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Smithfield Foods Inc. (NYSE:SFD)

Q1 2013 Earnings Call

September 4, 2012 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

Farha Aslam – Stephens Inc.

Ken Zaslow – Bank of Montreal

Christine McCracken – Cleveland Research

Brett Hundley – BB&T Capital Markets

Diane Geissler – CLSA

Akshay Jagdale – Keybanc

Robert Moskow – Credit Suisse

Vincent Andrews – Morgan Stanley

Ryan Oksenhendler – Bank of America Merrill Lynch

Tim Tiberio – Miller Tabak

Reza Vahabzadeh – Barclays

Carla Casella – JP Morgan

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Smithfield Foods Fiscal 2013 First Quarter Earnings call. For 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. If you need any assistance during the call, please press star then zero. 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

Good morning. Welcome to the conference call to discuss Smithfield Foods’ Fiscal 2013 First 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 2012. You can access the 10K and our press release on our website at Smithfieldfoods.com.

On our call today are Larry Pope, President and CEO, and Bo Manly, CFO. 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 Keira, and thank you all for joining the call this morning. I hope each of you had a good Labor Day holiday enjoying time with your families, as I did. I even hope you had some time to throw out some hot dogs or pork chops, or maybe some barbecue ribs. If you did, I sure hope they were ours.

Today we are reporting fiscal first quarter earnings of 61.7 million or $0.40 a share compared with 82.1 million or $0.49 a share last year. I remind you that last year’s first quarter included some charges that mean on an adjusted basis last year’s first quarter earnings were comparatively $0.69 a share instead of $0.49. These charges included a significant charge related to some outstanding Missouri litigation. I hope you saw in the release that we have now settled that litigation. After quarter’s end, we made all the agreed upon payments to the plaintiffs’ attorneys. This effectively resolves a major issue that has lingered since the PSF acquisition.

I also hope that you saw that we have continued to strengthen the balance sheet with a new debt financing. This financing effectively clears the overhang surrounding debt issued a few years ago and repositions our company’s balance sheet. Bo Manly will speak to this issue in his comments.

On the operating side, our results reflect the ongoing turmoil in all protein and grain-based businesses today, high volatility and increasing cost of production primarily tied to higher grain costs. Just three months ago, corn was below $6 a bushel and trending downward. Experts were forecasting a record corn crop in the area of 15 billion bushels. Remember that? Our hedge positions didn’t look so good at that time. Now just a few months later, corn has reached new records highs, soybean meal continues to move even higher, and the crop estimates have been reduced by nearly a third. Suddenly, our hedge positions make us look like we were all geniuses. I promise you, we were not – just executing our strategy to control cost.

This uncertainty surrounding hog production is why we changed our hedging philosophy and practices a few years ago. We can’t predict the future and don’t try. We hedge to control cost and manage our hog production margins. This is not easy. Sometimes the futures markets simply don’t provide the opportunity, but we are trying to take some volatility out of our hog production earnings.

I am pleased to report that hog production raising business was profitable for the first quarter and looks to be break-even or a small to modest loss for the full fiscal year. Our second and third quarters will likely reflect losses as a result of expected seasonally lower live hog prices; however, we suspect our results will be substantially better than the industry average as a result of our favorable corn and soybean meal positions we have spoken about so many times.

Our fresh pork results this quarter were disappointing. We did not have a good quarter in fresh pork. As most of you know, the summer months are generally the worst months of the year for fresh pork, and that was the case this year. Last year’s strong results were an exception to historical norms. The influence of high-priced product combined with 2 to 3% more meat to sell and sluggish retail demand all adversely affected our sales margins, particularly in the month of July. In addition, we suffered from losses tied to our export business resulting from a couple of plant de-listings. These things happen from time to time in the export arena. These issues have been largely resolved and we are again shipping most of the affected products. While I’m not nearly satisfied with this quarter’s results, I am not really worried about fresh pork and fully expect fresh pork profitability to be fine for the year.

While I was not happy with our fresh pork results, I am especially pleased with our packaged meats results. This quarter’s results were a record for any first quarter. The business continues to be a strong focus of the management team quarter after quarter and year after year. We continue to increase our marketing spend double digits in what we believe is a smart and focused way. A 7% growth in our branded business and 4% overall is very encouraging, particularly given the macro environment. We have significant growth in a number of our 12 core brands which we spelled out in our press release. We also had significant grow in a number of product categories. The fact that we had strong growth in volume combined with strong growth in margins is very encouraging. Certainly modestly lower raw material costs helped, but this business is performing well.

We had solid growth across all key channels, from retail to food service and deli, and this reinforces our commitment to our plan. I can’t say enough things about our packaged meats business. It is very solid and we continue to believe that we still have significant upward potential in this business. We will be bringing online a new $80 million state-of-the-art hot dog plant in the fourth quarter of this fiscal year. We believe this new plant will be the most efficient and food-safe hot dog plant in the world. This should further enhance our margins and deliver a superior food-safe product in this important product category.

We are creating a significant new product pipeline that is just beginning to bear fruit. I hope you noticed our comments regarding our Farmland Oven Perfect line of products in the press release. I know some of you have already tested this product. I hope you liked it. We are excited about this new product launch. There is plenty left to do and we are on it.

I have commented numerous times that our strategy to control cost and margins in the volatile parts of the business like hog production to reduce their adverse impact on the business, and then stay focused on the meat business to drive more stable and increased earnings primarily tied to packaged meats. I wish I could tell you that we have eliminated all the volatility in the business, but that is simply not true. I do, however, think we are continuing to make progress in muting a significant part of it. Overall, this was a solid quarter in a very volatile period, and while fresh pork was weak, I am not worried about it. Hog production costs are under control and our packaged meats business is on a role.

