January 3, 2017 / 3:21 PM / 9 months ago

Fitch Assigns 'BBB' IDR to Smithfield Foods; Outlook Stable

(The following statement was released by the rating agency) CHICAGO, January 03 (Fitch) Fitch Ratings has assigned an Issuer Default Rating (IDR) of 'BBB' to Smithfield Foods, Inc. The Rating Outlook is Stable. Smithfield's ratings benefit from a one-notch upgrade from its stand-alone credit profile due to Fitch's view of a moderate parent-subsidiary linkage. Smithfield is 100% owned by WH Group, Inc. (WH Group) which Fitch rates 'BBB+'/Stable. The company's stand-alone credit profile of 'BBB-' reflects its leading position in the global pork industry, growing mix of higher-margin packaged meats, and reduced financial leverage. These positives are balanced against the lack of diversity across other proteins, higher potential earnings volatility than larger more diversified peers, and that dividends could constrain on-going FCF. Fitch expects Smithfield to generate over $1 billion of EBITDA annually in most years with moderate volatility due to periodic changes in industry supply/demand dynamics and raw material costs and that leverage will be sustained at or below 2x. At Oct. 2, 2016, Smithfield had $2.3 billion of total debt. Pro forma for the redemption of $250 million of its 5.25% notes due August 2018 on Oct. 21, 2016, total debt was approximately $2 billion. KEY RATING DRIVERS Leading Share in Pork: Smithfield is the largest hog producer and pork processor in the world, generating $14.3 billion of net sales and $1.2 billion of EBITDA during the LTM ended Oct. 2, 2016. The firm is No. 1 in U.S. pork processing (26% share) and U.S. hog production (15% share) and distributes products via the retail, deli, and foodservice channels. Smithfield's September 2013 buyout by WH Group provides greater access to China, which is the world's largest and fastest-growing market for pork and improves utilization for hog production. Exports from the U.S, which are subject to periodic trade restrictions, represented 25% of fresh pork tonnage in 2015, up from 23.5% in 2011. About 10% of net sales are from Smithfield international segment consisting of businesses operated in Europe and joint ventures in Mexico. Positive Mix but Limited Diversification: Smithfield has increased its mix of higher-margin more stable packaged meats but remains concentrated in a single protein. Fitch believes a lack of product diversification results in higher business risk versus diversified peers due to potential animal disease, foodborne illness, and consumer shift among competing proteins. For the LTM period ended Oct. 2, 2016, packaged meats represented $7.3 billion or 51% of Smithfield's net sales and 76% of its $959 million of operating profit, up from 46% of sales and 56% of operating profit in 2012. Packaged meats profitability has improved as a result of pricing actions, volume growth that has averaged over 2% yearly since 2012, and lower raw material costs. However, Fitch believes volume growth of more than 1% - 2% and continued pricing actions could be a challenge given increased competition as protein peers also move up the value chain and in light of consumers' growing preference for fresh versus processed foods. Smithfield's packaged meat volume was flat for the nine months ended October 2016. Moreover, visibility on pork raw material costs is also limited beyond 2017 given the commodity nature of the global protein industry. Smithfield views 9%-11% as the normalized margin range for its packaged meats business. Earnings Volatility, Hedging Dependence: Smithfield is generating record operating earnings due to an increased mix of higher-margin packaged meats, low raw material costs and strong protein demand. 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 be more severe than other categories of protein production. Fitch anticipates that Smithfield's fresh pork and packaged meats segments can generate at least $1 billion of EBITDA in most years. However, moderate volatility in consolidated earnings is expected due to the potential for on-going periodic losses in hog production. Efficiency, Margin Improvement Opportunities: Smithfield's normalized 4%-6% margin in pork processing trails public competitors by as much as 2% but the company is engaged in numerous projects to increase processing yields and reduce distribution costs in order to close that profitability gap. Consolidated margins have improved since 2015 due to the firm's "One Smithfield" initiative