Item 2. Management’s Discussion and Analysis
ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following information in conjunction with the unaudited consolidated condensed financial statements and the related notes in this Quarterly Report and the audited financial statements and the related notes as well as Management’s Discussion and Analysis of Financial Condition and Results of Operation contained in our Annual Report on Form 10-K for the fiscal year ended April 28, 2013 .
EXECUTIVE OVERVIEW
We are the largest hog producer and pork processor in the world. In the United States, we are also the leader in numerous packaged meats categories with popular brands including Farmland®, Smithfield®, Eckrich®, Armour® and John Morrell®. We are committed to providing good food in a responsible way and maintaining robust animal care, community involvement, employee safety, environmental, and food safety and quality programs.
We produce and market a wide variety of fresh meat and packaged meats products both domestically and internationally. We operate in a cyclical industry and our results are significantly affected by fluctuations in commodity prices for livestock (primarily hogs) and grains. Some of the factors that we believe are critical to the success of our business are our ability to:
▪
maintain and expand market share, particularly in packaged meats,
▪
develop and maintain strong customer relationships,
▪
continually innovate and differentiate our products,
▪
manage risk in volatile commodities markets, and
▪
maintain our position as a low cost producer of live hogs, fresh pork and packaged meats.
We conduct our operations through four reportable segments: Pork, Hog Production, International and Corporate, each of which is comprised of a number of subsidiaries, joint ventures and other investments. The Pork segment consists mainly of our three wholly owned U.S. fresh pork and packaged meats subsidiaries : The Smithfield Packing Company, Inc., Farmland Foods, Inc. and John Morrell Food Group. The Hog Production segment consists of our hog production operations located in the U.S. The International segment is comprised mainly of our meat processing and distribution operations in Poland, Romania and the United Kingdom, our interests in meat processing operations, mainly in Western Europe and Mexico, our hog production operations located in Poland and Romania and our interests in hog production operations in Mexico. The Corporate segment provides management and administrative services to support our other segments.
First Quarter of Fiscal 2014 Summary
Net income was $39.5 million , or $.27 per diluted share, in the first quarter of fiscal 2014 compared to net income of $61.7 million , or $.40 per diluted share, in the same quarter last year. The following summarizes the operating results of each of our reportable segments and other significant changes impacting net income for the first quarter of fiscal 2014 compared to the first quarter of fiscal 2013 :
▪
Pork segment operating profit decreased by $57.2 million due to higher raw material costs and weakness in certain export markets.
▪
Hog Production segment operating profit increased by $43.4 million primarily due to 6% higher market hog prices.
▪
International segment operating profit decreased by $13.9 million , hurt by higher feed costs in Eastern Europe and Mexico.
▪
Corporate segment results decreased by $6.8 million primarily due to acquisition related costs and fees associated with the Shuanghui and KCS transactions, which are described below.
21
Definitive Merger Agreement
On May 28, 2013, we entered into an Agreement and Plan of Merger (the Merger Agreement) with Shuanghui International Holdings Limited (Shuanghui) and Sun Merger Sub, Inc., a wholly owned subsidiary of Shuanghui (Merger Sub), pursuant to which Merger Sub will merge with and into the Company (the Merger), with the Company surviving the Merger as a wholly owned subsidiary of Shuanghui. Shuanghui is the majority shareholder of Henan Shuanghui Investment & Development Co., which is China's largest meat processing enterprise and China's largest publicly traded meat products company as measured by market capitalization.