With that said, let me turn it over to Bo Manly for his comments, and I will come back to you with some thoughts about the rest of the year. Bo?

Bo Manly

Thank you, Larry. Good morning ladies and gentlemen. Smithfields’ first quarter net income was $62 million or $0.40 per diluted share compared to last year’s first quarter net income of 82 million and EPS of $0.49. Despite a difficult environment for hog production and fresh meat, record margins and strong year-over-year core brand growth validate our consumer packaged meats business strategy. Our packaged meats segment contributed record first quarter operating profits of $131 million.

The continued strength of our packaged meat business is complemented by our ongoing efforts to strengthen the balance sheet as well as executing stock repurchase to enhance shareholder value. During the first quarter, we repurchased 7.4 million shares. We have used $350 million over the past five quarters to purchase a total of 17.4 million shares, more than 10% of shares outstanding.

First quarter consolidated sales were flat at 3.1 billion compared to a year ago as lower average values across the whole chain from live to packaged meats were offset by volume increases of 5% in fresh pork and 4% in total packaged meats. Lower hog production sales reflect 5% lower volume as scheduled in the first phase of the hog production cost reduction program. International sales declined 8% as negative foreign currency translations offset volume increases in Romania and Poland.

The packaged meat segment operating margin improved from 7.5% to 9.8%. These record packaged meat results and improved international margins were not sufficient to fully offset margin declines in fresh pork and hog production, resulting in a consolidated operating margin decline from 5.6% to 4.3%.

First quarter operating profit was $132 million, down 24% year-over-year principally due to losses in fresh meat and lower operating profits in hog production offsetting a $29 million increase in packaged meats operating profit year-over-year. While lower raw material costs were beneficial to packaged meat margins, the 29% increase demonstrated the strength of our packaged meat segment. Packaged meat operating profit margin was $0.21 per pound, exceeding the normal range and above the $0.17 profit last year. We continued to invest resources in our core brands with new product development, increased mass spending, and state-of-the-art production facilities. These investments provided a platform for growth in total packaged meats volume of 4% in the first quarter compared to a year ago, and more importantly a 7% growth in our core brands driving volume gains across all key segments – retail, food service and deli – as well as improvements in product mix and overall margins.

Despite solid exports, weak domestic demand in the fresh meat segment and higher year-over-year industry pork tonnage pushed USDA cut-out lower and squeezed fresh meat margins, particularly in July. The fresh pork segment lost $12 million or $2 per head compared to $35 million and $6 per head profit in the same period a year ago. Fresh meat margins have improved since the end of the first quarter and the pork group continues to strive to optimize fresh pork product mix and lower plant costs to improve fresh meat profitability. Management continues to believe the fresh meat segment will generate full-year operating profits in the normalized range of 3 to $7 per head.

Exports continue to support fresh meat values. Export volumes during the first quarter remained at near-record levels equivalent with export volume a year ago. The company’s large export carcass sale last fall will make year-over-year comparables very challenging in Q2 and Q3 of this fiscal year. While the hog production segment operating profits declines substantially year-over-year from $70 million and $18 per head to $23 million and $6 per head in the most recent quarter, our margin management activities muted the impact of higher cost feed and lower hog prices. Hog raising costs were $67 per hundredweight live in the first quarter compared to $63 a year ago. Our margin management program will help maintain hog raising costs in the mid-$60 per hundredweight range for the balance of this fiscal year using the current future strip. The next few quarters will be difficult for the swine production industry in general with predicted industry break-evens as high as the mid-70s; however, our hog production risk management strategy will significantly dampen the impact of high priced corn and meal.

We will not be 100% immune to seasonally lower hog prices and potential operating losses this fall. We anticipate hog price recovery moving into the second half of the fiscal year. If the recovery is moderate, hog production operating profits will be below the normalized range but positive. With a weak or no price recovery, operating profits could show a modest loss.

International segment operating profits were $16 million in the first quarter compared to a break-even last year. High European hog prices and favorable commodity positions contributed to very strong results in both Polish and Romanian hog production operations, averaging $30 per head profit. Animex showed improved packaged meats results year-over-year. Recent European export approval contributed to an improved sales mix and profitability in our Romanian fresh meat operations. Campofrio results were flat and Mexican joint venture operations profits declined $3 million.

We continue to see good European hog profits in the coming quarters, though moderated by higher feed prices. While we see international segment operating profits in the top half of the normalized range, the degree of European economic stress and international grain prices are areas we are keeping an eye on.

Income from equity method investments declined from $5 million in last year’s first quarter to $1 million profit this year, principally due to lower earnings in Mexican hog production joint ventures which offset improved fresh pork results at Norson. Campofrio continues to exhibit marginal performance, reflecting very difficult market conditions in western Europe.

SG&A expenses decreased $38 million or 16% compared to the first quarter a year ago. Absent a $39 million charge a year ago related to our Missouri litigation, SG&A expense would have been flat year-over-year. Interest expense decreased 12% or $6 million compared to last year due in large part to bond repurchases in fiscal 2012. We continue to project full-year interest expense at $170 million.

Depreciation in the first quarter was $58 million and capital expenditure were $61 million for the quarter, with a $300 million full-year CAPEX budget. Key balance sheet items reflect a decrease in cash in large part to fund a $145 million stock purchase, increase in seasonal inventories and commodities, and reclassification of $560 million of convertible and unsecured notes from long-term debt to current. Cash and short-term borrowing capacity totaled $1.3 billion of available liquidity at quarter-end.

As I previously mentioned, we purchased $145 million worth of Smithfield shares during the first quarter. We have continued to buy stock during the second quarter under a 10B-5 plan. We believe at current price levels, continuation of our stock purchase program creates shareholder value. The current Board authorization of $600 million for stock purchases has $250 million remaining available.

