Fitch Affirms Smithfield Foods, Inc.'s IDR at 'BBB'; Outlook Stable
Source: Fitch Ratings, Inc.
29 Jun, 2020
Fitch Ratings - Chicago - 29 Jun 2020: Fitch Ratings has affirmed Smithfield Foods, Inc.'s (Smithfield) Long-Term Issuer Default Rating (IDR) at 'BBB'. The Rating Outlook is Stable.
Smithfield's ratings reflect its leading position in the global pork industry and significant presence in higher margin packaged meats that underpins the business profile. These positives are balanced against the limited diversity in other proteins and exposure to inherent volatilities in the hog production business and in pork processing due to periodic changes in industry supply/demand dynamics and raw material costs. Consequently, Fitch's rating for Smithfield takes a view on credit-protection measures and profitability "through the cycle" as operating earnings and leverage can be pressured for a period before reverting to historical metrics evidenced by LTM EBITDA ranging from approximately $900 million to $1.6 billion during the past four years. Smithfield's ratings benefit from a one-notch uplift from its stand-alone credit profile due to the moderate strategic linkage to its parent, WH Group Limited (BBB+/Stable).
Fitch expects the negative effects from the coronavirus pandemic due to Smithfield's exposure to the foodservice sector and supply chain disruptions are manageable with leverage (total debt/EBITDA) expected to rise to the low 2x range in 2020 due to earnings pressure with EBITDA projected between $1.1 billion to $1.2 billion but return to under 2x in 2021 as profitability improves. This compares to leverage of 1.8x and EBITDA of $1.4 billion at the end of 2019. Leverage for the LTM period (March ending) was 1.5x.
Fitch believes Smithfield will adjust capital allocation policies including capital spending and dividends as required to appropriately manage its leverage and liquidity profile. Subsequent to the first quarter in response to operating environment uncertainties, Smithfield entered into short-term bank agreements with various lenders that increased liquidity by $475 million, resulting in available liquidity in excess of $2 billion.
KEY RATING DRIVERS
Coronavirus Pandemic Implications: Fitch expects the impact on revenues for the consumer discretionary sector from the coronavirus pandemic to be unprecedented as mandated and proactive temporary closures of food service establishments severely depressed sales during the initial lockdowns in March, April and May. Numerous unknowns remain including the length of the outbreak and re-emergence of wide scale COVID-19 infections that could hinder foodservice re-openings and the cadence at which it is achieved; the economic conditions and outlook exiting the pandemic including unemployment and household income trends; the impact of government support of business and consumers; and the effect the crisis will have on consumer behavior.
First quarter results for 2020 were strong as Smithfield's EBITDA increased by more than 100% from a year ago to greater than $400 million as a result of improved profitability in all segments except for packaged meats supported by several factors including increased exports, higher volumes, improved sales prices and improved profitability within the Hog Production segment. First quarter results also included a material charge for unsaleable inventories and uncollectible accounts in anticipation of the challenges within the foodservice channel.
Smithfield's exposure pre-COVID-19 to the foodservice channel was roughly 20% of U.S. pork sales (fresh and packaged). Fitch anticipates the Packaged Meat segment will experience greater negative effects given loss of higher margin sales and greater exposure to foodservice than the Fresh Pork segment. The company has been able to offset a portion of the sales loss in the foodservice channel with increased volume going to retail. However, given the pandemic related disruptions that has caused lower volumes and negative mix shift combined with plant shutdowns/operating inefficiencies and increased operating costs including bonus payments to front-line workers, second quarter operating performance will be materially lower than a year ago.
Fitch expects an improvement in the operating trajectory in the back half of 2020 and into 2021, although the coronavirus pandemic will continue to weigh on profitability given expectations for increased operating costs, continued production inefficiencies and the likelihood of further plant shutdowns.
For 2020, Fitch forecasts EBITDA will decline in the double-digit range, to between $1.1 billion to $1.2 billion compared to $1.4 billion in 2019. Fitch projects the Packaged Meats segment will generate less than $600 million in operating income (EBIT) which will be dependent on the extent of the recovery in the foodservice channel. This compares to roughly $850 million in 2019. Operating income in the Fresh Pork segment is expected to be modestly higher than 2019 ($194 million) supported by expectations for continued export demand. With the international segment having only modest exposure to the foodservice channel, operating income is expected to be relatively similar to 2019 of approximately $150 million.
In 2021, Fitch anticipates improved earnings for Smithfield supported by a lessening of COVID-19 impacts, improved foodservice demand, increased plant efficiencies but projects EBITDA in the range of $1.2 billion to $1.3 billion that could remain approximately 8% to 12% below 2019 given our expectations for ongoing cost headwinds, lower foodservice demand relative to 2019 levels and limited visibility with the operating environment.
Supply Chain Disruptions: A key risk for protein processors during the coronavirus pandemic is the potential for plant closures and increased levels of employee absenteeism due to COVID-19 outbreaks of its employee base. Plant closures, which so far have been temporary in nature (couple days to two weeks), have occurred across pork, beef and chicken processing plants to varying degrees for all major protein processors. Smithfield has experienced five temporary closures across its 45 U.S. production facilities during the April and May timeframe. The higher levels of employee absenteeism and safe social distancing practices have also decreased production volumes and led to higher levels of plant inefficiencies.
Pork production levels have rebounded in June compared to the trough point experienced earlier this year. According to USDA data, since the last week in April when industry capacity utilization experienced a low point of 54% with estimated federally inspected pork production of approximately 60 million pounds (compared to 100 million pounds at the beginning of April), capacity utilization and daily pork production have experienced a material recovery with pork production averaging more than 90 million pounds and capital utilization of approximately 90% for the week ending June 12th.
