Pilgrim's Pride - Earnings Call - Q2 2018
August 2, 2018
Transcript
Speaker 0
Good morning and welcome to the Second Quarter twenty eighteen Pilgrim's Pride Earnings Conference Call and Webcast. All participants will be in listen only mode. At the company's request, this call is being recorded. Please note that the slides referenced during today's call are available for download from the Investor Relations section of the company's website at www.pilgrims.com. After today's presentation, there will be an opportunity to ask questions.
I would now like to turn the conference over to Denim Winato, Director of Investor Relations for Pilgrim's Pride. Please go ahead.
Speaker 1
Good morning and thank you for joining us today as we review our operating and financial results for the second quarter ended 07/01/2018. Yesterday afternoon, we issued a press release providing an overview of our financial performance for the quarter, including a reconciliation of any non GAAP measures we may discuss. A copy of the release is available in the Investor Relations section of our website along with the slides we will reference during this call. These items have also been filed as eight Ks and are available online at www.sec.gov. Presenting to you today are Bill Lovett, President and Chief Executive Officer and Fabio Sandri, Chief Financial Officer.
Before we begin our prepared remarks, I'd like to remind everyone of our Safe Harbor disclaimer. Today's call may contain certain forward looking statements that represent our outlook and current expectations as of the day of this release. Other additional factors not anticipated by management may cause actual results to differ materially from those projected in these forward looking statements. Further information concerning those factors has been provided in today's press release, our 10 ks and on our regular filings with the SEC. I'd now like to turn the call over to Bill Lovett.
Speaker 2
Thank you, Donovan. Good morning, everyone. Thank you all for joining us today. For the 2018, consolidated net revenues were $2,840,000,000 versus $2,750,000,000 from a year ago, resulted in an adjusted EBITDA of $283,000,000 or 10% margin versus $449,000,000 a year ago or 16.3% margin. Adjusting for the derivative loss, adjusted EBIT was $212,000,000 or 7.5% margin compared to $375,000,000 or a 13.6% margin last year.
Our net income was $107,000,000 compared to $234,000,000 in the same period in 2017, while adjusted earnings were $0.53 per share compared to $0.92 per share in the year before. We'd like to show our gratitude to our team members for once again delivering a solid performance in the wake of a challenging pricing environment in The U. S. Protein sector in Q2. Their commitment and dedication have helped us deliver good results despite some counter seasonal softness in the commodity sector during the quarter.
The results are a testament to the breadth and diversity of our portfolio, which is structured to generate more consistent, higher margins over time under different market environment in the segments that we're in while giving us the opportunity to capture any upside. At the same time, we're leveraging our key customer approach to continue driving growth for us beyond the average market conditions. Though we're pleased with the progress we've made in terms of our relative performance to our peers over the last eight years in every region we operate, we're not satisfied and will continue to refine our portfolio strategy, which we believe will give us even more differentiation versus our competition. The investments we've made over the past few years are operating at expected levels, while the acquisitions are continuing to generate greater value and contribute to the evolution of our portfolio and supporting our vision to become the best and most respected company in our industry. During Q2, we saw some counter seasonal softness in The U.
S. Large bird deboning segment, whereas demand was much more in line with normal seasonality in the less commoditized segments and chicken continues to represent meaningful value compared to alternative proteins. The sources of negative impacts to our US business were large bird cutout, live production and breeder costs, investments in brands and prepared foods growth, as well as salary and wage increases given to our team members. These impacts to profitability were partially offset by improvement in portfolio mix, fee conversion rate, plant costs and yields. Customer demand and margins within our small bird and case ready operations have remained strong and our leading share in these markets have continued to give us a competitive advantage relative to our peers with a more narrow market approach.
On the other hand, industry environment within the commodity big bird deboning segment during Q2 was counter seasonal and very challenging. Even though supply of large bird deboning volume was only marginally up compared to a year ago, based on our analysis of public market data, we believe retailers in general were featuring less chicken in favor of more beef and pork to drive their top line performance, which had a measurable impact on overall chicken demand at retail. While this dynamic was not materially affecting the market balance of the case ready birds, it was impacting the supply and demand of the commodity sector. And although it's difficult to determine with certainty when retutters are going to revert to spending more of their promotional dollars back to chicken, based on historical trends, we believe the shift could begin as soon as late summer since chicken continues to be very competitive relative to other proteins and is also a very good traffic generator for many retailers. In food service, while consumers are favoring chicken options with the continued upward trends of chicken servings year over year, traffic in food service has not increased with chicken demand being outpaced by growth in availability.
To further insulate our margins from market fluctuation, even within the main vertical strategies in place to improve our product diversity and market exposure, one example is our Sanford, North Carolina facility, which we have converted from a commodity big bird, deboning plant to a specialty organic case ready plant last year. And it has continued to exceed our expectations and profitability target. We also recently converted one of our big bird deboning plants to full no antibiotics ever to reduce the impact from commodity working with key customers to support their growth expectations to improve our margin profile and provide a more consistent performance despite market fluctuations. Amid continued uncertainties regarding the direction of international trades in The U. S, export chicken prices have remained stable and inventory has also gone down, which we view as positive.