Subsequent to the end of the first quarter, Smithfield issued $1 billion of 6 5/8ths 10-year bonds. We believe this transaction took advantage of one of the most favorable debt markets. We have significantly reduced any financing liquidity risks for the foreseeable future. In addition, these transactions have eliminated all secured term debt and encumbrances, increased liquidity, and lowered our borrowing costs.

Concurrent with the bond issue, we tendered for our outstanding 2013 7 ¾ unsecured and 2014 10% secured notes. Subsequent to the tenders, we called the outstanding balance of the 2014 notes. In total, we redeemed $694 million of face value debt, and related to the debt extinguishment we recorded a charge of $121 million in our second quarter, representing $0.49 per share. We also amended our $200 million revo-term loan to extend the maturity two years to fiscal 2019. We are excited about the opportunity to refinance our balance sheet. Our debt maturity profile has dramatically improved with only $400 million of our 2013 convertible debt maturity between now and fiscal 2017. We intend to retire the 2013 debt through a combination of cash flow and possible new refinancing.

We are pleased to recently achieve a global settlement to our longstanding Missouri nuisance litigation. This will have no impact on current earnings.

In conclusion, we are very pleased with the packaged meats margins and volume growth shown this past quarter, particularly in our core brands. We expect continued strong performance throughout this year. Fresh pork results in Q1 were disappointing, however, cut-out values and fresh meat margins have improved in recent weeks. We continue to optimize mix and work toward lower plant costs. We expect full-year results to rebound into the normalized range.

Historic high feed prices will pressure domestic hog production results; however, our margin management program will reduce our exposure to record corn and meal costs and blunted the impact of lower hog prices. We will not achieve margins in a normalized range this year, but our hedging activities will substantially limit any loss and put us in striking distance of a modest profit.

Let me emphasize this is not a replay of 2009 – 2010. We have more risk protection on feed and live animal values. We’ve worked to improve our non-feed cost structure and competitiveness. We’ve developed alternative feed ingredients and diversified sources of grain, and we have stable pork group profits four times liquidity compared to that period, and aside from a manageable level of 2013 converts we have no debt maturities for as far as the eye can see.

We will emerge from the impact of this feed crisis in a stronger competitive position. Our main European export competitors and producers in our key European export markets are liquidating and/or consolidating. We will emerge with a strong market position in hog production and fresh meat. Finally, packaged meats will provide solid results for this fiscal year, but hog productions will fight for every penny of contribution. It will be a tough but solid year.

We continue to execute on our consumer packaged meat growth strategy as well as manage live hog margins to provide more consistent operating profits and growth. We will complement these activities with continued stock purchases and enhanced shareholder value.

Thank you very much for your time and attention. Now back to Larry.

Larry Pope

Thank you, Bo. As I look forward to the rest of the fiscal year, I think from the standpoint of Smithfield Foods it looks fine. I know everyone is concerned about the corn crop, and they should be. We will all get better information next week. We should all be concerned about the soybean meal market, which continues to escalate; but we have good hedges in place. Our positions are substantial but not nearly 100%, so we still have exposure but not nearly the exposure I think the rest of the industry has. I think our hog production business will be fine. We will probably lose money for the remainder of the year, but this may well set up for a very good year next year.

We are continuing on our path towards 100% conversion of our company-owned sows to pen gestation by 2017. I think that will work to our advantage over time. I also think that the recent run-up in corn prices means that anyone contemplating sow expansion will give that a second thought. You have probably all seen that sow slaughters have turned positive in a significant way over the past six weeks. There will almost certainly be less beef and less chicken as we move into next year. This should bode well for everyone in the protein industry. Our fresh pork business is moving into the seasonally better time of the year, which should bode well for profitability of fresh pork over the next two quarters.

While grain costs are high in this country, they are higher elsewhere in the world. Corn is over $9 a bushel in Mexico and close to $10 a bushel in China. This should help our export business. We had record export shipments last year in our second and third quarters, so this year will be tough to match or exceed what we did last year as we have no carcass orders to China like we had last year. At this point, I do not see us matching last year’s record numbers; however, I do think exports will continue to be good for Smithfield and the rest of the industry. The USDA is forecasting exports to be 4 to 5% above last year. We agree with their forecast. Given the strong first half, the industry will likely have decreased exports in the second half largely tied to the loss of the carcass contracts.

I think our packaged meats business will be good to very good. The business continues to get better. We think our marketing plans are effective and driving new distribution and new authorizations. Our pipeline of new products is continuing to build and mature. I have said before, we are on the 20-yard-line of a 100-yard field. There is a lot of opportunity in front of us. We have strong brands and good, smart people who are beginning to truly activate these brands. I am very pleased with what I see.

We think we have our costs under control and are focused on lowering them even further. We have strong marketing plans in place which we think will benefit the bottom line over the rest of the year. The progress we have made in packaged meats only makes me more excited about the future in this business.

I am fully aware that we are in uncertain times and I know there will be more hurdles to jump, but that is what we do every day. This is not a simple business, and while I don’t expect record profits this year, I do think we will deliver another solid year driven by success in our packaged meats.

I hope you noticed the stock buyback that Bo made reference to and we commented in our press release. I must confess that I think our stock is undervalued, but I won’t complain. If investors don’t appreciate the progress we have made and are making, we will continue to make buying back our stock a priority. I think this is a great company and getting better. I am confident of it.

Thank you. Keira, now we’ll be happy to take questions.

Keira Lombardo

Thanks 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 for questions.

Question and Answer Session

Operator

[Operator instructions]

And first we’ll go to the line of Farha Aslam with Stephens. Please go ahead.

Farha Aslam – Stephens Inc.

Hi, good morning.

