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Item 2. Management’s Discussion and Analysis

2014-08-11 compared with 2014-05-14 · 149 added, 85 removed, 166 unchanged (59% of the section changed)

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 .

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 Operations 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.

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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.

We conduct our operations through five reportable segments:

Fresh Pork, Packaged Meats, Hog Production, International and Corporate.

See Note 12—Reportable Segments for additional information about changes to our reportable segments during the current quarter.

The Fresh Pork segment consists of our U.S.

fresh pork operations.

The Packaged Meats segment consists of our U.S.

packaged meats operations.

The Hog Production segment consists of our U.S.

hog production operations.

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.

Second Quarter Summary of Results

Net income for the three months ended June 29, 2014 was $142.9 million compared to net income of $32.4 million in the three months ended June 30, 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 June 29, 2014 compared to net income for the three months ended June 30, 2013 :

Fresh Pork operating profit increased by $48.6 million primarily as a result of higher fresh pork market prices.

Packaged Meats operating profit decreased by $ 14.3 million as raw material costs increased significantly and could not fully be passed on to customers.

Hog Production operating profit increased $98.4 million primarily as a result of significantly higher live hog market prices and lower feed costs.

International operating profit increased by $30.4 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.

Porcine Epidemic Diarrhea Virus (PEDv)

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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.

The EPA's "partial waiver" 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.

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EPA will consider public comments before setting the final standard.

Recent comments by senior EPA officials suggest that the final 2014 standard will include higher volumes than the November 2013 proposal due in part to greater overall domestic consumption of transportation fuel.

However, it is expected that the final volumes will continue to maintain overall blending volumes at E10.

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.

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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.

On March 28, 2014 and on July 29, 2014, the U.S.

Court of Appeals for the District of Columbia Circuit rejected a judicial challenge to these rulemakings by a coalition of industry groups.

The Canadian and Mexican governments are also challenging the 2013 Rule before the Dispute Settlement Body of the WTO.

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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.

Market fundamentals continue to be supportive of our business on a number of fronts.

Domestic protein demand is impressive.

Although Russia has banned US pork imports, international demand from other countries remains strong.

This, combined with lower domestic protein production, should support high hog and pork prices for the duration of 2014 and beyond.

Notwithstanding a bullish hog production outlook, PEDv concerns seem to have thwarted market expansion for now.

In addition, corn is currently trading at the lowest level in three years.

This should translate into normalized fresh pork margins and high, above normalized hog production margins in 2014.

We remain focused on maximizing our existing business through increased consumer marketing programs, product innovation and capital investment to further establish ourself as a leader in consumer packaged meats.

We expect to deliver packaged meats margins in the normalized range in 2014.

We see enormous growth potential for our US business through organic improvement, particularly in packaged meats.

Synergy opportunities with WH Group are advancing.

For example, Smithfield branded premium chilled fresh pork sold at Smithfield kiosks in Mainland China has been well received by consumers with strong sales and customer traffic.

We opened three new kiosks in July, bringing our total number of kiosks to 21, and plan to continue to expand throughout China to cover the major first-tier and second-tier cities by the end of the year.

The early success of our Smithfield kiosks in China underscores the synergistic effect of our merger with WH Group.

As part of WH Group’s global platform, we will continue to create value through organic growth and synergy initiatives, while leveraging the benefits of positive market fundamentals in the US.

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 .

The tables presented below compare our results of operations for the three and six months ended June 29, 2014 and June 30, 2013 .

As used in the tables, "NM" means "not meaningful."

Three Months Ended March 30, 2014 and March 31, 2013

Three Months Ended June 29, 2014 and June 30, 2013

Three Months Ended

March 30, 2014

March 31, 2013

June 29, 2014

June 30, 2013

(in millions)

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Selling, general and administrative expenses

(Income) loss from equity method investments

Operating profit

Interest expense

Income before income taxes

Income tax expense

Sales and gross profit

Sales increased primarily as a result of higher domestic pork market prices.