At the effective time of the Merger, each share of the Company's common stock issued and outstanding immediately prior to such effective time (other than shares held by the Company or its wholly owned subsidiaries, or by Shuanghui or Merger Sub) will be automatically converted into the right to receive $34.00 in cash, without interest and less any applicable withholding taxes (the Merger Consideration). In addition, upon completion of the Merger, all then-outstanding stock-based compensation awards, whether vested or unvested, will be converted into the right to receive the Merger Consideration, less the exercise price of such awards, if any. A special meeting of the Company's shareholders (the Special Meeting) has been scheduled for September 24, 2013 for the purpose of voting on the approval of the Merger Agreement, the related plan of merger and the Merger. The closing of the Merger is subject to various conditions, including the condition that the Merger Agreement and the related plan of merger be approved by the affirmative vote of the holders of a majority of all of the outstanding shares of the Company's common stock entitled to vote thereon at the Special Meeting. The closing of the Merger is also subject to certain regulatory approvals and other customary closing conditions. Additional information about the Merger and the Merger Agreement is set forth in the Company's Current Report on Form 8-K filed with the Securities and Exchange Commission (the SEC) on May 29, 2013 and in the Company's definitive proxy statement filed with the SEC on August 19, 2013 (the Proxy Statement) with respect to the Special Meeting.
The Merger will provide us with the opportunity to expand our offering of products to China through Shuanghui's distribution network. Shuanghui will gain access to high-quality, competitively-priced and safe U.S. products, as well as our best practices and operational expertise. We do not anticipate any changes in how we do business operationally in the U.S. and throughout the world. The Merger would provide our shareholders with significant and immediate cash value for their investment, and would ensure that we continue to execute on our strategic priorities while maintaining our brand excellence, community involvement, and our commitment to environmental stewardship and animal welfare.
The Merger will be financed through a combination of cash provided by Shuanghui, rollover of certain existing Company debt and the proceeds of the Merger Sub Notes. The Merger Agreement does not contain a financing condition.
The Merger is expected to close in the second half of calendar 2013. The financing of the Merger is more fully explained under "Additional Matters Affecting Liquidity" below.
If the Merger is consummated, it is currently contemplated that the Merger will be accounted for as a business combination using the acquisition method of accounting. As such, it is expected that our financial statements in the future will vary in important respects from our historical consolidated financial statements. The purchase consideration is expected to be allocated to our tangible and intangible assets, liabilities and noncontrolling interests based on their respective fair values as of the date of the Merger. Certain of these adjustments will impact future net income.
Strategies for Growth
Our strategies for growth include:
•
Capitalize on export opportunities. We believe our balanced geographic footprint will position us to capitalize on growing pork consumption trends across Europe, Asia and the Americas. We have an experienced international sales force and management team to support this growth.
•
Increase capital investment to upgrade facilities with new machinery and equipment to improve our competitive cost structure and achieve least cost and best in class operations. We expect $300 million to $350 million in annual capital expenditures over the next several years to fund this investment.
•
Continue higher investment in marketing and advertising programs to build brand equity and grow sales. Our plan is to increase our annual marketing and advertising expenditures by double digits for the foreseeable future. Currently, marketing and advertising expense represents approximately 2% of domestic packaged meats sales.
22
•
Build a strong product pipeline to drive packaged meats volume and margins. We have established a culture of innovation, focusing on five strategic areas: packaging, health and wellness, convenience, taste and pork consumer solutions. These platforms have a strong focus on product differentiation highlighting quality and convenience, better-for-you foods, including lower sodium, lean protein, and natural ingredients, and new taste experiences.
•
Emphasize our hog production assets as a strategic point of difference. We believe that our vertically integrated platform is a competitive advantage for the Company as it allows us to meet customer specifications. Both domestic and export customers are asking for differentiated products, from gestation pen pork to ractopamine-free meat, and we are uniquely positioned to fill this demand. Our facilities in Clinton, North Carolina and Bladen County, North Carolina are 100% ractopamine-free.
Porcine Epidemic Diarrhea Virus (PEDv)
The USDA has identified PEDv in the United States for the first time. PEDv is an industry wide issue, but it is currently affecting primarily Midwest swine operators. Currently, there has only been a very limited impact from the virus on the Company's hog raising operations. Nevertheless, we are subject to risks relating to our ability to maintain animal health and control PEDv. Therefore, we are unable to predict whether the disease will impact our operations or market prices in the future.
