SMITHFIELD FOODS INC 10-Q

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 Transition Report on Form 10-K for the eight months ended December 29, 2013 . On September 26, 2013, we merged with a wholly owned subsidiary of WH Group in a transaction accounted for as a business combination. Unless the context otherwise requires, all references to “Successor” refer to Smithfield Foods, Inc. and all its subsidiaries for the period subsequent to the Merger. All references to “Predecessor” refer to Smithfield Foods, Inc. and all its subsidiaries for all periods prior to the Merger. 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. Summary of Results Net income for the three months ended March 30, 2014 was $105.3 million compared to net income of $18.2 million in the three months ended March 31, 2013 . The following summarizes the operating results of each of our reportable segments and other significant changes impacting net income for the three months ended March 30, 2014 compared to net income for the three months ended March 31, 2013 : ▪ Pork segment operating profit increased $51.4 million as a result of significantly higher meat prices. ▪ Hog Production segment operating results increased $69.9 million as a result of a significant increase in domestic live hog market prices and lower raising costs. ▪ International operating profit increased $22.6 million due to higher sales and lower raw material costs in our European operations as well as an increase in equity income from our joint ventures in Mexico. 20 Porcine Epidemic Diarrhea Virus (PEDv) The United States Department of Agriculture (USDA) identified PEDv in the United States for the first time in 2013. PEDv, a disease that only infects pigs, not humans or other livestock, is an industry-wide issue and has a significant presence in U.S. swine. Our herds in several regions in which we operate are affected as PEDv continues to spread throughout the U.S. We are subject to risks related to our ability to maintain animal health and control PEDv. We are unable to predict the extent the disease will impact our operations or market prices in the future. Renewable Fuel Standard The federal Renewable Fuel Standard (RFS) program requires that bio-fuels be blended into transportation fuels at ever-increasing volumes up to 36 billion gallons in 2030. In October 2010, the Environmental Protection Agency (EPA) granted a “partial waiver” to a statutory bar under the Clean Air Act prohibiting fuel manufacturers from introducing fuel additives that are not “substantially similar” to those already approved and in use for vehicles of model year (MY) 1975 or later. Prior to EPA's decision, the ethanol content of gasoline in the United States was limited to 10 percent (E10), which created a barrier, commonly referred to as the “blendwall,” to the expansion of blended bio-fuels as prescribed by the RFS. The EPA's decision allows fuel manufacturers to increase the ethanol content of gasoline to 15 percent (E15) for use in MY 2007 and newer light-duty motor vehicles, including passenger cars, light-duty trucks and medium-duty passenger vehicles. In January 2011, the EPA granted another partial waiver authorizing E15 use in MY 2001-2006 light-duty motor vehicles. Judicial challenges to these rulemakings by a coalition of industry groups were dismissed. On November 15, 2013, the EPA proposed volume requirements and associated percentage standards that would apply under the RFS program in calendar year 2014 for cellulosic bio-fuel, biomass-based diesel, advanced bio-fuel and total renewable fuel. EPA’s proposal reduces the volume of renewable fuels mandated by statute and reflects EPA’s current estimate of what will actually be produced in 2014. EPA’s proposal reflects a concern that existing transportation infrastructure is unprepared for higher blends of bio-fuels in transportation fuels such as E15 and that the reduction in required volumes will maintain a blending percentage at E10 through 2014. EPA will consider public comments before setting the final standard. Although the long-term impact of the RFS is currently unknown, studies have shown that expanded corn-based ethanol production has driven up the price of livestock feed and led to commodity-price volatility. We cannot presently assess the full economic impact of the RFS program on the meat processing industry or on our operations. Country of Origin Labeling Following a World Trade Organization (WTO) panel ruling on a complaint by Canada and Mexico that existing U.S. country- of-origin labeling (COOL) requirements violated the United States’ WTO obligations, USDA published a new rule effective May 23, 2013, Mandatory Country of Origin Labeling of Beef, Pork, Lamb, Chicken, Goat Meat, Wild and Farm-Raised Fish and Shellfish, Perishable Agricultural Commodities, Peanuts, Pecans, Ginseng, and Macadamia Nuts . 78 Fed. Reg. 31367 (May 24, 2013) (the 2013 Rule). The 2013 Rule requires, in part, that labels on covered meat products must list separately, in sequence, the specific country where the animal was “born,” the country where it was “raised,” and the country where it was “slaughtered.” The rule also prohibits combining or commingling of meats with different “Born, Raised, and Slaughtered” combinations in the same package at retail. Judicial challenges to these rule-makings by a coalition of industry groups are pending. The Canadian and Mexican governments are also challenging the 2013 Rule before the Dispute Settlement Body of the WTO. If the Canadian and Mexican WTO challenge is successful, then USDA will be faced with the choice of re-formulating another country of origin regulation, seeking amendments to the underlying statute, or subjecting U.S. industries to substantial retaliatory tariffs. Although the long-term impact of COOL is currently unknown, industry groups have indicated that the rules impose additional costs on the industry including costs associated with segregation of livestock, record-keeping and new packaging and labeling along with potential retaliatory trade measures under WTO rules. We cannot presently assess the full economic impact of COOL on the meat processing industry or on our operations. 