Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Smithfield Foods Inc. (NYSE:SFD)

F2Q12 Earnings Call

December 8, 2011 9:00 am ET

Executives

Larry Pope – President, Chief Executive Officer

Bo Manly – Chief Financial Officer

Keira Lombardo – Vice President, Investor Relations, Corporate Communications

Analysts

Jeff Farmer – Jefferies & Co.

Christine McCracken – Cleveland Research

Ryan Oksenhendler – Bank of America Merrill Lynch

Diane Geissler – Credit Agricole

Tim Ramey – D.A. Davidson

Christina McGlone – Deutsche Bank

Farha Aslam – Stephens Inc.

Will Sire (phon) – Credit Suisse

Lindsay Drucker Mann – Goldman Sachs

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Smithfield Foods Fiscal 2012 Second Quarter Earnings call. Throughout the conference, all participants are in a listen-only mode. There will be an opportunity for your questions. Instructions will be given at that time. As a reminder, today’s call is being recorded.

With that being said, I’ll turn the conference now to Ms. Keira Lombardo. Please go ahead.

Keira Lombardo

Thank you. Good morning. Welcome to the conference call to discuss Smithfield Foods’ fiscal 2012 second quarter results. We would like to caution you that in today’s call there may be forward-looking statements within the meaning of federal securities laws. In light of the risks and uncertainties involved, we encourage you to read the forward-looking information section of the Company’s 10-K for fiscal year 2011. You can access the 10-K and our press release on our website at smithfieldfoods.com.

On our call today are Larry Pope, President and Chief Executive Officer; and Bo Manly, Chief Financial Officer. This is Keira Lombardo, Vice President of Investor Relations. Larry will begin our call this morning with a review of operations, followed by Bo who will review the Company’s financial results. Then Larry will provide our outlook for the future, after which the line will be opened for questions.

Larry?

Larry Pope

Thank you very much, Keira, and good morning ladies and gentlemen. Thank you to our second quarter call. I’m pleased to report another very strong quarter for the Company. We are following five straight record quarters. Unfortunately, I don’t have the luxury of telling you this is the sixth straight quarter. I guess the comparables that I’m up against are getting to be pretty significant at that point, but it is still the Company’s third-best quarter ever; we’re just comparing against last year’s second quarter, which was one of the two prior best quarters the Company has ever had.

We are reporting this morning $121 million in net income for the quarter or $0.74 a share. That compares last year to $0.80 a share on an adjusted basis, reporting $144 million, but adjusted that’s $0.80 a share so we are just a little shy of last year’s exceptionally good second quarter. On a year-to-date basis, we’re reporting lower at $1.23 versus $1.32, but I remind you – and Bo will speak to this more fully – that we had a fairly significant charge of about $0.14 a share in the first quarter related to a litigation charge that we took in Missouri litigation. So adjusting for that, we are on a year-to-date basis above last year, which I remind you was a record year for the Company.

The business is in excellent shape, both the fresh pork business and the packaged meats business. I am pleased on many fronts of this business. I’m going to speak fairly briefly about the hog production side of the business and the international, and then I’m going to make most of my comments related to the fresh and particularly our packaged meats business that I am very, very pleased with.

On the hog production side of the business, we reported a very solid quarter. We continued to face high price corn, although we do have high priced live hogs so that’s covering that and giving us the opportunity to make a little money on the live production side of the business. We do continue to see some high cost, although all of you are aware of what’s happening to the corn market out there and so there is a little bit of light at the end of this tunnel, and we are seeing the future in live production better than we had previously. Those of you who have followed us, Bo and I, as we’ve been around the country, we’ve been communicating that to you; and Bo, again, will speak to that more fully.

As well, we’ve got our cost improvement program that is now deep into its second year, and we are seeing the benefits of that show up in our live production costs. That’s still a full year away from having its full benefit, and so that’s still to come as we go forward.

The international side – I like to tell people Europe’s a mess, and our international business suffers as a result of that, although I think we’ve got some bright spots. I’ll let Bo speak to those. We’re not nearly satisfied with the performance of what’s going on, particularly our European businesses; but I think we are taking steps and I think we are positioning ourselves so when the European market does straighten itself out, our businesses will be in good shape to take advantage of that.

What I want to turn my comments this morning to on a more fully basis is what I think is going on inside the pork group. I am just over-the-top pleased with how good a job the management team is doing in this segment of the business, even in spite of a high live hog price which adversely impacts – for those of you who follow the industry – the cut-out and what we’re doing from a sales margin standpoint on the fresh pork side of the business as well as the margins we’re continuing to achieve on the packaged meat side of the business and the growth that we’re able to achieve in spite of higher priced raw materials and in spite of the fact that many of the categories we routinely compete in are not growing.

George Richter and his team, he has put together one heck of a good team. I am extremely proud of this management team. We continue to reinforce that and I’ll talk about that and marketing in a minute; but we have an exceptionally good management team in place who are highly focused on what they’re doing and it is showing up every day in the results this company is delivering. This is part of the five-year plan that I’ve been talking about for year after year after year. On a year-to-date basis, the cut-out, which is—I think most of you know how the cut-out is calculated that follow the industry. That’s down pretty significantly; however, our sales margins in terms of what we make relative to the market is up very nicely, so our sales organization on fresh pork is delivering every day better margins to this business.

I would be remiss if I didn’t point out the benefit that these exports markets are affording this fresh pork business. We are seeing both our business outpace the industry in spite of the industry’s very strong growth. I think for the quarter, we calculate that the industry is up about 24% year-over-year on the export markets, and we’re up even more than that. In fact, for our quarter, our export business represents more than 30% of our fresh pork sales, and as I have reminded you on many occasions, our export business is a margin improvement business. We don’t use that as a place to get rid of excess capacity. We use the export markets only when we’re able to value-add as a result of that. Our export and international group, which is headed up by Joe Luter IV, is doing an excellent job of going beyond just the trading business to building customer relationships on the other side of the trade. This is helping us both in Asia and in North America. We are seeing growth and relationship growth that we are extremely pleased with.