Outlook
The commodity markets affecting our business fluctuate on a daily basis. In this operating environment, it is difficult to forecast industry trends and conditions. The outlook statements that follow must be viewed in this context.
The first quarter is seasonally the weakest period for fresh pork and should be the least profitable for the Company in fiscal 2014. We will continue to execute our long-term strategic growth plan to improve earnings and migrate the Company more towards a value-added consumer packaged meats company. We believe this plan will produce broad-based gains in volume, market share and distribution across our core brands and key product categories. The combination of those gains, an improving product mix toward differentiated, branded and value-added products, as well as loosening export market restrictions in our fresh pork business and higher contributions from our international meat processing business, should provide significant long-term growth potential for Smithfield.
For fiscal 2014, we expect fresh pork operating profit on a per head basis to average in the low to mid-single digits. We expect our packaged meats business to continue to post strong results in fiscal 2014 with operating margins averaging in the middle part of our newly established normalized range of $.15 to $.20 per pound. Lower raising costs, higher hog prices and improved efficiencies and productivity in our Hog Production segment should result in operating margins in the mid-single digits on a per head basis for fiscal 2014. In our International segment, we anticipate improvement in results for the remainder of fiscal 2014.
23
RESULTS OF OPERATIONS
Significant Events Affecting Results of Operations
Acquisition of Kansas City Sausage, LLC
In May 2013 (fiscal 2014), we acquired a 50% interest in Kansas City Sausage Company, LLC (KCS), for $36.0 million in cash. Upon closing, in addition to the cash purchase price, we advanced $10.0 million to the seller in exchange for a promissory note, which is secured by the remaining membership interests in KCS held by the seller. Additionally, we entered into a revolving loan agreement with KCS, under which we agreed to make loans from time to time up to an aggregate principal amount of $20.0 million . The aggregate amount of any obligations incurred under the revolving loan agreement is secured by a first priority security interest in all of the assets of KCS.
KCS operates in Des Moines, Iowa and Kansas City, Missouri. In Des Moines, KCS produces premium raw materials for sausage, as well as value-added products, including boneless hams and hides. The Kansas City plant is a modern sausage processing facility and is designed for optimum efficiency to provide retail and foodservice customers with high quality products. With our strong ongoing focus on building our packaged meats business, and with 15% of the U.S. sow population, this joint venture is a logical fit for the Company. It is expected to provide a growth platform in two key packaged meats categories — breakfast sausage and dinner sausage — and to allow us to expand our product offerings to our customers. These categories represent over $4.0 billion in retail and foodservice sales annually.
KCS is managed by its Board of Directors, which makes decisions that most significantly impact the economic performance of KCS. We have the right to nominate and elect the majority of the members of the Board of Directors of KCS, and based on the associated voting rights, we have determined that we have a controlling financial interest in KCS. As a result, the acquisition of our interest in KCS was accounted for in the Pork segment using the acquisition method of accounting. Currently, KCS generates approximately $200 million in sales annually.
Consolidated Results of Operations
The tables presented below compare our results of operations for the three months ended July 28, 2013 and July 29, 2012 .
Sales and cost of sales
Three Months Ended
July 28,
2013
July 29,
2012
%
Change
(in millions)
Sales
$
3,393.3
$
3,091.3
10
%
Cost of sales
3,089.1
2,759.1
12
Gross profit
$
304.2
$
332.2
(8
)%
Gross profit margin
9
%
11
%
The following items explain the significant changes in sales and gross profit:
▪
Sales increased significantly due to higher volumes across all segments, higher pork prices in the U.S. and the acquisition of KCS.
▪
The decline in gross margin was primarily caused by higher raw material costs and weakness in certain export markets.
Selling, general and administrative expenses (SG&A)
Three Months Ended
July 28,
2013
July 29,
2012
%
Change
(in millions)
Selling, general and administrative expenses
$
205.2
$
201.1
2
%
24
The increase in SG&A is primarily attributable to acquisition related costs associated with the Shuanghui and KCS transactions.
