Surging Commodities Have Created a Window of Opportunity

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Thanks to a confluence of events, prices for corn, soybeans and wheat have been surging recently. And that has set agricultural equipment stocks afire. Shares of irrigation equipment maker Lindsay Manufacturing ( LNN ) have surged more than +10% since last Thursday, while Deere ( DE ) has made a similar move since last Monday. The same can be said for many other sector names, a number of which now sport price-to-earnings (P/E) ratios that are starting to get frothy.

It may be too late to make a quick hit on this farm belt trade, but another sector has suddenly become very attractive simply because these commodities are seeing a surge in prices. I'm talking about the major producers of chicken, beef and pork. Their costs just went up, and their shares just went down. Yet viewed in the context of traditional long-term earnings power, these stocks are suddenly quite cheap.

To fatten up livestock, farmers buy up massive amounts of corn and soybeans, which often account for a big chunk of operating expenses. But these "protein" producers have little control over revenue, even as their expenses rise and fall. The supply of animals on the market controls pricing, which is dictated by supply and demand on global markets. So with expenses rising and those costs unable to pass through, profit forecasts are falling.

For example, back in July analysts thought poultry producer Sanderson Farms (Nasdaq: SAFM) would earn $6 a share next year. Now they think profits will be at least 20% below that view.

But Sanderson's profit forecasts are dropping for another reason as well: the nation's production of chicken and other poultry is set to rise +3% next year, according to the U.S.D.A. And rising supplies usually means falling prices in this industry. Yet that's not the case for beef and pork, as those producers have shown a great deal of discipline by culling herds. Fewer hogs and cattle coming to market next year mean that prices should rise, according to the USDA's World Agricultural Supply and Demand Estimates (WASDE) surveys. By this time next year, global beef production should be -4% lower. (Pork production is slumping now, but is expected to rebound by the second half of 2011.)

So if expenses are rising for all protein producers but the revenue pictures are diverging, investors need to be selective. Smithfield Foods, which focuses solely on the pork market, is looking increasingly attractive, as the company should benefit from surging pork prices. Goldman Sachs expects hog prices to rise +25% to +30% next year, which should be more than enough to offset rising feed costs. If feed costs pull back to historical levels, then earnings could really take off. After a recent pullback, shares of Smithfield Foods trade for less than 10 times projected 2011 profits.

A long-term shot at poultry
Even as poultry producers are struggling from near-term expense hikes, their shares are setting up for a long-term buy. That's because these stocks tend to rise and fall in conjunction with earnings forecasts. Those forecasts have been cut lately, and shares of Sanderson, Tyson ( TSN ) and Pilgrim's Pride ( PPC ) now trade closer to their 52-week low than their 52-week high. Yet estimates should soon hit a bottom -- and so should share prices.

Looking into 2011, other factors are conspiring to take profit forecasts back up. For example, poultry exports to China and Russia are finally starting to rebound after recent embargoes were lifted. And poultry producers have a much greater ability than pork and beef producers to alter industry supply dynamics, as it takes much longer to fatten a hog or cow. As a result, poultry production is likely to peak in the first half of 2011 and start dropping from there as farmers realize lower prices and move to bring supply back in line with demand.

Shares of the major poultry producers are trading for around eight times next year's downwardly revised 2011 profit forecasts. An expansion of the multiple to around 10, coupled with an eventualuptick in forecasts, should set the stage for meaningful upside -- once this current round of rising feed costs have been cycled through to the investment community.

Action to Take --> Smithfield's pork focus makes its shares attractive right now. Investors need to show more finesse with the poultry stocks, however. Wait until quarterly results are out and lagging analysts finally reduce their estimates. Once that happens, forward estimates are likely to find a floor -- as are share prices. As estimates start to rebound in ensuing months, shares are likely to rebound at an even more robust clip as the P/E multiple expands.

-- David Sterman

David Sterman started his career in equity research at Smith Barney, culminating in a position as Senior Analyst covering European banks. David has also served as Director of Research at Individual Investor and a Managing Editor at Read More...

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Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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This article appears in: Investing , Commodities , Investing Ideas
Referenced Symbols: DE , LNN , PPC , SAFM , TSN

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