Short-Term Struggles, Long-Term Potential: Tyson Foods Stock

Investment Thesis

I have been diving deep into the food space lately. I believe it is an ever-growing industry with many strong tailwinds. Additionally, I find it easier to find quality companies, which dominate certain niches with their established global supply chains.

One of these companies was Archer-Daniels-Midland (ADM). I recently published an article about it. Although I really liked the business and its market leadership, I was concerned about the short-term headwinds, mainly the normalization of the food supply chain and food prices. Just three days after I rated the company “Hold”, the unpredictable happened, and an investigation into the nutrition segment’s accounting practices started. The stock is down 24% since.

Continuing my efforts to find a quality company in the food space, I stumbled upon Tyson Foods, Inc. (NYSE:TSN). It fits my criteria for leading in its niche and I do believe it is an impressive company with an established presence. However, similar to ADM, short-term headwinds including but not limited to the upcoming debt maturities, unfavorable pricing environment, and declining margins make this company a “Hold”.

I will closely monitor Tyson Foods and ADM, updating my investment thesis and potentially upgrading them to a “Buy” once I gain sufficient confidence.

Company Description

As one of the world’s largest food companies, Tyson Foods holds a dominant position in the protein sector. Since it was founded in 1935, it has built its capabilities to become vertically integrated into the protein supply chain. Its operations span from feed production and breeding stock to contract farming, processing, and marketing of chicken and other specialty products.

It is also one of the leading poultry breeding stock suppliers. These are chickens or other types of poultry that are specifically raised and selected for reproduction purposes.

Scale matters in this industry. It not only provides leverage in sourcing raw materials but also in securing large retail partners. For major clients like Walmart, which constitutes nearly 19% of Tyson’s sales, the company’s vast capacity and extensive network make it an indispensable supplier.

Tyson Foods is truly a leader in the protein space with brands such as Tyson, Jimmy Dean, Hillshire Farm, State Fair, and BallPark. These brands are either the largest or the second-largest players in their own niches, as seen below.

Tyson Foods operates across four key segments: beef, pork, chicken, and prepared foods.

The biggest segment among the four is beef, which generated 37% of total revenue in FY2023. This part of the business focuses on turning live, fed cattle into beef products. In the beef segment, Tyson buys live cattle, primarily from independent feed yards and public auctions, and processes them into various beef products. This segment also offers specialty products like hides and various meats.

These products are sold to supermarkets, food distributors, restaurants, hotel chains, schools, healthcare facilities, and the military.

The pork segment, which generated 11% of total revenue last year, works similarly. The company buys live market hogs and processes them into various pork products that are sold to similar types of customers as ones in the beef segment.

The second biggest segment is chicken (33% of total revenue). This segment is truly vertically integrated. The company raises grandparent chickens, who lay fertile eggs. These eggs are hatched to produce parent chickens, which are then raised to lay more eggs. Chicks are sent to farms to grow. Once they become adult chickens, they are processed into final products.

The company operates an entire value chain from breeding, to processing and distribution. The products of this segment are chicken strips, nuggets, patties, and other chicken parts. This segment also runs feed mills to create special feed for the chickens.

The prepared foods segment, making up 19% of total revenue, specializes in ready-to-eat items including sandwiches, pepperoni, bacon, and a variety of snacks and meals.

An overview of the revenue mix and segments’ operating margins over time can be found below. Over time, the revenue mix of these segments has remained relatively stable, with the beef segment, for instance, consistently contributing around 38.5% since 2016. However, operating margins across these segments have fluctuated, with prepared foods and beef showing increased profitability post-pandemic, while the other segments experienced margin declines.

10-Year Outlook

The joint agricultural outlook report from the Organization for Economic Cooperation and Development (OECD) and the Food and Agriculture Organization (FAO) for 2023-2032 outlines key trends shaping the future of the meat industry.

The report highlights the expectation for downward pressure on the growth of meat demand because of the high and rising consumer costs and weak income growth. This is anticipated especially in the early years after 2023.

As a result of this weaker demand, nominal meat prices are expected to modestly decrease in real terms over the next decade.

Despite these trends, the report forecasts a 2% increase in global average per capita meat demand from 2022 to 2032. With population growth factored in, the consumption of poultry, pigmeat, beef, and sheep meat is projected to grow by 15%, 11%, 10%, and 15%, respectively, by 2032.

The chart below shows the share of proteins for each meat type in total meat protein consumption. As 95% of Tyson Foods’ revenue is generated in the U.S., it makes more sense to look at the high-income countries (orange) line.

