An Overlooked Emerging Market Food Sector
Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As any international investor knows, all roads tend to lead to the US for the top-down investor. Across so many sectors the US tends to have a leading player, but in this article I want to focus on a sector that doesn’t. In other words artificial sausage casing! As obscure as this theme sounds, it is actually exposed to a number of favorable trends in emerging market food consumption trends and the replacement of gut with artificial casing. Investors should not be afraid to tread off the beaten path in order to generate returns. It's where the likes of Peter Lynch found their best successes.
US Options Investing in Protein
The case for investing in protein is a strong one, however it usually comes with a significant amount of vagaries that add risk to an otherwise attractive long-term proposition. It is well understood that increasing urbanization and wealth in emerging markets is causing a shift in consumption toward protein, but investing in this trend is not as easy as it may appear. For example, Smithfield Foods (NYSE: SFD) and Tyson Foods (NYSE: TSN) have both seen their exports to emerging markets like China rise in recent years but, they have also seen sharp rises in feed costs, which always tend to threaten margins.
Another interesting option for US investors is market leading egg producer Cal-Maine Foods (NASDAQ: CALM). I have a detailed write-up of Cal-Maine in an article linked here. What makes this company interesting is that it previously demonstrated the ability to generate super profits in a rising feed price environment. Alternatively, investors might look to invest in a foreign US-listed producer like Brasil Foods (NYSE: BRFS) although this brings with it the usual uncertainties of rising input costs coupled with foreign exchange risk.
I want to focus on a little discussed sector.
The Case for Sausage Casing Stocks
As the population grows and emerging markets become wealthier the demand for protein will increase. Whilst this puts pressure on prices, it will also increase the demand for cheaper protein options like sausages. In addition, the increasing mechanization of sausage production is encouraging the utilization of artificial casings especially as sheep gut casing is subject to pricing pressures and uncertain supply. The artificial gut casing market is set for strong and sustainable growth.
What makes the casings producers attractive is that even if protein prices rise, sausages will still be seen as a low cost alternative, so their customers should still be in expansionary mood even if their input prices (protein) are rising.
The Leading Players
In order to demonstrate these favorable trends, I want to outline the performance of the leading player in the market, namely Spanish listed company Viscofan.
Sales growth has been consistent across all market conditions. In addition the only drop in gross margins occurred in 2008 where costs rose very strongly in the first half and then demand moderated with the recession. However in 2009, margins increased strongly as commodity input costs reversed trend.
Naturally, the future investment focus has been on China and the leading players in the market have all been stepping up investment in that region. Viscofan and another leading player, UK-listed Devro, have been actively looking to expand sales in China. The market in China is somewhat fragmented and lower quality local producers like Shenguan have good market share. The challenge for the foreign producers is to go aggressively for volume production or in a limited way but with quality offering. Indeed, Devro and Viscofan have chosen opposite options. Devro China volumes actually declined last year as the company pulled back on lower margin volumes, in favor of focusing on higher margin quality. Meanwhile, Viscofan is investing in a collagen plant in China in an effort to grab market share via competitively priced volumes.
Viscofan is the clear leader in the industry and is the only company to offer casings across the four main sub sectors (skinless, collagen, fibrous and plastic) with Devro being the leader in the collagen sector, while Viscofan dominates the skinless sector. Finland’s Visko-Teepak is also a leading player but unfortunately the company is private.
Too Much Investment?
Over recent years all these companies have had to engage in investment programs in order to build capacity. This doesn’t come without operational risk and might suggest that these companies have to engage in ongoing and cash draining capital expenditures. I decided to take a closer look at this with regards Viscofan.
The evidence suggests that -- on one metric of cash flow generation -- Viscofan has been well able to expand sales without suffering cash outflows. Indeed, the underlying cash flow generation is quite strong. Once it is out of its expansionary phase of capital expenditures, I would expect strong cash flow generation from 2013 onwards.
For obvious reasons, I suspect many investors would be cautious on buying a Spanish stock but in reality the company has relatively little exposure to the local economy although any unexpected rise in corporate taxation would weigh heavily on the whole market. Another option is the UK-listed Devro. However, I think Viscofan is more interesting due to its larger size and more diversified product offering. I also like its China expansion program. Well worth a look.
SaintGermain has a position in Viscofan. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.
