Pilgrims Pride Corp

NASDAQ:PPC

Earnings Call Transcript 2017-Q4

[Operator]

Good morning and welcome to the fourth quarter and year-end 2017 Pilgrim’s Pride earnings conference call and webcast. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. At the company’s request, the 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 Dunham Winoto, Director of Investor Relations for Pilgrim’s Pride. Please go ahead.

[Dunham Winoto, Director, Investor Relations]

Good morning and thank you for joining us today as we review our operating and financial results for the fourth quarter and year ended December 31, 2017. Yesterday afternoon we issued a press release providing an overview of our financial performance for the quarter and for the year, 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 8-Ks and are available online at www.sec.gov.

Presenting to you today are Bill Lovette, 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-K, and our regular filings with the SEC.

I’d now like to turn the call over to Bill Lovette.

[Bill Lovette, President, Chief Executive Officer]

Thank you, Dunham, and good morning everyone. Thank you for joining us today. For the full year 2017, net revenues were $10.77 billion versus $9.88 billion from a year ago, resulting in adjusted EBITDA of $1.39 billion or 12.9% margin versus $1.03 billion a year ago or 10.4% margin. Our net income was $695 million compared to $441 million in the same period in 2016 while EPS was $2.79 a share compared to $1.73 a share in the year before.

For the fourth quarter of 2017, net revenues were $2.74 billion versus $2.37 billion from a year ago, resulting in an adjusted EBITDA of $241 million or 8.8% margin versus $205 million a year ago or 8.7% margin. Our net income was $134 million compared to $71 million in the same period in 2016, while earnings were $0.54 per share compared to $0.28 per share in the year before.

Our team delivered strong performance during 2017, and we are again very proud of their contributions. As we have continuously stated, our goal is to create a portfolio strategy which is designed to deliver more robust performance for the mid to long term rather than the short term, and structured to minimize the full peaks and troughs of the commodity markets.

Last year, we achieved some important milestones to build on that strategy to improve upon our existing portfolio to generate more value for shareholders and get further in our vision to becoming the best and most respected company in our industry, creating an opportunity of a better future for our team members. In 2017, we completed several strategic capital investments to position ourselves well for the future, to further increase our product portfolio differentiation, strengthen key customer relationships, and improve our margin profile. Our Sanford, North Carolina facility continues to operate well following the conversion from a commodity large [indiscernible] operation to USDA certified organic tray pack processing. This project was done on time and on budget and contributes to us being the leading producer of organic chicken in the world. Together with our GNP acquisition, the conversion also gives us leadership in premium branded and no antibiotics ever chickens, while putting us ahead of our internal target to offer a differentiated portfolio for our key customers.

In addition, we finished the planned expansion at Moorefield, West Virginia, adding 10% to our higher margin, fully cooked prepared foods capacity which continues on track to recover well from our improved operations. Also in prepared foods, we are nearing the perfect order rate as we are quickly returning to our previous target of best-in-class service while the seasonality in meat prices in the U.S. should be more favorable for our prepared foods input costs.

We also entered new geographies and markets last year to better serve key customers while leveraging our teams’ operational excellence in acquiring assets and transforming their performance. The integration of GNP is proceeding well and we have extracted more synergies than expected, contributing a 600 basis point increase in margin since the acquisition early last year, as we applied our methodologies to generate operational improvements. As of quarter four, our GNP operation is already at par with our legacy segment. Finally, our purchase of Moy Park in quarter three has created the largest global chicken and chicken-based prepared foods company while adding further diversification to our existing portfolio, increasing our footprint and generating improved margin performance and reducing volatility.

During Q4, our consolidated results were well balanced. U.S. operations were solid despite some impact from Puerto Rico, while Mexico continued to improve through the quarter and finished strong with a very slow start due to the after effects of earthquakes and hurricanes in the central region. In the U.K. and continental Europe, we experienced strong revenue growth and consistent margins and outstanding customer service during the Christmas campaign. U.S. domestic demand was in line with normal seasonality as chicken represents a great value compared to other proteins. Margins within our small bird and case ready operations have remained healthy, and our leadership in these markets will continue to give us a meaningful advantage relative to our peers, who may have a narrower market focus.

We believe our strategy of offering a more differentiated product within each bird size and targeting key customers will continue to enhance our margin profile and provide more consistent results despite market fluctuations. While food service traffic was flat in 2017, chicken servings are continuing to grow and menu importance is at its highest point according to NPD. Also positive was chicken dollar growth, which has outpaced volume growth and is an indication that the industry has increasing volume at greater profits.

Prices for commodity large bird deboning products in Q4 climbed sequentially in line with normal seasonality. Export volumes, which account for a large portion of the large deboned category, were also impacted by expiring import quotas in many international destinations; however, demand in pricing for U.S. chicken in international markets has rebounded since the beginning of the year and as new quotas are approved. Other cuts are also following the same positive trend. Wing prices dropped from record levels but have started increasing in the new year, while tenders and dark meat prices have also bounced off their Q4 seasonal lows supported by improving cold storage data.