which entails realigning its decentralized operating structure to optimize its back-office, manufacturing and logistics infrastructure. Management expects this initiative to result in 100-150bps of margin improvement, of which roughly 75% will be realized through 2016. Reduced Leverage, Constrained FCF: Smithfield's financial strategy is guided by its parent's commitment to maintain total debt/EBITDA below 2x on a consolidated basis. Smithfield has significantly reduced leverage, paying off roughly $1.4 billion of debt since the buyout. At Oct. 2, 2016, total debt/EBITDA was 1.9x, down from over 4.0x at the time of the acquisition. The company has also made over $400 million of voluntary contributions to its pension plan over the past two years and is committed to maintaining $500 million-$1 billion of liquidity including cash on hand and revolver availability. Fitch expects total debt/EBITDA to be sustained at or below 2x over the intermediate term but believes FCF will be constrained by the upstreaming of dividends to WH Group given significant cushion under the company's restricted payment basket and the parent's stated policy of paying dividends at or above 30% of net income. WH Group's dividend is supported by cash flows of Smithfield and Shuanghui Development, the leading pork and packaged meat producer in China. Large-scale M&A is not viewed as a near-term risk. KEY ASSUMPTIONS Fitch's key assumptions within the rating case for Smithfield include: -Consolidated revenue grows about 2% yearly beyond 2016 to the $15 billion range by 2019; -Consolidated EBITDA of $1.1 billion-$1.3 billion annually through 2019; -FCF is neutral to modestly negative, assuming capex in the $350 million-$400 million range and dividends consistent with 2016; -Total debt/EBITDA is sustained at or below 2x through 2019. RATING SENSITIVITIES Positive Triggers: Smithfield's ratings receive a one-notch benefit based on Fitch's view of a moderate parent-subsidiary linkage between WH Group and Smithfield. An upgrade is not expected over the intermediate term due to Smithfield's single-protein concentration, FCF that will be constrained by dividends to its parent, and potential volatility caused by the company's hog production operation. However, total debt/EBITDA sustained under 2x, a FCF margin of at least 2.5%, operating margins above the high-single-digit range, and a proven level of earnings stability over multiple protein cycles could result in a positive rating action. Negative Triggers: Total debt/EBITDA maintained above 2.5x, due to operating income declines and/or increased debt, higher than expected dividends to its parent, a sustained loss of market share and materially lower than expected profitability in packaged meats would result in a downgrade of Smithfield's ratings. A downgrade of WH Group's ratings or Fitch's view that there has been deterioration in WH Group's willingness to provide tangible support to Smithfield would also result in a downgrade. LIQUIDITY Fitch views Smithfield's liquidity as adequate. At Oct. 2, 2016, Smithfield had $278 million of cash, an undrawn $1.025 billion inventory revolver expiring May 2020, and a $275 million accounts receivables securitization facility maturing December 2019. Smithfield's credit facility subjects the company to a maximum debt/capitalization ratio of 50% and a minimum interest expense coverage ratio of 2.50x for which the company has significant cushion. Smithfield redeemed $250 million of 5.25% senior unsecured notes due August 2018 on Oct. 21, 2016. Pro forma for this redemption, long-term debt maturities over the next three years include $445 million of 7.75% senior unsecured notes due 2017, $201 million of 5.25% senior unsecured notes due 2018, and an aggregate of roughly $15 million of subsidiary notes priced at 5.7% and LIBOR plus 2.5% due 2019. FULL LIST OF RATING ACTIONS Fitch has assigned the following rating: Smithfield Foods, Inc. --Long-Term Issuer Default Rating (IDR) 'BBB'. Contact: Primary Analyst Carla Norfleet Taylor, CFA Senior Director +1-312-368-3195 Fitch Ratings, Inc. 70 W. Madison Street Chicago, IL 60602 Secondary Analyst Bill Densmore Senior Director +1-312-368-3125 Committee Chairperson Megan Neuburger Managing Director +1-212-908-0501 Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: --Historical and projected EBITDA is adjusted to add back non-cash stock-based compensation expense as reported in financials. 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