How to Play the Consolidation of the Food Industry

Hillshire Brands (NYSE: HSH  ) was up around 23% in a single session after Pilgrim's Pride (NASDAQ: PPC  ) offered more than $6 billion in cash for the company. If the deal goes through, it is likely to thwart Hillshire's own bid for competitor Pinnacle Foods (NYSE: PF  ) . Pinnacle Foods was down 7% on the likelihood of a failed deal.

Some shareholders were unhappy with Hillshire Brands for potentially buying a company with brands that they view as low growth. In addition, the acquisition would result in the suspension of the company's share-repurchase program.

Shares of Hillshire dropped by more than 7% after the company announced that it was buying Pinnacle Foods for $6.6 billion. It would have acquired brands like Birds Eye frozen vegetables and Wish-Bone salad dressings. Pinnacle should only grow earnings at half the average pace of the industry over the next five years.  

The good and bad of the deal
Yet many analysts viewed the acquisition as sound because they see some long-term strategic advantages like combining meats produced by Hillshire with vegetables produced by Pinnacle. One of the negative aspects was the high level of debt that Hillshire was going to take on.

On the positive side, Hillshire could acquire several large brands in categories in which it does not currently operate. Combining meat and vegetables would lead to better relationships as well as stronger negotiating positions with retailers. Bloomberg found that there were other synergies, such as the fact that Pinnacle does no business with one of Hillshire's largest customers, Costco Wholesale. Hillshire expected to realize annual cost savings of around $140 million by the third year with Pinnacle, thanks in large part to the reduced overhead and enhancements in the supply chain.

Bonds downgraded to "junk" status
Hillshire's bond prices were steady even though Fitch downgraded the company to junk status because of the acquisition of Pinnacle Foods. Fitch slashed Hillshire's credit rating to BB on estimates that the total debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio will rise to mid-5.0 times based on the estimated EBITDA of around $1.1 billion.

Moody's and Standard and Poor's will likely follow suit if the Pinnacle deal goes through. Moreover, the bond markets seem to be assured by the company's confidence in returning to the investment-grade status in three years.

Financial outlook
Earnings per share have been relatively stagnant and were flat in the latest quarter; however, the company turned around in the last quartet, earning $1.49 per share compared to a loss of $0.12 per share in the previous year. This year, the market expects an improvement to $1.72/share.

The company can use acquisitions to kick start growth; Pinnacle would have been the third one after it bought Van's Natural Foods for $165 million and gourmet jerky manufacturer Golden Island for $35 million.

The new deal
However, the downgrade and potential boost in earnings from adding vegetables to its meat portfolio might not matter. If Hillshire is acquired, it would have to abandon its bid for Pinnacle Foods. That would likely send shares of Pinnacle lower. On the other hand, shares of Hillshire are soaring. Pilgrim's Pride wants to buy Hillshire for $45 a share. This deal would be a positive for Pilgrim's Pride, as the two companies focus in different areas of the meat market. Pilgrim's Pride is a chicken company, while Hillshire focuses on packaged meat.

Things really heated up in the M&A market when Tyson topped Pilgrim's Pride bid to buy Hillshire the next day. Tyson hoped to buy Hillshire for $50 a share. In response, Pilgrim's Pride announced it was willing to pay $55 per share. Hillshire now trades close to $60 and is up 77% year to date. Mr. Market believes that Tyson could come in with an offer to top Pilgrim's Pride, which is why shares of Hillshire are trading above the $55 offer price. 

Bottom line
The Pinnacle acquisition makes long-term strategic sense, and the price appears to be fair considering the advantages. However, none of that will matter if Pilgrim's Pride or Tyson buys up Hillshire. Based on the run up in Hillshire's stock, investors should watch the stock carefully before purchasing. However, a Pilgrim's Pride or Tyson buyout of Hillshire could be a long-term positive for the winner.

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