Freezer inventories have dropped 30% off the October high, reflecting better demand for dark meat from export destinations as avian influenza has affected many of the chicken producing regions globally. We are encouraged by the rebound in prices off the Q4 lows during January, which we believe is reflecting normal seasonality.

The integration of GNP, as I said, is going very well and we are on track. As we stated on the last call, we’ve made great progress in improving the profitability of GNP. Margins have improved by over 600 basis points since the acquisition early last year as we applied our methodologies to generate operational improvements. GNP assets are already operating at the same level as our legacy assets, and we expect more potential for improvements at GNP as we increase scale of that business.

In Q4, we experienced continued growth with our Just Bare brand and made considerable progress towards national distribution, which is our goal. Just Bare has remained the number one fresh chicken brand sold on Amazon with 2017 dollar sales increasing nearly 3.5 times versus the previous year. Amazon estimated grocery sales are up 59% year-over-year with fresh meat capturing the number two spot in the fresh category. Additional growth efforts with Amazon include supply chain improvements, future innovation collaboration, and exploration of the new formats.

We have identified and are in pursuit of exciting growth opportunities in new markets that index significantly higher for the target Just Bare consumer to expand beyond where the brand is currently distributed. Among purchasers of the brand, slightly more than four out of 10 have actually recommended Just Bare to a family member or friend, and 86% are extremely or somewhat likely to recommend the brand in the future, according to our 2017 brand tracker study. We intend to double our ACV distribution by the end of calendar year 2018.

To further support growth and market potential, we are also transitioning Just Bare to a new clean package design which testing showed significantly improved the on-shelf impact scores. The brand’s organic line was the first to transition with the rest of the product line adopting the new design later this year. Additional benefits of the new package include reduced packaging costs and increased production flexibility, which is necessary to support national expansion.

We had a challenging quarter in Mexico mainly due to logistics and infrastructure dislocations caused by a couple of major earthquakes that occurred mid to late September, as well as hurricanes. Demand was significantly impacted and took a bit longer than expected to normalize, driven by industry supply chain bottlenecks that prevented quicker recovery. While October and November were particularly difficult, market conditions improved substantially towards the end of the quarter and continue to recover well into the new year, as supply and demand balance has largely corrected. Despite Q4, our long term outlook for Mexico has not changed and we expect chicken demand to continue to outperform in the future as consumers look for better protein options to improve their diet, given rising income levels.

To satisfy this demand, our team remains focused on operational excellence and innovation. We expect continued growth in demand in 2018 and expect another strong financial result. As a part of our strategy to strengthen our competitive positioning in Mexico, we’ve maintained the pace of new, innovative product introductions. We continue to make very good progress in prepared foods and are generating great results under both the Pilgrim’s and Del Dia brands. Our business grew significantly in 2017 as both brands have continued to receive very good acceptance by consumers.

Production at our Vera Cruz complex is continuing to ramp up nicely and we’ll double the size of that facility, including the feed mill and the hatchery. Our Mexican team remains committed to relentlessly pursue operational and management excellence in every aspect of our business, and longer term we continue to believe Mexico represents a very good growth prospect as demand for protein continues to outstrip supply.

Our new U.K. and continental Europe operations reported robust sales growth and consistent margins in Q4 supported by strong cash flows. Our team was able to generate this strong performance due to a better focus on cost control, excellent customer relationships, and a culture of constant innovation, and despite a changing competitive landscape, a market that is facing some commodity cost headwinds. As for our future growth, we’ve recently opened a new state-of-the-art hatchery in Newark, England, and the first hatch has been successfully completed. Besides Newark, we have also been investing to optimize our production facilities to take advantage of market conditions.

The integration process is going well as we expect to generate $50 million in synergies over the next two years. Our U.K. and continental Europe operations have a great existing track record of sustained earnings growth and the business has established a reputation for providing fresh, high quality and locally farmed poultry products and is based on a best-in-class production platform. We have a broad product portfolio, including significant emphasis and capability in prepared foods that is supported by value-added innovation capabilities.

We continue to be very excited about the potential of our opportunities in our new U.K. and continental Europe operations because it creates a stronger, more diverse and much more stable global chicken and chicken-based prepared foods leader in Pilgrim’s. The acquisition aligns well with our strategic priorities as we continue expanding our geographical and brand footprint and extending our global poultry leadership position in attractive new markets while providing us a solid platform in the region for future growth.

We’re already seeing some of the results of sharing knowledge due to the acquisition. During the quarter, we gained significant share at a large retailer, highlighting our newly acquired operations are already benefiting from our teams’ enhanced focus on our key customer strategy. We will continue to extend that key customer strategy to the U.K. and continental Europe as we see incremental joint value creation opportunities there as we’ve seen in the U.S. and Mexico, which will drive volume growth and margin expansion long term.

Turning to commodity costs, corn prices have risen about $0.20 from the January low but still remain relatively low amid plentiful U.S. and global supplies. The USDA is forecasting ending stocks up 2.352 billion bushels, up 59 million bushels from last year following the second largest U.S. crop on record. Favorable economic conditions mean demand continues to grow along with supply, thus we will continue to monitor production of the U.S. as well as in South America and the Black Sea.

