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 Operations contained in our report on Form 10-K for the twelve months ended January 3, 2016 . 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 Smithfield®, Eckrich®, Farmland®, 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 five reportable segments: Fresh Pork, Packaged Meats, Hog Production, International and Corporate. 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 in Mexico, our hog production operations located in Poland and Romania, our interests in hog production operations in Mexico, and our former investment in CFG. The Corporate segment provides management and administrative services to support our other segments. In February 2015, we announced an organizational realignment and key senior management appointments that unify all of our independent operating companies, brands, marketing and employees under one corporate umbrella. We believe moving to a more centralized structure allows for a more efficient and effective approach to customers, best utilizes management talent, maximizes the manufacturing platform and plant efficiency and optimizes marketing, innovation and brand management. First Quarter Summary of Results Net income for the first quarter of 2016 was $121.0 million compared to net income of $97.0 million for the first quarter of 2015 . The following summarizes the operating results of each of our reportable segments and other significant changes impacting net income: ▪ Fresh Pork operating profit increased by $66.7 million primarily as a result of lower raw material costs. ▪ Packaged Meats operating profit increased by $ 34.6 million as a result of higher sales volume and lower raw material costs. ▪ Hog Production operating results decreased by $77.1 million primarily as a result of favorable hedging results in the prior year and lower live hog market prices in the current year. ▪ International operating profit decreased by $1.7 million primarily due to unfavorable foreign currency translation. 18 The following table provides a reconciliation of net income to EBITDA and adjusted EBITDA for all periods presented. EBITDA and adjusted EBITDA are non-GAAP measures. We believe EBITDA is a useful measure to our investors because it excludes the effects of financing and investing activities by eliminating interest and depreciation costs. We also believe adjusted EBITDA is a useful measure as it excludes the effect of non-operating activities. EBITDA and adjusted EBITDA are not intended to be substitutes for our comparable GAAP measures and should not be used by investors or other users of our financial statements as the sole basis for formulating decisions as they exclude a number of important cash and non-cash charges. Three Months Ended April 3, 2016 March 29, 2015 (in millions) Net income $ 121.0 $ 97.0 Interest expense 32.0 34.7 Income tax expense 57.1 43.7 Depreciation and amortization 58.6 58.0 EBITDA $ 268.7 $ 233.4 Non-operating loss — 12.8 Adjusted EBITDA $ 268.7 $ 246.2 Tender Offer In January 2015, we commenced a cash tender offer for our 7.75% senior unsecured notes due July 2017, 5.25% senior unsecured notes due August 2018, 5.875% senior unsecured notes due August 2021 and 6.625% senior unsecured notes due August 2022, subject to a maximum aggregate purchase price up to $275 million (2015 Tender Offer). The 2015 Tender Offer expired in February 2015. As a result of the 2015 Tender Offer, we paid $275.0 million to repurchase $258.1 million of principal and recognized losses on debt extinguishment of $12.8 million, including the write-off of related unamortized premiums and debt issuance costs. 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 the 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. In 2013, the EPA issued a proposed rule that would have reduced the volume of renewable fuels mandated by statute and reflected the EPA’s estimate of what would actually be produced in 2014. In April 2015, the EPA entered into a proposed consent decree which would have them propose the 2015 RFS by June 1, 2015 and to finalize the 2014 and 2015 RFS targets by November 30, 2015. On May 29, 2015, the EPA proposed to establish the annual percentage standards for cellulosic biofuel, biomass-based diesel, advanced biofuel and total renewable fuels that apply to all gasoline and diesel produced or imported in years 2014, 2015 and 2016 as well as the volume of biomass-based diesel for 2017. The proposed volumes are below statutory levels, but above historical output of renewable fuels. On November 30, 2015, the EPA finalized RFS standards for 2014, 2015 and 2016 at higher levels than the proposed volumes, but below statutory targets. The 2016 standard is set at 18.11 billion gallons of renewable fuels, or 10.10% of the motor fuel pool. 19 Representative Bob Goodlatte (R-VA) has re-introduced legislation in the 114th Congress that would eliminate the conventional (corn starch) ethanol mandate, cap the blendwall at E10, and require the EPA to set cellulosic standards at production levels. Additionally, Sens. Dianne Feinstein (D-CA) and Pat Toomey (R-PA) have introduced similar legislation which would eliminate the conventional ethanol mandate. 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, the 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. 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. As of February 9, 2015, industry opponents dropped their lawsuit against the USDA. The Canadian and Mexican governments challenged the 2013 Rule before the Dispute Settlement Body (DSB) of the WTO. On October 20, 2014, the DSB issued panel reports finding in favor of Canada and Mexico and against the United States' 2013 Rule. An appeal of the DSB's ruling brought by the U.S. was rejected. Canada and Mexico are seeking a combined $3.2 billion in retaliatory tariffs against a range of U.S. agricultural and manufactured product exports, including frozen and chilled pork products. In December 2015, a WTO Arbitration Panel report set retaliatory tariffs against the United States at just over $1 billion. In December 2015, Congress passed and the President signed into law the Fiscal Year 2016 omnibus spending legislation which included legislative language to repeal the WTO-noncompliant components of the COOL statute. Although Canada and Mexico still have the right to initiate retaliatory tariffs against the U.S. under WTO rules, there is no indication that they intend to do so and the revocation of mandatory COOL for meat has essentially settled the dispute. 