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Market Preview: Smithfield-PSF Deal - How will it affect the industry?

by 5m Editor
23 September 2006, at 1:39pm

US - Weekly U.S. Market Preview w/e 22nd September, provided by Steve R. Meyer, Ph.D., Paragon Economics, Inc.

The buzz in the hog and pork business this week is all about the acquisition of Premium Standard Farms (PSF), the second-largest hog producer in the United States, by Smithfield Foods, the largest hog producer in the country. The numbers are pretty mind-boggling:

  • The new company will have over one million sows in the United States or about 20% of the total.
  • The new company will produce in excess of 20 million pigs/year -- probably more like 23-25 million pigs, giving them a market share of nearly 25%.
  • The new company will continue to be the largest contributor to the Pork Checkoff, paying somewhere between $10 and $12 million annually to the National Pork Board.
  • The new company will operate nine hog slaughter plants with a total daily capacity of 120,200 head, about 28.5% of where slaughter capacity will be this fall when Indiana Pack has its expansion up and running and the full second shift is operating at Triumph Foods.
  • The purchase price was pegged at $810 million. It includes PSF's hog operations in Missouri, Texas and North Carolina and packing plants in Milan, MO and Clinton, NC.

Yes, it's a big deal no matter how you cut it. But how will it affect the rest of the industry?

The Department of Justice (DOJ) uses the Herfindahl-Hirschman Index (HHI) to measure concentration. The index is computed by adding up the squared market share of all companies in a given industry. The squaring feature means that large firms count more. Consider this example:

Situation 1 Situation 2
Firm A 20% 40%
Firm B 20%
Firm C 20% 20%
Firm D 20% 20%
Firm E 5% 5%
Firm F 5% 5%
Firm G 5% 5%
Firm H 5% 5%
Four-firm Concentration 80% 85%
Hirfendahl-Hirschman Index 1700 2500

The traditional four-firm concentration ratio increases by only 5 percentage points when Firm A buys Firm B. Not a shocking move, right? But it makes sense that a firm with 40% market share may have a bit more power in this situation and the HHI alerts us to this possibility by increasing 800 points or nearly half of its previous level.

Based on slaughter capacity, the Smithfield-PSF combination will drive the HHI for pork packing from about 1275 to 1485. Those numbers will differ from what you see from DOJ because the department will use actual hog slaughter, not capacity. But these numbers will be in the ballpark and the change will be quite close, I think.

DOJ classifies sectors with HHI between 1000 and 1800 as "moderately concentrated" and considers a merger that increases HHI by 100 or more points in this range to have potentially negative effects. A sector doesn't reach "highly concentrated" status until the HHI exceeds 1800. This merger will not get pork packing even close to that level.

Quite predictably, some legislators have called for the Department of Justice to review the deal and have expressed grave concerns about the effect the merger may have. DOJ should definitely take a look at it because it involves the two largest firms in the production sector (even though that is not nearly as concentrated as the packing sector) and it trips one of DOJ's established triggers by increasing the HHI more than 100 points in an already moderately concentrated sector.

However, the hand-wringing is a bit much. Senator Charles Grassley contends that it will hurt independent hog producers by limiting the number of places they can sell their hogs. Just how many independent producers have ever sold a hog to PSF's Milan, MO plant? There may be a few, but they are quite rare. And, while there are independent producers who sell hogs to PSF's Clinton, NC plant, I'm not sure I see how this merger will force them out. The combined sow herds of Smithfield and PSF along the eastern seaboard will be no larger than the companies' separate sow herds now.

I do not believe this merger will have any impact on hog prices. PSF-Missouri has never been a player in the midwestern cash market, so how would merging them into Smithfield make any difference? Both Smithfield and PSF-North Carolina buy hogs on the eastern seaboard for Corn Belt price, less transportation costs. Putting them together will not change that practice. They just have to pay enough in North Carolina to keep "independent" producers from putting the pigs on a truck to the Midwest. It's simple, spatial economics.

There is no law against big. There are only laws that prohibit certain conduct in the marketplace in order to keep market performance near competitive ideals. I'm not sure I like this kind of "big" but I don't think it will change the pork industry dramatically.


5m Editor