SmithField Foods' Credit Addiction

Larry Pope, chief executive of Smithfield Foods, assured investors at the Barclays Capital "Back-to-School" Consumer Conference that steps taken by the world's largest hog and pork producer have reduced its risk of violating debt covenants. Can the company, which has a historic appetite for binge buying, actually stop its credit addiction and transform itself into a profitable, packaged-meats purveyor?

Ignoring the fact that it operates in a cyclical industry --- fluctuations in demand and commodity prices (livestock -- primarily hogs -- and grains and fuel) have historically affected its results -- the company pushed a growth through acquisition strategy for the last 20 years. The company has now shifted its overall focus from acquisitions and capital spending to integration of prior acquisitions and debt restructuring. Industry overcapacity, a delayed recovery in consumer demand from the more recent economic downturn (exacerbated over swine flu concerns), and an onerous debt-load. Like an unemployed, college graduate with overdue credit card bills, in my opinion, the company had to stop buying more companies -- or face bankruptcy.

At the Barclay's Consumer Conference on September 10, Larry Pope shared recent efforts to restructure the balance sheet and improve liquidity. Unfortunately, he did not share anything material that had not been previously disclosed. To date, steps taken include successfully negotiating a new $1.0 billion line of credit (of which $706 million is accessible) that currently contains no applicable maintenance covenants, the pushing out of near-term maturities to 2012 - 2014, and increased liquidity (from $487 million last year to $1.17 billion - including its unused borrowing capacity).

Capital expenditures averaged about $365 million per annum in the last three fiscal years (ended each June), primarily related to plant and hog farm improvements and expansion of packaged-meats facilities. Given its shift in priorities, the company expects to reduce capex significantly below the $174.5 million spent in fiscal 2009.

Although operating costs should fall as the company trims its sow herd by a targeted 10 percent to 13 percent, the company is on the hook for significant (non-cancellable) obligations this fiscal year, including $48.4 million in leased facilities and equipment, $1.3 billion in livestock purchase commitment, and $16.3 million associated with previously announced plant closings.

The company has reduced its net debt by more than $1.1 billion from last year. Has Smithfield really changed its profligate spending? Total debt is still a worrisome 54 percent of total capitalization and $850 million raised in July and August (due in 2014) is being repaid at 10 percent interest. Plus, the company's estimate of $65 - $70 million in quarterly interest expense going forward is actually more than $60.5 million paid in the most recent quarter (and the $45 million spent in the prior year quarter).

If you can't borrow it -- just dish out more common stock: Smithfield sold 21.7 million shares at $13.85 in a common stock offering on September 17. Of note, Paul Fribourg, chief executive of agribusiness giant Continental Grain, which owns 8.8 percent of Smithfield's stock, resigned as a director. In his opinion, the stock offering was unnecessary,, especially given the dilution to all shareholders. As existing liquidity prior to the offering was sufficient to cover working capital needs, why issue shares at a 21 percent discount to the 52-week high? The attendant issuance of more stock is one way to meet the stated goal of reducing debt-to-total capitalization below 50 percent in the next 24 months, as additional investor purchases of stock from the company props up stockholder equity.

Smithfield will continue to raise hogs and produce fresh pork, but management is intent on changing the cyclical nature of profits. Going forward, packaged meats sold under the Armour, Butterball, and LunchMakers (among other) brands, will be playing a larger role. Again, my confidence in current management to "get the job done" is lacking: packaged-meat sales of pork products actually declined two percent in the first quarter of 2010, as increases in average selling prices could not offset a 9 percent decline in volumes, according to first-quarter financials. Although the reported operating of $101 million in the quarter came entirely from packaged-meats, a more telling signal of a company's ability to perform is cash flow -- $66.5 million in the quarter. However, exclude changes in operating assets and liabilities of $89.4 million (which are easy to manipulate quarter-to-quarter), and poof -- no free cash flow.

On August 7, Standard & Poor downgraded the company's credit rating from 'B' to 'B-,' citing ongoing challenges in the pork industry and a liquidity profile "pressured by high debt leverage and encumbered assets."