A hog operation, Bacon Bits Inc., owned by Boss Hog, was recently in touch to discuss their situation. Bacon Bits is a 1,200 sow farrow to isowean operation in Southern Manitoba which has historically shipped weanlings into the U. S. Bacon Bits expanded to its present size eight years ago with the security of some pretty strong and historically supported U. S. contracts. The good years, although cyclical, allowed the business to attract superior staff, achieve outstanding production, maintain state of the art facilities and aggressively repay the debt acquired for the expansion. All of this may be in jeopardy given the losses in the industry through recent months.
Bacon Bits received a sizeable CAIS payment for fiscal ’07 and has managed to keep all operating accounts current and has adequate working capital to comfortably cash flow the next eight weeks. Boss Hog approached us extremely concerned that he may need to make the decision to leave the industry. He was looking for insight into the factors he needs to consider in making this life altering decision. We started with a summary of Boss Hog’s present position:
—Bacon Bits Inc., is currently losing around $34 per isowean, which translates into a $22,000 loss every week.
—The value of the barn, once thought to be worth over $3 million, is almost negligible with lenders estimating the value at $360,000 given the market conditions.
—Cull sow values recently dropped again due to industry cull and limited kill space.
—Bacon Bits Inc., has a strong AgriStability reference margin.
—Its current financial lender agreed to 12 months of interest-only payments starting December of ’08.
—No further borrowings are available from present lender without additional security provided including a personal guarantee.
RISKS OF STAYING IN
Using the risk vs. reward template, we wanted to identify and quantify the potential risks associated with remaining in the industry as compared to anticipated potential reward at some point. The risks were identified as follows:
—Continued cash losses. These losses need to be funded by personal cash injected into the operation or additional borrowings that are supported by personal guarantees and additional security, company owned or personal.
—Erosion of AgriStability margin. If negative margins continue, at some point, no further payments will be triggered due to erosion of historical reference margin.
—Opportunity cost of time spent managing Bacon Bits Inc. Mr. Hog could work off farm and build personal equity.
Potential rewards were identified as follows:
—The industry returns to profitability.
—Further AgriStability payments for fiscal ’08 and ’09 losses.
—Restored equity and fair market value of the company through appreciation of barn and livestock
A projected cash flow was completed to quantify the risk. This projection indicated that losses of $525,000 would need to be funded to carry the business an additional six months. With working capital adequate to support the next eight weeks, Mr. Hog would need to fund $350,000 to keep the business operating to the end of that six-month period. The reality is that Mr. Hog will need to clearly understand what is at risk and what is he willing to risk.
Given a lifelong career in the hog industry, Mr. Hog has decided that he is willing to use personal cash and a limited personal guarantee to fund the losses for a period of six months. Mr. Hog is hopeful that present market conditions will improve over the next six months, but he knows that if they do not that he will not be able to fully liquidate immediately due to pregnant sows. Feeding these sows for an additional period of time will prolong the cash burn. For that reason, Mr. Hog will have to reassess his position prior to the end of the six-month period to further weigh risk against reward. At the point when the risk becomes greater than what Mr. Hog is willing to support, that will be the point when he begins planning his exit from the industry.
Prolonged losses going forward will erode Bacon Bits Inc.’s AgriStability margin. As this reference margin decreases, risk to the producer increases. This is only a risk if the barn remains in operation and business.
An additional AgriStability consideration is how long the business must remain in operation to qualify for a potential 2009 payment. Incurring short-term losses in order to qualify for a sizeable payment may put the company further ahead in the long run. If the hog operation is insolvent (more liabilities than assets), then this payment may simply be allocated to creditors once received.
Prior to farming, Mr. Hog welded on the oil and gas pipelines. With current pipeline projects, there is a significant earning potential available but Mr. Hog would need to leave his ownership and management position at Bacon Bits to capitalize. If potential AgriStability payments net of operating losses plus anticipated increase in asset values when the industry recovers is greater than off-farm employment, then he should continue to operate the barn.
At some point, the hog industry will rationalize itself locally and internationally, balancing supply and demand and restoring profitability for those who remain. Following this return to profitability, the value of assets involved in operating a hog operation will rise accordingly. When this increase in fair market value of assets returns, that provides an opportunity for a producer who desires to exit the industry to obtain a reasonable price for his operation.
At the end of the day, those in the Agriculture Industry are taking risk. For those in the hog industry, this risk is unprecedented. Calculating and understanding the risk is critical to ensure that one doesn’t get into a position he or she regrets, driven by emotion and not by calculated risk assessment.
Andrew DeRuyck and Mark Sloane manage two farming operations in Southern Manitoba and are partners in Right Choice Management Consulting. With over 25 years of cumulative experience, they offer support in farm management, financial management, strategic planning, and mediation services. They can be reached at [email protected]and [email protected]or 204-825-7392 or 204-825-8443.