Larry Pope

Good morning, Farha.

Farha Aslam – Stephens Inc.

A question on hog production and on packaged meats. Your confidence in packaged meats margins going forward, do you think that margins will be above the first quarter level for the rest of the year, given that the first quarter tends to be the most difficult? And in hog production, do you expect profits—you were saying marginally positive to marginally negative. Is that based on your current hedges or changes in the market that you’re expecting? So two-part question in one.

Larry Pope

Farha, let me answer the packaged meats, and Bo’s our new resident expert on hog production because Bo took over responsibility for the live production business effective August 1, so he gets to walk into a storm with a raincoat on.

On the packaged meats side, we had a terrific quarter and I don’t expect that we will replicate these $0.20 margins in the remaining three quarters of the year. And I remind you that we originally started with a $0.10 a pound goal. George Richter raised that goal to $0.15 when it appears to be a lay-up for our organization, and now we’re producing numbers above that on a regular basis, above $0.15. So I think it’s going to be very good but I don’t believe that we’re going to continue to deliver $0.20 a pound for the rest of the year.

With that, Bo, I’ll let you address the hog production side.

Bo Manly

Sure. Farha, I think in conjunction with the statements I made earlier, if we have no improvement in pricing of live animals, our hedges and the current future strip would indicate that we would have probably a modest loss – in single digits, certainly low single digits. If we do get an improvement in price as we look forward in hog production, we do think that there’s going to be some reaction in terms of the cutbacks that we see both here in the United States with sow slaughter as well as across the country. But if we get a couple of dollars more in terms of hog pricing between now and the end of the fiscal year, we should have some positive results.

So we’re right on that edge at this point in time. We think we’ve got a very small, limited amount of potential exposure if we don’t get any change in hog prices, but if we do have modest improvement it will be a profitable year for us.

Farha Aslam – Stephens Inc.

Great. Thank you.

Operator

And next we’ll go to Ken Zaslow with Bank of Montreal. Please go ahead.

Ken Zaslow – Bank of Montreal

Good morning everyone. I guess I have a two-part question as well. Can you compare and contrast why you’re more optimistic on the international hog side than you are on the domestic side? It seems like you think that there’s more upside on that, because I would have thought that they would have paralleled a little bit better. And then are you guys actually making cuts as well?

Larry Pope

Ken, let me tell you that we are—at this point, we are not making any cutbacks, any reductions in sows. We’re in the midst of finalizing our restructuring of our hog farms, and actually we’re going to have a few more hogs for the fall, but that was already part of the plan – not big numbers, but that fills out the kills in the east where we’ve been actually short at the plant. So—but the hog price in Europe is certainly higher than it is in the United States, and they’ve had some cutbacks even earlier, so at this point it still looks solid on the live production side in Europe.

Ken Zaslow – Bank of Montreal

Great, thank you.

Operator

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

Christine McCracken – Cleveland Research

Good morning. Just on the big increase we’ve had in slaughter over the last month or so, I’m curious – is that a function of the fact we under-killed over the summer, or are we actually pulling ahead hogs into the fourth quarter? And as it relates to then your outlook for hog prices as we end the year, typically you’d think that given the large number of hogs that we’re expecting through the end of the year, that you’d see lower prices. I’m just curious, if we’re pulling them ahead, could it mean that actually the outlook is a bit better in the short run?

Larry Pope

Christine, I’ve actually done some investigation on that last point. I had some of the same thoughts you had. No, I don’t really think—from the sources we have, I don’t think that we have pulled hogs ahead from the fall, and I was hoping that maybe we had. I don’t think that’s true, and so I still think that there’s going to be a good, solid fall hog run and I don’t think—at least, there’s nothing to me today that tells me that this live hog market is going to jump back up because we’re going to have sort of a (inaudible) fall run. I don’t have anything to prove or anything to support that statement, so.

Bo Manly

I think some of what you’re seeing, though, in terms of increased slaughter certainly is reflecting of more gilts moving back into the system—

Larry Pope

That’s right.

Bo Manly

--which maybe accounts for a percent and a half, a couple percent perhaps on a week-to-week basis. But I think that there is some reaction on the part of some of the farmer feeders, the guy growing corn and with 1,000 sows, that if he’s supporting his own hog operations strictly with his own corn, he may be pulling hogs a little bit sooner than he would otherwise only because he doesn’t go out and buy corn. When his bin is done, then he’s in a different situation, so I think you may have some forward selling. I don’t think it’s dramatically pulling ahead. Just a little bit lighter weight, and I think you’ve got some gilts in the mix.

Christine McCracken – Cleveland Research

But weights are actually up.

Larry Pope

They’ve come down—I know what you mean. We say year-to-year they’re up, but they’ve actually come down pretty dramatically here in the last 10 weeks. They’ve come down a good solid 10, 12 pounds. I realize you’re saying year-to-year weights are actually up on a comparative week-to-week in the same time last year. Was that the point you were making, Christine?

Christine McCracken – Cleveland Research

Yes.

Bo Manly

I think we’re playing catch-up there on weights. It will correct itself here.

Larry Pope

I think that’s right.

Christine McCracken – Cleveland Research

All right, thank you.

Operator

And we’ll go to Brett Hundley with BB&T Capital Markets. Please go ahead.

Brett Hundley – BB&T Capital Markets

Hi, good morning guys. This is Brett Hundley standing in for Heather Jones. Larry, you touched on this. I just want to confirm it real quick – regarding the mid-60s raising cost, is it fair to say then that that’s generally locked in, or is there just some risk vis-à-vis a changing of the futures or something like that?

