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Lenders Tell It Like It Is

If you're not a "low-cost producer," you're out of the ball game. No cost-cutting measure, no set of facilities, no packer contract can overcome poor production.

If you're not a “low-cost producer,” you're out of the ball game. No cost-cutting measure, no set of facilities, no packer contract can overcome poor production.

People have a hard time quantifying that — but I can assure you — production is the ultimate driver in keeping costs in line,” emphasizes Mark Greenwood, senior financial services executive at AgStar, Mankato, MN.

“If you are not getting good production, there's almost no way you can be a low-cost producer,” chips in Lee Fuchs, vice president of capital markets at AgStar's Northfield, MN, branch.

Strong words from the leading lender to pork producers in the U.S. Carrying upwards of $600 million in their hog loan portfolio, AgStar holds about $400 million in loans and services and another $200 million in loans sold to other financial institutions. About half of the top 40 pork production systems in the U.S. are clients.

With that considerable financial commitment, you can bet Greenwood and Fuchs have studied the formula for success and survival in the narrow-margined 21st century pork production business.

Defining Success

“Pounds out the door” is Fuchs' definition of production success.

“How many pigs do you need to produce in order to pay your bills?” adds Greenwood. “That's a quantifiable number.”

“If you don't keep the crates full and the barns full, it can be difficult to impossible to exceed cost of production targets,” says Greenwood. “I can show you a producer who had virtually no debt on his facilities, but his breakeven cost was $48 because his production was bad.”

Greenwood uses 2002 economics from University of Missouri agricultural economist Ron Plain to reinforce his point. On a “per-carcass hundredweight” basis, all pigs averaged about $49.50 — or $37-38/cwt. on a live price basis. Some suggest that covered breakeven costs.

Greenwood disagrees. “I'd say they are closer to $40-41/ cwt., depending on sell weights and a few other things. The average producer last year lost a minimum of $3/cwt. or about $8-10/hog, pretty consistently,” he says.

Using easy math, the harsh reality is a 2,500-sow operation, averaging 20 pigs/sow/year, marketed 50,000 hogs last year and probably lost $400,000-500,000. And those margins include all (packer) contract pigs, Greenwood reminds. Producers selling on the open market probably averaged $8/head less than that, so some producers lost $16/head.

Yes, it's a bleak picture, but all is not lost, the lenders agree. Pork production remains a cyclical business. When low prices encourages liquidation, hog numbers decline and prices climb to profitable levels again. Producers are able to recover some of their losses and make some gains.

Being realistic, however, Fuchs doesn't think the upside is likely to last very long. The reason: too many benefits of integration.

“The producers and packers who are integrated have such an advantage when hogs are high (priced) because they don't have to pay quite as high a price for their hogs. When they transfer the hog from production into the packing plant, they can essentially transfer it at a price that is (equal to) their cost of production,” Fuchs notes. “Their cost of production may be $40 while all of the other packers are paying $50 on the open market. That's a huge advantage.

“The whole industry isn't that way, by a long shot, but there's enough of it out there that the integrated model has a big advantage, while the non-integrated packer can't compete,” he continues.

In those circumstances, some (non-integrated) packers may encourage producers to expand, or more likely, reduce slaughter capacity. The net effect is to increase supply or reduce demand and drive hog market prices down to make them more competitive.

“It's a vicious circle,” agrees Greenwood. “I call it a ‘shift in the marketplace.’ Prior to 1998, the average price of all pigs was $46. Because of vertical integration and where we're at in this industry, that number is going to be much closer to a $38 to $42 window. I think it will hover in that area for a long time.”

Fuchs agrees: “You may see spikes for a short time, but the key is, it will be short.” Spikes could hit $50, even $60. “They will pay it for a couple of weeks or months, then the price will come back down because it's unsustainable,” he continues. “It's a dilemma that producers should be aware of — the odds of producers being able to recover their losses is going to be more difficult than ever — unless they are low cost.”

Having come full circle to the importance of being a low-cost producer, the lenders emphasize these key elements for producers to focus on.

