The Food Industry Gets Messy With Recent M&A Activity

Growing up, we all had our favorite name-brand foods, and a lucky few of us were able to stock up on these coveted delicacies with each trip to the supermarket.

But what happens when the economy takes a nosedive and these name-brand treats are no longer affordable? As private labels have slowly become staples of household cabinets, the big name companies have similarly refused to sit idly by and watch the knock-offs knock their stocks off. ConAgra Foods (CAG 0.77%) learned this the hard way as it prepares to divest its private label business that it paid a hefty price for just three years ago.

And on the broadline distribution side, US Foods and Sysco (SYY -0.51%) saw their dreams of controlling 75% of the market implode as the FTC and Justice Department moved to block the deal.

So where is the food industry headed?

A full transcript follows the video.

Sean O'Reilly: We're talking big food on this consumer goods edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly joining you here from Fool headquarters in Alexandria, Virginia. I am joined today by the one and only Vincent Shen. How are you today, sir?

Vincent Shen: Hey, Sean. A lot of very current news to talk about today.

O'Reilly: Yeah. This is important because I eat food and the industry's not doing so well. I hope they start doing better.

Shen: Depends on how you look at it. I know what you mean.

O'Reilly: Regardless. So first and foremost: Sysco.

Shen: Ah, yes. The Sysco situation -- we're going to be talking a bit about M&A and the food industry today.

O'Reilly: Who knew the U.S. government was worried about competition so much in the food supplying space?

Shen: One the one side it's going to be food distribution and on the other side it's going to be more actual makers of some of these packaged goods that we love. Like my personal favorite, Slim Jims.

O'Reilly: Oh my God.

Shen: But we'll go to that later. Really, right now the big news was announced yesterday that Sysco plans to purchase US Foods. We're talking about the number one and number two biggest broad line food distributors in the country. They're really the only bigger, national players with the reach large product portfolios to be the top of the heap. Essentially, a federal district court judge sided with the FTC when the FTC sued to block the deal, even though that was a split decision. It was three-to-two among the commissioners themselves.

O'Reilly: To their point though, these are the number one and two largest food companies, right?

Shen: Yes, exactly. Beyond that you have smaller competitors. Within the industry you also have regional players and things like that, but these are the two biggest. They would be joining to create an even bigger...

O'Reilly: Did you come across what kind of market share the combined entity would have?

Shen: Yes. Actually, it's estimated the combined entity would have controlled about 75% of broad line distribution. You can take that as you will.

O'Reilly: From what I know about antitrust law, the government usually gets iffy in the 40s and 50s. So, this does not surprise me at all.

Shen: I'm also a bit surprised by the split among the commissioners, considering some of the numbers and the metrics behind this.

O'Reilly: Yeah. You said it was three-to-two.

Shen: It was three-to-two. The original deal was about a year and a half ago. December 2013. About $8 billion in value. So Sysco was going to pay $3.5 billion, split cash and stock -- not in half, not 50/50 -- and then they would take on a bunch of US Foods' debt, too. In any merger deal they're talking about synergies, efficiencies...

O'Reilly: Cost cutting.

Shen: Exactly. So they're thinking within a few years of integration they'd be able to recognize at least $600 million annually in synergies. A lot of big benefits for them. I'm sure they would have better power, better pricing power, their suppliers; they would potentially be able to lower prices for the consumers. I'm sure they argued that as well.

O'Reilly: I'm sure there's a lot of situations where there's a Sysco truck and a US Foods truck going to the same grocery store.

Shen: And offices, and in similar places where it all could have been integrated.

O'Reilly: Yeah.

Shen: This combined entity is huge. Market share side is estimated about 75%. Revenue side, they would have had $65 billion. Though they did make some concessions right from the get go. They were getting some push back from the FTC. They've spent a lot of time working with the agency and figure out what they need to do in order to be able to go through with the deal. In one of their overtures they setup a side deal with Performance Food Group -- it's similar to the Reynolds deal in tobacco.