Chicken remains an excellent source of protein at a great value for many consumers in the international marketplace, and we believe future growth prospects are unlikely to materially change considering The U. S. Access to low cost grain and a technological advantage. Our prepared foods business is continuing to rebound and growing at a solid pace of 13% in revenue and 6% in volume. During the past few years, we've been investing in our U.
S. Prepared foods plants, operations and our people to expand our capacities and our capabilities. We are continuing in the build out stage for innovation, marketing to drive strong growth for the future. The investments and focus have driven the increase in performance and potential for further growth remains. We remain fully committed to Prepared Foods to give us an improved margin profile by reducing earnings volatility.
We are also heavily investing to support the future growth of our well regarded Just Chicken brand and it steadily exceeded our expectations with key customer segments. Just Bare Chicken remains the top choice of consumers on Amazon Fresh in Q2 and we continue to increase marketing support for the brand via strategic partnerships that allow us to grow our efforts in supply chain, supply chain improvements, future innovation, and increased opportunity for natural national growth. Just BARE chicken has recently expanded our rotisserie distribution in the Northeast of Midwest markets, increasing brand awareness and distribution growth. We continue to see significant market opportunities and we've made considerable progress toward our ultimate goal of national distribution. In Q2, we completed the transition to a new clean package design for the majority of our product line that better supports the market growth potential for Just BARE chicken.
We see many benefits from the change including significantly improved on shelf impact scores based on internal testing, a reduction in packaging costs and increased production flexibility which is necessary to support a national expansion. We've had a very strong performance at our Mexican operations in Q2 driven by very good demand and also supply constraints within the industry due to less favorable growing conditions in Mexico. The performance is a continuation of our Mexican operations consistent outperformance over the main competitor in the past few years, demonstrating that the strength of our market strength of our portfolio and the dedication of our team members, we grew faster than the market in volume growth during the quarter to generate a very robust EBITDA performance that was an improvement sequentially from an already strong Q1, partially offsetting the results for less favorable peso dollar exchange rate as well as higher feed input costs, which we sourced from The U. S. While the market strength supported the strong performance in Q2, our team's focus on operational excellence and offering differentiated products also contributed to the improvements in the operations.
We continue to place a high priority on Mexico given our expectations that demand will remain on a very robust growth trajectory given the steady rise in disposable income of Mexican consumers. The market environment in Mexico can be volatile quarter to quarter, but historically for the full year, we've recorded very good margin performance consistently. For Q3, we expect normal seasonality for the region and expect another year of strong growth in earnings for Mexico in 2018. As a part of our strategy to strengthen our competitive position, we've maintained the pace of new innovative product introductions. Our prepared foods are growing at double digit rate and generating great results under the premium Pilgrim's and ZELVIA brand.
Both brands have continued to receive very favorable acceptance by consumers. Despite our strong position, we are continuing to look for new opportunities to grow in fresh, especially at retail. Production at our Veracruz complex is continuing to ramp up in line with expectations, and we're on track to double the size of that facility, including the feed mill and the hatchery by the year end. Our Mexican team remains committed to relentlessly pursue operational and management excellence in every aspect of our business. Longer term, we believe Mexico represents an excellent growth prospect as demand for protein continues to outstrip supply.
Our European operations have continued to report an improved performance compared to last year with a 5% growth in volume and 70 basis point rise in EBIT margins compared to last year as ideal weather for barbecue across The UK drove strong demand for our fresh chicken. Our team members also improved the operations and contributed to the strong performance by continuing to focus on comp cost optimization, cost control, excellent consumer relationships, synergy capture, and a culture of constant innovation. The business has already established or has an established reputation for providing fresh, high quality, and locally farmed poultry products and is based on a best in class production platform. We're always looking for opportunities to improve these operations while maintaining the consistent margin performance. The integration process is going well and we are ahead of our $50,000,000 in expected synergy targets over the next two years with the detailed projects to support these now being clearly defined and starting to be executed.
We benchmarked operational efficiency and productivity and have found more opportunities to create value through feed formulation, yield management and labor efficiency in our European operations. Our focus on key customer strategy continues with progress in Q2 with customers to give us a more resilient margin structure, which we will continue to enhance through ongoing operational improvement initiatives. We will continue to invest to optimize our production facilities across Europe to make them more efficient and competitive. Although early, the increase in operational focus is already starting to pay off as our European operations have improved their relative performance over the competition. Beyond that, we're looking to deploy capital and opportunities across Europe to drive future growth and further improve diversification.
We're investing in value added operations to support further innovation with a significant investment to expand our gluten free capability on a target to be commissioned in Q3, targeting a growing consumer trend for gluten free products. The plant based protein market is growing strongly in The UK as a part of a wider flexitarian diet approach. We believe the innovation we're developing in Europe can be adapted to other markets we're in, giving us yet another way to tap in the consumer desire for an alternative form of protein. The plant based protein product range of Moy Park includes veggie burgers, spring rolls and taquitos, cheese sides, veggie ingredients, donuts and pies for food service and retail channels. Although still small, we expect volume from this segment to grow strongly over the next few years driven by robust consumer demand.