U.S. soybean ending stocks are forecasted to increase by 228 million bushels following a record U.S. crop. Similarly, global stocks are forecasted up 2 million tons to 98.1 million tons, even in the face of ever-increasing soybean demand. Soybean mill prices have rallied about $50 from the January low over concern of dry conditions in Argentina. Conversely, estimates for the Brazilian soybean crop continue to increase. Given the global surplus of both grains and oilseeds, we do not expect feed cost input to be a headwind to earnings in the medium term. On a forward-looking basis, we will continue to monitor the evolving situation in Argentina as well as the planting prospects for both the U.S. and Brazil.

For 2018, the USDA is forecasting total U.S. chicken industry production to increase at a similar pace to 2017. The breeder flock is up 3.2% year-over-year according to USDA, and there is an increase of 1.1% in pullets placed that includes both from producers and primary breeders. Part of the increase is in the primary breeders segment, given the breeder market share shifts and recent change to a new generation of breeders. For the producers, the new generation of ross and cob [ph] breed optimizes yield but sacrifices egg productivity and hatchability in addition to higher pullet mortality. This shift to new breed is yet to be completed and we believe the loss of productivity is structural in the order of 1.4% decline in boiler chicks hatched per layer. Considering this loss of productivity and higher mortality, to support our growth and total hedge on the magnitude that USDA is projecting, there is a requirement for significantly more breeders than in the past.

We believe industry growth over the next few years will continue to be well supported of a balanced supply and demand environment and we’re confident that our business will have the ability to outperform, given our broad portfolio and presence in all bird categories as well as strong relationships with our key customers. We think our key customer approach is strategic and creates an opportunity to further accelerate growth in important categories by providing a more differentiated product portfolio and giving us a competitive advantage.

Operationally, the capital investments and restructuring we’ve made to the portfolio also benefits results in 2018 and beyond. We see the recovery in pricing for many cuts in the new year as a positive, indicating solid demand for chicken continues. Despite greater availability of other proteins, the outlook for chicken demand in 2018 remains intact as the supportive export environment will capture much of the increase in total U.S. production across all protein complexes, while continuing strong U.S. economic conditions will motivate households to demand better quality, higher priced cuts of meat which ultimately translates to more overall consumption.

More importantly, globally chicken remains the fastest growing protein in demand, and U.S. chicken remains very competitive. While we’re already well balanced in terms of our bird size exposure, we’ll continue to look for opportunities to shift our product mix and reduce the commodity portion of our portfolio by offering more differentiated, customized products to key customers while also optimizing our operations, pursuing our operational improvement targets.

With that, I’d like to ask our CFO, Fabio Sandri to discuss our financial results.

[Fabio Sandri, Chief Financial Officer]

Thank you Bill, and good morning everyone. Before I begin, please note that because we closed the acquisition of Moy Park during Q3, the U.S. GAAP guidelines regarding common control entities requires our reports to consolidate the full quarter and year of Moy Park into our financials. In the filings, our year-to-date and year-ago results have also been adjusted accordingly. Under this requirement, considering Moy Park both in 2017 and 2016 for the full year 2015, net revenues were $10.77 billion versus $9.88 billion from a year ago, with an adjusted EBITDA of $1.39 billion or a 13% margin compared to $1.03 billion or a 10% margin for the year before. GAAP EPS was $2.79 per share compared to $1.73 in the year before. Adjusted operating margins were 12% in the U.S., 11% in Mexico, and 4% in Europe respectively.

We reported $2.74 billion in net revenue during the fourth quarter of 2017, resulting in an adjusted EBITDA of $241 million or an 8.7% margin. That compares to $2.37 billion in net revenue and an adjusted EBITDA of $205 million or 8.7% margin the year before. Net income was $134 million versus $71 million in the same quarter of 2016 for an 89% year-over-year increase, resulting in earnings per share of $0.54 compared to $0.28 in the same quarter of last year.

Our fresh chicken operation in the U.S. continued to generate strong results for the full year and solid performance in Q4 despite losses from the hurricane that hit Puerto Rico and affected our assets on the island and disruptions in the U.S. We are very proud of our team members who have worked tirelessly to rebuild the operation of our facilities and our partners while assisting with rebounding and rebuilding the local community. Adjusting for the Puerto Rico damages and the restructuring and acquisition costs of GNP and Moy Park, EBIT in the USA was $136 million or 7.2% margins for Q4, and $878 million or 11.8% margins for 2017.

Chicken has continued to be a compelling value proposition to customers both in terms of overall price and in convenience for the end user in retail and food service, despite higher availability of other proteins. Small bird and case ready were strong for us, and while the cut-out of the commodity business seasonally declined during Q4, it has started to recover well in the new year, supported by an improvement in cold storage data. The integration of GNP, like Bill mentioned, is better than planned and they have great progress in increasing the profitability with margins significantly higher than when we first acquired the business just over a year ago and on par with our legacy operations.