(Income) loss from Equity Method Investments
Three Months Ended
July 28,
2013
July 29,
2012
%
Change
(in millions)
CFG
$
(0.1
)
$
(0.1
)
—
%
Mexican joint ventures
3.0
0.4
(650
)
All other equity method investments
(1.2
)
(1.0
)
20
(Income) loss from equity method investments
$
1.7
$
(0.7
)
(343
)%
The decline in profitability of our Mexican joint ventures was largely driven by unfavorable foreign currency transaction losses.
Interest expense
Three Months Ended
July 28,
2013
July 29,
2012
%
Change
(in millions)
Interest expense
$
41.8
$
42.5
(2
)%
Income tax expense
Three Months Ended
July 28,
2013
July 29,
2012
(in millions)
Income tax expense
$
16.0
$
27.6
Effective tax rate
29
%
31
%
The decline in income tax expense is attributable to the decrease in pre-tax profitability.
25
Segment Results
The following information reflects the results from each respective segment prior to the elimination of inter-segment sales.
Pork Segment
Three Months Ended
July 28,
2013
July 29,
2012
%
Change
(in millions, unless indicated otherwise)
Sales:
Fresh pork (1)
$
1,363.4
$
1,261.0
8
%
Packaged meats
1,487.0
1,338.6
11
Total
$
2,850.4
$
2,599.6
10
%
Operating profit (loss): (2)
Fresh pork (1)
$
(36.5
)
$
(12.0
)
(204
)%
Packaged meats
97.9
130.6
(25
)
Total
$
61.4
$
118.6
(48
)%
Sales volume:
Fresh pork
4
%
Packaged meats
2
%
Total
4
%
Average unit selling price:
Fresh pork
4
%
Packaged meats
9
%
Total
5
%
Hogs processed
4
%
Average domestic live hog prices (per hundredweight) (3)
$
70.66
$
66.47
6
%
——————————————
(1)
Includes by-products and rendering.
(2)
Fresh pork and packaged meats operating profits represent management's estimated allocation of total Pork segment operating profit.
(3)
Represents the average live hog market price as quoted by the Iowa-Southern Minnesota hog market.
In addition to the information provided in the table above, the following items explain the significant changes in Pork segment sales and operating profit:
▪
Sales were positively impacted by higher slaughter volumes and weights, solid demand for pork in the U.S., which drove pork prices higher, and the acquisition of KCS.
▪
Fresh pork operating margin decreased to a loss of $5 per head from a loss of $2 per head as sales margins were adversely impacted by weakness in certain export markets. The first quarter is historically the most difficult time of the year for fresh pork.
▪
Packaged meats operating margin decreased to $.16 per pound from a record $.21 per pound as a result of higher raw material costs, particularly bellies.
26
Hog Production Segment
Three Months Ended
July 28,
2013
July 29,
2012
% Change
(in millions, unless indicated otherwise)
Sales
$
872.4
$
728.8
20
%
Operating profit
$
66.5
$
23.1
188
%
Head sold
3.84
3.62
6
%
Average domestic live hog prices (per hundredweight) (1)
$
70.66
$
66.47
6
%
Raising costs (per hundredweight) (2)
$
68.15
$
66.93
2
%
——————————————
(1)
Represents the average live hog market price as quoted by the Iowa-Southern Minnesota hog market. These prices do not reflect premiums we receive or the impact of hedging on our actual sales price.
(2)
Includes the effects of grain derivative contracts designated in hedging relationships. Does not include the effects of grain derivative contracts that are not designated in hedging relationships for accounting purposes.
In addition to the information provided in the table above, the following items explain the significant changes in Hog Production segment sales and operating profit:
▪
Sales and operating profit were positively impacted by higher sales volumes and higher live hog market prices.
▪
Sales and operating profit were positively impacted by higher sales premiums for ractopamine-free hogs and improvements in productivity resulting from the cost savings initiative.
