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DAVID KRUSE

By Staff | Jun 26, 2009

Smithfield Foods is an integrated hog producer. Historically, when hog prices are poor and producers are losing money, pork processors are doing well, paying less for hogs, improving packing margins.

Integration allowed Smithfield Foods to offset production losses during cycle troughs with processing profits so that they could expand market share over traditional producers, who, when they lose money, have nothing to offset the loss with.

Under those conditions, after enough subsequent hog cycles, integrated producers would eventually own the industry. Many large producers, such as those partnered in Triumph Foods, saw modeling themselves after Smithfield Foods as the only way to survive long term.

I expect, much to their surprise, integrated producers are finding out that this cycle is different. Producers are losing money as usual, but packers were losing $5/hog last week due to exceedingly weak pork demand. Instead of positive processing margins offsetting production losses, negative processing margins were compounding the production loss. Smithfield Foods posted its first annual loss – $190.3 million – since 1975.

Smithfield Foods was not the least cost hog producer, reportedly losing $20 per hundredweight last quarter, in part because it was still feeding $6/bushel hedged corn.

CEO Larry Pope said, “I strongly believe that the hog production industry has reached an inflection point where, due to deep and extended losses, liquidation is now a recognized reality by all in the industry.

To date, Smithfield has already reduced the size of its U.S. herd by 2 million market hogs annually, and we are initiating a further reduction of 3 percent of our U.S. sow herd, effective immediately.

This reduction, combined with the additional cuts by our fellow producers, should shrink supply to a point where the industry can return to profitability. This liquidation is long overdue.”

In an industry that has been playing the game “see who has the equity to be the last man standing,” Smithfield Foods sold off its beef division in order to gain the liquidity to survive as a hog producer. Integration may not have helped them much this cycle but they will not give up on the model.

Smithfield Foods stock dipped below $6/share in November 2008 and again in March 2009 with the recent recovery rally again rolling over. Losses should slow, but the real goal of recovering profitability is still elusive and dependent upon the actions of the rest of the industry.

CEO Pope claims to have reduced the company’s sow herd 10 percent earlier, and is liquidating another 3 percent. If accurate and everyone in the industry had done likewise, hogs should be selling profitably right now.

The hog industry has to become comfortable with modifying production so all can produce profitably instead of relying on losses to force producers with the least equity from the industry as the way to reduce production. Forcing those with the least tolerance to lose money has historically been the way liquidation has occurred as the hog market cycles.

The industry has reached an “inflection point” as CEO Pope describes it. Here it makes more sense for all producers to reduce production 10 percent than force 10 percent out of business, taking two-thirds of the rest of the industry’s equity with them.

There were a lot of arrogant millionaires in the hog industry before this cycle slide started who didn’t think the consequences of this stubborn reluctance to modify production through. This cycle should be a learning experience.

It was not that the industry had received poor advice. Economists and advisors warned that 10 percent liquidation was needed. Producers just refused to take the good advice that they were given.

If hog producers had modified their production, they would not have drained their equity and would have sustained profitability. Instead, producing at full speed until many go broke is just plain stupid.

The commercial hog industry has benefited from some amazing productivity. I look at the foodies and how they think hogs should be produced and the production efficiency of the two systems. They are so incomparable, they are polar.

Yet foodies are making money selling niche hogs, while commercials are talking to bankers about modifying loans to avoid defaulting. The only way for commercial producers to benefit from their productivity is to manage it. Circovirus vaccines should have made producers money, but not after their use unleashed a new surge of overproduction that killed profits.

Pork should be faring very well in the grocery store today at current prices. Retailers are featuring it and it is very competitive. Consumers are getting a bargain. The only good that beef producers can see in today’s low pork prices is that hog producers are going broke selling it that cheap.

That kind of competition is temporary.

David Kruse is president of CommStock Investments Inc., author and producer of The CommStock Report, an ag commentary and market analysis available daily by radio and by subscription on DTN/FarmDayta and the Internet.

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