The environment in Mexico was challenging in the quarter mainly due to logistical and infrastructure disruptions associated with the earthquakes and hurricanes that impacted both demand and supply while delaying a quick recovery. Our results also reflect a $6 million loss due to the exchange rate changes. Adjusting for these effects, our EBIT in Mexico for Q4 would have been 4% for the quarter and 11% for the year.

We saw significant improvement in the market as we exited the year, and starting in the new year conditions have continued to improve. Despite a challenging Q4, 2017 was another great year and our long-term outlook for Mexico remains unchanged as we believe the country will continue to be a platform for future growth in chicken consumption as consumers seek better diets on higher disposable income.

As part of our goal 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 started to generate good results with prepared food volumes 50% higher than a year ago amid our Pilgrim’s and Del Dia brands capturing 35% of the prepared food market. To maintain the momentum, we have also launched fresh chicken under the premium Pilgrim’s brand, including no antibiotics ever, which has strong demand. This strategy is supportive of our goal to increase our high margin differentiated products while having product coverage from entry level to premium, both fresh and prepared, in Mexico. Production at the new complex in Vera Cruz is ramping very well, and its performance is exceeding our expectations. We expect to double the size, including the feed mill and hatchery.

The new U.K. and continental Europe operations produced strong sales growth and consistent margins. 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 while protecting the downside. We are targeting $50 million in synergies over the next two years, including optimization of the product portfolio, operational synergies, and implementation of the zero base budgeting. We will increase efficiency across the value chain by enhancing sourcing and production, improving live costs, yield improvements, and the global management of feed sourcing. We will leverage our marketing and sales infrastructure to optimize SG&A costs.

We have a proven history of capturing synergies and delivering significant improvement. In our most recent deals, we have meaningfully exceeded our initial targets while building on and improving the performance of the business beyond just the underlying markets. We are confident we have the methodology and the team to execute the growth [indiscernible] at our U.K. and continental Europe operations and leverage their expertise and experience to improve the rest of our global operations.

During Q4, our SG&A was higher than the year before at 3.9% of sales, reflecting the inclusion of additional GNP operations, the support for expanding the Just Bare brand nationally, the investments for our new prepared foods products both in the U.S. and Mexico, as well as the addition of the new U.K. and continental Europe operations. We also increased the bonus accrual in Q4 to match the excellent achievements of our goals for this past year.

We reached a total of $140 million of operational improvements and synergies in 2017 compare to our combined goal of $194 million, as the disruption at our plants and higher labor costs affected some of the improvements we had regionally expected. During our 2018 budgeting process, our team members have identified and are creating action plans to capture $185 million in additional operational improvements during 2018 in the U.S. and Mexico that together with the $25 million target of synergies from Moy Park for this year will add $210 million to our bottom line, supporting the evolution of our mix and production capabilities and improving our ability to service key customers throughout the globe.

We will continue to prioritize our capital spending plans this year to optimize our product mix that is aimed at improving our ability to supply differentiated, less commoditized products and strengthening our partnership with key customers. We expect to invest $300 million to $350 million in capex to account for the inclusion of GNP and U.K. continental Europe within the budget. We reiterate our commitment to investing on strong return on capital employed projects that will improve our operational efficiencies and tailor customer needs to further solidify our competitive advantage.

In Q4, we already realized some benefits of the tax reform that reduced our tax rate. We estimate our tax rate to be around 24% for 2018, down from our previous tax rate of 35% in the U.S. We will use the benefit of the lower tax to continue to invest in our operations, investing in both strategic long-term and fast payback projects, but more importantly we will invest in our people. We expect $50 million in raises for our labor force in the U.S.

Our balance sheet continues to be strong given our continued emphasis on cash flow from operations, focus on management of working capital, and disciplined investment in high return projects. During the quarter, our net debt reached $2.1 billion with a leverage ratio of 1.49 times pro forma less 12-month EBITDA, below our optimal range of 2 to 3 times. Our leverage remains at a low level and we expect to continue to generate strong cash flows, increasing our financial capability to pursue strategic options. Taking into consideration the bond issue last September, the outlook for 2018 interest expense should be in the range of $100 million.

We will continue to maintain a strong balance sheet and relatively low leverage. We will remain focused on exercising great care in ensuring that we create shareholder value by optimizing our capital structure by preserving the flexibility to pursue our growth strategy. We will continue to consider and evaluate all relevant capital allocation strategies that will match the pursuit of our growth strategy, and we continue to review each prospect according to our value creation standards.

Operator, this concludes our prepared remarks. Please open the call for questions.

[Operator]

[Operator instructions]

Our first question comes from Ken Zaslow with BMO Capital Markets. Please go ahead.

[Ken Zaslow, BMO Capital Markets]

Hey, good morning everyone. Just a couple questions. First is when you think about your quarter in terms of the profitability that was hit by the earthquake, the hurricanes, can you separate that out, and how much of that was in this quarter and how much will be evaporated going forward? How do we think about that?