Bo Manly

Brett, there is. We are not 100% covered in terms of our risk management program here. We have substantial coverage, and if there is an uptick in terms of corn prices from here, yes, you would have that continuing to increase but it will be muted by the impact we have from our existing hedges. So even if it did go up, it will not affect us as much as it will affect the rest of the industry – it would be the point, the walk-away I’d want you to have.

Brett Hundley – BB&T Capital Markets

All right, thanks for that clarification. And then just quickly, on the international segment guidance, can you guys just talk a little bit about your guidance there and your ability to reach that range, the midpoint there when you talk about the fundamentals that are occurring in that area – currency, et cetera. Can you just color that a little bit, please?

Bo Manly

I’ll try to do that. I’m not sure I’m smart enough to figure out European currencies and particularly where we’ve got both our major operations there, Poland and Romania, that aren’t part of the euro. They trade against the euro in terms of their domestic currency – it’s a tough situation. But as far as fundamentals are concerned, we have extremely hog prices in Europe, into the 80s range. We had very good positions. We were very aggressive in terms of trying to get as much cash, corn and wheat around us as possible at an early stage. We have favorable growing costs there, and so we think that we’ve got a couple of good quarters in terms of hog production ahead of us, and we should be reaching the good times for Animex. They have packaged meats operations in the fall do very well, and likewise we should have good throughput in Romania and continue to enjoy export opportunities there.

So we see a very good platform from a hog production perspective, and we should have better results in our meat operations as well.

Brett Hundley – BB&T Capital Markets

Great. Thanks, Bo.

Operator

Our next question is from Diane Geissler with CLSA. Please go ahead.

Diane Geissler – CLSA

Good morning. Larry, you talked about there being a little bit extra volume at retail in the quarter, and it sounds like to the extent that you might see a little bit of a pickup here in the fall just to kind of clear some of the animals out, what’s your viewpoint on the retail channel? I know there was some weakness there. There wasn’t as much featuring as you would have liked during the summer. Can you talk a little bit about your conversations with retailers and their expectations for the fall, given I think everybody knows protein prices are going to go up, so how does pork play into that dynamic?

Larry Pope

Well Diane, I think most of our comments we were making in terms of that were related to packaged meats. As you know, fresh meats, you can move them domestically or export, and we’ve certainly had some nice business pickup on the retail side but we’ve had nice pickups on the food service side. I mean, that’s actually been one of the driving forces in our brands and our total packaged meats business is on the food service side. We’re having mid-single digits in terms of the retail side, but on our core brands we’ve had double-digits when it comes to food service. So our food service business is actually better than our retail business. There was some sluggishness in things like ribs this summer, but we had a good Labor Day here so I think that will simply clear it’s way through.

I don’t think there’s any question, Diane, that this higher priced meat and not just pork – beef and chicken included – have certainly had some sticker shock to consumers as they’re walking in the grocery store, and they’re having to adjust to that. But our retail business is fine, our relationship with customers is good. I think everyone’s concerned about the price increases that they’re having to force through the retail channels and where the consumer simply—when their paychecks aren’t growing, can’t simply afford continue to buy the same level when the price is changing so much. And I want to say beef is having an impact on that. I mean, beef, at the prices its had, it’s having an impact on everybody – look at the meat case.

Diane Geissler – CLSA

Okay. And then I guess just on the export side, I know you sort of sounded a little bit of a cautionary note there simply because of the sheer magnitude of volume you ship year-on-year. But I have to believe that U.S. pork is still attractively priced versus what it costs to raise in some of these markets where corn is significantly higher than U.S. corn. Is your cautionary note just kind of to keep us in line versus the comparisons, and then you feel fairly confident about the export markets overall?

Larry Pope

Yes, Diane, there’s nothing negative. I don’t want to send any signal to you on the export front. Last year, we just had—we had, like, 100 million pounds of exports that went in the second quarter and another 100 million went in our third quarter. When you start doing the year-to-year comparisons, those are big, big numbers. Our export business and the industry’s export business is in very good shape; and you’re right – comparatively U.S. pork continues to be a value. So I don’t want to paint any picture that exports are bad; it’s just that we had that, once again, carcass contract with China that made the numbers just sort of blow out of the park last year. They’re going to be very good this year, they’re just not going to have comparisons with last year’s second half.

Bo Manly

And I’d also comment that I think we have seen as an industry a fundamental change in our cost of raw materials going forward. We’re not going to see $3 and $4 corn, or if we do see lower dips, it will be very momentary and not on a permanent basis. The higher corn prices makes U.S. pork more competitive in the world markets because we are the location for surplus corn in the world, and so everybody else trades at a premium to ours in the marketplace so that means our pork is more competitive. We’re seeing decreases in competition in terms of volume coming out of Europe, which is our main competitor, so I think as we look at the Asian markets long-term, we’ll continue to have an advantage there from a cost perspective and we’ll have less competition from our European compatriots.

So I look—I mean, if we’re going to get past this current bulge here that we have now, but as we get into next year I think fiscal 2014 from an export perspective looks very good for us.

Larry Pope

What I would tell you, Diane, from a Smithfield standpoint, we continue to build our management team related to the export business. We’re putting more people on the ground. We’re building stronger relationships, what I call through the traders into the actual customers, building a much better base of export business. As I think I said in the prior call, we’ve added that as another new channel, just like retail and food service. It’s an export channel for us. It’s not an opportunistic sale, and I think that the industry’s changed. We’re an exporter of product out of this country, and I think we’re attractively priced and there are some nice margins in this, and I think we bring real value to those export customers and it’s long-term and sustainable.

Diane Geissler – CLSA

Okay, great. Thank you.

Operator

And next we’ll go to the line of Akshay Jagdale with Keybanc Capital Markets. Please go ahead.