O'Reilly: Right.

Shen: Where they sold off...

O'Reilly: Give a couple of the brands.

Shen: To the number three player, essentially. So in this case they had this side deal with Performance Food Group. They were going to take over 11 facilities that belonged to US Foods and those facilities had about $4.5 billion in annual revenue, they were supposed to help turn them into a stronger player after the acquisition; obviously, all that's a moot point now.

Sysco's going to have to pay a breakup fee of $300 million to US Foods, and $12.5 million to Performance Food. That's the situation now. They're backing out of the deal. It's been acknowledged that it's not going to happen.

O'Reilly: That's a big win for US Foods right there. I was looking at the numbers for Sysco -- US Foods is private so we couldn't really get a good look at them -- but it doesn't surprise me that this deal fell through and as a food consumer I'm probably glad that one entity didn't control 75% of the market. That's neither here, nor there. I do agree that Sysco needed to do something to juice the bottom line because they're not a horrible business by any stretch of the imagination, but you look over the last five years and return on equity was awesome in 2010.

You're looking at 32%. That's the top 5% or 10% of the S&P 500 numbers. It's just been falling ever since. Now they're in the mid-teens, and all the while that income's gone from $1.18 billion in 2010 down to $931 million in fiscal year 2014, but revenue's gone from $37 to $36 billion. Everything's going the wrong way.

Shen: I'm really glad that you put some of these numbers in front of me, Sean. That revenue growth, at first you're thinking...

O'Reilly: "Oh, man."

Shen: It's great.

O'Reilly: You got this great company, it's a $37 billion company in 2010, and they're able to grow to $46 four or five years later.

Shen: Considering their size, exactly. It's not exactly a high growth industry. It looks great, but then you look at that bottom line. You can see how things are slowing down for them. They wanted that boost in the arm, I think.

O'Reilly: They needed to do something and of course they got their hand slapped for this merger. Now I'm wondering "What are they going to do?" They need to do something. They're currently trading for 22.5x forward gap earnings, according to a Capital IQ estimate, which is a compilation of a bunch of analysts. 22x earnings? That's not going to grow the bottom line much. I don't know what they're going to do.

Shen: Exactly. That definitely looks like an iffy situation. Though probably not quite as iffy as what we're talking about next.

O'Reilly: Yeah. Number two topic is ConAgra (CAG 0.77%) and they are essentially throwing the towel in on something they paid $5 billion for a couple of years ago. This is basically a derivative of the news that Jana Partners, an activist hedge fund, took a 7% stake in ConAgra and they sent a letter to the board saying "We're going to shake you guys up." This isn't surprising. They haven't even said how they're going to get rid of this private label business, but I'm interested to hear what we do know.

Shen: This is really recent. It was just announced this morning along with their fiscal Q4 earnings. Their earnings came in, they have some bright spots with two of their segments: commercial, and consumer foods. Then they made this acquisition that they integrated in early 2013, $5 billion, they're going to buy out Ralcorp, take on their private label food business, turn that into their third major segment and hopefully ride that growth wave.

O'Reilly: When I heard this story and you told me what was happening, if you had just asked me yesterday "Sean, if you had to speculate, how would you say ConAgra's private label business -- making private label products for Target, or all these stores that have their own giant brand of ketchup and all that -- how would you assume they're doing?" I would be like "Pretty good."

That's actually been one of the changes I've seen over my lifetime at the grocery stores. There's more and more private label offerings. You've got Heinz ketchup, and you've got the store brand ketchup. 20 or 30 years ago that wasn't the case. I was just surprised that this private label business is not doing well.

Shen: In terms of an image thing, I feel in the past when I was younger, we always shunned the private label brands as not being quality, didn't look good, didn't look appealing compared to these big, national brands.

O'Reilly: Then you realize there's no difference because you looked at the ingredients.