[Bill Lovette, President, Chief Executive Officer]

Yes, I think it was around $20 million, Ken, in Q4, but we don’t expect that to be an ongoing event. As a matter of fact, in Mexico since the first of the year, we’ve seen our margins return to historically great margins for the start of the year. I think Mexico, if you think about Mexico quarter to quarter, we see volatility, but when you combine four quarters into a year and then you start comparing year to year, it’s amazingly consistent. We don’t see that changing in 2018.

[Fabio Sandri, Chief Financial Officer]

Yes Ken, we have direct and indirect effects of the hurricanes and the earthquakes. The direct effect was mainly in Puerto Rico where we had losses in our property and we had the plant completely shut down. The indirect effect in the U.S. and Mexico was increasing inventory disruption in the production and disruption into the logistics, and that has cleared already in Q4. We don’t expect any further impact.

[Ken Zaslow, BMO Capital Markets]

My second question is when I think about the U.S. margin structure in 2018 and ’19, do you think it’ll be similar to ’17? How do you think of it relative to ’17?

[Bill Lovette, President, Chief Executive Officer]

Yes, it’s a good question, and I think that’s really a good way to describe it, is we constructed our 2018 plan and saw the outcome, and we do that bottom-up, not top-down. It really looks a lot like 2017, and actually as Fabio mentioned in his prepared remarks, with the operational improvements that we expect to realize in 2018, it could be even better, so we’re bullish on 2018 in all three geographic reporting segments, and the U.S. is leading the pack there.

[Fabio Sandri, Chief Financial Officer]

Yes Ken, industry production was up 2.5% in 2017 according to the USDA, and the cut-out price was actually up $0.07 despite the higher production of beef and pork as well in the market. Adding all the planned capacity for the next three years, if all plants are online at the expected time and considering the ramp-up period, and considering that the plants will have the labor required to operate, by the way, we will add 2.5% more capacity in 2018 and 2.7% more capacity in 2019. We believe that this increase in supply is very adequate to the increase in demand given the growth in exports and the growth in domestic food service and retail that we are seeing.

[Ken Zaslow, BMO Capital Markets]

Great, appreciate it.

[Operator]

Our next question comes from Heather Jones with Vertical Group. Please go ahead.

[Heather Jones, Vertical Group]

Good morning guys I wanted to go back to Mexico, U.S. When I look at Q4 sales, and I’m just right now talking about the U.S., when I take out the extra week and adjust for a GNP run rate, the year-on-year increase is similar to--very similar to Q3 and Q2, but obviously the year-on-year improvement in EBIT is much lower. So you’ve got the impact from the hurricane and Mexico and all, but I was also wondering if you could just help us think about the dynamics in Q4 as far as other costs and all, like what caused the performance to deteriorate relative to Q3, and what will go away as we head into ’18.

[Bill Lovette, President, Chief Executive Officer]

I think, and Fabio can supply more data, but the one big thing that occurred between Q4 and Q3 is we saw significant price decline in Q4. I think maybe Q2 and Q3 prices were much higher than we anticipated, and then in Q4 they fell a little bit harder than we might have anticipated. That was the biggest driver in the U.S.

[Fabio Sandri, Chief Financial Officer]

Yes, the volumes are higher because of the GNP operation, around 6%, while the volumes, if you take that out, were flat in the domestic USA. The reduction in volumes is mainly due to the increase of [indiscernible] and the reduction in weights of the birds in the Sanford plant from the conversion from big bird to organic case ready. Also in Q4, we saw some significant non-recurring events just like the Puerto Rico impact and the increase in SG&A because of the increase in bonus accrual.

[Heather Jones, Vertical Group]

Okay. Then your inventories were up--you mentioned an inventory impact, I can’t remember if it was from Puerto Rico or from Mexico, but you mentioned an inventory impact. But your inventories year-on-year, comparing apples to apples with Moy Park, were up 30%. I mean, that seems a little bit for just Puerto Rico, so was just wondering if you could help--

[Bill Lovette, President, Chief Executive Officer]

Yes, part of that, Heather, was planned and part of it was unplanned. The part that was planned, we--in order to boost our fill rates and service levels on our prepared foods product and getting ready for both school lunch program period and wing season, we built more prepared foods inventory than is typical, okay, so that was the planned part. The unplanned part as the slowdown in export volume a little bit more than we would have anticipated, but we felt like as we rounded the corner into 2018, prices would recover, and I think it’s going to turn out to be a good thing because we’re selling those export products at significantly higher prices now than we would have sold them had we not put them into inventory then.

[Fabio Sandri, Chief Financial Officer]

We also increased the inventories, Heather, because of GNP. If you consider the 2016 ending inventories, GNP was not included in there. We included Moy Park, of course, because of U.S. GAAP rules, but GNP was not included.

[Heather Jones, Vertical Group]

Okay. Then I’m hoping you guys can help me with something that is just puzzling me. You mentioned the breed changes, and like you said, that’s not done.

[Bill Lovette, President, Chief Executive Officer]

That’s right.

