On more than one occasion I've written of my preference for companies that serve the processed/packaged food space in favor of those that sell commoditized fresh/frozen products. That's certainly true in the protein sector, where I much prefer the prospects of a company like Hormel (NYSE:HRL) to those of Tyson (NYSE:TSN). However, Smithfield (NYSE:SFD) is a curious case. Although it is one of the many ways traders can invest in everyday products, this company has both a sizable fresh and packaged meats business.

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First Quarter a Tale of Two Businesses
How well Smithfield is doing depends upon which details get your focus. The company's reported revenue missed only slightly and operating earnings were slightly below expectations, but there was more at play beneath the headlines. Revenue fell slightly this quarter, with pig farming (production) revenue down about 3%, while processing, fresh pork and packaged sales were up/down less than a point. International sales dropped more than 7%, but make up only about 10% of sales.

Profitability is where things get interesting. Operating income plunged 40% from last year and about 4% from the prior quarter. Although hog farming profits were steady on a sequential basis at about $6 a head, which marks an 80% decline from last year. Likewise, fresh pork profitability plunged to a loss of $2 per head (versus a normal range of $3 to $7 a head in profits). On the flip side, packaged meats came in at 21 cents per pound in profits - up almost one-quarter from last year and 30% from last quarter - and stand above not only sell-side expectations but management's own guidance for long-range profitability.

Battening Down the Hatches
Investors have had ample time to process the impact the drought has had on the American economy and on the fresh/frozen meat businesses of companies like Tyson, Smithfield, Pilgrim's Pride (NYSE:PPC) and the like. For now, Smithfield management is keeping a brave face, believing that lower production levels and the company's advantaged cost position will support margins.

Maybe, but I'm skeptical. I think the bigger risks to Smithfield are that feed/raising costs go up even more than feared and that consumers really push back on prices. Although packaged food companies like Kellogg (NYSE:K) have been seeing more favorable price elasticity lately (that is, higher prices are resulting in less lost volume than before), I'm not so confident that will hold for Smithfield. Likewise, I think expectations for big export contributions need to be tempered with the reality that there are foreign competitors with more advantageous cost structures targeting the same markets.

Is Packaged Obscured by the Fresh Pork Business?
Companies like Hormel and Hillshire Brands (NYSE:HSH) get quite a lot of attention for their higher-margin packaged meat businesses. There's nothing wrong with that per se, as packaged food businesses does show stronger profits and price stability during tougher times. The thing is, though, is that the market seems to forget that Smithfield has a pretty large and profitable packaged meat business as well. Smithfield doesn't offer all of the information an investor might want in teasing out the value of individual businesses, but one of two conclusions seems to be true. Either the market values Smithfield's packaged meats business much less than Hormel's or Hillshire's (despite good growth, margins and brands), or the market believes that the company's fresh meat operations destroy value. Now, I'm fine with the notion that commodity protein businesses aren't worth a lot, but I don't think I'd go so far as to say it destroys value.

The Bottom Line
I do believe that the market is currently undervaluing Smithfield, especially since consumer staples is often a popular sector among investors, but I also acknowledge the risk that packaged meat profits will normalize while fresh pork performance could worsen even further. Then there's also the risk that the market will always more or less punish Smithfield for having that fresh meat business (or at least do so during periods where fresh protein is out of favor). At today's prices I much prefer Smithfield to Tyson. I also think investors with a value inclination ought to run their own numbers on the packaged-versus-fresh value conundrum. It may just be the case that Smithfield is a decent enough stock to consider buying today for its packaged businesses and that the eventual recovery in fresh pork could lead to decent gains in the year or two ahead.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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