Morgan Stanley is out with a negative call on Smithfield Foods (NYSE:SFD):
Investment conclusion: We are lowering our F2010 EPS estimate from -$0.95 to -$1.85 on lower lean hog prices and higher expected interest expense relative to our last model update. While corn and soybean meal costs have also declined and SFD’s pork margin should benefit from lower lean hog prices (as lean hogs are an input in this segment), this will not offset bleak lean hog price curve. With consensus expecting just a loss of $0.41, we are also issuing a negative trading call (RTI) as we do not believe that the stock will outperform as consensus estimates are likely reduced.
What's happened? Since SFD reported earnings on June 16th, front-month lean hog prices have declined by 14% and the lean hog futures curve now indicates that SFD’s F2010 average lean hog price could be ~$11/cwt lower than we previously expected. The current futures curve indicates that, on a cash basis, hog producers are expected to lose ~$40-$45/head for the remainder of C2009 and ~$30/head into spring 2010, with losses continuing through C2010 (though we acknowledge that the curve is fairly illiquid more than 6 months out).
Remaining Equal-weight. While liquidity concerns have been alleviated (for now, at least), we do not expect to see a positive catalyst that would allow for hog production to return to profitability in the foreseeable future. In particular, at current corn/soybean meal prices,lean hog prices need to rise to ~$69/cwt in order to hog producers to break even-- ~$22-23/cwt above current levels. As such, we see no reason for SFD shares to trade materially above its $12 tangible BV.
Investment Thesis Review: We are not constructive on the “long term” “normalized” outlook that consensus holds. While protein cycles remain intact, we believe that cost and demand curves have shifted such that producers will make less money for a shorter period of time at the top of the cycle and lose more money for a longer period of time at the bottom (while generating less cash flow due to working capital step-ups).
Firm is also issuing negative Research Tactical Idea:
We believe the share price will fall relative to the country index over the next 30 days.
This is because lean hog prices have traded down recently, which will prolong losses in SFD's hog production segment. We believe consensus estimates for F2010 need to be materially reduced in light of the recent trade off in lean hog prices, and the stock should underperform the S&P 500 as a result. Also note that we are reducing our F2010 EPS estimate from -$0.95 to -$1.85 (below the -$0.41 consensus estimate) as a result of lower lean hog prices and higher expected interest expense relative to our last model update. While corn and soybean meal costs have also declined and SFD’s pork margin should benefit from lower lean hog prices (as lean hogs are an input in this segment), this will not offset bleak lean hog price curve. We estimate that there is about a 70% to 80% or "very likely" probability for the scenario.
Action: Morgan Stanley's new F2010 estimate is by far the lowest on the Street (consensus stands at -$0.41 and the previous low was -$0.95 - also by Morgan Stanley). While the impact from the lower hog prices should not come as a total surprise, estimate cut of that magnitude is bound to raise some eyebrows. Add the newly issued Research Tactical Idea to the mix and we have a nice setup for a short. The stock will probably open flat at the open and see pressure afterwards, giving you about 5-10 minutes to get fills.
Target for covering? I'd expect around 5% move today so let's say $12. Would expect even more but book value at $12 limits the downside.