Smithfield Foods: King Pig Among Pork Producers

Includes: HRL, PDA, sda-old, SFD, TSN
by: Markos Kaminis

Smithfield Foods (NYSE: SFD), best known as the world’s largest pork processor and hog producer, reported earnings a few weeks ago that exceeded expectations by $0.05 before inclusion of discontinued operations. Besides operating as the world’s leader in hog production and pork processing, Smithfield is the fifth largest beef processor in the U.S. The company also has its hoofs in turkey production, but Smithfield is the serious king pig, as its pork segment processes about 26 million hogs annually, accounting for 26% of the country’s market share.

During its earnings conference call, management mentioned that it was in discussions with COFCO, a major Chinese trading company. What really enthused investors and the analyst community was management’s discussion of China’s deficient pork supply, and the degree of opportunity that might exist for exporters into the market.

After significant discussions with Chinese market participants, SFD’s team speculated that as much as 20% of China’s hog market may be lost to disease. Smithfield’s President and CEO, C. Larry Pope then compared that 20% loss to the U.S. market, stating,“that could be a 100 million hog shortage, and that’s as large as the whole U.S. production.” He continued, “If they have to solve even a part of that, it could be enormous.” Commenting on speculation that Smithfield might be in discussions with the Chinese, SFD’s chief enthusiastically stated, “I can report to you today that we have been having substantial conversation with a very large Chinese trading company, the company COFCO.” He expanded, “We have been having conversations with them about some sizeable shipments, even this fall and winter, into China.”

A day after alluding to the possibility, SFD entered into agreement with “an undisclosed trading company” to deliver 60 million pounds of Pay-lean free pork to China through year-end. After labeling the deal as “modest,” management also indicated that more agreements could ensue.

Now 60 million pounds sure sounds like a lot, but we were wondering just how important that really is to the American meat processor. Well, in fiscal year 2006 (ended Apr.), Smithfield sold 3.5 billion pounds of fresh pork products. 60 million pounds of pork is just 1.7% of that, so this is really not as big as it sounds. And it’s not even as important as 1.7%, since SFD sold another 2.4 billion pounds of processed pork that same fiscal year. So, that puts it into proper perspective for you, and probably explains why SFD shares rose on the news, but then returned profits in the days that followed the announcement.

Still, the fact remains that a new and huge market has opened up to Smithfield, and this sale may only be the chop of a larger pork. So, the shares’ price reversal may have allowed even smarter money than the money that figured out how lean the deal was, an opportunity to enter.

Before we decide if that’s the case or not, let’s study the company’s fiscal first quarter report, and then take a look at valuation. Smithfield reported a Q1 revenue increase of 21.5%, benefiting significantly from three acquisitions since last October. Still, management was disappointed with fresh pork sales, while enthused with the performance of its processed pork segment. We took note of management’s recognition that some of its rivals did better than Smithfield in the fresh pork segment. SFD blamed its own weakness in the business to seasonal issues, but if peers did better, that means there was either a market share shift or those peers found new markets that SFD is not significantly exposed to. The way to figure this out is to study peer results and just plain get to know the industry better.

SFD has been pursuing a strategy geared to increase the sales of processed pork, since segments of this market offer better margin than fresh pork sales. As a result of this value-added effort, the company’s operating margin from continuing operations widened 70 basis points, year-over-year, to 2.8%. That’s a lean profit margin that’s characteristic of the industry, but the fact is that Smithfield and its peers have seen pressure on feed prices. In its conference call, SFD’s management indicated that recently rich corn prices have reached the live hog market. Smithfield has built a vertically integrated operating structure in an attempt to contain volatile pricing, but the company is still a net buyer of hogs on the open market. In any event, management noted that corn prices have receded some of late.

Smithfield grew earnings from continuing operations at a 31% clip, thanks to acquisitions and aided by the disposition of poor performing assets. This was especially impressive due to the company’s debt burden and share dilution born from its acquisitive activity. SFD’s acquisitions have been accretive to operations, as its earnings per share growth overcame a near 19% increase in diluted shares outstanding this past quarter.

Okay, so we can say the company is improving its operations, and we can speculate that a bonus opportunity may avail itself in China. But are the shares attractive for purchase?

Looking at industry statistics without detailed review of the company’s peers, which we recommend if in fact you are choosing between them, we studied SFD’s valuation. The shares trade at a P/E discount to industry rivals on average, and toward the bottom of the peer group in terms of price-to-book value. The company also offers a lighter return on equity than its peers. This, however, does not exclusively preclude the buy decision. No, in fact, it may support a buy decision, but only if one factor is present.

That necessary factor that would lead us to recommend the purchase of SFD, is change. If there is reason to believe SFD is an improving operation, then we could argue that its valuation would move toward its peer average. Well, if you are betting the change will be driven by China alone, then you are in fact gambling. Smithfield’s management said on its conference call that any pork producer that built new capacity based on anticipated Chinese demand would be foolish, because they argued their view that China would want to feed the Chinese over the long-term and was using Smithfield only as a near-term stopgap. Now, just because SFD’s management team believes this to be so, does not mean China will not become a significant importer of proteins.

Your favorite Greek here happens to believe China’s bursting population is not to be ignored, childbirth limits or not. Also, China’s industrialization is drawing farmers and ranchers into the more lucrative manufacturing industry. The country recently became a net importer of grain, so it is entirely possible that the current taste of pork importation might just make it easier for the behemoth to indulge in the trade in the future. Whether China uses pork as a tool in its stealth trade war with the U.S. will likely greatly depend on other supply opportunities and the health of its own pens.

Another reason we like Smithfield’s outlook is its movement to create more value-added revenues. We believe the company will continue in the direction of expanding processed food production, and drive more value creation. Now, it still has a debt burden to eat at, with debt standing at more than 50% of capital, but we anticipate the new CFO, Mr. Carey Dubois, is strong enough to handle the challenge. As an analyst, I would spend a couple more days before confidently recommending the shares, but I take some confidence in the fact that approximately nine analysts currently recommend buying or accumulating the shares, while four recommend hold and one sell.

We expect SFD’s valuation will move toward its peers, but over the course of the next twelve months, we see the price-to-book value likely improving well short of its closest peers’ 2.5X, perhaps reaching 2.0X instead. Using SFD’s book value of $2.91 billion on July 29th, the shares would be valued at approximately $44, representing about 33% appreciation potential from the closing price on September 14, 2007. Still, one major risk could oink this theory. Tyson Foods (NYSE: TSN) just cut its '07 profit forecast partly on higher than expected live cattle costs, a business Smithfield participates in. Now, while Smithfield procured 15% of its cattle from its own live cattle feeding operations in FY 07, its beef segment operations generated 19% of its total sales. That's not negligible.

If the Chinese opportunity does not materialize, we believe the company’s operations are improving enough to move SFD’s valuation in the direction of its peers. However, because of this newly surfaced risk related to the cattle/beef industry, and our mosaic theory that Smithfield could also see impact, our enthusiasm is limited for SFD despite its valuation discount. The downside is probably somewhere near TSN's price-to-book value of 1.42, which would put downside price risk near $31.24, representing a 6.3% decrease in value. A lot depends on the difference in importance of beef production for TSN and SFD, but with a thumbnail estimate of 6.3% potential downside and 33% potential upside, we would take a modestly positive view on SFD shares.