  • Vertical coordination or integration: If possible, pursue some sort of integration or vertical coordination that allows you to capture some of the value on the meat side. Carcass premiums serve as a “synthetic” way of adding value, but the potential is somewhat limited — say $3-4/carcass.

  • Functioning under the Wal-Mart model: “Unfortunately, no matter what industry you're talking about, only the strong survive,” points out Greenwood. Although Wal-Mart entered the retail food industry just 5-6 years ago, they are now the nation's largest food retailer — approaching 20% market share.

    Fuchs adds: “Wal-Mart, specifically, is having an impact on hog prices because they are putting pressure on the retailers (major grocers), who (in turn) put pressure on packers, who put pressure on producers.”

    The Wal-Mart concept is fairly simple — handle a large volume very efficiently, and make a small margin. “They won't let those margins get real wide because that allows an opportunity for competitors to come in. They (Wal-Mart) can take market share away with a lot less margin — and they will do it. They're ruthless,” explains Fuchs.

  • 2,400-sow model of efficiency: Whether building, buying, or selling, 2,400 to 2,500 sows is the industry model. “You've got to be able to produce 1,000 pigs per week,” explains Fuchs.

    Finishing units are usually built for 1,000-1,200 pigs, with a goal of stocking them with single-source pigs managed all-in, all-out.

    “Those who survive with less than 2,400 sows are very, very efficient, have very low costs and very low overhead. Usually, they provide all of their own labor and many raise their own feed grains,” Greenwood adds.

  • Budgets make you better: “The excuse that production is too variable (for a budget) is a poor one. What you breed today, you're going to market 10 months later. There's no reason you can't have a budget,” Greenwood presses. “You need some form of standard for labor, utilities, feed, whatever. The best producers have budgets and find a way to always reduce their costs.”

    “You can create your own standards in a budget,” advises Fuchs. “Your best standards are (to compare) against yourself, not against the industry. Use your own benchmark, improve on that and get better every day.”

  • Partner up: “I think a guy who's got 600 or 1,200 sows has to look at all of his options,” says Greenwood. “I still think those producers can survive, but they have to do their job better than a guy with 50,000 sows. It's a different management mentality.”

    They encourage producers to partner up. They may want to convert farrowing and nursery facilities to finishing, for example, and partner up with others to buy a 2,400-sow unit. “That way, you've got the model you need to be competitive,” says Fuchs.

    Another, perhaps less palatable, option to independent-minded 600- or 1,200-sow operators is to convert facilities into finishers or sow units and be a contract farrower or finisher for one of the other systems. “Yes, you lose your independence, and you don't own animals any more, but there are boatloads of contract finishers who are making returns in the double digits. Being a part of that model is an option that some should consider,” Fuchs says.

    Marketing groups offer another opportunity. “You've got to market in numbers in order to increase your value — 100,000 or 200,000 hogs with the same quality, same genetics,” advises Greenwood. “All packers want to deal with fewer clients. If you don't have enough numbers to get a decent contract, you're cooked.”

    Fuchs adds: “It's not just the packer-producer transaction. It's also the case in almost anything in agriculture. Size matters. Volume gives you clout.”

  • Opportunities remain: The lenders enjoy talking about AgStar's “beginning program” that allows young adults to get into the pork production business.

They are on contract with another producer who's efficient, they're efficient themselves as contract finishers, and, they're consistently making double-digit returns, explains Fuchs.

Contract growers are being paid $36-37/pig space/year. Generally, they have debt service of $26-28/ pig space/year, plus some other costs such as utilities, taxes and insurance, explains Greenwood. “They're making close to $6-8/pig space. We generally figure they will make between $4,000-5,000 per 1,000-head finishing barn for their labor. This is a good source of income for producers who have 4,000 finishing spaces. They can make $16,000-20,000 per year,” Greenwood adds.

They cite a client who took out his first loan while in high school. Now 22 years old, with 6,000 finishing spaces, they expect him to be debt-free in six more years.