Sanderson Farms Clings to a Hold

The company is profitable the way both a "defensive" commercial banker and an "enterprising" venture capitalist gauge corporate performance.

(To learn more about the Earnings Power Chart, check out my book It's Earnings That Count.)

These factors give me confidence that the stock is worth holding into the first-quarter report.

Drilling Down to the Quarters

In addition to studying annual results, you also want to look at quarterly numbers.

A lot can happen to a business in a year, and in Sanderson's case, it did.

Sanderson's first three quarters were robust, as the Quality of Earnings chart below shows, but the fourth quarter was disappointing.

Quarterly Details Not So Flattering Sanderson capped 2004's good performance with a disastrous quarter

In fact, 2004 was the worst fourth quarter going back to 2001, as the following chart reveals.

The Worst in a While The fourth quarter of 2004 is the black sheep of the final quarter for the last four years

Why this poor showing?

Because Sanderson's gross margin was 10.1%, its lowest quarterly performance in seven quarters and 370 basis points below the average of the last four fourth quarters. Gross margin is revenue less cost of goods sold, divided by revenue. The higher this ratio, the better. It means a larger share of each revenue dollar is available for other expenses like employee salaries, R&D, debt service and, of course, stockholders.

Sanderson Farms' Gross Margin (%)
Fiscal year	Q1 (Jan.)	Q2 (Apr.)	Q3 (Jul.)	Q4 (Oct.)
2004	18.8	25.4	24.5	10.1
2003	9	14.1	15.9	19.2
2002	10	11.3	11.4	10.5
2001	4.9	9.9	12.7	15.6
4-Year avg.	10.7	15.2	16.1	13.8
Source: Earnings Power.com

Sanderson operates in a commodity industry, as the wide swings in its gross margin suggest. The company is a bit of a price-taker, meaning it doesn't haven't a lot of control over the prices it can charge consumers or the prices it must pay for feed ingredient costs. The latter is a chief component of the cost of goods sold.

A disappointing fourth quarter notwithstanding, management does an impressive job of managing its balance sheet. In fact, Sanderson's return on equity and return on investment trounce the industry averages. I also like that debt and leases are just 9% of total capital. The less money you owe, the less likely you'll go bankrupt.

My other concern is valuation. Based on what I believe are conservative assumptions, Sanderson's "real worth" is in the mid-$40s. This means the price-intrinsic value ratio is 100%; in other words, there is not the "margin of safety" that renowned value investor Benjamin Graham famously advocated, in case of miscalculation or bad luck.

Sanderson Farms Intrinsic Value Assumptions
Forecast period (years)	10
Revenue growth	12% years 1-4; 10% years 5-7; 8% years 8-10
Gross margin	8.60%
Selling, General & Administrative	4.4% of revenue
Marketing & advertising	1% of revenue
Tax rate	38% of pretax profits
Capital spending	10.4% of revenue in year 1; 2.8% years 2-10
Depreciation	2.5% of revenue years 1-10
Working capital investment	3% of revenue years 1-10
Cost of equity	12%
Source: EarningsPower.com

(To learn more about estimating a firm's intrinsic value, check out Streetsmart Guide to Valuing a Stock, by Gary Gray, et al. The authors also have a free Web site that automatically calculates intrinsic value based on current financials. Their fair value number for Sanderson is $169.)

First-quarter 2005 results are due Feb. 24, and I will share highlights with RealMoney readers. My chief interest is to see if the gross margin climbs to at least 10.7%, which is the average of the last four Nov.-Jan. quarters. I believe it will, in part because management says that due to some forward purchasing on feed, they expect $60 million to $65 million in savings. A reduction in cost of goods sold increases the gross profit margin.

In sum, Sanderson is a well-run business, and I see additional growth in the next several years. If the stock falls to $30 (resulting in a 65% price-to-value ratio), I will aggressively add to my position.

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At the time of publication, Heiserman was long Sanderson Farms, although positions may change at any time.

Hewitt Heiserman conceived the Earnings Power Chart, Earnings Power Box and Earnings Power Staircase. A financial analyst for the past 15 years, Heiserman is a member of the Boston Security Analyst Society and the Association for Investment Management and Research. He also authored It's Earnings That Count, a book published by McGraw-Hill. For additional information, please visit www.earningspower.com. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].

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