We continue to support our customers' development and expect to see further growth this year by interest in meat free snacking. While the retail landscape in The UK is undergoing an evolution, we're already seeing positive results from this acquisition with significant share gain late last year at a large retailer and several other projects with key customers in the first half of this year to further optimize these relationships, highlighting how our newly acquired operations are already benefit benefiting from our team's enhanced focus on our key customer strategy. We'll continue to extend our key customer strategy to Europe as we see incremental joint value creation opportunities here and we have seen in The U. S. And Mexico, which will drive greater earnings performance.
Moving on to commodities. Corn and soybean prices rallied to start Q2 driven by drought related production losses in South America before falling significantly in June reflecting uncertainty over the escalating trade conflict between The US and China. In July, USDA lowered their expected Chinese soybean exports by 8,000,000 tons and increased their US soybean carryout by nearly 200,000,000 bushels to a record 585,000,000. Although corn stocks are expected to decrease in twenty eighteen-nineteen, trade uncertainty and better than expected crop position or crop conditions also brought corn prices to their yearly lows in July. With prospects for better than expected corn yields and major headwinds from U.
S. Soybean exports, feed input prices are likely to remain low in the short term. To further reduce the impact of volatility, we've covered our soy and corn needs through this growing season. In Europe, we have positions that will protect us well until late in this year. We will continue to monitor the progress of The US crop as well as volatile trade situation between US and China to determine the appropriate course of action for our positioning in the grain markets.
For 2018, the USDA is expecting total US chicken industry production to grow at a rate less than last year's. While the overall size of the breeder flock may seem high relative to historic levels, part of that this increase is the primary breeder segment given the breeder market share shifts and recent change to a new generation of breeders. This shift to new breed is yet to be completed. Our most recent data on egg productivity, hatchability, and chick mortality driven by the breed shift have remained challenged and limit egg supplies. We believe the loss in productivity is structural in the order of 1.4% decline in broiler chicks hatched per layer.
Considering this loss of productivity, higher mortality, the support of growth in total heads, and the magnitude that USDA is projecting, there's a requirement for significantly more breeders than in the past. Also, we believe that the tight labor conditions in The US will govern the pace of industry capacity additions in the near to midterm. Despite more availability of other proteins, the outlook for chicken demand is in the less commoditized segments this year remains solid overall as supply and demand remains in good balance. With The US economy continuing to be strong, very low unemployment together with higher disposable incomes, households are looking for better quality, higher priced cuts of meat, and also more overall consumption. While US retailers are putting more emphasis on competing protein in terms of feature activities, we believe our relationships with key customers give us an added level of protection.
Globally, chicken remains the fastest growing protein in demand and US chicken continues to be very competitive. While we're already well balanced in terms of our bird size exposure, we will continue to look for opportunities to shift our product mix and reduce the commodity portion of our portfolio by offering a more differentiated product to key customers while also optimizing our existing operations to pursuing our operational improvement targets. We believe our key customer approach is strategic and creates a basis to further accelerate growth in important categories by providing a more customized and innovative products to give us a clear competitive advantage. Given our experience with state of the art deboning equipment in Europe and The US and our quest to continuously improve the work environment and safety of our team members, we've made steady advances in developing robotic solutions for our processing facilities. Our focus has been on addressing process steps where both ergonomics and employee fatigue due to repetitive motion are key concerns.
We're excited about the progress to date and are in a position to test a proprietary commercial scale, proof of concept robotic technology in a labor intensive process area where no automated solution exists today. As we shared last quarter, current plan is to test this technology in the later latter part of q three, which remains unchanged. We believe our commitment in developing advanced automation technology will not only create a sustainable competitive advantage, but also allow us to economically address the ongoing issue of labor availability in our industry. In the coming months, we'll also release our Pilgrim's 2017 sustainability update, which will detail our 2017 performance and important environmental, social and economic topics and provide an update on our progress toward meeting our 2020 sustainability goals. We're confident that our focus on sustainability will continue to position Pilgrim's as a global leader industry leader in a production of high quality sustainable chicken products.
And with that, I'd like to ask our CFO, Fabio Sandre, to discuss our financial results.
Speaker 3
Thank you, Bill, and good morning, everyone. Before I begin, as a reminder, because we closed the acquisition of Moypark during Q3 of last year, The U. GAAP guidelines requires us to report the consolidated historical full quarter of Moypark into our financials. In the filing, our year to date and year ago results have also been adjusted accordingly. Under this requirement, considering Wayfarer both in 2018 and 2017, we reported $2,840,000,000 in net revenue during the second quarter of twenty eighteen, resulting in adjusted EBITDA of $283,000,000 or a 10% margin.
That compares to $2,750,000,000 in net revenue and an adjusted EBITDA of $449,000,000 or a 16.3% margin the year before. Adjusting for the $24,000,000 grain derivative loss and one time events, our adjusted EBIT was $212,000,000 or a 7.5% margin compared to $375,000,000 or a 13.6% margin the year before. Net income was $107,000,000 versus $34,000,000 in the same quarter of 2017, or a 54% year over year decrease, resulting in adjusted earnings per share of $0.53 compared to $0.92 in the same quarter of last year. Adjusted operating margins were 7% in US, 17% in Mexico, and 5% in Europe. Our fresh chicken operations in US operated well under the market conditions of Q2.
