To The Moon

Summary

• Tyson Foods has struggled in the past year due to high commodity costs and difficulties passing increased input costs onto customers, leading to a massive stock devaluation.

• The company is facing significant labor shortages and rising costs due to years of subjectively short-sighted business decisions.

• Reduced animal farm production levels will likely remain due to farm worker shortages and severe financial distress among smaller farms, partially driven by Tyson's "Monopsonistic" buying power.

• Tyson's distributable cash flow may fall dramatically as its operating margins collapse and it is forced to increase capital investments due to aged facilities.

• Tyson appears likely to suffer from negative investment trends as the market realizes the firm's long-term challenges.

Scott Olson/Getty Images News

The past three years have been volatile for the global food market. The US meat industry has seen exceptionally high volatility due to significant shortages and constraints in the market. In general, beef and chicken prices have reversed from all-time highs since 2021 as the market's shortages become less extreme. However, those two commodities remain significantly more expensive than before 2020. Key companies like Tyson Foods $Tyson(TSN)$ have fared poorly over the past year as they struggle to one-time heightened input costs onto customers. One factor is the elevated cost of the commodities, but the largest is likely the significant labor shortage in the meat packing industry.

Around the middle of 2021, I was among the few analysts with a bearing outlook on Tyson Foods, as detailed in "Tyson Foods: Growing Cost Pressures Likely To Cause Profit Margin Decline." At that time, the company was performing exceptionally well as it managed to sell products at elevated prices and had not yet seen a significant increase in input costs. For years, the company has benefited from near-monopolistic pricing power. However, it may be better described as a "Monopsony" because it is a single buyer of meat products in many geographic areas. As such, it often pushes prices down from the farmers it buys from, causing a series of substantial price-fixing lawsuits over recent years. These lawsuits are a direct risk to the company, but more importantly, they have lowered its capacity to pass increased input costs onto customers.

Tyson is in a relatively different position today than when I covered it nearly two years ago. TSN has declined by around 31% in value while its operating income has collapsed. Its forward earnings outlook is very low, and it may be stuck with negative income for a prolonged period, particularly if consumers continue to push back against increased prices. While the company is not overleveraged or undercapitalized, it may face added cost pressures should it need to borrow money in light of its depleting cash position. I believe TSN's floor may be materially lower than many investors expect.

The "End of an Era" in The Meat Market?

Recent decades have seen tremendous consolidation in the meat industry, with most US and Western markets dominated by four companies, with Tyson holding the leading US share. While it is not necessarily clear that the cause of increased meat prices is due to these firms, increased regulatory pushback against them in light of the scandal is likely negatively affecting their pricing power authority, particularly in the purchasing market. Since Tyson has taken actions to keep purchasing prices low, many ranchers and chicken producers have faced significant financial strains, leading to a lack of supply growth among animal producers. That trend has created a shortage that is not necessarily good for Tyson, as the animals are now in relatively short supply. This trend is evident in the trends of beef vs. live cattle prices. See below:

Live cattle vs. Beef futures price (TradingEconomics.com)

Tyson profits primarily from the spread between processed and unprocessed animal protein prices. Beef initially became very expensive in 2021 due to processing shortages, while live cattle became cheap as overall demand declined. That trend created excess profits for Tyson as it bought at lower input costs and sold at significantly elevated prices. However, the opposite is true today as the number of available cattle declined due to farmer losses in 2021, creating much higher input prices today. Further, high beef prices have shifted consumer demand away from higher beef prices, causing a sharp decline in Tyson's selling prices.

In general, a similar trend can be seen in the chicken and poultry markets. The first chart below represents US chicken spot prices or the "cost" of Tyson purchasing many pre-processed products. The second chart illustrates poultry futures prices, an indicator of the "price" at which Tyson sells its products. See below:

Data by YCharts

Chicken spot prices remain around 75% higher than before 2020, despite a relatively sharp decline last year. However, poultry prices are falling far more quickly. See below:

Poultry Futures Prices (Trading Economics)

Poultry prices are only around 15-20% above their pre-2020 level after seeing significant declines over the past year. Over recent years, chicken producers have considerably reduced animal production levels due to extremely thin margins. This trend is potentially due to Tyson's aggressive purchasing power; however, that plan has backfired as the company now faces falling consumer demand (as seen in chicken breast prices) and significantly elevated raw chicken costs.

To make matters worse, Tyson still faces significant labor shortages as it struggles to fill meat processing jobs with qualified workers. Tyson ranks exceptionally high when it comes to workplace injuries. The company recently also ran into issues after it was found that children were working in one of its more extensive facilities; however, they were working on behalf of an external contracting company. In light of the significant worker shortage, Tyson is being forced to improve working conditions and increase wages. However, these efforts will further increase costs that may not be easily passed onto consumers, as indicated by the recent declines in consumer meat prices (or impending consumer price decline as indicated by futures prices).

Tyson May Be Stuck With Chronic Losses

As a result of these issues, it is no surprise that the company's operating income has collapsed due to a sharp decline in its gross margins. Last quarter was one of its first with a negative operating income in many years. See below:

Data by YCharts

The dominant view among most analysts, and that offered by Tyson's managers, is that its very sharp margin decline is part of a natural cyclical pattern that will not last long. To an extent, that is true, as extreme margin growth in 2020-2021 led to a natural market contraction as households shifted purchasing patterns and farmers reacted to lower prices. However, I believe this trend will last much longer and may become considerably deeper before it ends. Indeed, if it is the "end of an era" for monopsonistic purchasing power and monopolistic selling power, it will take time and potentially considerable profit pains before the industry's immense imbalances are finally corrected.

