Cagle’s (CGL.A): A tempting value trap

Cagle’s (CGL.A) is a small poultry provider with a lot of appealing valuation numbers and positive trends. Credit issues remove it from consideration as a value investment, but after one or two more quarters it could re-emerge as an appealing play for value investors.

The company has not been valued highly or particularly profitable for some time. The company turned a small profit in FY2010 but hasn’t seen a strongly profitable year since 2005, which probably kept investor sentiment toward Cagle pretty negative. Turning that trend around, though, seems to get investors quite excited: the price nearly doubled in November (peaking at $11.64) when the company announced a second straight quarter of solid profits. It promptly started dropping and fell to its present price.

The company’s overall financial position has been improving over the past year. Long term debt has declined by almost 30% in the past two quarters and they have extended the maturity on roughly half of their long term debt to 2013, at which point they would have repaid nearly all of it if they continue at their current pace. Current ratio is up slightly to 1.65 and they have access to plenty of short term credit, so liquidity shouldn’t be an issue.

In terms of earnings valuation, Cagle looks like a steal. P/E is only 4.69 and P/FCF is 4.95. Most of that comes from recent improvements to gross margins, which in recent quarters are almost double the average for the previous fiscal year. Year over year, the change was an improvement to 11.6% from 6.6% in the 2Q of 2011 (ending October 2, 2010). This is a massive departure from the company’s historical performance, where gross margins tended to either be in the low single digits or negative. This leads to the first major question about CGL: are those improvements sustainable?

My initial reaction was “no.” According to CGL’s reports, a $.10 per bushel price change for corn leads to a $.75M increase to COGS. A $10 per ton increase for soybean meal does likewise. Since corn prices are at their highest level in two and a half years, that makes me uncomfortable.

Comparing year over year performance surprisingly shows the opposite of what I would have expected. From July-October 2009, corn prices hovered between $3.00 and $3.50 for the most part. During the same period in 2010, they increased almost continuously from $3.70 to $4.65, with a brief spike to $5. Nevertheless COGS was 10% lower in the most recent quarter. In the FY2010 10-K Cagle claimed that their new facilities at Pine Mountain Valley would offer a substantial decrease in costs through improved efficiency and judging by the decrease in costs that they achieved in the face of rising feed prices it seems like they succeeded.

So the improvements are based on internal factors, which should make the new margins sustainable in the absence of price changes for corn/soy. Prices have changed, however, and continuing increases in feed costs will probably squeeze margins back to single digits or below. The price of corn is up about $1.50 since the beginning of October, which will probably add about [15 x $.75M / 2] or $5.6M to COGS. Subtracting that from last quarter’s results as a “what if?” ends up with an operating loss of ($467,000). Interest payments would have extended the loss to ($805,000) before an tax benefits.

That potential loss leads to the fundamental problem with Cagle – its debt covenants. The footnotes contain a fun fact about the covenants for Cagle’s revolver: CGL must maintain a tangible net worth of $40M at all times after January 4, 2011. Current book value is $41.9M, which means that there is a $1.9M cushion standing between CGL and default. The hypothetical loss outlined above would have eaten up half of that cushion. Even worse, CGL’s business is moderately seasonal and the two forthcoming quarters represent the “slow” period. Judging by the results of the past three years, sales are about 10-15% lower in the second half of Cagle’s fiscal year and the company has lost money during that period in years (like FY2008 or FY2010) where the first two quarters were profitable.

Since prices for corn in Cagle’s 4Q (Jan-Apr) are around $6.50 at the start of this quarter, the increase to COGS could potentially be even higher. Even if prices merely hold steady, that’s a COGS increase of over $10M. An investment in Cagle at this point is essentially a bet that corn prices won’t cause the company eat through that cushion and default.

I’m not prepared to make a bet on where corn will go, so I would say steer clear. In fact, if corn continues to rise, especially to its 2008 highs, CGL might even make an attractive short or distressed play (after a technical default).

Current Price: $7.25
Corn Prices:

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