What happened to Pilgrim's Pride (PPC)?

HoughtonAndAtkeson answered one year ago …

On Sept. 25, poultry producer Pilgrim's Pride (PPC) put out a press release that announced it expects "significant loss" for the fourth quarter. The company indicated, "The loss results from high feed-ingredient costs, continued weak pricing and demand for breast meat, and the significant negative impact of hedged grain positions in the quarter."

This time last week, PPC was trading at about $12 per share. By Friday's close, the stock had dropped to $3 and change -- the lowest price in the company's history.

A profit-margin squeeze in the chicken business doesn't explain a three-day, 71% drop stock price. So what's behind the stock's crash?

It turns out that "the company does not expect to be in compliance with its fixed-charge coverage ratio covenant for the fiscal year ending Sept. 27."

Essentially, Pilgrim's Pride is at risk of going belly-up because it's not able to fund its short-term working capital requirements.

In a credit boom, lenders would waive the debt covenants. Today, in this volatile, cash-strapped market, it's an opportunity for the lenders to get their money back.

We can explain it better with an example that also shines some light on the murky credit-default-swap (CDS) market, which emerged about 10 years ago as a way to trade put options on debt.

Originally, the CDS market was meant to be an insurance program for lenders. For example, if we loaned Pilgrim's Pride a million dollars, we could go to an insurance company such as American International Group (AIG) and pay a premium of about $3,000 a year to protect our principal.

If Pilgrim's Pride defaulted, then AIG would pay our million back to us, much in the way an insurance company would pay you for your property if it's destroyed by fire.

In 2005, large hedge funds realized they could buy credit-default swaps for low premiums and, if the companies defaulted, receive large amounts of cash. These hedge funds didn't originate a loan and seek to buy insurance; they simply bought a CDS.

Essentially, they had a put on the debt of a company.

If the company did well, the hedge fund would lose its premium paid. If the company did badly, then they would receive a ridiculous amount of money.

Even if the company didn't go under, the price paid for the debt insurance policy would rise (i.e., the spread would widen) and they could sell their policy (CDS) for a profit.

Ten years ago, the CDS market was about $1 trillion. Today, it is about $72 trillion in notional dollars (though the accounting has some complexities). It is all off-balance-sheet. It is not regulated. It is much bigger than the total debt load of the United States that is on-balance-sheet.

So what does this have to do with Pilgrim Pride's slide?

U.S. companies -- run-of-the-mill, S&P 500 (SPX) non-financial-sector companies -- use short-term debt to fund their daily operations, which usually carries terms of 90 days or less.

In the case of Pilgrim's Pride, it is used to buy chicken feed, payroll, office supplies and other items that the company consumes on a regular and short-term basis to operate.

This short term debt (working capital) comes from money-market funds. Money-market funds have been able to offer investors slightly higher yields than Treasuries because they primarily buy short-term corporate debt.

Because the companies are large, have been around for years and the debt is short-term, money markets have been considered very safe … until recently.

Two weeks ago, the U.S. government made a bet. It decided to let Lehman Brothers go out of business without government interference. The lenders to Lehman, including money-market funds, got hammered on their Lehman debt holdings. Since then, about a half-trillion dollars have been pulled out of money-market funds and put into short-term Treasuries.

With money market accounts losing funds at such a rapid rate, U.S. corporations are finding it increasingly difficult to fund their short-term capital needs.

For PPC, that means:

* No short-term lending = no chicken feed.
* No chicken feed = no chickens.
* No chickens = no chicken jobs and higher prices for remaining chickens at the store.
* No jobs and higher food prices = harder to pay the mortgage on the overpriced house that is underwater.

You get the idea -- weakening trends in employment, housing, mortgage-backed securities, credit cards, auto loans, etc.

Unfortunately, Pilgrim's Pride is in good company with other names like Ingersoll-Rand (IR), Deere (DE) and Eaton Corp (ETN), all of which closed at 52-week lows recently.

The stock is up today because it reached an agreement with its lenders to waive the terms … for now anyway. It will be interesting to watch how PPC navigates this in the long term.