21 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. 2014 is off to a great start with record first quarter earnings. Looking forward, continued strong fundamentals driven by reduced hog and pork supplies, organic growth opportunities, as well as synergies with WH Group should fuel significantly improved year over year results. Hog production volumes will be lower due to PEDv, pushing hog and pork prices higher. The combination of lower corn costs and higher hog prices will generate strong hog production margins. At the same time, as part of WH Group’s global platform, we will continue to efficiently allocate resources by adjusting our Chinese exports to maximize value. We will also continue to grow our business organically by strengthening our brand positioning and lowering costs through improved efficiencies and productivity across all business segments. As such, we expect normalized operating margins, on a full year basis, in our fresh pork, packaged meats and international businesses despite higher input costs. RESULTS OF OPERATIONS Consolidated Results of Operations The tables presented below compare our results of operations for the three months ended March 30, 2014 and March 31, 2013 . As used in the tables, "NM" means "not meaningful." Three Months Ended March 30, 2014 and March 31, 2013 Successor Predecessor Three Months Ended March 30, 2014 March 31, 2013 % Change (in millions) Sales $ 3,422.1 $ 3,326.9 3 % Cost of sales 3,025.4 3,067.9 (1 )% Gross profit 396.7 259.0 53 % Selling, general and administrative expenses 215.4 208.0 4 % Income from equity method investments (15.1 ) (7.8 ) 94 % Operating profit 196.4 58.8 234 % Interest expense 40.8 42.8 (5 )% Non operating income (1.1 ) — NM Income before income taxes 156.7 16.0 879 % Income tax (benefit) expense 51.4 (2.2 ) NM Net income $ 105.3 $ 18.2 479 % Sales and Gross Profit ▪ Sales increased primarily as a result of higher domestic meat prices. ▪ Gross profit increased primarily as the result of higher sales and lower hog raising costs which more than offset the increase in pork processing raw material costs. Selling, General and Administrative Expenses (SG&A) ▪ The increase in SG&A is primarily attributable to higher variable compensation expenses stemming from higher year-over-year operating results, an increase in professional fees and smaller gains on non-qualified retirement plan assets. These increases in SG&A were partially offset by lower pension expense. 22 Income from Equity Method Investments ▪ The increase in profitability in the current year is primarily driven by higher hog prices in Mexico. Income Tax Expense ▪ Taxable income relative to permanent items, the mix of income between jurisdictions, and the expiration of certain federal tax credits as of December 31, 2013 impacted the effective tax rate for the current year. The prior year was impacted by income relative to permanent items, the mix of income between jurisdictions, state income tax credits, and federal legislation during that period that reinstated certain federal tax credits retroactively to January 1, 2012. Segment Results The following information reflects the results from each respective segment for the three months ended March 30, 2014 and March 31, 2013 . Three Months Ended March 30, 2014 and March 31, 2013 Successor Predecessor Three Months Ended March 30, 2014 March 31, 2013 % Change (in millions) Sales: Pork: Fresh Pork $ 1,387.1 $ 1,187.2 17 % Packaged Meats 1,548.5 1,594.5 (3 )% Total Pork 2,935.6 2,781.7 6 % Hog Production 849.5 834.0 2 % International 374.7 350.3 7 % Total segment sales 4,159.8 3,966.0 5 % Intersegment sales (737.7 ) (639.1 ) 15 % Consolidated sales $ 3,422.1 $ 3,326.9 3 % Operating profit: (1) Pork: Fresh Pork $ 58.9 $ 21.8 170 % Packaged Meats 121.3 107.0 13 % Total Pork 180.2 128.8 40 % Hog Production 9.5 (60.4 ) 116 % International 36.9 14.3 158 % Corporate (30.2 ) (23.9 ) (26 )% Consolidated operating profit $ 196.4 $ 58.8 234 % —————————————— (1) Fresh pork and packaged meats operating profits represent management's estimated allocation of total Pork segment operating profit. Pork Segment ▪ Current year sales increased 6% despite 2% lower volume in the Pork segment due to the timing of Easter. The increase was driven by an overall 8% increase in average selling prices. • Current year fresh pork operating profit significantly increased due to higher fresh pork market prices which more than offset higher raw material costs. 23 • Packaged meats operating profit in the current year increased 13% due to a 7% increase in average selling prices. Hog Production Segment ▪ Current year sales and operating results benefited from a 16% increase in domestic live hog market prices. Lower feed costs also benefited operating results in the current year. International Segment ▪ Sales were positively impacted by a 27% increase in volume which was partially offset by a 17% decrease in average selling prices. These changes were driven by a 17% and 8% increase in hogs processed in Poland and Romania, respectively. ▪ Current year operating profit was positively impacted by higher sales and lower feed costs in Europe along with higher equity income from our Mexican joint ventures. Corporate ▪ Current year results were negatively impacted by professional fees associated with the preparation of the postponed initial public offering of WH Group and post-merger activity as well as an increase in variable compensation. 