▪
Raising costs increased as a result of higher priced feed.
27
International Segment
Three Months Ended
July 28,
2013
July 29,
2012
% Change
(in millions)
Sales:
Poland
$
299.2
$
273.3
9
%
Romania
70.9
63.5
12
United Kingdom
19.1
20.9
(9
)
Eliminations
(13.2
)
(10.9
)
(21
)
Total
$
376.0
$
346.8
8
%
Operating profit (loss):
Poland
$
3.9
$
14.1
(72
)%
Romania
2.2
4.9
(55
)
United Kingdom
0.5
(0.4
)
225
Other (1)
(4.7
)
(2.8
)
(68
)
Total
$
1.9
$
15.8
(88
)%
Poland: (2)
Sales volume
22
%
Average unit selling price (3)
(12
)%
Hogs processed
19
%
Raising costs (per hundredweight)
13
%
Romania: (2)
Sales volume
—
%
Average unit selling price (3)
8
%
Hogs processed
3
%
Raising costs (per hundredweight)
12
%
——————————————
(1)
Includes the results from our equity method investments in Mexico and our investment in CFG.
(2)
Percentages computed based on local currency amounts.
(3)
Excludes the sale of live hogs
In addition to the information provided in the table above, the following items explain the significant changes in International segment sales and operating profit:
▪
Sales volumes in our Polish operations increased primarily due to a 19% increase in hogs processed. Higher volumes of lower value by-products that resulted from more processed hogs effectively diminished the overall average unit selling price in the current year. Higher hog raising costs negatively impacted operating profit in Poland.
▪
Sales and operating profit in Romania benefitted from significantly higher sales prices, but profitability declined as a result of substantially higher hog feed costs.
▪
Results from our Mexican joint ventures decreased by $2.6 million primarily due to unfavorable foreign currency transaction losses.
28
Corporate Segment
Three Months Ended
July 28,
2013
July 29,
2012
% Change
(in millions)
Operating loss
$
(32.5
)
$
(25.7
)
(26
)%
Operating results in the corporate segment declined primarily due to acquisition related expenses incurred in connection with the Shuanghui and KCS transactions.
LIQUIDITY AND CAPITAL RESOURCES
Summary
Our cash requirements consist primarily of the purchase of raw materials used in our hog production and pork processing operations, long-term debt obligations and related interest, lease payments for real estate, machinery, vehicles and other equipment, and expenditures for capital assets, other investments and other general business purposes. Our primary sources of liquidity are cash we receive as payment for the products we produce and sell, as well as our credit facilities.
We believe that our current liquidity position is strong and that our cash flows from operations and availability under our credit facilities will be sufficient to meet our working capital needs and financial obligations for at least the next twelve months. As of July 28, 2013 , our liquidity position was approximately $1.0 billion , comprised of $823.2 million in availability under our credit facilities and $192.8 million in cash and cash equivalents.
Sources of Liquidity
We have available a variety of sources of liquidity and capital resources, both internal and external. These resources provide funds required for current operations, acquisitions, integration costs, debt retirement and other capital requirements.
Accounts Receivable and Inventories
The meat processing industry is characterized by high sales volume and rapid turnover of inventories and accounts receivable. Because of the rapid turnover rate, we consider our meat inventories and accounts receivable highly liquid and readily convertible into cash. The Hog Production segment also has rapid turnover of accounts receivable. Although inventory turnover in the Hog Production segment is slower, mature hogs are readily convertible into cash. Borrowings under our credit facilities are used, in part, to finance increases in the levels of inventories and accounts receivable resulting from seasonal and other market-related fluctuations in raw material costs.