Our EBIT in The US was $124,000,000 when adjusted for the derivative market to market, or 7% margin for Q2. Small bird and case ready continued to be strong for us, and demand was in line with normal seasonality in the non commodity sectors, with small bird pricing measured by EMI at near all time highs, as chicken has continued to be a compelling value proposition to customers despite higher availability of other proteins. On the other hand, the large bird deboning commodity was a counter seasonal and challenging during the most of the quarter, while rebounding at the end. As Bill mentioned, we believe the commodity sector was hurt by increasing emphasis by the retailers and food service on non chicken promotions. Our sales in the prepared segment continue to improve relative to last year, with an increase of 6% in volume.
Despite the counter seasonal trend of the commodity segment, we have the portfolio diversification to all bird sizes, including small birds and case ready, and also international operations, which is designed to minimize the volatility and protect the downside. The environment in Mexico was very strong in Q2, exceeding our expectations due to our improved operations and a strong demand for chicken. Our EBIT in Mexico for Q2 was $62,000,000 or a 17% margin. While the market was supportive, we also have a very strong team in Mexico who have been over delivering performance for us in terms of relative performance to the major competition in past few years, due to their strong operational focus and excellent determination. Considering the strain and momentum in the start of 2018, we believe Mexico will have another strong year despite normal volatility during the quarters.
And our long term outlook for Mexico remains very positive, as we believe the country will continue to be a platform for future growth in chicken consumption as consumers seek better diet and higher disposable income. To support the growth in Mexico, we continue to invest in our production at the new Veracruz complex, which is tracking well, and its performance is exceeding our expectations. And we expect to double the size of the operation, including expansions in the feed mill and hatchery by the end of this year. As part of our target to improve our differentiation in Mexico, we have been increasing our focus on prepared foods, including adding products using the premium Pilgrim's brand. Our investments have continued to produce very good results with prepared foods volume 34% higher than a year ago and our Pilgrim's and Del Dia brand capturing roughly 35% of the prepared food market.
To maintain our growth and continue to innovate, we launched fresh chicken under the premium Pilgrim's brand, including no antibiotics ever, which have continued to see strong demand. Our strategy is supportive of the goal to increase our higher margin differentiated products, while having product coverage from entry level to premium, both in fresh and prepared in Mexico. In Europe, during Q2, our operations continued to improve sales and margins. Our adjusted EBIT in The UKEurope was CHF 27,000,000 or 5% margins for Q2. The integration is going well and we are excited with the geographic diversification and growth potential for us, while evolving our portfolio and creating a sustainable advantage through opportunities to capture the upside in the market, but protecting the downside.
We're slightly ahead of our target of $50,000,000 in synergies over the next two years, including optimizing the product portfolio, operational synergies and implementing zero based budgeting. We have increased efficiency throughout the value chain by enhancing sourcing and production, improving life cost, yield improvements and the global management of feed sourcing. We will leverage our marketing and sales infrastructure to optimize the SG and A costs. We have a very good history of successfully capturing synergies and delivering significant improvements. In those cases, we have meaningfully exceeded our initial synergy targets while building on and improving the performance of the business beyond just the underlying markets.
We are confident we have the technology and team in place to similarly continue to grow the profits of our European operations and leverage their expertise and experience to improve the rest of our global operations. Despite of the evolution of the retail market in UK, we are already seeing some positive results from the acquisition with significant share gain at a large retailer and several other projects with key customers in the first half, and we'll continue to strengthen our additional relationships while supporting an improvement in financial performance of the business. During Q2, our SG and A reached 3.1% of sales, reflecting the inclusion of support for expanding the Just BARE brand nationally, the investments for our new prepared foods products both in U. S. And Mexico, as well as the addition of the new European operations.
We recognized a onetime derivative loss of $24,000,000 to reflect our position amidst what was a very volatile grain market, which increased at the beginning of Q2 before declining significantly as we ended the quarter, driven by noise around challenging international trade expectations. As you mentioned, as of today, we have coverage on feed through the end of the growing season in US and for much of the remainder of the year in Europe. We remain on track to reach our target of two ten million dollars in operational improvements and synergies for 2018, reflecting the benefits of the acquisition and supporting the evolution of our mix and production capabilities and improving our ability to service key customers throughout the globe. We'll continue to prioritize our capital spending plans this year to optimize our product mix that is aimed at improving our ability to supply innovative, less commoditized products and strengthening our partnership with key customers. We expect to invest between 300,000,000 and $250,000,000 on CapEx to account for the inclusion of the GNP and the Europe within the budget.
We reiterate our commitment to invest on strong return on capital employed projects that will improve our operational efficiencies and tailor customer needs to further solidify our competitive advantages. Our balance sheet continues to be strong, given our continued emphasis on cash flow from operating activities, focus on management of working capital and disciplined investment in high return projects. During the quarter, our net debt reached $2,000,000,000 with a leverage ratio of 1.6 pro form a last twelve months EBITDA, below our optimal range of two to three times. Our leverage remains at the low level, and we expect to continue to generate strong cash flows, increasing our financial capability to pursue our strategic intentions. The outlook for 2018 interest expense remains at about $130,000,000 on a normalized basis, reflecting the payment of the Moy Park corporate bonds, the issuance of the add on on bonds replacing it and the new credit facilities in U.