President Trump's executive order instructing meat and poultry processing plants to remain open during the coronavirus pandemic combined with updated guidance issued by the Centers for Disease Control and Prevention (CDC) and Occupational Safety and Health Administration (OSHA) has provided improved clarity and consistency regarding standards with processes and protocols that address safe operating practices within meat processing facilities.
Nevertheless, supply chain challenges are expected to remain over the near-to-medium term with additional temporary closures and reduced efficiency levels in processing plants likely given the large scale and labor-intensive nature of meat processing operations, the uncertainties with further COVID-19 outbreaks within plant facilities, and the potential for on-going levels of employee absenteeism during the coronavirus pandemic. The greatest plant risk for Smithfield is the Tar Heel, NC pork processing facility, which is a vertically integrated location with a daily slaughter capacity of more than 30,000 head.
Leading Share in Pork: Smithfield is the largest hog producer and pork processor in the world, generating $16.6 billion of net sales and $1.6 billion of EBITDA during the LTM period ended March 2020. The firm is No. 1 in U.S. pork processing (more than 20% share) and U.S. hog production (approximately 15% share) and distributes products via the retail, deli, and foodservice channels. Smithfield's value added packaged meats business, which provide higher margins and more stable cash flow than commodity products, enhances the firms' credit profile.
The company's vertically integrated business model provides assured supply, product traceability and serves as a natural hedge to swings in hog prices. However, consolidated performance is dependent on Smithfield's ability to continue to successfully hedge volatility in hog production where losses can at times be more severe than other categories of protein production.
Limited Protein Diversification: Smithfield's sales are primarily U.S. centric and concentrated in pork. Fitch believes a lack of diversification across proteins and the significant reliance on the U.S. market results in higher business risk versus more diversified peers like JBS S.A. due to the potential impact from animal disease and foodborne illness on herds and input costs, tariff/trade disputes and imbalances in supply/demand fundamentals. In 2018, profitability in Smithfield's hog production and fresh pork segments were materially pressured due to increases in hog supply and the unprecedented increases in pork processing capacity combined with tariff/trade disputes in key export markets and abundant competing proteins. Consequently, operating profit for the two segments fell to a deficit of $94 million compared to a profit of $272 million and $377 million in 2019 and 2017, respectively.
Smithfield's has increased its international exposure during the past several years, which consists of operations in Poland, Romania, the United Kingdom and joint ventures in Mexico through bolt-on acquisitions that have included pork processing, packaged meats and chicken processing. These investments also increased Smithfield's presence as a low-cost exporter to Central Europe and Asia, which has benefitted due to the African swine fever (ASF) virus outbreak. In 2019, the international segment contributed roughly 14% of Smithfield's net sales in 2019 compared to approximately 10% in 2016. Over the longer term, Fitch anticipates Smithfield will continue to look for tuck-in acquisitions and pursue growth investments to bolster its portfolio in a disciplined manner.
Leverage Expectations: Smithfield's financial strategy is guided by its parent's commitment to maintain long-term leverage below 2x on a consolidated basis. LTM leverage (total gross debt/EBITDA) as of March 29, 2020 was 1.5x compared to 1.8x at the end of 2019, with the leverage improvement driven by strong operating results during the first quarter. Fitch projects leverage will increase during 2020 to the low 2x range due to the earnings pressure related to the coronavirus pandemic. Over the medium-to-longer term, Fitch expects leverage will moderate back to 2x or less.
The company has also made more than $900 million of voluntary contributions to its pension plans since 2014. The plan was approximately 81% funded (fair value of plan assets / pension benefit obligation) at the end of 2019 based on qualified and non-qualified plan assets and liabilities. Fitch assumes additional contributions are made over the forecast period.
U.S. Protein Outlook: U.S. pork production is expected to be up roughly 0.5% for 2020 according to the U.S. Department of Agriculture (June 2020 forecast) compared to pre COVID-19 expectations of approximately 4%. Pork production and capacity utilization levels were materially impacted by the negative effects of the COVID-19 outbreak as the rate of hog slaughter slowed materially during April and May. For the second quarter, the USDA is forecasting pork production almost 7% below the year ago period with a relatively flat second half of the year.
Exports remain an important outlet for U.S. pork processors representing roughly 25%of overall demand. An outbreak of the ASF virus in China during 2019 severely decimated pork production in the country, which is expected to take several years before pork production returns to previous levels. The disease resulted in more protein products, including pork, directed to China in 2019 as U.S. pork exports increased 169% to roughly 1 billion pounds in 2019, representing 17% of total U.S. pork exports and 12% of China imports. Fitch believes Smithfield's export sales percentage is in-line with total exports for the industry.
During the first four months of 2020, U.S. pork held a 19% share of Chinese pork imports, compared to approximately 8% for the same period a year ago according to USDA data. Total U.S. exports for 2020 are expected to increase by approximately 14% driven by the demand from Asia. Among the significant industry risks are a downturn in the economy of a given export market, the imposition of increased tariffs or sanitary barriers, and strikes or other events that may disrupt production affect the availability of ports and transportation.
Parent Subsidiary Linkage: Smithfield's ratings receive a one-notch uplift from its stand-alone credit profile due to Smithfield's ownership by the parent, WH Group. Fitch believes a moderate linkage exists between Smithfield and WH Group given the strong strategic importance and operational ties to the U.S. operations. Fitch also views Smithfield and WH Group's financial polices as aligned demonstrated by past actions to lower and/or defer dividend pay-outs to the parent during periods of increased capital investments and earnings stress.
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