I know you all focus on what’s going on in Asia and believe that’s driving—and particularly China, driving all of this export business. I’m here to report to you this morning that is not totally the case. We’ve got nice growth, very nice growth in countries outside of China. When we saw the tariffs come down in Korea short-term this summer, our business in that country, as many in the industry saw, went up dramatically. That shows to us and demonstrates to us the opportunity that we have as the Korean free trade agreement continues to come into effect and these trade barriers are reduced. One thing that this company and this industry can do is we can compete very well in the international markets as we’re given the opportunity to do so, and that is certainly having a big impact on the profitability in the fresh pork part of this business. I’ll talk about my outlook and where I see that going forward, but yes, the exports are part of this profitability. We’re well above what we call normalized margins in fresh pork and that looks to be the case going forward.

On the packaged meat side, that again—this seems to the recurring story quarter after quarter after quarter, and I hope it will continue to be the recurring story quarter after quarter as we go forward. I’m pleased to report for the first time in quite some time, I’m reporting increased volume, and although that volume is only 1% growth overall, that’s not the story. The story is the improvements that we’re making on our branded business. Our brand and our core brands are up 5%. In many cases, the categories we compete in are not growing or are down. Our retail in several of our major brands are up double-digit increases in volumes, and this is our Smithfield and our Farmland brand, our Armor brand, our Curly’s brands. Our retail business is doing extremely well. It is being offset to some degree by some weakness in the food service side of the business. I have reported to you in the last quarter that I thought food service was coming back. We continue to see some weakness even as we came deeper into the second quarter. Our food service business – and I think others are reporting as well – that the food service business is not as strong, and that is adversely impacting our overall volume. However, the business where we’re focusing the marketing efforts is growing and has a significant impact on the bottom line.

I want to talk about for just a minute where we’ve been in terms of how we’re getting where we are today. This has been part of a five-year journey to get here. We started realizing that one of the things we had to do five years ago was get this organization right, and what we did was talk about how we ought to be structured and we reduced the IOCs down from the significant number we had in the past down to three major IOCs, and that’s what we have today. That’s sharpening the organizational structure. We then created the management team around that, headed up by George Richter, who has lots of experience, and the IOC presidents we’ve got in place, I wouldn’t add up the years because I don’t want to embarrass them with how big the number would be. But I assure you there is an enormous amount of experience now at the IOC in terms of the management team. We had to get the management team right.

Then we had to get our cost structure right, so what we did is close seven plants between processing plants and a fresh meat plant. We’ve done that. We had to get the compensation plan straight. We changed the compensation plan for our management team to tie all of this management team to the total of the core pork group profitability instead of their individual IOCs. Then we had to get the brands right, and we sat down and made an intelligent look at the brands that we had and rationalized our brands from 100 brands down to the 12 brands that we were going to focus on.

Then we had to get our marketing straight because we’ve had diverse marketing plans and decided that we’re going to determine a strategic approach to how we’re going to market around those 12 brands and we’re going to move our emphasis and marketing to go forward to the consumer and look back, as opposed to looking from the manufacturing side and push it forward. You will see some of the marketing programs that we’ve had that that’s happened. We are now going out with consumer-focused marketing and that, aligned with the arrangements we’re having by talking directly to our customer and having customer focused marketing, one, helps them drive our business. It’s making these brands move.

We also realized that we had to create a new product pipeline. I sat last week in a marketing—in a full-day marketing session. It was only supposed to last an hour and a half. This organization was going to show me that they had new products in the pipeline, and for the first time I’m hearing this organization talk about pipeline. And that meeting didn’t go for an hour and a half. That meeting went for nearly six hours of us sitting there, going from one product to the next product. I am impressed with the people that we are putting on board in this company. We didn’t have the full complement of marketing talent that we needed to execute these marketing strategies, so we’ve gone out and go marketing talent. We have some good talent in the Armor Eckrich business that we acquired through the ConAgra purchase a couple years ago, but we needed to strengthen the talent of our Farmland and Smithfield organizations. We’ve brought in some very strong talent from outside this industry, and particularly outside this company, and we’re taking advantage of that. We’re learning some things from other industries to teach us how to do this business.

I’ve got to remind all of you that we live in a pretty tough neighborhood. We don’t live in the cracker, candy and cookie neighborhoods where everything is plush and the lawns are green. We live in the meat district. Our competition is tough. Our competition has good cost structures. Our competition knows how to play the game. Smithfield, from a marketing standpoint, has not been able to be rough and tough with the organization; but guess what? We’re sending ourselves to school. We’re learning this stuff, and I think our competition sees that we can compete with them in a very serious and very real way, and we’re in a position where we’ve got good brands priced at the right price for this marketplace. We’re not trying to be the highest priced guy in the grocery store. We’re trying to be the guy who sells to the everyday consumer. We think we’ve got the brands that are priced right for our consumers, and we understand now how to talk to our customers and the consumer and we realized that we’ve got to deliver innovative products and we’ve got to have a competitive cost structure.

We’ve done most of this. I’m pleased to announce that this quarter we announced that we’re breaking ground on a new hot dog and lunch meat plant in North Carolina. It’s going to be state-of-the-art. It will be the first quarter of calendar 2013 that hot dog plant will be in place, and I suggest to you that it’s going to be a very, very well positioned plant, both close to the raw materials and from an innovative standpoint. We’ve got capacity and we’re going to be in a position to lower the cost of producing those products pretty dramatically.

So this gives me an enormous amount of confidence in terms of where we’re going. We are shortly going to be announcing formally that we have built a new innovation center in Smithfield, Virginia. It’s not some Taj Mahal. We don’t have big, big money invested in this. We took a smaller plant, renovated it, built an innovation center around, but it’s the foundation for us. We’re going to walk into this thing. We are getting the talent around us, and the one thing I’ll commit to you is that you won’t hear me complaining about the fact that we’re spending more marketing dollars and that’s not why we’re getting the margins. Our people understand they’ve got to do the marketing and still get the margins. They cannot let margins suffer. Our packaged meat business is still delivering in the normalized range in spite of dramatically higher raw material costs in a tough neighborhood. We are still continuing to deliver quarter after quarter after quarter very solid margins, and our innovations are not just in packaged meats. We’ve got some good products and some new products that will be packaging and new seasonings that are coming out on the fresh meat side. Our marinated fresh pork program, which we count in fresh pork, not packaged meats, is doing extremely well. This is nice product, consumer oriented, consumer ready product that has a lot of potential for further growth and enhancement in that side of the business that so oftentimes we all forget about the fresh meat side of the business.