Akshay Jagdale – Keybanc

Good morning. Larry, you’ve been very vocal, you and the management team and the Board, regarding your share price and how it’s undervalued. I just wanted to find out if there’s anything else you could do structurally or anything else you’ve thought of to do to create shareholder value. Obviously there’s been major improvements in the operations over the last few years. You are buying back shares aggressively, and I also noticed that in your proxy you’ve changed the compensation structure for the management team such that it is more in line with total shareholder value. So is there anything else structurally that you can do? Does it make sense to be vertically integrated, because it seems like the hog production side of your business, although you are significantly outperforming the industry, is where the valuation gap lies. But I’m just trying to get into your brain here and see how you’re thinking about it.

Larry Pope

Akshay, I would tell you that this management team is focused on shareholder value, and the buyback of these shares is demonstrative of that and the fact that we’re looking forward with a lean towards buyback even further. That’s every day. I understand your question about structural changes, and I know there’s been discussion among people in the industry about why doesn’t Smithfield just sell off its live production business and focus on just the meat business. Fundamentally, I’m telling you that I believe this live production business is going to have another day, and it could be next year, that day when you might very well be sitting after the first quarter or second quarter next year and saying, Larry, why in the world did you sell your hog farms? Look at the kind of money the farms are making. We’re going to have less live hogs next year. We’re going to have less beef and less chicken, and there’s going to be day when there is going to be some modestly priced grain and some high priced meat, and there’s going to be a big day in the live production side of the business.

And while I admit the last three or four years have not been fun in that business, it brings real value to our meat processing operations, and in the east coast we’d be dead. We wouldn’t have any meat processing operations in the east without live production, and no one today is particularly interested in just being in the live production business. They want to be in the chain, and so what we’re doing is now tying our farms, and Bo’s responsible for this in his new responsibilities, of those farms very tying very closely with our manufacturing side and the meat processing side. I talked about the 100% conversion to pen gestation – as you know, that’s now in vogue. That’s the conversation of many of our food service and retail customers. We can provide that. We have control over our feeding programs. We have control over antibiotic usage. We can control that and we can sell that through. That’s our charge to management, and I think we’re going to prove this live hog production business can really be a strong asset and is not just going to be profitable when grain is cheap and hogs are high.

Akshay Jagdale – Keybanc

Okay, great. I’ll pass it along. Thank you.

Operator

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

Robert Moskow – Credit Suisse

Hi, thank you. I just wanted to ask, Larry, within packaged meats you had a great quarter, but pricing was down. Can I assume it was down around 4% or so because volume was up 4?

Larry Pope

I guess we can calculate—is 4--? Yeah, our people—Ken Sullivan is telling me that number is 4%. You’ve got the number exactly.

Robert Moskow – Credit Suisse

Okay.

Larry Pope

But you had more fresh meat (inaudible) and more overall pounds were being sold, and you’re comparing back against last year when there were some really outrageous, outrageous raw material costs. So there’s no question that prices coming back a bit helped that business, but still high.

Bo Manly

Well, and the $0.21 is above our normalized range, so—

Larry Pope

That’s right.

Bo Manly

--we really think that it’s an unusual quarter. We had some very good programs in place and the raw material side worked in our advantage.

Robert Moskow – Credit Suisse

And I guess my question is how long do you think that environment will last for you? You know, the sow slaughter I assume is leading to lower costs for sausage, and then the cuts of meat—you know, you’re getting better sliced meat costs as well. Can you kind of break down packaged meat as to which parts of your business enjoyed the best benefit?

Larry Pope

Oh yeah, I’ll give you right off the top. I don’t even go through that in my conversations. Let’s start with sliced bacon – that’s sort of a commodity product, and we’re the biggest slicer in the country. Our business in bacon was extremely good for the quarter, but beyond that our boneless smoked meat business was good, our hot dog business was good. Our breakfast sausage was good, our dry sausage was good. This is not a one-dog or one-horse trick here. We had this across a lot of the product categories and lower raw material costs helped us, so I don’t want to downplay that and Bo makes his point valid. But I think that we are continuing to have some—I’m very pleased with what I see in our sales and marketing organizations. We’ve beefed up those organizations with high-quality people. They have gotten their heads around the programs that are effective at delivering the value both from a brand and a volume standpoint to our customers. We are enjoying some of now the best relationships with our customers ever, and I think that our brands are not at the top of the price point. We’re in the midpoint were 80% of consumers shop, and we are right down the middle of the fairway when people are going into the grocery store looking for something to buy. And as the food service organizations are trying to control their menu pricing, I think they turn to us because I think we can deliver to them a good product at a value price, and we can still make a dollar on it.

Robert Moskow – Credit Suisse

Larry, within the complex of packaged meats, where do you think the costs are going to start going up higher first? Would it be in, like sausages, or would it be in bacon or would it be in sliced meats? Where would it start going up?

Larry Pope

Gosh, I don’t know where I would—and Bo, I don’t know if you have any comment. That has to do with the dynamic of which individual cut is certainly seasonally in. I mean, bellies went down substantially. Bellies have come right back in terms of pricing.

Bo Manly

I think the point is we have a very broad base of packaged meats. It is not dependent upon one particular prime or one particular cut, so there can be differences in cut-out value period to period. But overall, I think that we’re well positioned to be able to absorb price increases across all of the primals in our packaged meats business, and when the day is said and done we’re sticking with our prognostication of the upper end of the normalized range for the balance of this year. So probably $0.21 is not in the—

Larry Pope

Where we have we guided them to in terms of the normalized—

Bo Manly

The high end of the normalized range.

Larry Pope

What is it?

Bo Manly

That would be somewhere $0.15 to $0.17.

Robert Moskow – Credit Suisse

Okay, okay. Thank you.

Operator

And we’ll go to Vincent Andrews with Morgan Stanley. Please go ahead.