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. Our most exciting growth prospect is the ongoing development of our packaged meats business. Although we have experienced meaningful and consistent improvement in packaged meats margins, we believe significant growth potential remains. We will continue to strengthen our consumer-focused marketing programs and promote innovation to improve our product mix toward branded, value-added products. We expect these actions to result in continued broad-based gains in packaged meats sales, volume, market share, distribution and margins. With our organizational realignment, we are taking steps to build on our strong results in 2015 as we continue to solidify Smithfield's position as a global leader in branded packaged meats. There is a plethora of benefits to moving to a centralized structure and unifying all our resources and brands together as “One Smithfield,” which should position us to take advantage of growth opportunities in the following ways: • Leveraging Smithfield's size and scope in pork industry; • Maximizing our manufacturing platform and distribution system; • Approaching the market more efficiently and effectively; • Best utilizing management talent across company; • Aligning our operations to provide better customer service; • Optimizing operations in areas like brand management, manufacturing, sales, and marketing; and • Strengthening marketing, brand building and innovation across all brands. 20 We will continue to sharpen our strategic focus and drive operational improvements across our entire platform, including our Fresh Pork, Hog Production and International divisions. We are focused on growth and believe that Smithfield is in an ideal position to continue to achieve strong results in 2016. 21 RESULTS OF OPERATIONS Consolidated Results of Operations The table presented below compares our results of operations for the first quarters of 2016 and 2015 . Three Months Ended April 3, 2016 March 29, 2015 % Change (in millions) Sales $ 3,306.3 $ 3,616.5 (9 )% Cost of sales 2,893.9 3,210.4 (10 )% Gross profit 412.4 406.1 2 % Selling, general and administrative expenses 208.1 221.9 (5 )% Income from equity method investments (5.8 ) (4.0 ) 44 % Operating profit 210.1 188.2 12 % Interest expense 32.0 34.7 (8 )% Non-operating loss — 12.8 100 % Income before income taxes 178.1 140.7 27 % Income tax expense 57.1 43.7 31 % Net income $ 121.0 $ 97.0 25 % Sales and gross profit ▪ Sales decreased primarily as a result of lower average selling prices of domestic fresh pork products and lower domestic live hog market prices. ▪ Gross profit increased primarily as a result of lower pork processing raw material costs and lower hog raising costs. Selling, general and administrative expenses (SG&A) ▪ The decrease in SG&A is primarily attributed to lower marketing and advertising costs. Income from equity method investments ▪ Equity income in the prior year was negatively impacted by our former investment in CFG. Current year equity income was negatively impacted by lower hog prices in Mexico. Interest expense ▪ The decrease in interest expense is primarily due to lower debt balances in the current year as a result of various debt repayment activities in the prior year. Non-operating loss ▪ During 2015, we recognized a loss on debt extinguishment of $12.8 million as a result of the 2015 Tender Offer. Income tax expense ▪ Our effective tax rate was 32% and 31% for the first quarters of 2016 and 2015, respectively. Both the current and prior year effective tax rates were impacted by taxable income relative to permanent items and the mix of income between jurisdictions. Additionally, the prior year effective tax rate was impacted by the expiration of certain federal tax credits. 22 Segment Results The following information reflects the results from each respective segment for the first quarters of 2016 and 2015 . Three Months Ended April 3, 2016 March 29, 2015 % Change (in millions) Sales: Fresh Pork $ 1,118.2 $ 1,334.1 (16 )% Packaged Meats 1,745.3 1,709.6 2 % Hog Production 620.3 806.4 (23 )% International 316.8 330.2 (4 )% Total segment sales 3,800.6 4,180.3 (9 )% Intersegment sales (494.3 ) (563.8 ) (12 )% Consolidated sales $ 3,306.3 $ 3,616.5 (9 )% Operating profit (loss): Fresh Pork $ 99.9 $ 33.2 200 % Packaged Meats 207.1 172.5 20 % Hog Production (83.5 ) (6.4 ) (1,209 )% International 14.2 15.9 (11 )% Corporate (27.6 ) (27.0 ) (2 )% Consolidated operating profit $ 210.1 $ 188.2 12 % Fresh Pork ▪ Sales decreased 16% due to a 13% decrease in average selling prices and a 4% decrease in volume. ▪ Operating profit increased to $13 per head from $4 per head due to lower raw material costs. ▪ We processed 7.7 million hogs in 2016, relatively unchanged from the prior year. Packaged Meats ▪ Sales increased 2% due to a 2% increase in volume. Average selling prices remained relatively unchanged from the prior year. Current year sales volume totaled 742.8 million pounds. ▪ Operating profit increased to $0.28 per pound from $0.24 per pound due to lower raw material costs. Hog Production ▪ Sales decreased 23% due to favorable hedging results in the prior year, lower domestic live hog market prices and a 2% decrease in head sold. Head sold during the year amounted to 3.9 million . ▪ Operating results decreased to a $21 loss per head from a $2 loss per head due to lower sales, partially offset