So I am excited. I hope you see that said that we are targeting a 3% growth in our overall packaged meats for the year. We’re only up slightly here at this point. We’ve got some digging to do as we get through the last six months of the year. We are working on it. I think we’ve got a lot of things coming. It may be—we may not make the number, I don’t know; but I can tell you this organization is truly focused on that and it is showing up in the bottom line in categories like bacon and ham and sausage, right in our strike zone. For those of you who saw us on the road, Bo and I, we showed you some categories. We are dramatically outpacing – dramatically outpacing – the industry and the category, and some product categories like bacon, which is sort of a basic product, our new products like PouchPack bacon is a whole new innovative product, but it’s just bacon, for goodness sake! But customers have recognized Smithfield is presenting them something different. We’re getting much closer to the customers. Customers want to talk to us. We’re helping them plan their buy. Our hedging and risk management group is helping our customers. We’re telling them when to buy the product, when is the best time, and they appreciate that. And we got the raw material. People understand that we got the product. We’ve got traceable programs. It’s helping us internationally when the opportunity affords itself for opportunities in China, as an example. We’re the people to get the business.

This is a good time to be the CEO of this company. All the things we’ve done these last several years are now beginning to really show up on the P&L. I hope you get a little bit of my excitement coming through because I’m very pleased with this quarter. But before I give you my outlook, I want Bo to put a little color on the production and the international and the balance sheet and such, and then I’ll speak to the outlook after you, Bo. Thank you.

Bo Manly

Thank you, Larry. Good morning everybody and seasons greetings. I’m extremely satisfied to report second quarter net income of $121 million compared to the record 144 million in the same quarter last year, generating an EPS of $0.74 and $0.86 in respective quarters. While our results are slightly below last year, they are significantly better than our next best second quarter results by a wide margin.

Net income for the first six months of this year was 203 million, down from the record of 220 last year; however, our results show strong and consistent performance in our key segments – fresh pork, packaged meats, and hog production. When the second quarter GAAP EPS is adjusted for a $6 million or $0.02 early debt extinguishment charge, non-GAAP EPS is $0.76 compared to a previously reported adjusted EPS of $0.80 in Q2 a year ago. Similarly, if six-month GAAP earnings are adjusted for the first quarter’s $39 million Missouri litigation charge, our first six months’ adjusted non-GAAP earnings exceed last year’s record results too.

We are pleased with our financial performance across several fronts. Fresh pork results, while down from record levels a year ago, remain above its normalized range. Robust exports bode well for continued strong fresh pork results. Packaged meats contributed results in their normalized range in spite of higher raw material costs. We’re excited by the growth in packaged meats tonnage, particularly in our core brands of 5% despite headwinds faced in many packaged meats categories.

Hog production demonstrated continued results in the normalized range. Raising costs are coming down, reflecting lower cash grain costs. This has improved our outlook for hog production results in the second half of the year. This is an improved scenario compared to what I described in our Q1 earnings call. We anticipate costs to continue to decline modestly into fiscal 2013.

While international earnings are down compared to a year ago, the results are improved in all principal segments against (inaudible) performance in Q1. We are optimistic that lower grain costs and higher meat values will improve European hog production results and when combined with modest improvements in meat operations should lift segment performance in the second half of the year.

We’re very pleased that the EU commission this week approved export capabilities enabling our Romanian integrated pork operation to export to other EU countries and in effect access to all other world markets. This is the biggest event in the seven-year history of our Romanian investment. The worldwide pork market is sufficiently efficient that it’s nearly impossible to compete if you do not have access to work markets.

Sales for the quarter were 3.3 billion, up 10% compared to the prior year. Revenues benefited from higher average selling prices across all segments. Pork segment sales benefited from an export-driven 3% fresh meat volume growth. Core brand packaged meats tonnage increased 5% while overall packaged meats volume grew 1%. Hog production sales grew due to hog price averaging 20% higher than a year ago, offsetting lower volume due to sales of non-integrated hog farm operations last January.

Gross profit margins for the second quarter and the first half were 12.7% and 12.9% respectively. These are down from historically high levels in the prior year, particularly in the second quarter of last year when lower meat values helped both fresh pork and packaged meats to contribute record results. Lower international gross margins in Q2 reflect overall market pressures in Europe as well.

For many of the same reasons, consolidated operating profit in the second quarter declined to 7% from 9% compared to a year ago. Six months year-over-year operating profits declined 58 million while domestic results for the first six months were comparable. The shortfall is almost entirely lower international profits.

Pork segment results for the second quarter compared to a year ago declined 18 million principally due to lower per-head profits in the fresh pork segment. Despite this dip, fresh pork margins remain above the norm with solid export demand that should continue.

Total packaged meat segment profits were strong and comparable to last year with volume increases offsetting a $0.01 per pound lower packaged meat profit level. Ham and belly and trimming prices remained near record levels, putting pressure on margins. In spite of this, our consolidated core brand sales strategy demonstrates our brands can pass on increased raw material costs.

On a trailing 12-month basis, our packaged meats cost of goods sold increased at a double-digit pace. We were successful in raising our selling prices to recover over 90% of these cost increases and additional map spending. Hog production operating profits were 64 million in the second quarter, a decline of 14 million compared to a year ago. Hog production profits per head of $16 are down for the quarter from last year’s $18 but remain well in the normalized range. Hog raising costs for the year peaked in the second quarter at $64.46 per live hundredweight, driven 20% higher by elevated grain costs compared to a year ago. We expect raising costs to remain near these levels in the mid-60s for the balance of the year, moving lower into the next fiscal year. Profitability will trend lower in the third quarter and rebound in Q4. We expect full-year results at the high end of the normalized range.