Vincent Andrews – Morgan Stanley

Thank you. My question is just sort of a roll-forward of some of your comments earlier, Larry, on the consumer, and I’m just thinking out another 12 or 18 months, assuming grain prices and the curves are what they are, and maybe a little bit upwardly biased. If the consumer is seeing sticker shock today at current chicken, pork and beef prices, what’s going to have to happen between now and then for the consumer to want to accept what would definitively have to be higher chicken, pork and beef prices in an environment where unemployment is what it is and gas prices are back up and so forth? So what do you envision happening in the next 12 to 18 months?

Larry Pope

Well, I guess the consumer is going to see some prices on some products that they have not seen before, and so every time—that’s sort of like when gasoline went from $2. to $3, and $3 to $4, and $4 to $5. I mean, consumers react to that, and they certainly react when they start seeing bacon at $5 a pound. But the other side of that is when you look at pork and you look right beside at the price of beef, I mean, if you got sticker shock on pork you have a heart attack when you look at beef. So I think the value shift may very well come to us as beef becomes more and more expensive, and seafood is already out of the range of a lot of consumers on a regular basis.

So I think they are going to have to adjust. I think near-term they’ll think about how to spend their consumer dollars, and so we’ll have to see whether retail demand falls off from that. But what we might see is it rotate away from even higher beef to our pork products, because I think that is still—pork is still a value in the meat case.

Vincent Andrews – Morgan Stanley

So when you roll all that up, you think you’ll gain more from pork than you’ll lose, by the same thesis, down to chicken, and at the same time you still feel comfortable with your normalized margins on the processing side even though just the math makes it harder to earn the same percentages on an operating profit basis as the top line goes higher and the COGS go higher. So that still all pencils out okay to you?

Larry Pope

Well obviously if I had a crystal ball, I would love to know that’s true. I would tell you that I think our marketing programs will help cover some of that, and we are taking market share. We are improving our market share in the retail categories, so I think the combination of all of that and moving out of—moving away from or less of our product being tied to private label and our lesser brands and more of it tied to our 12 core brands which sell at higher prices for better margins. If you put all that together, yeah, I feel good. I feel good about it. We’re still going to be fine.

Vincent Andrews – Morgan Stanley

Okay, thanks very much. I’ll pass it along.

Operator

And next we’ll go to the line of Ryan Oksenhendler with Bank of America. Please go ahead.

Ryan Oksenhendler – Bank of America Merrill Lynch

Hey, good morning guys. I was wondering in terms of the volume growth in packaged meats this quarter, how much of it was access to the new food service accounts? You know, if you can give a breakdown of your same store sales kind of number year-over-year versus the new distribution that you’ve had. And then can you give us an idea of what gave you access to those new accounts, or how did you get those new accounts?

Larry Pope

Well I will tell you, Ryan, that’s the first time in the meat business I’ve ever had somebody ask me for same store sales, because I’m not sure we keep track of that customer by customer. We are getting some new food service customers and we’re getting more distribution with some of our existing food service accounts. As you well know, it takes time to develop a food service account. Those can be very long periods in coming together. I think that our whole vertical integration program that we have, that we can sell what I call storied program, and we can give them both assured supply and they know where the pigs are coming from, which matters more and more than it ever has in the past, I think is clearly to our benefit. Our customers realize that we’re a supplier they can count on. If they’re buying from somebody else who is having to source their raw material, they’re not sure they’re going to be able to get it, particularly as they look forward and they know there’s going to be less available out there.

On the retail side, I think that’s a jungle battle where we’re competing with all our other competitors out there, and it’s whoever can play the best game with their marketing programs and best pricing and get the consumer to pick up their product. That is certainly guerrilla warfare, but I’ll tell you, I think we’ve got good guerrillas. And so I think our marketing programs are showing off and our consumers are buying the program, and I think we’ve got good people. Smithfield has never been a marketing company. We don’t consider ourselves a consumer marketing company, but we are becoming a consumer marketing company. We are coming out there with new products. Our customers realize that they are seeing products coming through the product pipeline that they like, and so hopefully I like to tell our competition maybe they can finally hear our footsteps. If not, maybe they can look out the side mirror; maybe they see us beside them. But it’s an exciting time in the packaged meats side of this business.

Ryan Oksenhendler – Bank of America Merrill Lynch

Okay, thanks. And then just one quick follow-up – in terms of the margin outlook that you gave for hog production, somewhere between a slight loss and a slight profit, is that on a per-head basis or is that in absolute?

Bo Manly

Both.

Ryan Oksenhendler – Bank of America Merrill Lynch

Both? Okay, thank you.

Operator

And we’ll go to Tim Tiberio with Miller Tabak. Please go ahead.

Tim Tiberio – Miller Tabak

Good morning. You mentioned that you’re very positive on the long-term outlook for fresh pork and you’re comfortable in the export markets, but we’ve been reading that Japan is opening—reopening the market to certain Brazilian protein companies. Is that a concern to you longer term, that we might see more competition for U.S. pork or Brazilian pork in the next few months?

Bo Manly

It will not come in the next few months. It is an issue if you look out over the long term – the next 10 years, 15 years. Just getting Japanese approval does not create any Japanese sales. It’s a very, very long process to attract customers and gain product recognition in that marketplace. Smithfield has been at it for over 25 years and has one of the most successful programs with several of the key trading companies – Sumitomo, Maribani (ph), et cetera, and many others. So I think that we have competitive advantages because of our position. It will create some more competition there, but I think it will impact those with lesser positions in that marketplace than ours. I think that we’ll continue to have a preeminent position in the Japanese market.

So if you’re looking 10 years out, yeah, I think it could be an issue; but certainly over the next three to five years, it will take a long time for the Brazilians to achieve traction in the Japanese market.