[Heather Jones, Vertical Group]

I mean, but that did start at least a year ago, I want to say a little more than a year ago, but yet the last couple of months’ data has shown a marked deterioration in egg yield. You also got higher mortality, and then we track chicks placed relative to egg sets, and that number is now the lowest it’s been in at least 10 years. What I think is happening is it sounds like producers are setting more eggs than they normally--they’re setting eggs that they wouldn’t normally set that maybe are lower quality, and so they’re not hatching as well. But just trying to figure out, because you’ve got higher mortality because of disease and cold weather, this egg yield issue is getting worse - much worse, and I’m trying to put it all together and figure out exactly what’s going on.

[Bill Lovette, President, Chief Executive Officer]

Well, actually I think you said it pretty well, Heather. As an industry, we transitioned to these new breeds that provide better yields, and that’s the big plus of going to these new breeds. The flipside and negative effect is these new breeds produce less eggs per henhouse, down about 1.4% versus the other breeds, and we have higher mortality and lower hatch. So the net effect of all of that is you’ve got to have more hens in production if you’re going to maintain your level of production of chickens that come to the plant. That’s why we’ve seen such a ramp-up in the laying hen inventory. My calculations, just back of the envelope, are we need about a million breeders in inventory more to produce the same number of chicks because of all the things that you said and I repeated, so it’s just a reality of changing this breed.

You know, when we bought GNP, they were using a breed that we had been transitioning away from, so we started harvesting the new breed several months ago, and we’ve seen as much as a 2% increase in yield on that new breed. But again, the downside is we’ve got to have more breeders in inventory and production in order to get the same number of chicks, so you’ve seen us do that, you’ve seen other companies do that. In fact, you’ve seen the whole industry do that, and that’s why we’ve had to place more pullets and we’ve also had to kill less hens. If you look at USDA data, the end of last year after about August, we killed significantly less hens because we were having to hold them to get the eggs; but of course, that older age hen flock also doubled down on less eggs and lower hatch.

[Heather Jones, Vertical Group]

But do you think--because I mean, if you look at the numbers, you’ve gone from a year-on-year change in egg yield per hen of a percent, percent and a half, to November and December was down about 3.5%, I think December was down 3.6%, so it’s gotten much worse. I just don’t understand--I understand what’s driving it, I don’t understand what caused the--I mean, I would argue that’s a step change in deterioration.

[Bill Lovette, President, Chief Executive Officer]

It is a structural change, and when these breeding companies are selecting for all these attributes, sometimes the desired attribute that ultimately is more dominant produces attributes like we’re discussing that are negatively correlated, and that’s exactly what we’re seeing. So this is structural, it’s going to be here for the period, but at the end of the day, we’re economically better off with choosing the breed that’s giving us the better meat yield, and that’s why companies like ours have done that.

[Heather Jones, Vertical Group]

Okay, thank you so much.

[Operator]

Our next question comes from Farha Aslam with Stephens. Please go ahead.

[Farha Aslam, Stephens]

Hi, good morning. A question on your core operations. Could you share with us your incremental cost savings that you’re going to get on core PPC, GNP and Moy Park in 2018?

[Fabio Sandri, Chief Financial Officer]

Okay Farha, we expect $210 million in operational improvements for 2018 - that is for the global operations. For Moy Park, we mentioned before it’s $50 million over two years, so our target for 2018 is $25 million. For Mexico, we expect $15 million of operational improvements in 2018, and for U.S. we expect $170 million.

[Farha Aslam, Stephens]

That’s helpful, and how much do you think falls to the bottom line of the $210 million?

[Fabio Sandri, Chief Financial Officer]

We did all of our plans already net of the increases that we believe will happen, both in terms of higher freight and higher labor costs, so we expect the full $210 million to hit the bottom line. Just to help, we typically see half of the improvement as an increase in revenues since we increased the yields, and half of the improvements are in plant costs as we improve our yields as well in our plant cost reduction and more efficient operations, and in our live operations.

[Farha Aslam, Stephens]

That’s very helpful. Then my final question is on the export markets. Bill, you highlighted that they’re doing very well. How do you think that’s translating into U.S. pricing, and your outlook for India opening up would be really helpful.

[Bill Lovette, President, Chief Executive Officer]

Yes, well it’s really supporting more the back half of the bird, and we’re seeing solid pricing, solid demand. Demand and supply are well balanced right now, and the improvement came from Q4 where it was pretty soft, because some of those countries had filled their quota and the quota expired. As we got new quota reopened, that spurred demand and therefore prices, so I think it’s very solid. I don’t expect [indiscernible] through the year.

[Fabio Sandri, Chief Financial Officer]

As back quarter prices increase internationally, we see an increase as well here in the leg meat or in the deboned dark meat here in the U.S. The prices are linked. The profitability of the deboned leg in the U.S. is higher than exporting back quarters, but every time the export market gets really hot, we see that increase in the U.S. as well.

[Farha Aslam, Stephens]

Okay, that’s helpful. Thank you.