International segment operating profits for the second quarter were $17 million, down significantly from a year ago but showing improvement from no profit in the first fiscal quarter. Animex earnings show growth since Q1 and higher hog prices and moderating grain prices have helped those farm profits in Poland and Romania. Our cautious expectation is now for the international segment profit to move in the lower half of the normalized range for the full year.

Income from affiliates declined compared to a year ago due to lower earnings in Campofrio and lower profits in our Mexican joint ventures due to higher corn prices and lower peso valuation. These conditions are likely to persist for the balance of this fiscal year. At the present time, we do not have any negative impact on our international enterprises, joint ventures or day-to-day operations at Campofrio as a result of European debt issues, real or perceived. We do not anticipate any significant future impact but we continuously monitor this issue.

SG&A expenses increased 28 million quarter-over-quarter or 16%. This increase was principally due to the impact of the Missouri farm litigation and 9% increase in marketing, advertising and promotion. We anticipate the rate of map spending for the full year will exceed last year’s map expenses by over 10%.

Interest expense declined 33%, reflecting dramatically lower total borrowings and more favorable borrowing costs. Quarterly interest expense near term will likely remain in the $45 million range.

The tax rate for the second quarter was 31%. We continue to expect full-year effective tax to be between 32 and 34%. Depreciation for the quarter was $60 million. We anticipate full-year depreciation to be around 250 million. Full-year CAPEX are estimated to be approximately 300 million, exceeding depreciation as well as last year’s spending rate as we invest strong cash flow in building our packaged meats capabilities and other internal opportunities.

Smithfield Packing Company announced last month construction of the state-of-the-art hot dog and lunchmeat facility. This $85 million plant will be located adjacent to our present North Carolina cooked meat facility. The new operation will create 200 jobs, lower costs with highly efficient operations, and increase packaged meats capacity. This new operation will necessitate the closure of the Company’s Portsmouth, Virginia facility.

We ended the second quarter with 1.1 billion in liquidity, including $136 million in cash. We’ve used cash flow in the first six months of this fiscal year to continue to improve the balance sheet and invest in opportunities to create shareholder value. We bought back 4 million shares in the second quarter, bringing our year-to-date total repurchases to 5.5 million shares, over 3% of outstanding. We have approximately $139 million remaining in stock purchase authorization. The number of shares outstanding at the end of Q2 was approximately 161 million shares.

During the second quarter, we bought 37 million of our 2014 10% secured bonds. These Q2 purchases resulted in a $6 million early extinguishment charge. Strong earnings and cash flow in this fiscal year on top of record results last year have continued to demonstrate our solid credit metrics. Net debt to capitalization ticked up 200 basis points in the second quarter to 37% due to the purchase of shares and investment of idle cash.

Twelve months trailing debt to EBITDA ratio clocked in at 1.8 to 1. EBIT to interest coverage rose to 6.0 to 1. The strength of these improved credit metrics have been recognized by the rating agencies. S&P upgraded Smithfield’s corporate rating in October one notch to BB- following upgrades by Moody’s in August. This is the second upgrade by both rating agencies in the last 12 months.

We do not have any domestic debt repayment requirements until May of 2013. We had a draw of 150 million on our short-term lines at the end of Q2 to help seasonally working capital needs. This has since been repaid. We anticipate healthy cash flow for the balance of the year. We intend to invest in sustainably growing our business segments while investing in our core brands. We will continue to entertain stock repurchases and bonds if available at attractive prices.

In conclusion, we have completed a very strong second quarter and first half of fiscal 2012. Industry fundamentals remain strong. We are very pleased with the profitability growth in our core brands. We anticipate packaged meats will continue to perform at its normalized range with expectations of stronger volume growth in the second half of the year. We expect fresh pork will continue to deliver margins above its normalized range on the strength of continued robust exports. We believe a comfortable balance domestically between restrained supply of pork and other proteins coupled with healthy exports is supportive of hog production results remaining in the normalized range for the coming quarters. Hog prices have drifted lower in recent weeks. As a result, hog raising costs will be modestly lower moving into our next fiscal year. International results have begun to pick themselves up off the floor and we anticipate returning international segment performance to its normalized range by the end of this fiscal year. Our marketing programs are improving our consistent value of our brands. Our cost reduction programs in fresh and package meats, hog production, and balance sheet improvements continue to create shareholder value as well.

Fiscal 2012 will be a very strong year for Smithfield. We are optimistic about industry fundamentals and our performance outlook for the next fiscal year as well.

Thank you very much for your time and attention. Please buy holiday ham – maybe two – and have a safe and happy holiday. Now, back to Larry.

Larry Pope

Thank you, Bo. I think that’s a good report. Before we take questions, I think the outlook is pretty good. We think the second half of the year is going to be pretty good for the Company. We think we’re positioned well. We’ve got some hedge positions in place that we think protect us. We may not get the full benefit as we’ve discussed a number of times. We have taken forward positions, so if corn drops dramatically we won’t get the full benefit of that drop, but we do see this as an opportunity to continue to hedge forward and protect our hog production side of the business, because we are focused on this package meats business. This management team is nowhere near satisfied with where we’re at, and in fact I would say we’re not just focused on the future and focused on improvements, but I would tell you we are obsessed with it. We have more opportunity in both fresh pork and in packaged meats than our competitors do. We look at our numbers compared to others at a detailed level, and I can tell you that we see opportunities that are continuing to be enormous for us. This management team is going to look forward to look at our customers and back.

If you took the opportunity yesterday, you would note that we updated our website to indicate that we were 30% converted on our farms from crate gestation to pen gestation, and we have reinstated our position that we will have our farms—all of our company’s farms converted from crate gestation to pen gestation by 2017, which was our original conversion date, in spite of the fact that we took a two-year holiday in order to deal with the downturn in 2008 and ’09. That’s related to our customers. They want us to do that and we’ve heard them loud and clear. This company is going to do what’s in the best interest of the business and in the best interest of our customers, and we think we are doing that. And so we think the future for us is really pretty good. The exports look excellent. The U.S. dollar looks like its going to continue to be in a position to yield benefits in terms of pricing on the export markets, and the fact that we can ship chilled product into Asia gives us an advantage over the European markets. And the relationships we’re building should sustain us in some of this export business even as the opportunistic sales go away.

