Description

Description

With the recent acquisition of Farmland Foods, Smithfield Foods widened its lead as the single largest producer and processor of hogs in the United States. We estimate SFD’s market share in hog production, post-acquisition, at 27%. Further, and cognizant of possible short term effects stemming from Mad Cow, SFD holds a highly profitable beef processing business (segments described in greater detail below). We SFD’s earnings momentum is poised to accelerate based on two catalysts: (1) The Farmland deal offers substantial synergies and (2) SFD’s incremental earnings are exposed to the highly cyclical hog raising business which is turning in SFD’s favor.

We believe SFD, including synergies from the Farmland Foods acquisition (based on our own estimates of synergies), holds a peak earning power of $3.00+ per share and can trade for at least 10x. Our target price is conservative $30+ per share. We believe our downside is protected by SFD’s projected 10%+ Free Cash Flow yield in Fiscal 2005 and 2006.

A Word on Mad Cow

In our view, Mad Cow represents a temporary obstacle to the SFD. We believe Mad Cow is a political problem, not a real one. We believe the lynchpin to restoring equilibrium to the beef industry lies with restoring the export market, primarily to Japan. Given the negative political implications of a prolonged embargo and the importance of the US Presidential Elections in November, we believe the Bush Administration will resolve situation with Japan much faster than the market currently expects.

Again, we believe Mad Cow is a political problem, not a real one. Others may differ. Certainly perception and negative sentiment will linger as long as the export embargo persists. Should we wrong about a speedy resolution, we believe these are the issues to consider:

• SFD’s earnings are primarily driven by Pork, and there is no Mad Pig.
• Possible that SFD’s domestic pork earnings overwhelm weakness in beef.
• Note that Japan is Net Short Food; US banned beef must be made up with other food sources; Perhaps American Pork and Chicken…which would benefit SFD’s overall business.
• On 1/13, Cargill, a private company, reported exceptional beef earnings only tempered by the tightness of supply; The reality of a very tight beef market resulted in superb earnings. SFD could easily do the same.


History

Run by CEO Joe Luter (owner of 5% of SFD’s stock) for over 20 years, SFD has grown via acquisition to its current place as the #1 hog producer and processor in the US. The acquisitions of Murphy Farms and Carroll’s Foods in 1999-2000 substantially increased the companies overall size and greatly increased the degree of vertical integration to about 60% of the company’s total business. Farmland Foods represents perhaps the final piece of the SFD plan to achieve maximum scale and scope in hog production and processing.

Overview

SFD operates in 3 broad segments: (1) Hog production, the raising of Hogs, (2) Pork Processing, the slaughter and packing of hogs, and (3) Beef Processing & International, primarily the slaughter and processing of beef, with some small but profitable international operations primarily in Poland.

(1) Hog production (15% of sales; 15% market share post-Farmland; 3.5x larger than next competitor) is a cyclical business. The typical “hog cycle” is 3-4 years. Owing to certain extraordinary factors, including (a) last summer’s Russian ban on American chicken and (b) bloated chicken inventories as a result, this cycle has been stretched (Note that Chicken, Pork, and Beef affect each other, the “Protein” chain; Supply & Demand imbalances in any one product affect the other two). Supplies of all 3 products are now LEAN. As such, we believe the Hog cycle is poised to rise and prices will reach a peak of $50+/cwt and remain there for an extended period of 18-24 months. At this price, SFD’s Hog production group, which currently is a minor money loser, could earn as much as $1.00/share alone.

(2) Pork Processing (70% of sales; 27% share post-Farmland) is a business more strongly tied to the overall protein cycle and poised to directly benefit from the substantial cost savings offered by the Farmland acquisition. Three major catalysts which are set to drive margins higher are:

• (1) As above, wholesale inventories of all 3 major proteins (beef, chicken, pork) are close to 10 year lows,
• (2) the enormous popularity of the Atkins and South Beach diets are driving protein prices to all time highs,
• (3) Farmland offers strong operational cost saving synergies.