[Operator]

Our next question comes from David Carlson with Keybanc. Please go ahead.

[David Carlson, Keybanc]

Thank you. A couple questions. I hope everyone is well. Wanted to ask, looking at the Europe segment, it appears SG&A during the quarter was only down about $1 million, maybe 2 to 3% year-on-year. Can you kind of--I know you said $25 million in savings for 2018, $50 million over two years, but can you talk about how much you’ve captured here in the first couple quarters under your control?

[Fabio Sandri, Chief Financial Officer]

Yes, we don’t expect any capture this quarter. Just to help you, we don’t expect a huge reduction in SG&A. Different from other operations where we can integrate the back office, the improvements in Moy Park are more on sharing our operational knowledge both in live operations and in plant, and in implementing our key customer strategy by focusing our R&D and our SG&A in the right customers, not in all customers.

[Bill Lovette, President, Chief Executive Officer]

Yes, to Fabio’s point, we’ve been very aggressive in placing our operational methodologies inside those operations. We’ve taken our labor management process and we’ve taken our live production process in. We’ve taken our revenue and mix management process there. We’re going to implement the same methodologies in the U.K. and continental Europe operations as we employed both in the U.S. and in Mexico, and we’re beginning to see significant improvements in labor cost, in yields, in productivity, in quality and service, and then we’ll take advantage of all of that by employing our key customer strategy the same that we did at Pilgrim’s seven years ago, where we won’t try to be everything to everyone. We’ll find those key customers where their needs align with our core competencies and then we’ll grow our volume with those customers and expand our margin with those customers. We plan to do that in the U.K. and continental Europe no different than we’ve done in the U.S.

[David Carlson, Keybanc]

Fair enough. Fabio, what was the impact you guys experienced? Maybe if you could parse out the impact that the U.S. segment experienced from higher labor and freight costs during the fourth quarter, and then did you--just a comment from a minute ago, do you anticipate the $170 million in cost savings in the U.S. segment, or I guess the $210 million overall, did you say that that would all fall to the bottom line?

[Fabio Sandri, Chief Financial Officer]

Yes. On the $210 million, we expect everything to fall to the bottom line as we already incorporated the increase in the freight, as we mentioned, and the increase that we believe will happen in the labor force.

In terms of the impact in Q4, I will say that there is no one size fits all strategy, or there is--we have P&Ls by plant, and we saw some of the lanes more affected by the constraints during the hurricane and the ELD, the electronic logging device mandate, more than others. We adapt our prices to our delivery options depending on the specific local conditions, so the impact was not in all of our operations but more significantly in some, and we adjusted our prices accordingly.

[David Carlson, Keybanc]

So pricing has already been taken to help offset those pressures. If you don’t mind me asking you to repeat, Fabio, if you don’t mind, your capex expectations for 2018, and then I’ll pass it off to the next caller.

[Fabio Sandri, Chief Financial Officer]

Sure. Adding the operations of GNP and Moy Park, we expect between $300 million and $350 million, which is higher than our depreciation and shows the commitment that we have with implementing strategic operations and improving our portfolio.

[David Carlson, Keybanc]

Thank you so much, guys.

[Operator]

Our next question comes from Adam Samuelson with Goldman Sachs. Please go ahead.

[Brooke Roach, Goldman Sachs]

Yes, thank you, good morning everyone. This is Brooke Roach on for Adam Samuelson. I was wondering if you guys could give us a little bit more color on your pricing and market outlook by key category, e.g. small bird, tray pack, big bird, and prepared.

[Bill Lovette, President, Chief Executive Officer]

So small bird pricing is very solid. Supply and demand for those small birds is such that we continue to see increasing demand both at retail and food service, and given the supply that’s really not growing, that continues to give us a lot of price courage for those products. In our tray pack operations, medium sized birds, we’re seeing great demand. We’re having to buy in meat from the outside to our tray pack operations because demand is currently exceeding our supply, our own supply, so pricing is very strong and I think will continue to be solid through the year there. Prepared foods pricing is steady, I would say. Actually as Fabio said in his prepared remarks, we’re getting some tailwinds there from lower priced breast meat that goes into some of those products. Export prices, as I mentioned before, are very solid and I think that will continue through the year as well.

[Fabio Sandri, Chief Financial Officer]

Just to add to Bill’s comment, according to the USDA, in 2017 the industry reduced the number of heads in the small bird segment by 1%, and the prices according to the EMI Small Bird Index are 3% higher than last year.

[Bill Lovette, President, Chief Executive Officer]

The other thing I would mention, in Mexico the live price, and about a third of our chickens in Mexico are sold in the live forum, the live price in January was significantly higher than the live price in January 2017, so that’s an indication that demand is improving in Mexico.

[Fabio Sandri, Chief Financial Officer]

Yes, the prices in pesos in the domestic market are 20% higher this year than they were a year ago, and the exchange rate has now moderated and is at the same level it was a year ago, so the prices are 20% higher both in pesos and in U.S. dollars.