Credit Facilities
July 28, 2013
Facility
Capacity
Outstanding Letters of Credit
Outstanding Borrowings
Amount Available
Inventory Revolver
$
1,025.0
$
—
$
(275.0
)
$
750.0
Securitization Facility
275.0
(88.6
)
(170.0
)
16.4
International facilities
143.4
—
(86.6
)
56.8
Total credit facilities
$
1,443.4
$
(88.6
)
$
(531.6
)
$
823.2
29
Cash Flows
Operating Activities
Three Months Ended
July 28,
2013
July 29,
2012
(in millions)
Net cash flows from operating activities
$
13.1
$
67.3
The following items explain the significant changes in cash flows from operating activities:
▪
Cash paid for domestic grain and other feed ingredients increased approximately $117 million .
▪
In fiscal 2014, we paid $5.4 million for the settlement of derivative contracts and for margin requirements compared to $67.9 million received in fiscal 2013.
▪
Cash paid to outside hog suppliers increased approximately $33 million due to a 6% increase in domestic live hog market prices.
▪
Cash received from customers increased significantly due to increased sales.
Investing Activities
Three Months Ended
July 28,
2013
July 29,
2012
(in millions)
Capital expenditures
$
(76.4
)
$
(61.2
)
Acquisitions, net of cash acquired
(32.8
)
—
Net expenditures from breeding stock transactions
(5.6
)
(6.5
)
Proceeds from the sale of property, plant and equipment
1.5
6.5
Advance note
(10.0
)
—
Net cash flows from investing activities
$
(123.3
)
$
(61.2
)
The following items explain the significant investing activities for the three months ended July 28, 2013 and July 29, 2012 :
Fiscal 2014
▪
Capital expenditures primarily related to plant and hog farm improvement projects, including the replacement of gestation stalls with group pens, which is more fully explained under "Additional Matters Affecting Liquidity" below.
▪
We paid $32.8 million , net of cash acquired, for a 50% interest in KCS.
▪
We advanced $10.0 million to the seller of KCS in exchange for a promissory note, which is secured by the remaining membership interests in KCS held by the seller.
Fiscal 2013
▪
Capital expenditures included $21.3 million related to our Kinston, North Carolina plant expansion project. The remaining capital expenditures primarily related to plant and hog farm improvement projects.
30
Financing Activities
Three Months Ended
July 28,
2013
July 29,
2012
(in millions)
Proceeds from the issuance of long-term debt
$
—
$
24.2
Principal payments on long-term debt and capital lease obligations
(457.2
)
(4.2
)
Net proceeds from revolving credit facilities and notes payable
449.0
6.5
Repurchase of common stock
—
(145.3
)
Other
—
0.2
Net cash flows from financing activities
$
(8.2
)
$
(118.6
)
The following items explain the significant financing activities for the three months ended July 28, 2013 and July 29, 2012 :
Fiscal 2014
▪
In July 2013 , we repaid the outstanding principal balance on our 4% senior unsecured convertible notes totaling $400.0 million .
▪
In May 2013 , we repaid the remaining outstanding principal amount on our 7.75% senior unsecured notes totaling $55.0 million .
▪
We drew $275.0 million on our Inventory Revolver and $170.0 million on our Securitization Facility to repay the aforementioned notes and for working capital needs.
Fiscal 2013
▪
We repurchased 7,421,231 shares of our common stock for $145.3 million as part of the Share Repurchase Program, which is more fully explained under "Additional Matters Affecting Liquidity."
Interest Rate Spread
As of July 28, 2013 , the interest rates on borrowings under the Inventory Revolver and the Securitization Facility were LIBOR plus 3.25% and the lender's cost of funds of 0.22% plus 1.15% , respectively. The Inventory Revolver interest rate spread is based on a pricing-level grid in the agreement and determined by our Funded Debt to EBITDA ratio (as defined in the Second Amended and Restated Credit Agreement, dated as of June 9, 2011, among the Company, specified subsidiaries of the Company, Rabobank Nederland, New York Branch, as Administrative Agent, specified lenders, and the other specified agents and arrangers, as amended).
Guarantees
As part of our business, we are a party to various financial guarantees and other commitments as described below. These arrangements involve elements of performance and credit risk that are not included in the consolidated condensed balance sheets. We could become liable in connection with these obligations depending on the performance of the guaranteed party or the occurrence of future events that we are unable to predict. If we consider it probable that we will become responsible for an obligation, we will record the liability on our consolidated balance sheet.