I am upbeat. I am excited, and I think there’s a bright future here. With that, Keira, we’d welcome some questions.

Keira Lombardo

Thank you, Larry. In order to provide the opportunity to as many analysts as possible to ask questions, we request that you ask only one question. If you have another question, please get back in the queue. Operator, please open the lines.

Question and Answer Session

Operator

Certainly. Ladies and gentlemen, if you would like to ask a question today, please press the star then one. You’ll hear a tone indicating you’ve been placed in the queue. Again, star, one if you have a question.

First we go to Jeff Farmer with Jefferies & Company. Please go ahead.

Jeff Farmer – Jefferies & Co.

Great. Thank you and good morning.

Larry Pope

Good morning, Jeff.

Jeff Farmer – Jefferies & Co.

Just looking for some color on the Asian export countries, specifically where South Korea and China are in their own hog production cycles, and I guess more specifically, does that even matter in terms of seeing continued export strength moving forward?

Larry Pope

Yeah, I don’t think there’s any question that we compete against the domestic markets, so when those markets are strong the exports aren’t as robust, and your guess on where China is is as good as mine and anyone else on this call. I think that the Chinese issue is a longer term issue, but I think they will be forced to make export buys. South Korea’s has been hit this summer and we’ll see how much of that returns back, but the Korean free trade agreement will be taking effect at the same time, so that combined with Japan, which is also very strong, I think those export markets, we’re probably getting a little bit of a bubble here. But even the midterm, I think, is pretty solid for all those countries.

Bo, you have any impact on that?

Bo Manly

I think historically we’ve seen when, I’ll call them fringe countries in the production area, those that don’t have surpluses of corn when they’ve got to be buying corn on the open markets – when they’ve had difficulties health-wise and their industries have shrunk, they rarely come back to their original levels. I guess Taiwan would be probably the best example and you probably have some examples in the Japanese area as well, that they typically don’t come back if they’re not truly competitive in the world markets.

Larry Pope

Thank you, Jeff.

Operator

And we’ll go to Christine McCracken with Cleveland Research. Please go ahead.

Christine McCracken – Cleveland Research

Good morning.

Larry Pope

Good morning, Christine.

Christine McCracken – Cleveland Research

Just on your positions, I know it’s a sensitive area for you, but in the past and today you talked about your free cash position may be limiting some of the downside—or sorry, some of the upside should free cash drop. Historically you’ve said that you were more optimistic on the hog markets so you had stayed out that market in terms of selling your hogs forward. I’m just curious – as you see the markets have been really strong for next summer, why wouldn’t you have locked in production margins for the balance of the year at what I’d consider above historical levels?

Larry Pope

I didn’t say we hadn’t, Christine. I didn’t say that. I said we said the last call that we were leaving ourselves open for a fair amount of our live—you know, for the hog price, and we as well have recognized that live hog market has moved up. There could still be some upward movement there, but I would tell you that we have taken advantage of some of that. So the thing I was making reference to is that these corn markets have come back. The assumption would be that the live production business has gotten substantially better. When you’ve got a good portion—a substantial portion of your corn already hedged, when the corn market comes down, it has not impact on your P&L because you’re already hedged. So that was the point I was making, is that it would appear that the raising costs were coming down. They were in large measure already locked in, so sort of irregardless of where the markets go, we’re pretty much where we’re going to be.

Christine McCracken – Cleveland Research

You haven’t said how far forward you’ve gone, right?

Larry Pope

No. As you know, there’s a lot more depth in the corn market than there is in the hog market, so we’re looking well into calendar 2012, if that’s your question.

Christine McCracken – Cleveland Research

Okay. I’ll jump back in the queue. Thanks.

Operator

We go to Ryan Oksenhendler with Bank of America Merrill Lynch. Please go ahead.

Ryan Oksenhendler – Bank of America Merrill Lynch

Good morning. I just had a question on packaged meats – can you talk about the sequential decline in margins? I know the cut-out was up a little bit quarter-over-quarter, but I thought you would have had—you had the pricing in place, and given the mix benefit that you had last quarter, I thought that would have continued into this quarter, looking at the Nielsen data. So can you talk about the sequential decline? And then also, could you just talk about—it sounds like you’re having a different conversation with your customers than you had maybe two or three years ago, and what—are you seeing more shelf space, are you seeing more space in the deli counter, and kind of what are the avenues for growth there?

Larry Pope

Ryan, the second quarter of the year is not—we’re on packaged meats, now. It is not a big quarter of the year. It is seasonally one of the worst quarters because there really isn’t much of a holiday out there for us. It’s not like we got Memorial Day and Fourth of July to build to. In the third quarter, we’ve got the holidays we’re in right now that help. So you’re in a lull in terms of where the packaged meats business is, so I wasn’t surprised at all that our margins dropped off. We’ve also got a situation where we’ve got these rising raw materials, but we’re still staying well above our $0.10 goal. And I think that when we come out with our third quarter results, you might see the impact of that business as it returns back in the third quarter, so I wouldn’t worry much about that.

From our customer standpoint, I could take the rest of the day and cut everybody else from our call, but our relationship with our customers, of which I went to see our top two customers on what I call top-to-top visits this quarter, and I was extremely pleased – extremely pleased – with the conversation we had with those customers, and I think our—we’re trying to be customer and consumer oriented. They do see the value that we’re bringing and I couldn’t understate the fact that Smithfield is in the slaughter business and the fact that we’ve got the raw material for these packaged meats, particularly on the food service side, is a valuable asset. You guys oftentimes question those who kill hogs and why they’re in that business because the margins haven’t been there. For 20 years, it’s been the best place to be is the person who was in the processing business that didn’t do the slaughter. Well, I think that’s changed to some degree, and the person that’s got the raw material now can give assured supply, and that’s working to our benefit. The fact that we’ve got traceability to go along with it is really helpful in terms of our discussions, so those conversations with our customers get better and better, and with the innovative products we’re bringing to the marketplace, we’re getting more than our fair share of new placements.

