Expansion is happening across the U.S. swine industry this year, and it more than likely will continue into 2017.
Steve Malakowsky, a member of the “swine team” at AgStar Financial Services, based in Mankato, Minn., expects to see 120,000 to 140,000 more sows added to the U.S. swine herd this year, and he anticipates that number will be even higher next year.
“We’re seeing a fair amount of activity on the sow side of things,” Malakowsky says. That growth would be even higher, but producers in a number of states — Minnesota, South Dakota, North Dakota and Wisconsin — have had their expansion plans stalled for the time being due to hang-ups in the permitting process. “Even with these delays, conservatively I would say [facilities for] 120,000 to 140,000 sows are being built.” Once the permitting holds get worked out, Malakowsky says the sow increase may reach 250,000 between 2016 and 2017.
Malakowsky says producers caught in the permitting web have possibly altered plans or even changed a proposed site location for their expansion, but these changes add time to the process. “If you change location, that can add a year to the permitting process,” he says. “Location is paramount when siting a sow unit, but if it gets hung up in the permitting process, then you might have to go to plan B.”
Though these delayed sow expansions won’t be adding to the pork supply chain this year, Malakowsky foresees some of them coming online in 2017.
A question that begs to be asked, and one plenty of producers and ag lenders are asking each other, is, “Is now the right time to be jumping into expansion mode?” If a producer is contemplating expansion, what numbers do they and their lenders need to be most concerned about?
Malakowsky has been with AgStar Financial Services since 1997, and he experienced “tremendous growth over a very short period of time. The realization of 1998 quickly taught me a lesson in the swine industry, that whatever profits it gives, it can quickly take back,” he wrote in a column for National Hog Farmer in June.
Malakowsky wrote that producers needed a few years to build their balance sheets back up in the aftermath of 1998. “In 2007, I thought I saw the healthiest balance sheets I had ever seen. That was until now,” he wrote in his June column. “Without of doubt, I have never seen healthier balance sheets, the levels of working capital and the average production system in place today.”
With that in mind, what exactly do lenders look at on producers’ balance sheets?
Working capital per sow
To calculate working capital per sow, use the number of pigs marketed divided by a reasonable number of pigs a sow would produce to come up with an equivalent number of sows for each operation: X pigs marketed divided by piglets produced per sow equals sow base. The working capital is then divided by your sow base.
Malakowsky says, “We would like to see this target be over $600 per sow. Today, the average number we see is over $1,200 to $1,400 per sow. There is a tremendous amount of working capital today for most operations.”
With that target of a $600-per-sow working capital, and if you’re looking at a 5,000-sow operation, “you would want to have 5,000 times $600 in working capital,” or $3 million, to get the attention of a lender to proceed with an expansion.
“My recommendation to anyone looking to expand is make sure you maintain a minimum of $600-per-sow working capital after you expand. Now is the time to structure your balance sheets to maintain as much working capital as possible. Interest rates are low, and balance sheets are very strong, which gives you more leverage with your lender today,” he wrote in his column.
While a healthy balance sheet is important prior to getting an expansion loan, Malakowsky stresses the importance of that $600 target after the expansion. “Let’s say you’re at $1,400 today, and you’re going to expand your operation to a size large enough, but that it decreases you to $300 per sow, then I would strongly encourage with where the rates are today to restructure your business to at least maintain that $600-per-sow capital.”
“Balance sheets today are as strong as I have ever seen. Average working capital per sow is above $1,400. When looking at expanding your operation, it is important to have the proper mix for long-term debt and still remain liquid with over $700-per-sow working capital,” he says. “When looking at long-term debt, you want to target $4 to $6 per weaned pig principal and interest payment, depending on the mix of fixed assets for the operation.
“If they only own the sow unit, you would target the lower debt payment, and higher if they own finish barns, feed mill, etc.”
Producers should maintain 50% owner equity minimum on a market-based balance sheet from an audited statement. “We’re more inclined to be a little more lax and a minimum of 40% owner equity,” Malakowsky says. From an equity standpoint, the average producer has over 70% equity in their operations today, he says.
Malakowsky points out that if red flags appear on a producer’s balance sheet in working capital per sow, cash flow or owner equity, there has to be some offsetting strengths. “If it triggered one of those … maybe it’s something they negotiated, or something to help mitigate the risk in the operation.”
To Malakowsy, almost as important as a red flag as the working capital is cash flow if it isn’t set up right from a debt-structure standpoint. “I don’t even want to do that deal myself, because I know it won’t last long term.”
Malakowsky admits loan officers have to keep an open mind when dealing with producers if balance sheets may not show the numbers with which lenders are comfortable. “From what I’ve seen in the past, from a cash flow standpoint, it enhanced their overall cost structure of their entire business,” he says. “So look for some sort of trade-off. If we’re going to push cash flow and working capital, what does it do to the rest of your business? What other enhancements were there? In one case, it improved their cost structure of their overall business, so it was almost a no-brainer.”
As for what is the best decision to make for your operation on interest rates, Malakowsky believes that depends on several variables. With rates near historic lows again, looking at a restructure to lock and mitigate interest rate risk is worth considering. The first analysis he does when looking at a client’s current loan structure is to understand their cash flow needs. It is vital long term for all operations to have a payment structure that is reasonable and competitive on a per-pig basis. Second, if your rates are within reason and you are not growing your business, you might want to just keep your loan structure as it is.
For example, if you have a $1,200 debt per sow with a fixed rate amortized over 10 years, a 0.05% drop in rate will only reduce your cost by 14 cents per pig, assuming 26 pigs per sow per year. However, if you are looking at expanding your operation and currently have an accelerated debt structure, visit with your loan officer to determine your best payment structure to keep you competitive in any economic environment.
Even with these times of healthy balance sheets, Malakowsky says he has had to deny some projects, “because for various reason they aren’t where they need to be yet, but then it gets down to coaching them where they need to be for the long term.”
If you look at this industry from the late 1990s, some producers were able to have contracts that mitigated a lot of the risk that other producers weren’t fortunate enough to have. Those contracts went away, so now producers have to pretty much manage the risk of these operations on their own, “and that is why we’re looking at building up that working capital per sow over time to manage your business,” he notes.
Malakowsky says the last thing you want is to have the lender dictate what you need to do, “and those with a healthy level of working capital will not have to worry about that.”
The key to remember, when talking balance sheets, is profit is king.
“What producers need to remember is that even though there are new opportunities to expand as the result of new packing space, the product still needs to be sold profitably.”