Saturday, October 08, 2016

Why We Sold Tyson Foods In September

At the end of September our research led us to sell Tyson Foods (TSN) common stock in our client accounts. Our firm relies heavily on fundamental research in our stock research in order to uncover buy and sell opportunities for our clients' portfolios. What led us to our sell decision was not the direct reason TSN was down nearly 9% on Friday, but an indirect one.

As background, our firm added TSN to client accounts in May of 2015 following the stock's decline as a result of bird flu showing up in poultry in Arkansas where Tyson has poultry operations. In short, we felt the bird flu issue was a temporary one and that TSN would recover from this issue. Additionally, we expected TSN to benefit from its acquisition of Hillshire Foods that had closed in August 2014. The acquisition benefits materialized, the bird flu situation passed, and TSN's stock price recovered nicely. After our initial decision to purchase TSN on May 14, 2015 at $41.76, we trimmed the holding on May 19, 2016 at $64.88, a 55% gain after one year. One of our risk control disciplines takes into account position size and this was one of the reasons for trimming the holding in May. We sold the remaining TSN position on September 30 at a price of $74.52 and the sell was made for fundamental reasons.

Tyson's stock is not necessarily trading at an extended valuation, 18 times earnings at the time of our sell, when compared to the overall market. Additionally, the earnings growth rate for Tyson in the later part of 2015 and through September of 2016 has been strong. As the below snapshot of earnings shows, YOY growth ranged from 49.4% to 51.3% in Q3 2016. Fourth quarter (9/30/2016) is expected to see YOY growth of 33.5%.

Beginning in the December quarter though, YOY earnings growth is expected to decline to single digits, 7.1%. Further, without share buybacks, the YOY earnings growth rate would equal only 2.6%. Therein lies our issue with the stock. Tyson is a good company, but the company's stock price seems to have gotten ahead of earnings growth fundamentals at least near term. One factor that tends to serve as a headwind for stocks is when the growth rate of earnings is slowing over time, especially after being strong for an extended period of time historically. In this slowing earnings growth environment, often times a stock's valuation will adjust to account for the slowing earnings growth rate. This adjustment can occur either over time by trading sideways or can adjust in price be some decline in the stock's price.

This leads me back to the 9% decline in TSN's stock price on Friday. The decline was in response to a research report released by Pivotal Research Group. In the report Pivotal indicated there might be price fixing issues related to broiler chickens. The report's conclusion is related to a class action complaint filed on September 2nd, Maplevale Farms, Inc. v. Koch Foods, Inc. et al, According to Pivotal, "The complaint alleges that Tyson, together with Koch Foods and multiple other players in the broiler chicken business, systematically colluded to reduce production of broilers since about 2008. The mechanism for collusion is not a shady meeting in a hotel room, as was once done by players in the lysine market. Rather, the complaint alleges supply collusion occurred through nonpublic data exchange; detailed industry reports compiled on a daily or weekly basis by Agri Stats, Inc., a subsidiary of Eli Lilly and Co., and then sold back to industry participants."

In conclusion, all else being equal, at the time of our last sell of TSN, we believed the company's stock valuation needed to decline to a mid to low double digit P/E multiple given the slowing earnings growth rate. With Pivotal highlighting the recent class action lawsuit, this to could have a negative impact on TSN margins and future earnings growth. As a result TSN's stock price has and is adjusting to a P/E multiple that is more in line with the anticipated growth rate of TSN earnings. For investors, when earnings growth of a company slows from over a 40% growth rate to single digits, a stock's price will often adjust downward to account for this slowdown. On top of this, when secondary news like the above noted class action lawsuit comes out, a stock priced for perfection can decline sharply, as was the case for TSN Friday.

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