Ryan Oksenhendler – Bank of America Merrill Lynch

Thanks, guys.

Operator

And we’ll go to Diane Geissler with Credit Agricole. Please go ahead.

Diane Geissler – Credit Agricole

Good morning.

Larry Pope

Good morning, Diane.

Diane Geissler – Credit Agricole

I have a question on your raising costs. I think you said in the quarter they were 64 versus 54 pre-interest.

Bo Manly

Yes, that’s correct.

Diane Geissler – Credit Agricole

Could you tell me, do you see them—based on sort of your hedge position that you have currently, do you see them peaking in the second quarter, or will they be higher in the third quarter and then as those hedges roll off, and assuming corn stays sort of in the range we are today, it sort of rolls from there into fiscal ’13. Just kind of some commentary on when you see feed costs sort of peaking within your own P&L.

Bo Manly

Diane, I think you were correct, and I did state earlier that our costs did peak in the second quarter.

Diane Geissler – Credit Agricole

Okay.

Bo Manly

And we believe that they’re going to drift slightly lower from this mid-60s range. But we have made a change in our outlook. I think before we were looking for our cost actually to increase into the high 60s. We’re now believing that our cost short-term will be in the mid-60s and will drift lower as we move towards our next fiscal year.

Diane Geissler – Credit Agricole

Right. Well, certainly with the move we’ve seen in the market recently, the delta there is pretty meaningful. I guess I’m just thinking—you know, kind of the pushback I get on investors today with your stock and how the performance we’ve seen recently is kind of what’s the next catalyst? I mean, is fiscal ’13 going to be better than fiscal ’12 because that’s sort of kind of where investors are, especially as the export—as you put it, Larry, the opportunistic work that you’ve done in the export markets, as that maybe starts to wane in the second part of ’12—calendar ’12, should we look for lower grain to sort of give you guys the next leg up on earnings? Or do you see earnings peaking here and then moving lower?

Bo Manly

I don’t believe we’re peaking here and moving lower, Diane. I think that every indication that we have is that all of our major segments will be producing within their normalized range as we move into next year, and that certainly isn’t the case this year. As we look at areas like international, for example, that we’re below where we need to be and we’re hoping for improved performance in the back half of the year to bring ourselves up into that normalized range. So I don’t think we’ve peaked. I think we still have a lot of opportunity in front of us, particularly in the packaged meats area, and we look for normalized performance in our hog operations. I think if we continue to see exports move in the areas that we have this year, that it will probably be towards the higher end of the normalized range for fresh pork, consistent with where we are right now.

Larry Pope

Diane, I would tell you – if you look forward, I think chicken people are doing the cutbacks. We think there’s going to be a reduction in beef and beef production around the world. These economies are coming back a little bit, and so I think that part’s going to create a better demand—a demand curve for all proteins both domestically and internationally. And we’re seeing the growth in our packaged meats business – it’s just beginning to hit. So yeah, we might lose some of this opportunistic export, but I think the business is going to be very solid. I’m very optimistic, is the best word I could use. We don’t make predictions and this is a volatile business, but I tell you what – the fundamentals here are pretty darn good when I see the protein industry shrinking and I don’t see much expansion on the near term in terms of live hog expansion, so that should create a good environment for the business. And what I see coming from our sales and marketing side on the packaged meat side is very exciting, both that as well as what I think we’re doing on the fresh meat side with new innovative fresh meat products. I think it’s solid.

Diane Geissler – Credit Agricole

Okay. Well great, thank you so much for the commentary.

Operator

And we’ll go to Tim Ramey with D.A. Davidson. Please go ahead.

Tim Ramey – D.A. Davidson

Morning, thanks. Larry, any suggestion you should switch to decaf, I think should be ignored. We like your energy on the call this morning.

Larry Pope

Yeah, I only drink decaf. My wife will not allow me to drink caffeinated coffee!

Bo Manly

Tim, it’s the three donuts!

Tim Ramey- D.A. Davidson

With a side of bacon, I’m sure.

Larry Pope

That’s what the hole’s for.

Tim Ramey –D.A. Davidson

Yeah. The pork exports above 30%, we wrote in our note that we thought it could get there. I didn’t think it could get there in one quarter. You’ve made the statement that that was somewhat opportunistic. Do you think it can kind of hold in that level, or can it move higher? I mean, we haven’t really seen the impact of the Korean thing in the 2Q, so where are we at there? Is this a level that probably drifts back to the 25% level?

Larry Pope

Tim, I want to correct you a bit. You have seen a little bit of this Korea thing. Korea did some temporary tariff reductions and that had an instantaneous impact on the business. Our business in Korea shot up dramatically as a result of that. I think that’s a more realistic point, that 25% is probably where we are internally thinking. But I will tell you – we continue to be up-surprised on this export by the new markets that just keep showing up. I think of—we’ve got some sizeable business north of the border in the United States. I mean, we don’t think of Canada as much of an export market for this industry. It’s becoming a nice export market for us, and it’s not just a trader business with raw material – this is in-place customer relationship business with retails, fresh and process meats. So that’s an export market that few people even talk very much about. We all focus on what’s going on in Asia, but Asia isn’t the only market. And so there is no question we’ve gotten some business, and a lot of you know the business I’m talking about. How long that is going to continue to be with us, I don’t know. It’s certainly not something you can depend on, but the other markets—I mean, some of our relationships in Japan are just excellent. There’s just no way to say anything other than that.

But I think your estimation in that 25 percentage range is probably more realistic. I’d say that.

Tim Ramey – D.A. Davidson

Okay, thank you.

Operator

And we’ll go to Christina McGlone with Deutsche Bank. Please go ahead.

Christina McGlone – Deutsche Bank

Hi, good morning. Bo, do you think you could—can you explain again, you were talking about international and you were talking about the fact that I guess the EU has now approved Romanian hogs into the EU, and what you were saying about worldwide. Does that—I know that’s something you’ve been waiting for for a while, so does that—can you explain how it changes international, the dynamics there? And would that have the potential to raise that normalized profitability range that you’ve talked about?