Shen: Exactly. Now they've really stepped up the way things are packaged, the quality, and it's pretty competitive. Something that drove the popularity of the private label brands was the economic downturn in 2008. People were tight on money and suddenly they're turning to these lower cost options. So there was a lot of growth there and I think when ConAgra took on this deal they saw it as an awesome avenue of growth they would have.

O'Reilly: What were you saying? Private label brands generally enjoy profit margins of 10% to 15% higher than the national brands?

Shen: Yeah. In certain cases they're enjoying richer margins on these products, too. So it seems like a no brainer, but the issues is that it's not like these national brands are exactly sitting there and letting this happen. So they've narrowed that price gap significantly. It's come down to the point where the growth for private label brands has stalled...

O'Reilly: And all of a sudden if you're faced with 5¢ more you'll probably just buy the national brand.

Shen: Exactly. People do ultimately prefer to stick with that name brand, and if that price gap is no longer there, or isn't quite as big or appealing, that's where they're seeing the struggles.

O'Reilly: So they've already written down $2 billion for this division and they're just going to get rid of it completely?

Shen: Exactly. They've taken $2 billion in write downs, impairment of good will, different charges, and overall it's just been a disaster. They've had five straight quarters -- including this most recently announced one -- where sales for the private label segment have fallen. For this most recent quarter, operating profit fell 30% year over year in the private label segments. It's just really struggling.

The company is basically throwing in the towel, deciding to dedicate all the resources that they've been funneling trying to turn this private label business to their two better performing segments; being consumer and commercial foods.

O'Reilly: Do you think that's just an excuse? The whole "We don't have the resources" thing.

Shen: Excuse might not be right. I think it's an acknowledgment that they basically think they can't do it. It's not an efficient use of their resources. As a result they've announced this divestiture. There's no other details yet how that's going to be happening. I'm really glad you brought up the Jana Partners because when their stake came out...

O'Reilly: Stock rose.

Shen: 10% in mid-June; just a couple weeks ago. The stock price spiked 10% on that news. A lot of Wall Street analysts adjusted their price targets accordingly. It's an interesting situation where you have a company that has acknowledged through and through that they are not doing well at all with this major acquisition.

O'Reilly: I wonder who's going to buy them.

Shen: Through some of this other news, like the Jana Partners stake, their stock's trading pretty well. It's up 40% in the last year, including that 10% spike due to the recent Jana Partners news. It just seems odd considering how a major segment in the company is struggling so much.

O'Reilly: The past year I guess Wall Street's just thinking things are going to get shaken up and they'll turn the ship.

Shen: Yeah. They had the new CEO start earlier this year. A big focus for him has been "How do we right this ship?"

O'Reilly: Right.

Shen: Maybe it seems like the investors are very bullish on the fact that the company has been really receptive. They've said "We're happy to work with Jana Partners and the activist investor base to make sure our vision for this company is aligned." It didn't take long at all for some changes to come through with this announcement. What do you think now about the stock?

O'Reilly: I think a lot of any kind of upside is kind of gone now. Everything's 20/20 hindsight, of course, but ConAgra is trading at 20x this year's current earnings. Who am I to say "Those should definitely be trading at 25x or 30x"? I could not say that.

Shen: The thing is, for a company in major transition mode like this, where they're restructuring again by dropping this business; it's uncertain.

O'Reilly: Who's to say it will work?

Shen: Yeah. I do think it's a good thing they're going to be able to dedicate more resources. They can spend more in advertising and new product development for these better, stronger performing segments. There's no guarantees. I'm really surprised. For a company that's been struggling like this, that has traded up so much in the past year, I think for investors someone who's thinking "Maybe I should get into stock" to stop and think. Maybe wait to see how this reorganization comes through and how well they're able to do.

O'Reilly: Wise words. Very cool. Well thank you for your thoughts, Vince. I'll talk to you next week.

Shen: Cool. Thank you, Sean.

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