The Low-Cow, Mad-Carb Portfolio

By Jon D. Markman, Columnist, MSN Money
01/15/2004 07:17 AM EST

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It's not often that two contradictory investment themes duke it out in the supermarket of public opinion and taste at the same time. But that's the meat of the matter today in grocery aisles and trading rooms across the country as we witness the battle of Mad Cow vs. Atkins.

In one corner, we have the challenger -- an investment theme fronted by consumers who fear that the discovery of bovine spongiform encephalopathy in a Washington state Holstein shows our protein food chain has been compromised and therefore should be shut down.

In the far corner stands the current champ -- an investment theme fronted by people who believe a diet low in carbohydrates and high in protein, popularized by the late Dr. Robert Atkins, can keep them from getting fat as a pig.

Each theme logically argues against the other. If the beef-bashers are correct, it should be time to take a cue from Japan, Mexico and South Korea -- which have forbidden imports of U.S. beef -- and swap meatpacker stocks for shares of veggie processors like Fresh Del Monte Produce (FDP:NYSE - commentary - research), or the la-di-da organic grocery chain Whole Foods Market (WFMI:Nasdaq - commentary - research). If the beef-eaters are right, then it's time to take advantage of the current fear of frying and buy a lifetime supply of meat stocks.

Of course, there is a middle ground where all can dine and trade in peace, which I will propose in a moment. But first let's examine what's at stake and consider the major players.

Protein Craze Goes Mainstream

The food industry sells close to $600 billion worth of products in the U.S. every year, and beef accounts for an impressive 8% to 10% of that. Tyson Foods (TSN:NYSE - commentary - research), which entered the beef biz in a big way in 2001 by purchasing IBP, slaughters 37,000 cattle daily to keep up the pace of its $10.2 billion division.

The next-largest beef processor in America is Excel, a division of private conglomerate Cargill, with $8.7 billion in sales. Then comes Swift & Co., a private joint venture between investment firm Hicks Muse and food conglomerate ConAgra Foods (CAG:NYSE - commentary - research), with $5.5 billion in sales. Following ConAgra is Smithfield Foods (SFD:NYSE - commentary - research), with $2.2 billion in sales.

The growing popularity of low-carbohydrate diets -- the Atkins books alone have sold 15 million copies over 20 years -- has intensified Americans' interest in chowing more protein. The government reports that U.S. beef demand was up 10% in 2003, while chicken demand was up 8%. Egg sales are up as well, and an industrywide lack of enough layers to satisfy demand from low-carb breakfasters has served to push egg prices to 20-year highs.

No longer on the nutritional fringe, the approach has gone mainstream. A Morgan Stanley survey of 2,500 consumers late last year found that low-carb diets touch 24% of consumers today -- a figure four times higher than prior estimates. The survey found that 19% of Americans say that they've tried a low-carb regimen, and 5% more say they live with someone who has. About 10% of Americans say they are on a low-carb diet now.

These diets are popular because they feed into the great American theme of instant gratification. If you follow all the rules, it's pretty much a lock that you will lose 10 pounds in two weeks -- just like the ads say. And because the proteins with which you replace the carbs are more satisfying than most other dietetic fare, nutrition researchers have found that it's an unusually easy regimen for people to stay on. Moreover, scientists have concluded that it's not an unhealthy diet, despite allowing its adherents to basically ingest as much fat as they like.

Budweiser's Smooth Move

The really important thing investors need to know about the low-carb movement, however, is this: Morgan Stanley's research showed that while half the people who try the diet quit after six weeks and nearly three out of four will quit after 12 weeks, about 30% of those say they will continue to watch their carbs (and eat more protein) afterward. That matches up with 40% of people who say they limit their fat intake, and 40% of Americans who say they limit their sugar.

In summary, the low-carb approach appears to have leapt the tracks of status as just a fad and become an entrenched trend. And that means the nation's food companies have had to snap to attention. Anheuser-Busch (BUD:NYSE - commentary - research) has been among the leaders, creating a low-carb beer brand called Michelob Ultra last year and guiding it through clever marketing to a sensational 3% share of supermarket sales.

Johnson & Johnson (JNJ:NYSE - commentary - research) has benefited through a terrific sugar substitute called Splenda. And fast-food chains Subway, McDonald's (MCD:NYSE - commentary - research) and Carl's Jr., a unit of CKE Restaurants (CKR:NYSE - commentary - research), have all introduced and begun heavily marketing low-carb menu options -- mostly either chicken wraps or hamburgers bundled in lettuce instead of buns. According to Morgan Stanley, sales of low-carb-branded merchandise hit $520 million last year, compared to $120 million in 2002.

You might think that the discovery of mad cow in an animal fully integrated into the nation's food supply would stop this trend dead in its tracks. After all, doctors say that humans can acquire a brain-destroying fatal illness by ingesting meat from a bad cow -- and symptoms might not show up for years. Yet there appears to be no such widespread fear.

Sales at hamburger joints Wendy's International (WEN:NYSE - commentary - research) and McDonald's have not slowed down a bit -- and steak chains also report no effect. In the smackdown match between dieting and disease, high-protein dieters have essentially decided that they'd just as soon die thin.

Of Bakers and Butchers

How to take advantage of the scare? You wouldn't buy ConAgra -- owner of a broad array of brands including Peter Pan peanut butter, Wolfgang Puck's pizzas and Chef Boyardee canned spaghetti -- for its relatively minor beef interests. And Cargill is private.

So the focus for beef plays comes down to Tyson and Smithfield. It turns out each of these does a lot more than process cows, however. Smithfield earns most from extensive hog-processing operations. And while beef is Tyson's most important product -- accounting for 42% of profit -- analysts point out that any shortfall in sales should be made up by its industry-leading chicken and pork divisions.

Advantage, Smithfield? Not so fast. Digging deeper, it seems that most of Smithfield's beef comes from the slaughter of worn-out Holsteins -- that is, the exact dairy-cow species that is Patient 0 in Washington. Tyson fans, meanwhile, point out that their Arkansas-based company specializes in feedlot cattle and has long had strict guidelines against the use of spinal cords and brain matter in its hamburger meats.

With a forward price-to-earnings multiple of 12.50 despite expected income growth of 14% or better, and price-to-book and price-to-sales multiples well below historic averages, I think a nod of the 10-gallon hat must go to Tyson. A price around $17 ought to be achievable by the end of this year once the sector's psychology improves.

A few other companies also ought to have advantages stemming from both trends. Archer Daniels Midland (ADM:NYSE - commentary - research) and Bunge (BG:NYSE - commentary - research), two major U.S. grain processors, are expected to sell a lot more soy meal feed if the U.S. takes steps to ban the use of ground-up cattle in cattle feed.

Sanderson Farms (SAFM:Nasdaq - commentary - research) -- a small-cap chicken grower in Mississippi with strong cash flow, a P/E of 9.6 and a price-to-sales multiple of 0.59 -- should continue its campaign to grow about 15%-plus per year in a protein-hungry world. And micro-cap MGP Ingredients (MGPI:Nasdaq - commentary - research) is an interesting play on the obverse side of the coin: It develops wheat-gluten and fiber products that major bakeries can use to lower the amount of net carbohydrates in their breads.

All of these stocks are at low simmer now as investors ponder the future of the group. I'll watch the stocks in the table below and report back on their progress at midyear.