Bo Manly

We’ve yet to export our first pound, so we hope that that will come perhaps within the next 30 days, and that will truly be the tale of the tape. Let me just say that if you look at international pricing, you’ve got as much as $10 a hundredweight different carcass value between Hungary and Romania, and our plant is only 40 miles from the Hungarian border. So you can tell just the differences there in a market that is capable of exporting and reflecting world markets. Unfortunately, when you have a closed border, it’s difficult to reflect world markets. So there’s a tremendous potential there in offal and in red meat cuts. There’s no reason why Romania shouldn’t enjoy the same advantages in Asia that all of our other operations do on the export front, all the other European countries do as well. So it’s really putting them into the same category as the other European countries in terms of their export capabilities throughout the world, and it will make a big difference both in the EU and in the international export markets.

Larry Pope

Christina, to further on Bo, the opportunity there is to improve the P&L in Romania by some $20 million. It’s not going to change the world, but it will change the world for Romania. That business should change to the extent that we can access it, and we’ve got to do that. It’s a $20 million P&L pickup there on an annual basis.

Bo Manly

I think it’s even a bigger opportunity than what Larry described because it means that we can now grow the business, which we really didn’t feel comfortable doing before until we got this leg under the table. And it also gives us much greater opportunities in terms of the packaged meat side of the business. At the moment, no processed meat operators in Romania can buy Romanian meat because they can’t export their products outside the country, so we’ve been cut off from our own industries inside the country because of the quirks of the European regulations. So opportunities abound for us there, and it will allow us to go back to our original investment thesis there.

Christina McGlone – Deutsche Bank

Okay, thanks. And just a follow-up – can you talk about what’s going on in European hog supply, the fact that I think they’ve been losing money for a couple of years and now have—facing environmental regulations. Do you think we’re going to see the European herd continue to shrink?

Bo Manly

All indications are that for the fundamental reasons you described that it will continue to shrink. They have been going through some very, very high priced corn. They have had welfare legislation that’s now coming to bear on our industry, which is causing certain farmers to rethink whether they want to stay in the business. There has been some indication, though, that the cheaper corn that we now have could spur some growth as they move down the road; but frankly, you’re probably 18 months, 24 months from that production reaching the marketplace. So if they do see more optimism, then I think you may start to see that here in this country in the coming months as well – people starting to put some plans back up on the table. We don’t see any yet, but it’s hard to believe that economics won’t cause that to happen. But I don’t think you’re going to see any increase in the European volume probably for 18 to 24 months.

Larry Pope

And Christina, one of the things I would say is that the United States, given the cheap corn and the fact that we can sell chilled pork versus frozen pork, we have an advantage over Europe. There is a significant difference between the valuation of fresh versus frozen in that part of the world and a continuing demand to be more chilled versus frozen, and so the big opportunity – big opportunity – on a sustained basis for us is to ship chilled pork into those Asian markets, which we can do. We have to deal with some of the import issues about getting across the border. We have the ability and we ship chilled pork to Japan all the time – the industry does. We can ship it to Korea, we can ship it to China as well, and those have enormous potential on a longer term basis, and Europe will never be able to do that.

Christina McGlone – Deutsche Bank

Great, thank you.

Operator

Our next question is from Farha Aslam from Stephens Incorporated. Please go ahead.

Farha Aslam – Stephens Inc.

Hi, good morning.

Larry Pope

Good morning.

Farha Aslam – Stephens Inc.

Larry, clearly this year, the first half has been very, very strong and you’re coming off a very strong 2011 where you made about $3 a share. Do you think 2012 can match 2011 in terms of earnings?

Larry Pope

That sounds a lot like you were asking me to make a projection!

Farha Aslam – Stephens Inc.

No, just some color!

Larry Pope

I’m sure that’s not what you meant.

Farha Aslam – Stephens Inc.

Never.

Larry Pope

Because we don’t give guidance. I’m sure that’s not what you were asking.

Farha Aslam – Stephens Inc.

Of course.

Larry Pope

All I can tell you, Farha, is that last year was a good year. This year is going to be another good year, and I wish I could tell you that I knew what the cut-out was going to be January 1. The fundamentals are strong and the business looks good. We are up against some pretty tough competition in this third and fourth quarter. We’ve got some good things on the plate, so hang on. How about that?

Farha Aslam – Stephens Inc.

Sounds good. And just one quick follow-up to Christine’s question – so you’ve pretty much locked in your hog profitability at or above the normalized range in hog production group for the rest of 2012?

Larry Pope

Bo, you want to take that?

Bo Manly

That’s correct.

Farha Aslam – Stephens Inc.

Great. Thank you very much.

Operator

And we go to Robert Moskow with Credit Suisse. Please go ahead.

Will Sire – Credit Suisse

Hey, good morning. This is Will Sire in for Rob. I wanted to ask a little bit about exports. Larry, you had a lot of positive comments today. In terms of the margin impact in your fresh business, obviously it was a benefit. Could you give us some color on what the incremental benefit was, at least in the quarter?

Larry Pope

Let me tell—was it Will? Did I get the name right?

Will Sire – Credit Suisse

Yeah, that’s right.

Larry Pope

Okay, Will. Will, all I’ll give you, which I think is enough, is that exports have a bigger impact on margin than the percentage increase in the business, and so it is a very significant—so let me just say this. If more than 30% of our business, our fresh pork business is exports, the bottom line margin is even more than that because it’s a margin enhancement plan. And so it’s a big piece. It’s a sizeable part of the business, and so it’s extremely important to us, and I hope that helps you.

Will Sire – Credit Suisse

Okay. And if I can ask a follow-up, also on exports – you know, with so much growth there, have you guys thought about making any investments in Asia or in the region specifically, whether it’s in the fresh or the packaged meat side?