Gross profit increased primarily as a 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 and an increase in professional fees.

These increases in SG&A were partially offset by lower pension expense.

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

Our effective tax rate was 35% and 28% for the three months ended June 29, 2014 and June 30, 2013 , respectively.

For the three months ended June 29, 2014, 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.

The three months ended June 30, 2013 were 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.

Six Months Ended June 29, 2014 and June 30, 2013

Six Months Ended

June 29, 2014

June 30, 2013

(in millions)

Cost of sales

Selling, general and administrative expenses

Income from equity method investments

Operating profit

Interest expense

Non operating income

Non-operating gain

Income before income taxes

Income tax (benefit) expense

Income tax expense

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.

Sales increased primarily as a result of higher domestic pork market prices.

Gross profit increased primarily as a 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.

The increase in SG&A is primarily attributable to higher variable compensation expenses stemming from higher year-over-year operating results and an increase in professional fees.

These increases in SG&A were partially offset by lower pension expense.

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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.

Our effective tax rate was 34% and 17% for the six months ended June 29, 2014 and June 30, 2013 , respectively.

For the six months ended June 29, 2014, 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.

The six months ended June 30, 2013 were 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

The following information reflects the results from each respective segment for the three and six months ended June 29, 2014 and June 30, 2013 .

Three Months Ended June 29, 2014 and June 30, 2013

Three Months Ended

March 30, 2014

March 31, 2013

June 29, 2014

June 30, 2013

(in millions)

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Consolidated sales

Operating profit:

Operating profit (loss):

Packaged Meats

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Consolidated operating profit

——————————————

Fresh pork and packaged meats operating profits represent management's estimated allocation of total Pork segment operating profit.

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.

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 sales and operating profit increased due to higher fresh pork market prices which more than offset higher raw material costs.

Packaged Meats

Current year sales increased 19 % due to a 13% increase in average selling prices and a 6% increase in volume, primarily attributable to the timing of Easter.

Operating profit in the current year decreased as raw material costs increased significantly and could not fully be passed on to customers.

Hog Production

Sales were relatively unchanged from the prior year as the impact of higher domestic live hog market prices was offset by lower sales volumes.

PEDv was a significant factor in the volume decline and significantly impacted the market prices.

Current year operating profit benefited from a 30% increase in domestic live hog market prices and lower feed costs.

International

Sales were positively impacted by a 12% increase in volume which was partially offset by a 6% decrease in local currency average selling prices.

These changes were driven primarily by a 17% increase in hogs processed in Poland.

The effects of foreign currency translation also positively impacted sales by approximately $21 million.

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.

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.

Operating results in the Corporate segment were improved from last year, which included acquisition related expenses associated with the WH Group and Kansas City Sausage transactions.

Six Months Ended June 29, 2014 and June 30, 2013

Six Months Ended

June 29, 2014

June 30, 2013

(in millions)

Packaged Meats

Hog Production

International

Total segment sales

Intersegment sales

Consolidated sales

Operating profit (loss):

Packaged Meats

Hog Production

International

Consolidated operating profit

Current year sales and operating profit increased due to higher fresh pork market prices which more than offset higher raw material costs.

Packaged Meats

Current year sales increased 8% due to a 10% increase in average selling prices and 2% lower volumes.

Operating profit in the current year was unchanged as we were able to pass higher raw material costs to customers.

Hog Production

Sales were relatively unchanged from the prior year as the impact of higher domestic live hog market prices was offset by lower sales volumes.

PEDv was a significant factor in the volume decline and significantly impacted the market prices.

Current year operating profit benefited from a 23% increase in domestic live hog market prices and lower feed costs.

International

Sales were positively impacted by a 19% increase in volume which was partially offset by an 11% decrease in average selling prices.

These changes were driven largely by a 17% increase in hogs processed in Poland.

The effects of foreign currency translation also positively impacted sales by approximately $24 million.

