As I've written a few times before, when it comes to protein producers such as Tyson (NYSE:TSN), Smithfield (NYSE:SFD) and Pilgrim's Pride (NYSE:PPC), above-average year-to-year and quarter-to-quarter volatility is just the way these businesses are. While Smithfield delivered a surprisingly good fiscal second quarter, investors considering these shares need to realize that this is a tough industry in which to try to earn long-term economic returns.

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Fresh Pork Serves up a Better Fiscal Second Quarter
Happily for Smithfield investors, fiscal second quarter results came in similar to those at Tyson - down on a year-over-year comparison, but quite a bit stronger relative to expectations. Unlike Tyson, however, Smithfield saw better results in its core pork operations, as well as in the packaged food business.

Revenue dropped about 3% from last year, but increased 4% from the prior quarter and came in relatively close to expectations. Weak pricing lowered results in hog production by more than 6%, while the pork business declined about 2% on slightly higher volume. Within pork, however, packaged meat was up slightly. International sales were down more than 8%.

Margins were not strong, but once again the question is the performance relative to expectations. Gross margin declined a full point, while reported operating income declined more than 21%. Profits in hog production declined significantly (reversing to a loss), while pork profits rose more than 13%.

Predictable Unpredictability
Smithfield has always had a volatile business, and this quarter was no exception. Within pork, fresh pork was still down from last year, but the company showed a major sequential reversal with profits leaping from a loss of $2 per head to a profit of $13 (well ahead of the normal $3-$7 range). On the flip side, hog production profits fell to a loss of $8 per head from a $6 per head profit in the fiscal first quarter.

Packaged foods continue to grow nicely for Smithfield, but, here too, there is volatility. Like Hormel (NYSE:HRL), Hillshire Brands (NYSE:HSH), and Kraft Foods' (Nasdaq:KRFT) Oscar Mayer, Smithfield saw improving trends in the packaged foods business. Revenue was up very modestly on a 2% volume increase and profits improved nicely from last year, but per-pound profitability was down sharply (from 21 cents/lb to 15 cents/lb) on a sequential basis.

Looking ahead, I think Smithfield will continue to be choppy on a quarter-to-quarter basis, but I like the overall direction of the business. Smithfield's hedging performance doesn't always get its due, and I do believe that successful hedging will offset a lot of the damage from higher grain prices. At the same time, however, I do see potential ongoing risks to hog margins and I wonder if Smithfield will ever be able to neutralize the volatility in the packaged foods business.

Global Opportunity Vs. Balance Sheet Reality
I suspect that Smithfield would like to find more opportunities to improve its distribution and packaged meat business in Eastern Europe, Latin America and China. This sort of expansion wouldn't necessarily stabilize revenue growth or margins (there's plenty of volatility in the global protein market), but it would offer a good play on rising standards of living in these areas. While the company's balance sheet isn't necessarily a huge risk in and of itself today, there's, nevertheless, enough debt here that the company might not be able to make an especially large move without taking on a lot more leverage and/or diluting current shareholders with a sizable equity component.

The Bottom Line
Among domestic protein producers, I continue to prefer Smithfield over Tyson, though Tyson management deserves credit for what looks like more consistent performance. While I continue to prefer Hormel over Smithfield as far as the businesses go, Hormel rarely ever trades at an especially attractive multiple.

At today's prices Smithfield looks somewhat undervalued. I could see the shares moving into the mid-to-high $20s, but I would caution investors that the sector may not yet be through with reporting very volatile margins.

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

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