Larry Pope

Well, the only thing I’d tell you, as Bo likes to tell people, for two years we didn’t answer the telephone. We were busy paying down debt and we weren’t answering the telephone. We certainly are outward looking at this point. That’s clearly a big part of the world for opportunity. I don’t think you’re going to see us do something stupid – how about that – in terms of any kind of an acquisition in that part of the world. I would lean towards dipping my toe in the water if the right situation presented itself. It’s a part of the world where were 50% of all the—well over 50% of the pork in the world is eaten in Asia, and so it’s an area where Smithfield probably needs to be longer term, and if you look back 10 years – and I said that two years ago – if you look forward 10 years and look back, we will be there. But I don’t feel any pressure to have to be there today. We are certainly talking to people, but from an investor standpoint, we’re not going to leverage the balance sheet and we’re not going to dilute our shareholders on the way to doing that. So if we do something, it will be in a very measured way and it will be to improve and maintain this business we’ve got coming out of the U.S. today.

Will Sire – Credit Suisse

Okay, thanks Larry.

Operator

And we’ll go to Lindsay Drucker Mann with Goldman Sachs. Please go ahead.

Lindsay Drucker Mann – Goldman Sachs

Thanks. Good morning everyone.

Larry Pope

Good morning.

Lindsay Drucker Mann – Goldman Sachs

Just two quick questions. First of all, I was hoping you could just talk a little bit more about the packaged meats facility that you’re building. Can you tell us what the net increase in upgrading capability that that gives you? I know you’re shuttering a piece of another plant, so overall how much more upgraded meat capability in terms of tonnage you’ll have? And beyond just having more product to push through higher value channels, if there’s any other cost or other rationale, what other savings you expect or efficiencies you expect to incur from building this facility.

Larry Pope

That’s going to be somewhere in the 20 to 30 million pounds of increased, what we call sausage-based products there, so that will allow us to have a bigger hot dog footprint at very competitive prices. How about that?

Bo Manly

I would say, Larry, that that facility will be state-of-the-art and will probably replace production facilities that are probably two generations old, so it will be a substantial improvement in our efficiency and product capabilities there.

Larry Pope

Because this is a product category that’s come under a lot of pricing pressure and margins are tough in the hot dog business, and you need to be at this new technology. We’ve been putting this off for a while. It’s something we need to do and this will change the cost structure on this business in a pretty sizeable way. The other thing is from a food safety standpoint, there can’t be any better than this. I mean, no one ever touches the product so it’s a 100% food safety environment and our customers are appreciating that, that we can give them that kind of assurance, and we think that will help us as we go to market with that.

Bo Manly

At the same time, it’s not Star Wars technology. We use this in our operations in Europe, so we’re very familiar with it and we don’t see any operational issues.

Larry Pope

Yeah, (inaudible) has been running this technology for 20 years. It’s the new and improved, but it’s the same technology.

Lindsay Drucker Mann – Goldman Sachs

Okay. Is that 20 to 30 million net of the closures of other facilities?

Larry Pope

Yes.

Lindsay Drucker Mann – Goldman Sachs

Okay. And can you just square sort of how large the sausage-based product—you know, production capacity is in total in the U.S.? Like, how much incremental supply that would add?

Larry Pope

Why don’t I get Keira to call you? Keira, why don’t you do me a favor and call her after the call and give her—because it depends on product categories you put in there. Keira, why don’t you do that? Between you and Bo, why don’t you all get back to her?

Bo Manly

But it’s a very large category.

Larry Pope

Oh, it’s a small increase.

Bo Manly

Twenty of 30 million pounds is a small increment to the total.

Lindsay Drucker Mann – Goldman Sachs

Okay.

Larry Pope

But I want to give you more clarity on that.

Lindsay Drucker Mann – Goldman Sachs

Great, thanks. And then just lastly, I know including the divestiture, your hog production was down in the quarter. How much would it have been on an organic basis?

Bo Manly

I’m not sure I understood the question – in terms of had we not sold those operations?

Lindsay Drucker Mann – Goldman Sachs

Yeah, yeah, exactly. Excluding the fact that you sold that business, how much would it have been down? And then maybe if you can just give us some perspective on the pipeline of animals that you have, how much you would expect hog production to change in the next calendar year?

Bo Manly

I would probably say that had we not sold those operations, we would have been flat. Some of you that follow the details of that side of our business recognize that we have a cost improvement program that’s in place. We will as we move into fiscal 2013 actually get some of the volume benefits from that, particularly in our east coast pod, which may increase our overall hog production by 4 to 5% as we look at fiscal 2013 versus 2012.

Lindsay Drucker Mann – Goldman Sachs

Is that heads or pounds?

Bo Manly

Heads.

Lindsay Drucker Mann – Goldman Sachs

Okay, thanks.

Keira Lombardo

Operator, we’re going to end the Q&A portion of the call here and turn it over to Larry Pope for some closing remarks.

Larry Pope

Well thank you folks. Obviously you can tell I’m enthused even on decaffeinated coffee. This is—it’s fun. Our marketing plans are working. I think we’ve got a lot more good to tell you as we go forward. We will have bumps in the road. I’m sure we won’t execute this thing on all cylinders and we’re nowhere near 8, and so I’ll probably report some disappointments. But I can assure you we do know what we’re doing and this management team is rolling forward with some marketing plans, and I’m going to be excited about telling you those in the future.

Now in an effort to reach this 3% goal for the year, I would expect everyone on this call to be shopping for their (inaudible) sliced ham at the conclusion of this call, and there’s no reason you can’t buy one for your family members and give it as a gift. That will help us towards our 3% goal. In the meantime, we’ll try to sell a few on our own.

Thank you very much and a wonderful holiday season to all of you, and I hope you get to spend some quality time with your family. Thank you.

Operator

Ladies and gentlemen, this conference is available for replay. It starts today at 11:00 am Eastern time and will last until December 22 at midnight. You may access the replay at any time by dialing 800-475-6701 or 320-365-3844. The access code is 222760. Those numbers again – 800-475-6701 or 320-365-3844, access code 222760.

That does conclude your conference for today. Thank you for your participation. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Smithfield Foods' CEO Discusses F2Q12 Results - Earnings Call Transcript
This Transcript
All Transcripts