According to this chart, the share of beef, pigmeat, and sheep meat has been declining, while the share of poultry has been increasing. These trends are expected to continue.

Reviewing the long-term operating margins of Tyson Foods’ four segments reveals that the chicken segment has historically generated lower margins, averaging 4.1% over 20 years, compared to the overall business average of 4.5%.

Given the increasing market share of poultry, this could potentially lead to declining overall margins for Tyson Foods.

Recent Developments

Since the onset of the pandemic, Tyson Foods’ investors have faced disappointment. The stock crashed with the pandemic news and has never really recovered. While the S&P 500 (SP500) saw a 40% return in the two years following January 2020, Tyson Foods’ stock barely managed to maintain its pre-pandemic price.

The uncertainty in consumer spending and the reduced operations of restaurants, hotels, and other key customers during the pandemic raised fears of declining sales. Despite these concerns, the company’s total revenue continued to grow annually and remained steady in 2023.

However, the post-pandemic landscape proved challenging, with rising inflation adversely affecting the company. The cost of goods sold (COGS) increased significantly, particularly due to weakness in pork and chicken pricing and rising cattle costs, leading to a sharp decline in gross margin from over 12.5% to just 5%. The company had one of its worst years in terms of return on assets (ROA).

Further complicating matters were legal challenges regarding worker pay rates and a significant product recall, where approximately 30,000 pounds of dino-shaped chicken nuggets were recalled after consumers found small metal pieces in them. These developments put further pressure on the stock.

Credit Risk

Furthermore, Tyson Foods doesn’t find itself in its best financial position. As of September 2023, the company reported $588 million in cash, a figure that may appear sufficient but becomes concerning when considering upcoming debt obligations. Most pressing is the $1.25 billion notes at 3.95% interest, due for maturity on August 15, 2024.

On top of debt, cash is used to replace aging equipment and facilities, pay rent and interest, and in the case of Tyson Foods, buy back shares and distribute dividends. These obligations and upcoming debt maturities in 2024, 2026, 2027, and 2029, puts the business in distress.

Below are my projections for Tyson Foods’ cash position (as calculated by cash at the beginning of the year + annual free cash flow) and cash obligations.

Based on these projections, I believe tough times are ahead. The company appears unlikely to fully pay off its 2024 debt without refinancing. This means increased interest expense going forward.

Given the significant debt maturing in 2026 and 2027, the company could face substantial credit risk.

Valuation

The food production and processing industry is typically asset-intensive. Apart from the inventory it has, Tyson Foods has facilities and equipment worth $20 billion. The efficiency of these assets is what helps the company generate earnings.

That is why I think in this industry, the price-to-book [P/B] is a great multiple to assess what the market thinks.

The company’s adjusted P/B increased from 2.5x in 2014 to above 3.5x in 2017 with expectations of higher returns on assets. This can be seen in the previously shared adjusted ROA chart. It increased from 10% in 2014 to around 20% in 2016.

With the pandemic, it fell to slightly above 2x in 2020. With continued headwinds, it never recovered. Despite the company maintaining a high ROA, market sentiment anticipated a decrease.

2023 was a challenging year for Tyson Foods, largely due to short-term headwinds previously discussed. However, I am optimistic that the company can sustain an adjusted ROA of around 20%, as it has achieved in the past. The current pessimism in the adjusted P/B ratio, I believe, overlooks the potential for a medium-term recovery.

Therefore, I anticipate the P/B ratio could rebound towards 3x as Tyson Foods returns to normal operations, potentially leading to over 100% returns in the long term.

However, immediate obstacles like upcoming debt maturities, high-interest rates, and unfavorable pricing conditions may continue to weigh on the stock in the short term, delaying the market’s recognition of Tyson Foods’ potential.

Unfortunately, this high potential lacks the catalyst, indicating that while the long-term outlook remains promising, the near-term pathway to realizing this growth may not be straightforward or immediate.

Conclusion

My search for high-quality companies in the food industry hasn’t proved useful so far. Similar to ADM, I think Tyson Foods is an amazing business that is dominating its niche. However, it is currently facing significant short-term headwinds, which need to be navigated before it can resume normal operations.

While it has caused margins to shrink significantly, I believe unfavorable pricing is the least of their problems. The most critical issue for investors is whether Tyson Foods can refinance its looming debt under favorable terms.

Given these considerations, I am giving Tyson Foods a “Hold” rating. This reflects my cautious stance in the face of current uncertainties. It will remain on my watchlist, and I intend to reassess my position once these short-term risks subside and the investment landscape for the company appears more secure.