Fitch Rates Smithfield's Proposed Debt Issuance 'BBB'; Outlook Stable
Rating Action Commentary
Source: Fitch Ratings
10 Sep, 2020
Fitch Ratings - Chicago - 10 Sep 2020: Fitch Ratings has assigned a 'BBB' rating to Smithfield Food Inc.'s (Smithfield) proposed ten-year senior notes offering. The Rating Outlook is Stable. The net proceeds from the senior notes offering will be used to fund the purchase price of all of the 2021 notes and 2022 notes tendered for purchase pursuant to the tender offer. Any remaining proceeds will be used for general corporate purposes including debt reduction. The notes, along with the other outstanding senior notes, are guaranteed on a senior unsecured basis by each of Smithfield's subsidiaries that is a guarantor or borrower under the senior credit facility, ranking pari passu with Smithfield's existing unsecured debt.
KEY RATING DRIVERS
Coronavirus Pandemic Implications: Fitch believes negative effects from Smithfield's exposure to the foodservice sector and supply chain disruptions due to the coronavirus pandemic are manageable. Smithfield's exposure to the foodservice channel was roughly 20% of U.S. fresh and packaged pork sales prior to the pandemic. Results for 1Q20 were strong with improved profitability in all segments except for Packaged Meats.
Second quarter results were higher than Fitch's reduced expectations supported by strong processing margins within the Fresh Pork segment. The company offset a portion of the sales loss in the foodservice channel with increased volume at retail. However, operating performance was materially lower compared with the year ago quarter, negatively affecting the Packaged Meats segment, given reduce volumes, negative mix shift and increased operating costs, combined with plant shutdowns and inefficiencies.
Lower EBITDA Expectations: Fitch expects the operating trajectory to improve in 2H20 and 2021, although the pandemic will continue to weigh on profitability, given expectations for increased operating costs, ongoing food service weakness and production inefficiencies. Fitch forecasts 2020 EBITDA will decline in the high single-digit range, to $1.2 billion-$1.3 billion, from $1.4 billion in 2019. Fitch anticipates moderately improved earnings for Smithfield in 2021, supported by reduced effects from the pandemic, improved foodservice demand and increased plant efficiencies. Fitch projects EBITDA of approximately $1.3 billion, which could remain in the mid-single digit range below 2019's level.
Supply Chain Disruptions: Plant closures and increased levels of employee absenteeism due to coronavirus outbreaks among employees are key risks for protein processors. Plant closures, which so far have been temporary, have occurred across pork, beef and chicken processing plants to varying degrees for all major protein processors. Smithfield experienced five temporary closures across its 45 U.S. production facilities in April and May as higher employee absenteeism and safe social distancing practices have reduced production volumes and led to increased plant inefficiencies.
President Donald Trump's executive order instructing meat and poultry processing plants to remain open during the pandemic, combined with updated guidance from the government, has provided improved clarity and consistency on standards, with processes and protocols to address safe operating practices at processing facilities. Nevertheless, supply chain challenges are possible over the medium term given the potential for disease outbreak. 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.
Production Recovery: Pork production levels rebounded compared to the trough earlier in 2020. According to U.S. Department of Agriculture data, since industry capacity utilization bottomed at 54% in late April, capacity utilization and daily pork production have experienced a material recovery with pork production averaging more than 90 million pounds and pork processing approaching pre-coronavirus rates of capacity utilization. U.S. pork production is expected to be up almost 3% for 2020, according to the U.S. Department of Agriculture's August 2020 forecast, compared with 0.5% in June and pre-pandemic expectations of an approximately 4% increase.
Exports remain important for U.S. pork processors, representing roughly 25% of overall demand. An outbreak of the African swine fever in China during 2019 decimated pork production in the country, and pork production is likely to need several years to return to previous levels. The disease resulted in more protein products, including pork, being directed to China in 2019. U.S. pork exports to China increased 169% to roughly 1 billion pounds in 2019, representing 17% of total U.S. pork exports. Fitch believes Smithfield's export sales percentage is in-line with total industry exports. U.S. pork increased by 16% during 2Q20 from a year ago, according to the Agriculture Department driven by strong demand from China/Hong Kong. Overall, total U.S. pork exports for 2020 are expected to increase by approximately 19%. Among the significant risks are a downturn in a given market's economy, imposition of increased tariffs or sanitary barriers, and strikes or other events that disrupt production.
Leading Share in Pork: Smithfield is the world's largest hog producer and pork processor, generating $16.6 billion of net sales and almost $1.6 billion of EBITDA during the LTM ended June 28, 2020. The firm is No. 1 in U.S. pork processing, with a more than 20% share, and in U.S. hog production, with a roughly 15% share. It distributes products via the retail, deli and foodservice channels. Smithfield's value-added packaged meats, which provide higher margins and more stable cash flows than commodity products, enhance the firm's credit profile.
The company's vertically integrated model assures supply and product traceability and serves as a natural hedge against swings in hog prices. However, consolidated performance depends on Smithfield's ability to continue to hedge volatility in hog production, where losses can be more severe than in other categories of protein production.
Through the Cycle View: 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 before reverting to historical metrics. LTM EBITDA, for example, has ranged from approximately $900 million-$1.6 billion during the past four years.
Limited Protein Diversification: Smithfield's sales are primarily the U.S., and are concentrated in pork. Fitch believes a lack of diversification across proteins and the significant reliance on the U.S. market result in higher business risk versus more diversified peers like JBS S.A. (BB+/Stable) due to the potential impact from disease, tariff and trade disputes and imbalances in supply/demand fundamentals.
Profitability in Smithfield's hog production and fresh pork segments in 2018 were materially pressured due to increases in the hog supply and increased pork processing capacity, combined with tariff and trade disputes in key export markets and abundant competing proteins. Operating profit for the two segments was negative $94 million, compared with a profit of $272 million and $377 million in 2019 and 2017, respectively.
Smithfield has increased its international exposure in the past several years, with operations in Poland, Romania and the U.K. and joint ventures in Mexico through bolt-on acquisitions. These investments also increased Smithfield's presence as a low-cost exporter to Central Europe and Asia, which benefitted from the African swine fever virus outbreak. The international segment contributed roughly 14% of Smithfield's net sales in 2019, up from 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 consolidated long-term leverage below 2.0x. Total gross debt/EBITDA in the LTM ended June 28, 2020 was 1.4x, down from 1.8x at YE 2019, driven by strong 1Q operating results. Fitch projects leverage will increase in 2020 to around 2x due to the earnings pressure related to the coronavirus pandemic. Over the longer term, Fitch expects Smithfield will maintain leverage of 2.0x or less.
Smithfield 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 YE 2019 based on qualified and nonqualified plan assets and liabilities. Fitch assumes additional contributions will be made over the forecast period.
Parent-Subsidiary Linkage: Smithfield's ratings receive a one-notch uplift from its standalone credit profile due to its ownership by WH Group Limited (BBB+/Stable). Fitch believes moderate linkage exists between Smithfield and WH Group, given Smithfield's strong strategic importance and their operational ties. Fitch also views Smithfield and WH Group's financial polices as aligned, demonstrated by actions to reduce or defer dividend payouts to the parent during increased capital investments or earnings stress.
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