by lower feed costs. International ▪ Sales decreased 4% due primarily to changes in foreign exchange rates, which negatively impacted sales by $29.9 million , or 9% . On a constant currency basis, sales increased 5% due to a 11% increase in volume to 382.8 million pounds, driven largely by a 14% increase in hogs processed and a 14% increase in poultry processed in Europe, partially offset by a 5% decrease in average selling prices. We processed 1.2 million hogs in 2016. ▪ Operating profit was negatively impacted by foreign currency translation of $1.7 million due to a stronger U.S. Dollar. On a constant currency basis, operating profit was relatively unchanged from the prior year. 23 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 April 3, 2016 , our liquidity position was approximately $1.6 billion , comprised of approximately $1.3 billion in availability under our credit facilities and $260.6 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 April 3, 2016 Facility Capacity Borrowing Base Adjustment Outstanding Letters of Credit Outstanding Borrowings Amount Available (in millions) Inventory Revolver $ 1,025.0 $ — $ — $ — $ 1,025.0 Securitization Facility 325.0 (36.8 ) (87.9 ) — 200.3 International facilities 176.1 (3.4 ) (0.2 ) (49.2 ) 123.3 Total credit facilities $ 1,526.1 $ (40.2 ) $ (88.1 ) $ (49.2 ) $ 1,348.6 Cash Flows Operating Activities Three Months Ended April 3, 2016 March 29, 2015 (in millions) Net cash flows from operating activities $ (319.2 ) $ (4.5 ) The following items explain the significant changes in cash flows from operating activities: ▪ In the current year, we contributed $125.0 million to our qualified pension plans. ▪ In the current year, we paid $ 5.5 million for the settlement of derivative contracts and for margin requirements compared to $ 101.7 million received in the prior year. ▪ The current year included net tax payments of $ 51.0 million for domestic income taxes as compared to net tax refunds of $ 32.7 million in the prior year. ▪ In the prior year we received a cash dividend of $14.3 million from one of our Mexican joint ventures. 24 ▪ Cash paid for grain and other ingredients purchased by the Hog Production segment decreased approximately $29.0 million from the prior year. Investing Activities Three Months Ended April 3, 2016 March 29, 2015 (in millions) Capital expenditures $ (76.8 ) $ (67.7 ) Net expenditures from breeding stock transactions (14.9 ) (13.2 ) Proceeds from the sale of property, plant and equipment 0.3 1.1 Other (0.2 ) — Net cash flows from investing activities $ (91.6 ) $ (79.8 ) The following items explain the significant investing activities: ▪ Capital expenditures during both years primarily related to plant and hog farm improvement and expansion projects, including the replacement of gestation stalls with group pens, which is more fully explained under "Additional Matters Affecting Liquidity" below. Financing Activities Three Months Ended April 3, 2016 March 29, 2015 (in millions) Proceeds from the issuance of long-term debt $ 30.0 $ — Principal payments on long-term debt and capital lease obligations (0.2 ) (408.6 ) Proceeds from Securitization Facility — 230.0 Payments on Securitization Facility — (85.0 ) Net proceeds (payments) on revolving credit facilities 8.4 (14.6 ) Payment of dividends (73.6 ) — Net cash flows from financing activities $ (35.4 ) $ (278.2 ) The following items explain the significant financing activities: ▪ In the current year, we received proceeds of $30.0 million to finance certain activities in Romania. ▪ In the current year, we paid a $73.6 million dividend to our parent company. ▪ In the prior year, we paid $258.1 million of principal payments as a result of the 2015 Tender Offer as well as $150.0 million on our Rabobank term loan. ▪ In the prior year, we drew $145.0 million, net of repayments, on our Securitization Facility, primarily to repay other long-term debt, as noted above. Financial Position Our balance sheet as of April 3, 2016 , as compared to January 3, 2016 , was impacted by the following significant changes: ▪ Accounts payable decreased by $306.6 million mainly due to the timing of payments. 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. 25 As of April 3, 2016 , we continued to guarantee $6.4 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. Additional Matters Affecting Liquidity Capital Projects We anticipate capital expenditures of approximately $350.0 million for 2016 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 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 2015, we had completed conversions to group housing for 82% 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. Worldwide, we have pledged to convert all company sow farms by 2022. Our hog production operations in Poland and Romania completed their conversions to group housing facilities a number of years ago, and our joint ventures in Mexico are currently working toward the 2022 goal. 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 through the receipt of 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 Report on Form 10-K for the twelve months ended January 3, 2016 . 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 April 3, 2016 , margin deposits ranged from $39.9 million to $57.8 million (negative amounts representing margin deposits we have received from our brokers). The average daily amount on deposit with our brokers during the three months ended April 3, 2016 was $48.0 million . As of April 3, 2016 , the net amount on deposit with our brokers was $48.8 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. 26 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 report on Form 10-K for the twelve months ended January 3, 2016 . 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 Limited, 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 our report on Form 10-K for the twelve months ended January 3, 2016 . 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.