S. And Europe. We once again received great support from our lending partners with the offering, significantly oversubscribed to amend and extend the prior term loan and revolver facilities in U. S, simplifying our total debt structure and reducing our total interest costs. We have a strong balance sheet and a relatively low leverage.
We remain focused on exercising great care and ensuring that we create shareholder value by optimizing our capital structure, while preserving the flexibility to pursue a growth strategy. And we'll continue to consider and evaluate all relevant capital allocation strategies that will match the pursuit of our growth strategy and we'll continue to review each prospect accordingly to our value creating standards. Operator, this concludes our prepared remarks. Please open the call for questions.
Speaker 0
We will now begin the question and answer session. In the interest of allowing equal access, we request that you limit your questions to two, then rejoin the queue for any follow-up. To ask a question, you may press star then one on your touch tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys to minimize background noise. The first question comes from Farah Azlam of Stephens Incorporated.
Please go ahead.
Speaker 4
Hello?
Speaker 3
Hello. Good morning, Farrah.
Speaker 4
Hi. Good morning. Can you talk about your grain costs? Clearly, you took a mark to market extraordinary charge in the quarter. How does that flow through your p and l in the subsequent periods this year?
Any hedges on grain we could discuss kind of going forward?
Speaker 2
Thanks for the question, Farah. So our, would say our commodity risk management team continues to do a a very good job in managing our commodity risk. And so during the development and growing season for corn and soybeans, given the drought conditions that South America experienced and the lowering of of of the carry outs by USDA, we thought it prudent to hedge grain purchases with buying commodities futures contracts. And we did that at at the beginning and throughout the the mid part of the quarter. But as you know, the the the trade environment changed significantly with discussions among Chinese trade partners and European trade partners.
And that caused both corn and soybean markets to go down significantly at a very, very rapid pace. And in so doing, the value of those futures contracts decreased significantly. Our commodity team did a great job, as I said, in rolling those futures into physical corn and and soybean meal forward purchases. And so even though we took a onetime mark to market loss on those futures contracts, What we have now is forward bought physical feed ingredients at prices under the current market. And we have that position well into the harvest season.
So we feel like we're very well positioned from a competitive standpoint on our feed costs going through the rest of this growing season. So
Speaker 3
far, there's no impact on future performance or future results because we took the market to market position of $24,000,000 in this quarter. So it's as of we will buy the grain at market prices in the future. Right.
Speaker 2
But we did convert most of those futures contracts into physical again at prices lower than the current market is today.
Speaker 4
That's helpful. And then when you think about the pricing pressure in the commodity market, is that impacting pricing in the value added market? And how should we think about pricing for retail and pricing for value added into 19 given the current commodity pressure?
Speaker 2
Yes. I'm gonna assume the term commodity refers to the large bird deboning chicken sector. And and
Speaker 3
Yes.
Speaker 2
In that in that vein, it certainly doesn't help pricing on virtually any chicken products if they have to be priced today with the exception, I would say, of the the small bird components because those two markets are really not tied together. It it has affected some of the case ready pricing. And the primary impact there is during the summertime, we've seen, product that that comes from the big bird, segment go into case ready plants and get packed for the fresh retail market. When when demand, did not grow seasonally as it typically does this year, then that commodity, breast meat primarily, did not flow into those case ready plants and backed up into the other market channels, distributor and food service and so forth. And so that put, an immense amount of pricing pressure on, you know, those spot sales or the the most commoditized, portion of the the chicken market.
So, yes, I I would agree that it it has pressured all chicken products with the exception of of small bird components.
Speaker 3
Yeah. Just to support that, if you look at UB, which is the commodity index, it is down 22% year over year. While the prices according to the AMI small bird indexes are higher than last year, actually higher than the five year average and close to all time highs. Also, the gap between the small bird breast and the big bird breast is the highest we've ever seen.
Speaker 4
That's helpful. Thank you.
Speaker 0
The next question comes from Ken Zaslow of Bank of Montreal. Please go ahead.
Speaker 5
Hey, good morning, everyone.
Speaker 6
Good morning. Good morning, Ken.
Speaker 5
So I just have one question. When you think about you know, the chicken margin outlook, you know, what is the most likely course to re to to to reverse or or improve the chicken margin outlook, particularly on the commodity side? Do you think it's more about that we need to see, margins actually get worse so you can see a production cut? Or do you think that the promotional activity will pick up and you'll start to see a resurgence of of margins? Or is there another avenue where because we're at this kinda like middling level.
Right? That that that's neither terrible nor great, but but we wanna see some sort of inflection point. So what do you think is the catalyst to make it change?
Speaker 2
A couple of things, Ken. We definitely need to see more retail feature activity for chicken as as we've lost some of our share of that feature activity to beef and pork as as we previously said. And we think that we'll see a a pickup in that activity as we go later into to summer. Typically, we we do see that in in August going into to September. The other component that I would say is related to profitability and margin is declining feed cost.
