This Trade Could Deliver a Potential 42% Return in 3 Months

It’s been a good couple of years for chicken — well, maybe not for the bird itself, but certainly for the companies that produce it and for their shareholders.

Chicken consumption in the United States has been on the rise since the 1940s. It surpassed pork in 1996, and in recent years, overtook beef.

U.S. chicken availability per person has more than doubled since 1970, and Americans are eating roughly 60 pounds of poultry per person annually.

[ad#Google Adsense 336×280-IA]Taking a broader view, the global economy is stabilizing and the world’s growing middle class is demanding more protein, causing meat prices to rise.

The sector’s strength is evidenced by last month’s bidding war between Tyson Foods (NYSE: TSN), the largest U.S. meat company, and Pilgrim’s Pride (NASDAQ: PPC), the world’s second-largest chicken producer, for Hillshire Brands (NYSE: HSH).

Then there was last year’s $7.1 billion acquisition of Smithfield Foods by China’s Shuanghui International Holdings, the world’s No. 1 pork producer.

Today, I want to look at how to play the third-largest poultry processor in the U.S., Sanderson Farms (NASDAQ: SAFM).

This fully integrated poultry processor has company-owned feed mills and hatcheries, and markets and distributes 100% natural fresh and frozen chicken products. With plans to process over 3 billion pounds of meat in fiscal 2014, Sanderson has more than 11,000 employees and a network of over 800 independent growers. It ships to most U.S. states, as well as many developed foreign nations.

SAFM uses tight controls and automation to manage hatcheries, feed mills, processing and distribution in an effort to maintain consistency and its products’ “natural” classification.

At the end of 2013, Sanderson Farms controlled just 7.4% of the market. This leaves a ton of room for organic expansion or a merger/acquisition, which some analysts have highlighted as a viable option.

I’ve been researching the food industry for years now, and I have always found the chicken story, and Sanderson Farms in particular, compelling. In May 2013, I wrote an article in Forbes recommending SAFM when it was trading near $64. Shares are up more than 50% since then, but I don’t think the gains are over.

Sanderson’s efficient production, growth in exports and internal shift to more high-margin products is reflected in the company’s latest earnings report.

In late May, it reported fiscal second-quarter results that blew estimates out of the water. Earnings more than doubled year over year to $2.21 per share compared with expectations for just $0.53. Sales increased 6% from the same period a year ago to $660.7 million.

Following the strong quarter and positive outlook from the company, analysts have been upping their earnings expectations. In the past 30 days, estimates for the third quarter have risen from $2.83 per share to $3.24. And full-year EPS projections increased from $8.07 to $9.35 during the same time.

While the fundamentals are certainly bullish, it’s the charts, in my opinion, that make the trade.

SAFM has enjoyed a strong, stable bullish channel for the past year or so. It has outperformed the broader market, rising 48% in the past year versus 22% for the S&P 500, and also trades with less volatility than the index with a beta of 0.05.

There is a small double-top formation just below the $98 level that may serve as some near-term resistance, but if the broad market holds, I see SAFM taking out those old highs and quickly moving to new all-time highs in the $107 area.

SAFM Call Option Trade

Today, I am interested in buying the SAFM Nov 90 Calls for $12 or better. It is important to use a limit order with this trade as the bid/ask spreads tend to be wide.

Risk graph courtesy of tradeMONSTER.

This call option has a delta of 67, which means it will move roughly $0.67 for every dollar that SAFM moves, but it costs a fraction of the price of the stock.

The trade breaks even on expiration at $102 ($90 strike price plus $12 options premium), which is 5% above current prices.

I am looking for SAFM to move to at least $107, which should equate to roughly $17 in option premium, delivering a 42% profit.

Recommended Trade Setup:

— Buy Sanderson Farms (NASDAQ: SAFM) Nov 90 Calls at $12 or less
— Set stop-loss at $6
— Set initial price target at $17 for a potential 42% gain in three months

Jared Levy

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Source: Profitable Trading