goals to increase the percentage of specialty eggs, but in the past few years, the number has rather stagnated.

(Source: CALM Investor Relations)

It is a big problem for a company when it can’t determine the price for the products it sells, as management has only very limited control over revenue. In the case of Cal-Maine Foods, the situation is aggravated by the fact that management also has very limited control over its costs of goods sold. These costs are mostly determined by feed costs and especially by the prices for the feed ingredients - corn and soybean meal - and both fluctuate similar to egg prices.

(Source: CALM Investor Relations)

Dividend

Another reason why I am not so excited about Cal-Maine Foods as investment is the company’s dividend. It is not obligatory for stocks in my portfolio to pay a dividend, but if possible, I like to generate a passive income by way of dividend payments. Cal-Maine Foods is paying a dividend and has a very simple dividend policy: the company will pay out 1/3rd of the quarterly income. And as result of this dividend policy, the dividend fluctuates from quarter to quarter - similar to earnings per share. The dividend policy is very simple, but it also undermines my principle of stability and consistency a stock should have.

(Source: CALM Investor Relations)

But there is another problem: If the company is reporting a loss, it will not pay a dividend for a subsequent profitable quarter until it is profitable on a cumulative basis computed from the date of the last quarter for which a dividend was paid. As a result, Cal-Maine Foods didn’t pay a dividend for eight consecutive quarters since 2016 and only started to pay a dividend in the fourth quarter of 2018. And as it reported a loss of $0.41 per share in the fourth quarter of 2019 and a loss of $0.94 per share in the first quarter of 2020 (yes, CALM is already in its fiscal 2020), the dividend is suspended once again and we are already looking at a cumulative loss of $1.35, meaning that the company has to report at least $1.35 in profit before it will start to pay a dividend again. When looking at Seeking Alpha Earnings Estimates, it will take until November 2020 before the company will pay a dividend again, as the expected earnings of the next four quarters will not be enough to make up for the cumulated losses.

Modified Investment Philosophy

In the sections above, I presented several reasons why Cal-Maine Foods is not the company I would invest in today. Between 2016, when I started to get interested in Cal-Maine Foods, and 2019, when I sold the stock again, I modified my investment philosophy and commodity businesses don’t fit my investing style any more (with Compass Minerals International (CMP) being the exception).

While back in 2016 I mostly searched for stocks that seemed to be cheap, I am now especially searching for companies that offer high levels of stability and consistency. In my article about Sysco (SYY), I described the investment philosophy in more detail. I emphasized that it is never one single metric but always the combination of several different metrics that can tell us if we are looking at a superior business model. And it is not enough to look just at the last few quarters or one or two years, but we should look at longer time frames (at least one decade).

I will very briefly highlight some of the metrics I usually pay close attention to. Of course, revenue as well as earnings per sharegrowthis important, although it is not so much the absolute number but rather the consistency (revenue should grow with a stable pace and almost every single year). A second important metric is stablemargins. Gross margin and operating margin don’t have to improve but should be stable without huge fluctuations, and especially, a stable gross margin can indicate pricing power.Return on invested capitalshould be above 10% on average, and finally, the company should be able togenerate a solid cash flow, which can manifest itself in many different ways: low debt levels are a good sign, but a decreasing number of outstanding shares or a dividend can also indicate that the company is generating cash and distributing it to shareholders. But, of course, the company can also keep the cash on its balance sheet.

In my investing philosophy, the concept of wide economic moats plays a big role. I will look for high barriers to entry, and I will look for bargaining power over buyers as well as suppliers - and these are all factors that Cal-Maine Foods doesn’t have. Entering the business is extremely simple: Buy a hen and start selling the eggs! And as consequence, I don’t see CALM as an investment that is fitting my portfolio any more.

Conclusion

I still think that Cal-Maine Foods is fairly valued, and I don’t see much downside potential right now for the stock. For those holding the stock, I definitely won’t advise to sell right now and would describe my sentiment on CALM as somewhere between neutral and bullish. Cal-Maine Foods can perform quite well in the next few years and might turn out to be a good investment, but as I tried to demonstrate above, it is not the type of investment I am searching for.

Without any barriers of entry for the business, no bargaining power over suppliers or buyers, and no pricing power, Cal-Maine Foods doesn’t have any moat around its business and is not the type of company I would invest in today. When searching for stocks these days, I look for companies with a stable business model which can’t be attacked easily and for stocks we can therefore hold for the long term.

So far, I am still holding on to the cash position, but among the stocks I am watching very closely are 3M Company and Fresenius SE (OTCQX:FSNUF), as both companies seem to be valued attractively and - what is more important - show the consistency in numbers I like to see. Additionally, both stocks are paying a dividend and are both Dividend Aristocrats.If you are interested in companies with a stable and consistent business model one can invest in for the long-term, you might want to check out my marketplace service:Moats & Long-Term Investing.

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Disclosure:

I am/we are long CMP.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.