As you know, we started the year thinking that for us at least we would see as much as $150,000,000 cost impact to corn and and soy. Well, the trade talk has has taken that out and whereas we saw an increase in feed cost through most of q two, we believe based on the positions that we have today, we're going to see a decline in in feed cost. So more feature activity bringing greater demand at retail and then lower feed cost are the two components that I would offer.
Speaker 3
Just to give more color on what Bill mentioned, our live operation was impacted in U. S. By $48,000,000 because of the higher grain cost and the higher cheap cost despite better conversions than last year.
Speaker 5
And do you think that there would be I mean, you don't think there's a level in in which we would get a production cut? Because again, they're kind of like modest profitability for everybody. So there doesn't seem to be anything. So you think the way the margins get better is just you think the dynamics get better. You don't need a production cut.
Is that a fair assessment of what you're saying?
Speaker 2
I'm not sure about a production cut. I I will say that, we continue to be pressured by the the the the lack of productivity or the fall of productivity of our breeder flock. For sure we think that's a natural cap. We also see a natural cap in the labor supply issue that that all manufacturing and the whole economy faces in the in The US. So I think those two things will definitely, you know, create a ceiling on on production increases.
Speaker 5
Great. I appreciate. Thank you very much.
Speaker 0
The next question comes from Heather Jones of The Vertical Group. Please go ahead.
Speaker 7
Good morning. This is not one of my questions, but just something you just said, Fabio. I wanted to clarify. You said something about 48,000,000 impact from higher feed and chick costs in US, and yet in the queue, it says that feed costs were up $6,061,000,000 and all. So I'm just trying to figure out the disparities between those two real quick.
Speaker 3
Sure. Sure. And that's because that's not volume adjusted. We have 1.5% more volume in US, so that is the total impact. Okay.
If you look
Speaker 4
at Okay.
Speaker 3
I'm talking about rate and the impact of the cheap cost and higher feed, and, again, despite better conversions.
Speaker 7
Okay. So, moving on to questions. Talking of supply constraints, so we've seen an improvement in livability, hatchability. It's, you know, better than it's sorry. It's down year on year, but it's better than it was earlier in the year.
But was wondering if you could give us an update on what you're seeing on the on the breeder side. And just, you know, everyone's well aware of the multitude of plants that are coming on late this year into '19. And yet we have these breeder constraints. And just I'm wondering how you're reconciling the two in your mind.
Speaker 2
Yeah. So on the the current, you know, production footprint, while you're right, we've seen, an improvement from where we were with, chick per hen productivity, we believe that, the change is structural and we're not gonna get back to where we were, say, two to three, years ago. So that's gonna continue to put, somewhat of a ceiling on our ability to grow with our our current footprint, notwithstanding the fact that we do have more more complexes coming on. But in that regard, starting up a a new complex with a new labor pool is going to be, I think, difficult at best. And we've we've we've heard anecdotally of some operations that have been in operation for a couple of years now that still aren't up to a full capacity for no other reason than the lack of labor availability.
So we don't think that that's going to change in the next two to three years.
Speaker 7
But but, I mean, if you look at the if you just take the stated capacity of the new plants that are being added, and let's just say that's a it's a low single digit increase, but not one route. Let's just say it's two to 3%. If you look at these breeder constraints and the other constraints, I mean, how do you how do you think the industry gets to the point where it can populate those plants given these breeder constraints? How does that happen, or does the existing footprint have to shrink? I just I'm try having difficulty reconciling the two in my mind.
Speaker 2
I think that's a very good question. Know, I don't have the answer to that, Heather, because we're not one of the companies that is building a a new complex right now. So I would, you know, direct you to to ask those who who are. We've tried to further, switch, some of the breeds that that we still wanna change out. And we've been told by, the breeder that that we desire, to have this gonna be well into mid next year before we can even get, some of the new breed that that that we're trying to to purchase.
Speaker 3
I think just like Bill mentioned, Heather, the ramp up of these plants will take longer, not only because of the breeders, but also because of the labor. And we are seeing that happening in other segments and with chicken plants that have been recently opened. Just the ramp up will take instead of the normal nine months will take almost two years because of the breeders and because of the staffing.
Speaker 7
And then my second question is on y'all's relative performance. So when I look at where I model, think tray pack should have been for the quarter, small bird, big bird, and then just what I can assume a relatively conservative assumption on prepared foods, it seems like your relative performance deteriorated some even adjusting for that mark to market. It deteriorated some in Q2. So you mentioned some prepared foods investments. You mentioned some live production costs.
Speaker 0
Like, can you
Speaker 7
help us to understand what drove that and when that should, you know, reverse itself?
Speaker 3
Yeah. The the gap in in US, like I started to disclose, was around $48,000,000 with higher feed and shake cost, again despite better conversions than last year. Our operations actually improved by $10,000,000 with the operational improvement initiatives and increased volume, more than offsetting the increase in salary we gave to our team members. Our SG and A was $10,000,000 higher on investments, just like you mentioned, in our Just Pair brand and some admin expenses. If you look at the commodity cutout, it was 22% lower than last year and affected directly our big bird segment, impacting the bottom line by close to $120,000,000 while our non commodity segments and operational improvements in yields that manifest in sales improved our mix and price by $20,000,000 So if you look at the gap between last year and this year, these are the main buckets.