As of July 28, 2013 , we continued to guarantee $9.9 million of leases that were transferred to JBS S.A. in connection with the sale of Smithfield Beef, Inc. This guaranty may remain in place until the leases expire through February 2022.
31
Additional Matters Affecting Liquidity
Capital Projects
We anticipate annual capital expenditures in the range of $300 million to $350 million over the next several years to upgrade facilities with new machinery and equipment in order to improve our competitive cost structure and achieve least cost and best in class operations. These capital expenditures are expected to be funded with cash flows from operations and/or borrowings under credit facilities.
Share Repurchase Program
In June 2012 (fiscal 2013), we announced that our board of directors had approved a new share repurchase program authorizing us to buy up to $250.0 million of our common stock over the next 24 months in addition to the $250.0 million authorized during fiscal 2012 (Share Repurchase Program). In July 2012 (fiscal 2013), our board of directors approved an increase of $100.0 million to the authorized amount under the Share Repurchase Program. Share repurchases may be made on the open market, or in privately negotiated transactions. The number of shares repurchased, and the timing of any buybacks, will depend on corporate cash balances, business and economic conditions, and other factors, including investment opportunities. The program may be discontinued at any time. The Merger Agreement generally prohibits the Company from repurchasing any of its shares prior to completion of the Merger.
Since the inception of the Share Repurchase Program in June 2011 (fiscal 2012) and through July 28, 2013 , we have repurchased 28,244,783 shares of our common stock for $575.9 million , including related fees. As of July 28, 2013 , we had approximately 24.5 million available for future repurchases under the Share Repurchase Program.
Group Pens
In January 2007 (fiscal 2007), we announced a voluntary, ten-year program to phase out individual gestation stalls at our Company-owned sow farms and replace the gestation stalls with group pens. We currently estimate the total cost of our transition to group pens to be approximately $360.0 million, including associated maintenance and repairs. This program represents a significant financial commitment and reflects our desire to be more animal friendly, as well as to address the concerns and needs of our customers. As of the end of calendar year 2012, we had completed conversions to group housing for over 38% of our sows on Company-owned farms. We will continue the conversion as planned with the objective of completing conversions for all sows on Company-owned farms by the end of 2017.
Definitive Merger Agreement
The Merger Agreement contains certain termination rights for the Company and Shuanghui. Upon termination of the Merger Agreement under specified customary circumstances, the Company will be required to pay Shuanghui a termination fee. If the Merger Agreement is terminated in connection with the Company entering into an alternative acquisition agreement in respect of a superior proposal or making a change of recommendation, or in certain other customary circumstances, the termination fee payable by the Company to Shuanghui will be $175.0 million . The Merger Agreement also provides that Shuanghui will be required to pay the Company a reverse termination fee of $275.0 million (which is not exclusive in the case of a willful breach by Shuanghui) if the Merger Agreement is terminated under certain circumstances in connection with a willful breach by Shuanghui, termination primarily caused by the failure to obtain required U.S. or foreign antitrust or other regulatory approvals (other than the Committee on Foreign Investment in the United States), or termination as a result of the failure by Shuanghui to receive the proceeds of its committed debt financing and consummate the Merger.
On July 31, 2013, Merger Sub issued $500.0 million aggregate principal amount of 5.25% senior notes due August 1, 2018 and $400.0 million aggregate principal amount of 5.875% senior notes due August 1, 2021 (together, the Merger Sub Notes) as part of the financing for the acquisition of the Company. Upon the consummation of the Merger and release of the proceeds from escrow, the Merger Sub Notes will become unsecured obligations of the Company ranking equally in right of payment with all of our existing and future senior unsecured indebtedness. As a result, our cash interest payments are expected to increase significantly in future periods.