Regarding Point 3, while SFD Management has not been able to fully detail the Farmland synergies for analysts yet, we believe the integration of Farmland will allow (1) significant elimination of industry overcapacity and (2) eliminate the pricing impact of weak, bankrupt player on the overall industry. Based on the close proximity of Farmlands facilities to SFD’s current facilities, an important factor given the high transportation costs in Hog production, we believe SFD may be able to achieve $50-75 mm in annual cost savings. Points 1 and 2 (especially 1) reassure us that pricing power will remain firm across the protein chain for the next 12-24 months (Given our Mad Cow view above). Historically, oversupply of one of the other major proteins at any given time (beef or chicken) has hurt pork prices and held back SFD earnings power. For the 1st time in a decade, inventories of all 3 proteins are lean. In total, Hog Processing could earn as much as $2.25/share in 2005.

(3) Beef Processing and the International Group (15% of sales; 15% share post-Farmland) are also doing quite well. Meat Processing, focused on beef, especially has benefited from record beef production. We believe current estimates of $0.75 are more than fair and probably do not fully incorporate the effect soaring beef prices over a full year.

Catalysts

1. Owing to operational issues and with an eye towards a smooth closing, we believe SFD has kept on lid on the magnitude of the synergies and cost savings to be derived from the acquisition of Farmland. We expect to the company to more aggressively describe these savings early next year, possibly as soon as January.
2. Investor Relations is ramping up aggressively. We believe Smithfield Foods may have its first analyst day in many years in early 2004. We believe two broad themes, the turning of the hog cycle (finally!) and synergies from Farmland Foods will be highlighted.
3. Beating Earnings estimates. Having been burned for being too early on the Hog cycle over the past 12 months, analysts are naturally nervous about being overly ambitious with their EE’s. The average IBES EE for Fiscal 2005 (SFD is on an April year) is now $2.00/share. We believe this may be as much as 50% too low.


Risks

1. Corn & Soybean prices. Hog meal is composed of ¾ Soy beans and ¼ Corn. We believe Soy prices, which have been strong, have peaked. The Agriculture Department’s outlook for next year’s corn crop is very negative for corn prices. Either way, we believe SFD, which does not detail its hedges, is protected in its Soy exposure and stands to benefit, marginally, from possibly reduced corn prices next year.
2. Canadian Beef Ban. As Canada, owing to concerns regarding the health of their herd, is banned from exporting beef, domestic beef prices are quite low. This is having a temporary negative effect on prices, leading Canadian Hog producers to export an unusually large portion of their herd to the United States. We estimate this has hurt earnings so far to the tune of $0.10/share so far. We look for the lifting of the ban as a positive, but consider it unlikely ahead of US Elections (believing the political aspect of the ban is driving the decision process).
3. Leverage. SFD has approx. $2 billion of debt and is a BB+ credit. Debt reduction is a priority.
4. Extended Mad Cow negative sentiment/fear.


Valuation

We believe SFD will produce in 2005 peak earnings of $3.00+ and EBITDA of $750mm. We believe SFD’s numerous acquisitions undermine the value of historical valuation trading ranges and thus primarily rely upon our estimate of 10%+ Free Cash Flow yield, prospectively, to justify our investment decision.

Typically, Packaged Foods companies trade at 15x-20x earnings. However, owning to the cyclical nature of SFD’s business, the market has generally awarded it a multiple more in line with commodity food groups. SFD’s aggressive growth also skews its historical valuation metrics. We believe 8x to 12x earnings is a fair range and have used 10x, the mid-point, as our valuation target.

On an EBITDA basis, even ConAgra Foods and Archer Daniels, a company’s with somewhat similar earnings characteristics and mix of business, trades at about 8-10x EBITDA. We believe this implies a valuation for SFD of $36-45 per share. Too high? Probably. But even 10-20% haircuts to these prices yields substantial upside from SFD’s current price.

Catalyst

Catalysts

1. Owing to operational issues and with an eye towards a smooth closing, we believe SFD has kept on lid on the magnitude of the synergies and cost savings to be derived from the acquisition of Farmland. We expect to the company to more aggressively describe these savings early next year, possibly as soon as January.
2. Investor Relations is ramping up aggressively. We believe Smithfield Foods may have its first analyst day in many years in early 2004. We believe two broad themes, the turning of the hog cycle (finally!) and synergies from Farmland Foods will be highlighted.
3. Beating Earnings estimates. Having been burned for being too early on the Hog cycle over the past 12 months, analysts are naturally nervous about being overly ambitious with their EE’s. The average IBES EE for Fiscal 2005 (SFD is on an April year) is now $2.00/share. We believe this may be as much as 50% too low.