For years, as evidenced by many lawsuits and scandals, Tyson has capitalized on increasing market power by pushing down purchasing prices and promoting higher consumer prices. Indeed, it is natural and logical that a company with such a dominant market position will take such measures. Further, as evidenced by the company's labor conditions strains and closed facilities, Tyson has likely been chronically underinvesting in its physical facilities to try to drive high free cash flow. Now that it is struggling to maintain workers, it must aggressively increase CapEx spending at the expense of its free cash flow. See below:

Data by YCharts

This issue does not directly harm Tyson's bottom line, but it does compromise its ability to pay a dividend as it uses profits to renovate its old facilities. Before ~2002, the company was spending immense sums on capital costs but very little during 2005-2019. Today, that figure is rapidly rising to its 1990s levels, meaning it may need to reduce its dividend dramatically to afford increased capital investments, particularly if its operating income remains negative.

I believe Tyson is now paying the price for its various short-sighted business practices over the past two decades. Objectively, as is widely reported, the company consistently jeopardized its long-term relationships with farmers to push its gross margins higher. The company has also been widely implicated in price-gouging consumers, potentially contributing to declines in meat demand, particularly beef demand. That said, Tyson disagrees with this view. In my opinion, those potential meat consumption declines will likely last long-term; not as many "go vegetarian" but mainly due to smaller package sizes in the store, "shrinkflation" as Tyson (and peers) keep prices low by reducing per-package quantity.

Further, due to numerous systemic issues, I expect Tyson will continue to struggle with a labor shortage. At this point, a recession appears unlikely to aid that shortage because economic declines are abnormally skewed toward higher-income brackets, with low-income brackets still seeing fast wage growth. Had Tyson been more forward-acting in maintaining and improving worker conditions over recent decades, this may not be an issue today. However, the company is now stuck with chronically rising labor prices and a potential decline in worker quality. The increase in general labor strike action in the US poses a significant risk in light of the company's situation today. Indeed, the labor pool of poultry processing employees remains significantly constrained today. See below:

Data by YCharts

Lastly, I expect Tyson will continue to struggle with high commodity input prices as cattle, chicken, and pigs fall into short supply. Some portion of Tyson's supplies are owned by the company, but the majority of its sources are through external farmers. However, significant rancher and chicken farmer bankruptcies in recent years due to low prices and rising labor and other farmer input costs will likely cause this issue to be more permanent even if farmer profits rebound. Environmental conditions may also play a negative factor in impacting the production from animal farms. Until stability finally returns to the many underwater farms, Tyson will face higher commodity input prices that cannot be passed onto consumers (without negatively impacting demand).

Tyson's overall financial stability on its balance sheet is fine. The company does not have excessive debt or a lack of liquidity; however, its debt levels and liquidity are not necessarily strong. See below:

Data by YCharts

Tyson does have a relatively high debt burden and may need to raise cash should its cash flows continue to fall into negative territory. At this point, the company is not at risk of severe financial pressures since its time interest earned and financial leverage is not excessively high. However, as the company's margins fall and its capital expense needs rise, it is at risk of falling into that path, mainly due to elevated interest rates today. For now, Tyson's balance sheet is not a significant risk factor, but I expect the firm will need to cut its dividend if its operating cash flow remains low or negative over the coming years.

The Bottom Line

Overall, I am slightly bearish on Tyson and expect TSN to continue declining in value throughout the coming year. Fundamentally, Tyson's largest advantage, its pricing power in both selling and buying markets, is now its most tremendous burden. Since the company is the primary seller of US meat products and the dominant buyer of slaughtered animals, it now faces a heavy burden of excess authority. Essentially, due to its massive market power, the company is now on-the-hook for fixing the numerous issues in the US meat market, issues which I believe were created by the company's chronically short-sighted focus.

Accordingly, I do not believe TSN is facing a cyclical downturn but a secular decline attributable to immense issues in the meat industry. To fix these issues, I expect the company will need to make significant capital investments over many years and will likely be stuck with low or negative profit margins for years to come. Further, it is still exposed to cyclical risks as an economic slowdown or rise in unemployment will likely decrease demand for more expensive grocery items. Again, I do not believe it is reasonable to assume US households will lower their meat consumption back to historically normal levels, around 30-50% lower before the 1950s, which is approximately when meat industrialization began. Per capita US meat consumption is also about 30% higher than Europe's, suggesting demand could fall substantially if consumer prices remain elevated.

Tyson faces a mixture of long-term and short-term issues, which I believe will negatively impact its profits and distributable cash flow (due to rising CapEx). The severity and length of these strains make it challenging to forecast the company's income; however, I expect its profits to be near zero over most of the coming years as pressures continue. It may take time for Tyson's EPS to return to historical levels even after its operating margins rebound. Accordingly, I have no specific price target, nor do I believe TSN is so overvalued that it is a short opportunity. However, I expect its financial stability and dividend will erode over the coming years, likely leading to a more considerable decline in its valuation.

Source: Seeking Alpha