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.

LIQUIDITY AND CAPITAL RESOURCES

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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.

As of June 29, 2014 , our liquidity position was approximately $1.0 billion , comprised of approximately $930.0 million in availability under our credit facilities and $109.4 million in cash and cash equivalents.

Sources of Liquidity

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Credit Facilities

March 30, 2014

June 29, 2014

Outstanding Letters of Credit

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Amount Available

(in millions)

Inventory Revolver

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Operating Activities

Three Months Ended

March 30, 2014

March 31, 2013

Six Months Ended

(in millions)

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The following items explain the significant changes in cash flows from operating activities:

Cash received from customers increased due to higher domestic fresh pork market prices.

Cash paid for grain purchased by the Hog Production segment decreased approximately $459.3 million from the prior year.

In the current year, we paid $ 204.6 million for the settlement of derivative contracts and for margin requirements compared to $ 51.2 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.

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 .

Cash paid to outside hog supplier increased due to a 23% increase in average domestic live hog prices.

The current year included net tax payments of $ 82.2 million for domestic income taxes as compared to net refunds of $ 2.8 million in the prior year.

Cash interest payments increased approximately $ 12.0 million .

Investing Activities

Three Months Ended

March 30, 2014

March 31, 2013

Six Months Ended

(in millions)

Capital expenditures

Business acquisitions

Net proceeds (expenditures) from breeding stock transactions

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Net cash flows from investing activities

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.

The following items explain the significant investing activities for the six months ended June 29, 2014 and June 30, 2013 :

Capital expenditures during both years 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.

In May 2013, we paid $32.7 million, net of cash acquired, for a 50% interest in Kansas City Sausage Company, LLC (KCS).

In April 2014, KCS bought a meat processing business for $11.0 million.

Financing Activities

Three Months Ended

March 30, 2014

March 31, 2013

Six Months Ended

(in millions)

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Net cash flows from financing activities

The following items explain the significant financing activities for the three months ended March 30, 2014 and March 31, 2013 :

The following items explain the significant financing activities for the six months ended June 29, 2014 and June 30, 2013 :

In the current year, we drew $55.0 million on our Inventory Revolver and $50.0 million, net of repayments, on our Securitization Facility, primarily to cover margin requirements on our commodity derivative contracts.

In May 2013, we repaid the remaining outstanding principal amount on our 7.75% senior unsecured notes totaling $55.0 million.

In the prior year, we drew $225.0 million on our Inventory Revolver and $170.0 million, net of repayments, on our Securitization Facility as well as issued $200.0 million in long-term debt to repay the aforementioned notes and for working capital needs.

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 Company, Rabobank Nederland, New York Branch, as Administrative Agent, specified lenders, and the other specified agents and arrangers, as amended).

As of June 29, 2014 , the interest rate on borrowings under the Inventory Revolver and the Securitization Facility were LIBOR plus 3.25% and the lender's cost of funds of 0.20% 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 the Company, Rabobank Nederland, New York Branch, as Administrative Agent, specified lenders, and other specified agents and arrangers, as amended).

As part of our business, we are a party to various financial guarantees and other commitments as described below.

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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.

As of June 29, 2014 , we continued to guarantee $8.9 million of leases that were transferred to JBS S.A.

in connection with the sale of Smithfield Beef, Inc which closed in October 2008.

This guaranty may remain in place until the leases expire through February 2022.

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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.

We asked contract sow growers to convert by 2022 and offered a sliding scale of incentives to accelerate that timetable through the receipt of contract extensions upon completion of the conversion.

Risk Management Activities

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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.

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.

During the six months ended June 29, 2014 , margin deposits ranged from $38.5 million to $382.0 million .

The average daily amount on deposit with our brokers during the six months ended June 29, 2014 was $190.2 million .

As of June 29, 2014 , the net amount on deposit with our brokers was $252.2 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.

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Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-Q

Item 2. Management’s Discussion and Analysis