24 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 March 30, 2014 , our liquidity position was approximately $825.1 million , comprised of $735.5 million in availability under our credit facilities and $89.6 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 Successor March 30, 2014 Facility Capacity Outstanding Letters of Credit Outstanding Borrowings Amount Available Inventory Revolver $ 1,025.0 $ — $ (425.0 ) $ 600.0 Securitization Facility 275.0 (93.1 ) (145.0 ) 36.9 International facilities 141.3 — (42.7 ) 98.6 Total credit facilities $ 1,441.3 $ (93.1 ) $ (612.7 ) $ 735.5 Cash Flows Operating Activities Successor Predecessor Three Months Ended March 30, 2014 March 31, 2013 (in millions) Net cash flows from operating activities $ (379.4 ) $ 101.4 The following items explain the significant changes in cash flows from operating activities: ▪ In the current year, we paid $286.6 million for the settlement of derivative contracts and for margin requirements compared to $33.7 million in the prior year. ▪ Cash paid to outside hog suppliers increased due to a 16% increase in domestic live hog market prices, resulting in higher inventory levels. 25 ▪ The change in our fiscal year resulted in variable compensation payments being made in the first quarter of 2014. No such payments were included in the first quarter of 2013. ▪ Cash paid for interest increased approximately $14.3 million . ▪ Cash received from customers increased due to an 8% increase in average selling prices in the Pork segment and 27% increase in sales volume in the International segment. However, lower volumes of domestic packaged meat sales due to the timing of Easter partially offsets the increase in cash receipts. ▪ Cash paid for domestic grain and other feed ingredients decreased approximately $236.1 million . Investing Activities Successor Predecessor Three Months Ended March 30, 2014 March 31, 2013 (in millions) Capital expenditures $ (30.8 ) $ (68.2 ) Net proceeds (expenditures) from breeding stock transactions 3.4 (5.9 ) Proceeds from the sale of property, plant and equipment 0.5 1.5 Other (0.1 ) (0.4 ) Net cash flows from investing activities $ (27.0 ) $ (73.0 ) The following items explain the significant investing activities for the three months ended March 30, 2014 and March 31, 2013 : ▪ Capital expenditures during both the current year and prior year 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. Financing Activities Successor Predecessor Three Months Ended March 30, 2014 March 31, 2013 (in millions) Proceeds from the issuance of long-term debt $ 13.0 $ — Principal payments on long-term debt and capital lease obligations (10.0 ) (6.0 ) Proceeds from Securitization Facility 100.0 — Payments on Securitization Facility (60.0 ) — Net proceeds (payments) on revolving credit facilities 258.9 (26.8 ) Other — 0.7 Net cash flows from financing activities $ 301.9 $ (32.1 ) The following items explain the significant financing activities for the three months ended March 30, 2014 and March 31, 2013 : • In the current year, we drew $280.0 million on our Inventory Revolver and $40 million, net of repayments, on our Securitization Facility, primarily to cover margin requirements on our commodity derivative contracts. Interest Rate Spread As of March 30, 2014 , 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 0.21% plus 1.15% , respectively. The Inventory Revolver interest rate spread is based on a pricing-level grid in the agreement and is 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 26 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 March 30, 2014 , we continued to guarantee $9.2 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. 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/best in class operations. These expenditures are expected to be funded with cash flows from operations and/or borrowings under our credit facilities. Group Pens In January 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 anticipate the full cost of our transition to group pens will total 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 2013, we had completed conversions to group housing for over 54% of our sows on company-owned farms. We remain on track to finish conversion to group housing for all sows on company-owned farms by the end of 2017. Our hog production operations in Poland and Romania completed their conversions to group housing facilities a number of years ago. In January 2014, we announced the recommendation that all of our contract sow growers join us in converting their facilities to group housing systems for pregnant sows. We asked contract sow growers to convert by 2022 and offered a sliding scale of incentives to accelerate that timetable. Growers who commit to convert to group housing will receive contract extensions upon completion of the conversion. 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 Transition Report on Form 10-K for the eight months ended December 29, 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 March 30, 2014 , margin deposits posted by us ranged from $38.5 million to $382.0 million . The average daily amount we posted with our brokers during the three months ended March 30, 2014 was $131.9 million . As of March 30, 2014 , the net amount on deposit with our brokers was $334.2 million . Subsequent to March 30, 2014 , the required amount on deposit to our brokers has decreased allowing us to repay a portion of the outstanding borrowings on our Inventory Revolver. 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. 27 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 Transition Report on Form 10-K for the eight months ended December 29, 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 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 realize the anticipated strategic benefits of the acquisition of Smithfield Foods, Inc. by WH Group, 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 Transition Report on Form 10-K for the eight months ended December 29, 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.