Speaker 7
Okay. All right. Thank you so much.
Speaker 0
The next question comes from Jeremy Scott of Mizuho. Please go ahead.
Speaker 6
Hi. Good morning.
Speaker 3
Good morning. Yeah.
Speaker 6
Hoping you can expand on what you mean by refining your portfolio strategy in The U. S. Maybe you can answer in the context of short term versus long term. In the short term, how do you mitigate the pricing risk in Big Bird? I think in the past, you talked a little bit about buy versus grow, but just wondering to what extent that's effective when you have overall sales volume weakness.
And then over the longer term, when you look at the market today versus a decade ago and how your customer demands have changed, is the mid cycle earnings power of a large big bird plant, the Bony plant structurally lower today, or are we reading too much into this cyclical slump in breast meat?
Speaker 2
I'll offer a few examples. If if you remember February 2017 or last year, we converted a large bird deboning operation that was largely just sold on the the commodity spot market. We spent a $130,000,000 on the operation, converted it to an organic tray pack plant. That's changed the profitability of that operation significantly and continues to stay in line with our expectations. We have, some case ready plants, one newly acquired one to to be specific, where we don't have enough capacity to put all the meat in a in a fresh retail tray.
We're gonna spend some capital dollars to finish out the packaging portion of that plant so that we can get an optimum amount of of meat in a in a tray, and that's yet another example of changing our mix. In the large bird deboning segment, there are certain value added products even in those plants that we can develop and grow to take out the spot market effect if you will for those operations. So it's a continuing evolution of upgrading our mix and developing a more diverse portfolio even within our.
Speaker 3
One example of that is the conversion of one of our plants to the no antibiotic ever, which is the first conversion that we've done in the big bird segments. We are leading the other segments in that category, but now we just now converted one big bird operation to that. Another example is to use just like you mentioned more food service in a box with some branding and some specific trimming to specific customers targeting a much higher value added operation even within the commodity segment. Can you talk a little bit
Speaker 6
about the elasticity of your organic and ABF pricing when you have commodity price declines of such magnitude?
Speaker 2
Sure. When when we convert a facility to no antibiotics ever, the pricing on that product is is pretty well set. We don't we don't do that as a speculative activity thinking that we're just gonna go out and sell it and someone is gonna pay us more. We we already have agreements with customers when we do that to pay us a defined premium relative to, you know, the the traditional type products. So there's there's no question when we do that that we're going
Speaker 3
to have a higher
Speaker 2
margin for for the long term.
Speaker 6
And then the $25,000,000 increase in freight, can you talk a little bit about your conversations with your customers and maybe the process around packing that through? Or is that just you expect to fully absorb that as as long as it remains this high?
Speaker 2
Yeah. It it hasn't changed since we reported last quarter. We think that we'll realize an increase of about $30,000,000 through the year, And then we'll recover, you know, somewhere in the low to mid twenties, the low to mid 20,000,000, that. So most of that we're going to to to recover, and it's it's not gonna be a a material impact to profitability.
Speaker 6
Based on what you're seeing today, you do you expect that to be a tailwind in in '19?
Speaker 2
We don't think the the driver shortage, which is root cause of this, is going to get any better in 2019. So we think it's going to continue to be a challenge and we'll have to work with our customers to make sure that our products are priced in such a way that we cover those increase in freight costs.
Speaker 1
Got it. Thank you.
Speaker 0
The next question comes from Ben Fiori of Barclays. Please go ahead.
Speaker 8
Hey, good morning, Bill, Fabio. Thanks for taking my question. Just wanted to quickly follow-up on your strategy going forward. And I guess you've talked a lot about it, but obviously, there was the impact from the derivatives and then you decided to roll it into physical. You took the €24,000,000 hit.
So if we actually adjust for that, that is roundabout a two fifty basis points impact on your cost of sales just in The U. S. So going forward, are you basically just literally not going to engage that much in the derivatives market? We can really account for the write off in 2Q as a onetime event because we've not been seeing you guys adjusting for that in the past, and it just popped up now as an adjustment. So really want to make sure that we're not going to see derivatives.
I mean, I understand you do future positionings by physical, the feed ingredient, but just to understand where we are on that going forward, and then I have a follow-up on that.
Speaker 2
Sure. Well, we we view the use of derivatives as a risk management tool. And I would tell you, given the right, you know, market atmosphere, we're going to continue to use those as a tool when we see the need. The fact of the matter is we took the opportunity given the rapid fall in price on corn and soybean meal to convert those into to physical purchases. And so through most of the harvest season in this crop year, we've locked in our our feed ingredient cost.
But if markets change and we see the need to employ purchase of derivative contracts or or financial products again, then, you know, we'll we'll employ that strategy as needed.
Speaker 3
I think the reason for the call out was just to demonstrate the performance of the business during the quarter, not with some impact from future purchases because these are future purchases, not purchases from this quarter. I think that was the reason for the call out.
Speaker 8
Okay. And the roughly 250 bps assumption, that's correct. Right?
Speaker 3
Yes. And and okay.