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Risk Management Activities
We are exposed to market risks primarily from changes in commodity prices, and to a lesser degree, interest rates and foreign exchange rates. To mitigate these risks, we utilize derivative instruments to hedge our exposure to changing prices and rates, as more fully described under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Derivative Financial Instruments” in our Annual Report on Form 10-K for the fiscal year ended April 28, 2013 . Our liquidity position may be positively or negatively affected by changes in the underlying value of our derivative portfolio. When the value of our open derivative contracts decreases, we may be required to post margin deposits with our brokers to cover a portion of the decrease. Conversely, when the value of our open derivative contracts increases, our brokers may be required to deliver margin deposits to us for a portion of the increase. During the three months ended July 28, 2013 , margin deposits posted by us ranged from $29.6 million to $80.7 million . The average daily amount on deposit with brokers during the three months ended July 28, 2013 was $54.8 million . As of July 28, 2013 , the net amount on deposit with brokers was $80.7 million .
The effects, positive or negative, on liquidity resulting from our risk management activities tend to be mitigated by offsetting changes in cash prices in our core business. For example, in a period of rising grain prices, gains resulting from long grain derivative positions would generally be offset by higher cash prices paid to farmers and other suppliers in spot markets. These offsetting changes do not always occur, however, in the same amounts or in the same period, with lag times of as much as twelve months.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of consolidated condensed financial statements requires us to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions are based on our experience and our understanding of the current facts and circumstances. Actual results could differ from those estimates. There have been no significant updates to our critical accounting policies and estimates described in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended April 28, 2013 .
FORWARD-LOOKING STATEMENTS
This report contains “forward-looking” statements within the meaning of the federal securities laws. The forward-looking statements include statements concerning our outlook for the future, as well as other statements of beliefs, future plans and strategies or anticipated events, and similar expressions concerning matters that are not historical facts. Our forward-looking information and statements are subject to risks and uncertainties that could cause actual results to differ materially from those expressed in, or implied by, the forward-looking statements. These risks and uncertainties include, but are not limited to: the occurrence of any event, change or other circumstances that could give rise to the termination of the Merger Agreement, the failure to receive, on a timely basis or otherwise, approval of the Merger proposal by the Company's shareholders or the approval of government or regulatory agencies with regard to the Merger, the failure of one or more conditions to the closing of the Merger Agreement to be satisfied, the failure of Shuanghui to obtain the necessary financing in connection with the Merger Agreement, the amount of the costs, fees, expenses and charges related to the Merger Agreement or Merger, risks arising from the Merger's diversion of management's attention from our ongoing business operations, risks that our stock price may decline significantly if the Merger is not completed, the ability of the Company to retain and hire key personnel and maintain relationships with customers, suppliers and other business partners pending the completion of the Merger, the availability and prices of live hogs, feed ingredients (including corn), raw materials, fuel and supplies, food safety, livestock disease, live hog production costs, product pricing, the competitive environment and related market conditions, risks associated with our indebtedness, including cost increases due to rising interest rates or changes in debt ratings or outlook, hedging risk, adverse weather conditions, operating efficiencies, changes in foreign currency exchange rates, access to capital, the cost of compliance with and changes to regulations and laws, including changes in accounting standards, tax laws, environmental laws, agricultural laws and occupational, health and safety laws, adverse results from litigation, actions of domestic and foreign governments, labor relations issues, credit exposure to large customers, the ability to make effective acquisitions and successfully integrate newly acquired businesses into existing operations, and other risks and uncertainties described under Part I, Item 1A. “Risk Factors” in Smithfield's Annual Report on Form 10-K for the fiscal year ended April 28, 2013 . Readers are cautioned not to place undue reliance on forward-looking statements because actual results may differ materially from those expressed in, or implied by, the statements. Any forward-looking statement that we make speaks only as of the date of such statement, and we undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise. Comparisons of results for current and any prior periods are not intended to express any future trends or indications of future performance, unless expressed as such, and should only be viewed as historical data.
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