[Brooke Roach, Goldman Sachs]

Great, thank you. Then just one procedural follow-up question. Can you give us a little bit more clarity on the impact of tax reform in the quarter, and what was the underlying effective tax rate for 4Q on an adjusted basis?

[Fabio Sandri, Chief Financial Officer]

Sure. The permanent changes from 35% to 21% going forward, so from 35% tax rate in the U.S. we expect a 21%, but because of this change, we have some deferred tax liabilities that now we value at the new tax rate, and that helped us in $32 million during this Q4.

[Brooke Roach, Goldman Sachs]

Great, thank you. I’ll pass it on.

[Operator]

As a reminder, if you have a question, please press star then one. Our next question comes from Akshay Jagdale with Jefferies. Please go ahead.

[Lubi Kutua, Jefferies]

Hi, good morning. This is actually Lubi on for Akshay. I just wanted to dig a little bit deeper into your thoughts on the supply side. I believe you mentioned that the breeder flock is up 3.2% year-over-year in your prepared remarks. We’re actually seeing closer to 5% in the latest chicken and eggs report, and actually really it’s been that way--it’s been in that range since August, so I’m not sure what the discrepancy is there. But even if it’s 3.2%, just in terms of bridging to the gap to the roughly--you know, I think the supply outlook is around 2% for 2018, is that all just explained by the breeder change and the loss of productivity, why the breeder flock growth is higher than the production growth? In one of the earlier questions, somebody mentioned that this change really has been in place for over a year, so I would have thought that the year-ago comparisons would also include this reduction in productivity.

[Bill Lovette, President, Chief Executive Officer]

So what you’re seeing in the last six months of 2017 are in fact the breed change, and as a result of the breed change we significantly as an industry decreased the number of hens taken to slaughter. So we left them in production because we needed the eggs, that expanded the overall size of the breeder flock, but as the breeder hens get older, they become less productive, so that’s why you saw the expansion in the total flock. But at the same time, eggs per 100 were down for the whole year 2.2%, and chicks per layer was down 1.7%, so we’re having to put more breeders in production in order to maintain the same number of chickens that we desire to bring into the plant, that’s the long and short of it.

[Fabio Sandri, Chief Financial Officer]

And also Lubi, there is not only the breed change, there is also the generation change on that breed, so we are seeing not only ross but the competing breed is also changing the generation, and this new generation, despite having a better yield in terms of feed conversion and a better yield in terms of meat production or breast meat production, also produces less eggs. Just like Bill mentioned, when they select for some traits, selling more birds is actually their business but--so that is a point, that they need to sell more birds to us to produce the same number of eggs.

[Bill Lovette, President, Chief Executive Officer]

And chicks.

[Fabio Sandri, Chief Financial Officer]

And chicks.

[Lubi Kutua, Jefferies]

Got it, that’s helpful. Thanks. Then if I could just ask on your organic chicken business, if you could just provide some color on how big is that business today, how is it growing, and to the extent that you can provide any color just in terms of how we should think about profitability in that business relative to the rest of the domestic portfolio, that’d be helpful. Thank you.

[Bill Lovette, President, Chief Executive Officer]

That’s been--in my career, that’s been one of the best investments that I think I’ve been a part of in terms of how quickly the return improved. That was a large bird operation, very commodity oriented. We changed it to a tray pack operation which has been very profitable in and of itself, but then when we added the organic attribute, that took the profitability up significantly. It’s one of the most profitable chicken plants in the whole United States, and we’re very proud of it. We’re reaching the point probably in the next year to two years where we’re going to have perhaps make another decision to increase our organic production, because we’re going to run up against supply, and we’re either going to have to expand Sanford or we’re going to have go either build a greenfield or convert another operation. We haven’t made that decision yet, but I would say that decision is going to come at us within the next year or so.

[Fabio Sandri, Chief Financial Officer]

I’ll add, Lubi, that it is not only the organic, also our no antibiotic ever production has also increased beyond our expectations. We had our initial target of 25%, and today 31% of our total production is a differentiated portfolio in the U.S., either organic or no antibiotics ever.

[Lubi Kutua, Jefferies]

That’s helpful, thank you. I’ll pass it on.

[Operator]

This concludes our question and answer session. I would like to turn the conference back over to Bill Lovette for any closing remarks.

[Bill Lovette, President, Chief Executive Officer]

Thank you. We look forward to another great year in 2018 and remain positive on the outlook for chicken consumption. Despite greater availability of other proteins, our exports and continuing strength in the U.S. economy will compensate and drive more total protein consumption and absorb the supplies. With GNP and the newly acquired U.K. and continental Europe operations, we are much better represented globally and are well positioned to improve our margin profile and reduce volatility despite specific market conditions.

We will continue to look for opportunities in refining our portfolio to pursue differentiated customized products to satisfy our key customers’ needs in support of our vision of becoming the best and most respected company in our industry, creating the opportunity for a better future for our team members. We’d like to thank everyone in the Pilgrim’s family as well as our customers, and as always we appreciate your interest in our company. Thanks for joining us today.

[Operator]

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.