Fitch: Higher Operating Costs Threaten U.S. Commodity Food Profits in 2008

Business Wire, Dec 6, 2007

CHICAGO -- Commodity protein producers and processors; such as Tyson Foods, Inc. (Tyson), Smithfield Foods, Inc. (Smithfield), Pilgrim's Pride Corp. (Pilgrim's) and Hormel Foods Corp. (Hormel), have been absorbing high feed grain costs in their production operations and higher live animal procurement costs in their processing businesses. Commodity fruits and vegetable companies; such as Dole Foods Co. (Dole), Chiquita Brands Intl, Inc. (Chiquita) and Fresh Del Monte Corp (Fresh Del Monte) have had to adjust to excessive European banana import tariffs and heightened fuel and packaging expenses.

In 2008, elevated operating costs will continue to pressure the profitability of commodity food companies. While agricultural commodity prices are determined by a number of factors, Fitch anticipates that strong foreign grain exports and ethanol demand will continue to support higher than normal feed grain prices. Fresh produce companies could get some relief from a potential reduction in the current European Union banana tariff. However, their overall cost base will continue to exceed pre-2006 levels as fuel and packaging costs remain high in the near-term.

Fitch does not expect participants in the protein and fresh produce sectors of the food industry to have the ability to offset 100% of these costs with pricing. While consumers have been experiencing above average food cost inflation of 3.5-4.5%, commodity food companies have less pricing power than branded packaged food companies due primarily to less product differentiation. Most participants in the commodity food industry have adapted a branded value-added strategy which includes higher margin products in their portfolios. This strategy has been limited by the ability of these companies to fund required research and development, advertising and media spending and by the value consumers place on these more expensive products.

For the most part, these challenging marketplace dynamics are reflected in the ratings and outlooks for Fitch's universe of coverage. Nonetheless, the continued difficult operating environment, limited earnings visibility and lack of significant debt reduction could result in moderate deterioration in credit measures. Despite thin margins and minimal free cash flow, liquidity is not expected to be an issue for any of the companies in Fitch's universe.

Cash flow from operations should support scheduled debt payments, which are minimal, and investments in capital expenditures. The global protein industry is still relatively fragmented; therefore, any excess cash flow along with revolver availability could be used for small acquisitions. Nonetheless, less access to capital combined with a challenging cost environment will prohibit the larger scale debt-financed acquisitions seen in the past couple of years.

FEED COSTS PRESSURE PROTEIN INDUSTRY

The price of corn and soybean meal, two primary ingredients in animal feed, has increased over 80% and 40%, respectively since the beginning of 2006. As of Nov. 30, 2007, spot prices were approximately $3.80 per bushel and $290 per short ton. In 2008, the protein industry is expected to bear another year of high feed grain costs. The USDA currently expects 2008 corn and soybean meal prices to average $3.40 per bushel and $250 per short ton, respectively. Corn and soybean meal futures indicate prices will average approximately $4.15 per bushel and $290 per ton, respectively. Fitch anticipates that despite near record corn crops, strong foreign grain exports and ethanol demand will prop up feed grain prices.

The poultry processors are most at risk to heightened corn and soybean meal prices because these ingredients can represent up to a third of their variable costs. Tyson and Pilgrim's Pride both estimate that every one cent change in corn prices affects costs of good sold by approximately $3 million. As predominately fixed cost businesses, these companies have little ability to offset heightened feed costs without shutting down plant operations. Nonetheless, in order to maintain strong capacity utilization and market share, Fitch anticipates that the industry may continue to increase production despite high feed grain costs. Unless there is a significant increase in international demand, protein producers will realize lower pricing and weakened margins.

WEAK BEEF PROCESSING MARGINS

Fitch expects 2008 to be another tough year for beef processors, due to their high fixed cost structure, the continued low supply and high price of live cattle and relatively stable cut-out values. The cyclical, or once cyclical, downturn in cattle on feed since 2001 was compounded by droughts and Japanese export restrictions since 2003. Additional factors impacting the supply of cattle for slaughter include the naturally longer length of the beef supply chain, restrictions on Canadian beef imports and the cost/benefit decision of dairy cow slaughter versus milking as dairy prices remain attractive.

Dairy prices will remain higher than normal in 2008 as dairy farms continue to pass along elevated feed costs and dry milk exports to China remains strong. Dairy prices, therefore, could support high live cattle prices. Unlike commodity milk processors, such as Dean Foods Company (Dean), which typically pass along changes in raw milk costs to customers, beef processors will continue to bear the burden of above normal live cattle prices. Relatively more attractive prices for poultry, which is a substitute for beef, increased incidences of E.coli contamination and continued weakness in export demand will cap cut-out values in 2008. Beef processing margins for companies, such as Tyson, will therefore remain weak.