Speaker 8
Yes. And then my follow-up question, so if we adjust for that, I mean, clearly, we are in an environment where cost of sales is higher. But you've mentioned something, I just wanted to understand this right so that we get the outlook for the second half properly. So you've mentioned feed cost now is actually at a lower level than a year ago, and that's how it looks like if just take a look at the sheer pricing. But what you've locked in, what percentage does that compare roughly to your actual cost you had in the second half so that we get an understanding, at least from a feed ingredient point of view, how does cost of sales look like, on a year over year basis for the 2018?
Speaker 3
Because of the market to market of €24,000,000 what we believe now, the reality is that then we start with normal market prices in Q3, and that was the reason for the market to market hit. And when we transform this $24,000,000 from derivatives to physical, it's actually at a little better condition than the market is today. So expect to have a little bit of a benefit from that $24,000,000 market to market loss last quarter.
Speaker 8
Okay. Understood. Thank you very much.
Speaker 0
The next question comes from Adam Samuelson of Goldman Sachs and Company. Please go ahead.
Speaker 9
Yes, thank you. Good morning, everyone.
Speaker 3
Good morning, Adam.
Speaker 9
A lot of ground's been covered today. Wanted to ask a little bit about the second half, and I think last question covered kind of the view on a more a much more balanced year over year feed cost outlook for the back half. But thinking about the impact of the commodity businesses in Big Bird on the back half, I mean, Big Bird cutout remains 20% plus below year ago levels. Is your view that you we can go through some of the the outlook for the different cuts within that as we go into the fall? And thinking about, is it really we need retail features to kinda start sucking in a little bit more boneless breast meat to put some support into that market, at least relative to where to where we've been on a year on year basis?
Or do we or are we looking at a a point where boneless in the fall can be a dollar and leg quarters remain will start tracking below year ago levels and the wing comps get easy, but still the big you still have pretty challenging compares on on the cutout for for several more quarters.
Speaker 2
Right. So we would view, Adam, the the, you know, commodity market or the large bird deboning market in general as remaining challenging for the rest of the year. Although, we would believe that sometime yet this summer, we we may see some some lift from from retail features. But fact of the matter is we're sort of short on time that that we can enjoy that as we as we through Labor Day. And and I think that that you you called it fairly correctly with potentially wings getting a lift.
Would say tenders could could get a lift. By and large, we we think the the back half of the chicken will remain fairly steady, and the the breast meat component of that will remain fairly weak, through the rest of the year.
Speaker 3
Adam, if you could look at the comparable last year, during Q2, Q3 you have a very strong summer with very strong wind and very strong breast meat prices. But at the fall, we saw a big drop in prices last year as well. So the comps will get a lot easier for sure.
Speaker 9
No. Sure. That that's fair. But but just given the even without the feed cost kind of normalizing or settling out on a year on year basis, you still have the other kinda cost dynamics, which remain kinda in place. And I'm just wondering, I mean, given the implications of that for the industry, I mean, doesn't that put the big bird deboning industry in the red by the fourth quarter, given the normal seasonality of prices?
Speaker 2
It's possible. But, you know, from our standpoint, we're we're not gonna stand still. We're gonna continue to work on our mix, develop more value added products in that segment such that, we can get a better return than just the smart the spot market would avail to us.
Speaker 9
Okay. And then just a quick question, on Mexico, if I may. I know seasonally, the second quarter is always strong and you improved this quarter. But on a year on year basis, I mean, is the decline help me just think about the decline year on year in the in the Mexico business. I know currency wasn't helpful, but beyond that, just some of the pieces in Mexico and how how to bridge that?
Speaker 2
We think we're gonna have another great year in Mexico. And, you know, if you've noticed, through each year, the quarters are fairly lumpy. But, as I remember seeing the numbers yesterday, were amazingly consistent when you compare year to year. We don't think 2018 is gonna be a lot different than, than it's been the last couple years with with great performance, for the whole year.
Speaker 3
Yeah. Just like you mentioned, there is some volatility on quarter to quarter with q three not being as strong as the q two and q four. If you remember last year, we have, unseasonable weak q four because of the hurricanes and because of the, all the all the earthquake in in Mexico, and also the volatility in exchange rate. And we expect to have a stronger q four this year. So when you look at the total of the year, we expect them as strong of of a year as we have last year.
Speaker 9
Okay. That's helpful. I I appreciate the color. Thank you.
Speaker 0
This concludes our question and answer session. I would like to turn the conference back over to Bill Levitt for closing remarks.
Speaker 2
Thank you. And we look forward to a second half of twenty eighteen to remain positive on the outlook for chicken consumption globally. Despite the volatility in the commodity sector, we believe chicken continues to be the most compelling protein everywhere around the world. With our newly acquired European operations and last year's acquisition of GMP, we're much better represented globally and well positioned to improve our margin profile and reduce volatility despite specific market conditions. We will continue to look for opportunities including Europe to refine our portfolio and offer differentiated customized products while pursuing our key customer strategy in support of our vision in becoming the best and most respected industry creating the opportunity of a better future for our team members.
I'd like to thank everyone in the Pilgrim's family as well as customers and also thank you for your interest in our company today. Thank you for joining us.