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Smithfield Foods, Inc. (SFD): Will Patience With This Pork Producer Payoff?

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Insider trading SFDThough its stock is up around 40% from a 2012 low, Smithfield Foods, Inc. (NYSE:SFD) may have to navigate some near-term headwinds before making another move higher. Smithfield Foods, Inc. (NYSE:SFD), the world’s largest pork processor and hog producer, might be facing a very tough operating environment for at least the next six months. After reporting a 15% net profit decline on a 3% sales increase in its latest quarter, the combination of lower meat prices and a rise in production costs will likely continue to put pressure on the company’s earnings.

Supply, drugs, and drought could hurt results near-term

One obstacle to better profits would be an industry over supply. Recent U.S. Department of Agriculture (USDA) figures indicate that a record amount of pork could be produced this year. Their expectation for 10.7 million metric tons of production is the highest since at least 1970. Lower exports will also add to stocks. Large buyers, like China and Russia, have restricted purchases because of their aversion to ractopamine, a feed additive used in the U.S. This policy was an influential factor in a 14% reduction in American pork exports for the first two months of this year.

Hog production returns will also be pressured by a pass-through of higher feed costs. Drought conditions in the U.S. last summer caused sharp increases in grain feed prices that now seem to be influencing results. Smithfield Foods, Inc. (NYSE:SFD) saw its hog raising cost jump 7% from last year and soar 18% from 2011. They expect costs to remain at an elevated level until near the end of the year.

Cheap corn and solid demand could make this a cheap stock

While the industry’s short-term profit picture looks pretty bearish, further out, the outlook might be more sanguine. If the USDA’s expectations for a better corn crop are realized, it could be extremely beneficial to Smithfield Foods, Inc. (NYSE:SFD)’s bottom line. The government agency believes this year’s corn inventories could double as farms increase their harvest 31% to 14.1 billion bushels. In anticipation, corn futures have already tumbled about 25% from a record price of $8.49 a bushel set in August of last year. With a decent summer growing season, a continued drop in corn prices could significantly boost the company’s profitability.

Smithfield may also help demand by taking care of its ractopamine problem. The company said it will soon raise half of its hogs on feed that does not contain the drug. Two plants, which handle 43,000 hogs a day or about 10% of the U.S. industry, are already ractopamine-free and the company said it would convert a third plant on June 1.

Even after a nice rise over the last year, Smithfield Foods, Inc. (NYSE:SFD)’s stock price might be appealing for the long-term. Based on a cash earnings times market capitalization multiple valuation, the company’s reasonable business value looks to be around $31 a share. This assumes a more normalized operating environment with annual sales of around $13.4 billion, cash earnings of $396 million at a 2.96% cash profit margin and a multiple of 11x, relative to the company’s historical mid-2000’s margin of about 2.49% and an 11x to 12x multiplier range.

Comparison with other peer pork players

Tyson Foods, Inc. (NYSE:TSN) is one of the world’s largest processors and marketers of chicken, beef, and pork. The company has over $30 billion in annual sales with 40% of them beef related, 36% related to chicken, and around 15% to pork. The company reported that its latest quarter sales were around $8.42 billion with cash earnings of $162 million at an 1.92% margin, versus sales of $8.27 billion and cash earnings of $220 million at a 2.66% margin in the prior-year period. Increased feed costs and product supply/demand imbalances contributed to the reduced profitability.

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