Tim Tiberio – Miller Tabak

Okay, thanks for your time.

Operator

Our next question is from Reza Vahabzadeh with Barclays. Please go ahead.

Reza Vahabzadeh – Barclays

Good morning. Obviously the packaged meat profit per pound increased, what, $0.05 or $0.06 year-over-year, and then you had some internal factors helping that and some external factors. How much of the year-over-year improvement per pound was attributed to the lower input costs, and then how much of it was attributed to improved sales mix as well as higher volume?

Bo Manly

The increase was $0.04, not $0.05 to $0.06. It was $0.17 to $0.21. And at this point, we’re rather not comment on the breakdown of that in terms of fresh meat—or the raw material versus our marketing and increased spending there. But it was broad-based across all of the categories. It was broad-based against all of the retail channels and food service and deli, so it was very, very satisfying because it was so omnipresent across the entire category.

Reza Vahabzadeh – Barclays

Got it. And—

Larry Pope

But let’s be clear – Bo has made it very clear, guys, and I hope I’m eating my words here at the end of the second quarter and telling you we made a mistake and we did make $0.20 a pound again. But we are not sitting here today telling you that our go-forwards margins on packaged meats is $0.20 a pound. So even if the raw material costs go up, we’re telling you our packaged meats margins, we don’t think that we have got enough in place yet to maintain these $0.20 margins, and I hope I’m wrong. But the fact is—so if we come back a bit, I’m not going to be bothered by that.

Bo Manly

Most recently, we have increased our normalized margin range from $0.10 to $0.15 to $0.12 to $0.17, and we’ve indicated today that we believe on a full-year basis we’ll be at the high end of the normalized range.

Reza Vahabzadeh – Barclays

Bo, did you have the cash and the total debt outstanding at the end of the quarter as well?

Bo Manly

I’m sorry – can you repeat that question?

Reza Vahabzadeh – Barclays

Do you have the cash as well as total debt outstanding at the end of the quarter?

Bo Manly

At the end of the quarter, our total debt was 2.0 million and we had—or billion, rather, and we had $150 million in cash.

Reza Vahabzadeh – Barclays

Got it, thank you.

Operator

And we’ll go to Carla Casella with JP Morgan. Please go ahead.

Carla Casella – JP Morgan

Hi. My question is on the—you talked about the impact that beef is having in the meat case, and I’m wondering how long you expect that to occur, and if you’re seeing any kind of change in the way food service promotes the different items in the meat case.

Larry Pope

I missed that question. Repeat the beginning of that again?

Carla Casella – JP Morgan

You mentioned beef is having an impact on the meat case. I’m wondering how long you expect that to continue.

Bo Manly

I don’t see any let-up in terms of high priced beef at this point as long as we continue to have $8 corn, and I’m not sure that the reference to the meat case—the food service people, they don’t put anything into a meat case. So I think that they’ll have issues in terms of trying to have any menu items that are going to be cheap as far as beef is concerned.

Larry Pope

Well, we’re looking at less beef next year than this year. I don’t know what grain prices are going to be next year – it’s too hard to tell – but for the near term, they’re going to be elevated. So I think beef is going to be expensive. I don’t see any trend that’s going to push beef prices down. If anything, I think there could be some upward movement from even there.

Carla Casella – JP Morgan

Okay, great. And then have you set a new target in terms of your comfort level with leverage, given that you’ve done the refinancings and now you’re looking more at share buybacks. What’s your comfort level, your range for keeping leverage?

Larry Pope

Well, certainly we were uncomfortable at the leverage where we were a couple of years ago in 2008 and ’09, and into ’10. And so I think—Bo, have we given some direction to them in terms of our debt-to-EBITDA leverage?

Bo Manly

We have maintained that we want to keep a debt-to-capitalization ratio below 40% going forward. We’re in the low 30s now, so we have a little bit of headroom; but we like the position we’re in, we’re comfortable.

I would like to clarify – there was a question about the amount of available cash at the end of the quarter. We had about $150 million in domestic cash, and we had an additional amount of European and international cash tied up, so our total cash for the total company was about 208 million as opposed to 150.

Carla Casella – JP Morgan

Great, thank you.

Keira Lombardo

Operator, we’re going to end the questions here, please.

Operator

Okay, please continue.

Larry Pope

I just want to make some final comments that clearly we were not satisfied with our fresh meat business, and we—and the quarter certainly was a weak quarter, seasonally a weak quarter. But I think we didn’t have as good a quarter somewhat impacted by some of the export dynamics I talked about. I continue to believe that we have a packaged meats business to be proud of. I think looking forward our pork is going to be a value relative to the competing protein, primarily beef, and I think that’s going to work to our benefit. I think that we’re moving into seasonally better fresh pork. I think that we are working through that business. Our export business is returning than it was before, and I think from the live production side we have taken the appropriate steps to mitigate the impact. Exactly what happened this summer is the reason we changed our hedging program a few years ago. We did not know when corn was going to be $7 and $8 again. In fact, it came sooner than I thought; but the fact is we were prepared for this high-priced grain when it came, even when there was debate this summer about whether we should conceivably get off our hedges because grain was going to trend down. We did not.

We are controlling cost and trying to manage the margin. We’re going to maximize the meat side of the business. Our farms worked to benefit the meat business, and we’re selling that vertical integration story through to our food service and retail customers, and they are understanding it and appreciating it. All of this is accruing, I think, to a better future for Smithfield Foods, and I’m excited about where we’re at. I’m extremely pleased with my management team and what they’ve done this quarter, and I think we’ve got some good things to report to you in quarters to come.

I thank you very much for listening this morning and we’ll look forward to catching up with you in the second quarter.

Operator

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect.

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