Last week, General Mills (GIS 0.76%) unveiled its plan to acquire Blue Buffalo Pet Products (NASDAQ: BUFF), a leading natural pet food company.
In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Asit Sharma discuss the opportunity General Mills sees in this relatively small business, a few of the biggest concerns and risks regarding the acquisition, and the best-case results for the combination.
A full transcript follows the video.
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This video was recorded on Feb. 27, 2018.
Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, February 27th, and I'm your host, Vincent Shen. We're focusing our attention today on news that broke last week.
On Friday, food giant General Mills announced that it'd be acquiring Blue Buffalo Pet Products in an $8 billion transaction. We'll dive into the two companies and the deal itself, and I've enlisted the help of senior Motley Fool contributor, Asit Sharma, who's calling into the Fool HQ studio via Skype. Welcome back, Asit! How's it going?
Asit Sharma: Thanks a lot, Vince! Doing well! Listeners can't see this, but I'm wearing plaid today. But it's the last time I'm going to put this on, because I'm getting spring fever. [laughs]
Shen: [laughs] Alright, before we get started, I want to take a minute and share more information about The Motley Fool's $10,000 College Student Award. For any students who are over the age of 18 and attending a U.S. college, The Motley Fool is sponsoring a contest to encourage and support the next generation of investors. To enter, write a 500 to 1,000-word article on one of the provided topics, and a group of Fools here at HQ will choose the best write up and award the author $10,000, with an additional 20 runners-up getting $1,000 each. Whether you're a student yourself or know someone who might be interested, pass the word along. The competition closes April 30, 2018. We look forward to seeing your submissions. Terms and conditions apply. Please visit fool.com/competition for more details.
Back to our main story, General Mills, ticker GIS, is going to pay $40 per share to take over Blue Buffalo Pet Products, ticker BUFF. Most consumers are familiar with General Mills products. The company has over 100 brands, operates in over 100 countries. Some of the most notable ones include Betty Crocker, Pillsbury, Cheerios, Haagen-Dazs, Fruit Snacks, and Progresso.
The company reported $15.6 billion of revenue in the trailing 12-month period. Blue Buffalo is a much smaller business, about a tenth of that for their top line. In the world of pet food, though, Blue Buffalo is a very strong presence. They have a very solid reputation. Asit, can you give us some background on Blue Buffalo and the pet food industry?
Sharma: Absolutely. Blue Buffalo Pet Products was founded in 2002, when a man named Bill Bishop and his two sons, Billy and Chris, decided to form a company because their dog, Blue, had a series of health issues, including three bouts of cancer. These three gentlemen essentially wanted to replicate the way we eat. They knew that eating healthier foods has a lot to do with your own health in the human world, so for pets, they thought, "Why don't we put natural ingredients in pet food and see if we can go out and help other people who are also concerned about the health of their pets?"
And that business idea sparked the company which has grown since 2002 into, as you mentioned, Vince, a leading company in this category. It has annual revenue of $1.2 billion. It's grown its revenue by a compounded annual growth rate, or CAGR, of about 12% over the last three years. And listeners who have pets and are into this Wholesome Natural pet food category probably are familiar with some of the following brands. These include BLUE Life Protection Formula, BLUE Wilderness, BLUE Basics, BLUE Freedom, and BLUE Natural Veterinary Diet.
Shen: Yeah. Blue Buffalo has their overarching brand, they have about five different food lines, as you mentioned, Asit. Blue Buffalo is definitely a leader in terms of the natural food category for pet food, what they call Wholesome Natural. The important thing to note is overall, the U.S. pet food market is about $30 billion annually, and it's growing at 3% to 4% each year. That's better than the broader consumer products market, so that's a part of the story here for how this deal came together.
I think pet foods in general are attractive for a few reasons, those being consistent growth, like we've seen in that broader market, 3% to 4% annually. Also, it's one that's seeing what they're calling premiumization and humanization. The idea there is, younger pet owners, especially the millennial generation, and across age groups, really, consumers have obviously shown a clear preference for healthy, natural foods. To a lot of families, pets are just as important and deserving of higher-quality food. That's the humanization element. Also, how consumers are driving to the more premium products in that category.
Lastly, management mentioned a few things I thought were interesting. That's the stability of demand for pet food, and how it creates a subscription-like buying pattern. Consumers are likely to remain loyal to specific pet food brands for the duration of their pets' lives. Pet food purchases are non-discretionary, so the demand, again, is very stable.
With Blue Buffalo leading the Wholesome Natural niche, that represents about 10% of the pet food market by volume but 20% of its sales. It's also supposed to be the fastest-growing niche or part of the pet food industry. The company made up only about 7% of U.S. pet food sales in terms of market share, so a smaller player in the market. Blue Buffalo notes in its 10-K, it estimates that it feeds only about 3% of pets in the U.S., so they see an opportunity there to grow domestically for sure.
Turning our attention to the deal itself, that $40 per share buyout price that General Mills is offering represents a 17% premium to the stock's previous close. Or if you look at it from a 60-day volume weighted average price basis, it's about a 23% premium. Asit, I got the feeling during the investor call that given Blue Buffalo's strong growth and their brand, General Mills is leaving a lot of the company intact in terms of how they're going to integrate things. Can you speak to what that looks like?
Sharma: Sure. General Mills is going to leave the current leadership team in place. That includes Billy Bishop, who is the son of Bill Bishop. He's the CEO responsible for the company's growth over the past few years. What General Mills is looking to do is replicate the success they had with Annie's, which many of you are familiar with. This is the natural snack brand. My family knows it because they have a great natural macaroni and cheese that my kids like. When General Mills acquired Annie's, it was able to keep the same leadership team and keep a double-digit compounded annual growth rate. And that's the objective here, to continue this 12% growth rate plus, as I mentioned.
One of the ways they're going to do this is leave the manufacturing in place. Now, the company, Blue Buffalo Pet Products, has a manufacturing facility in Joplin, Missouri, which is humongous. It sits on 89 acres, and it's over 400,000 square feet. In this facility, they manufacture dry pet food and have a full distribution service center. For those of you who are wondering how General Mills, which has always been a cereal and snacks company, is suddenly able to jump into the pet food business, well, they have this system in place to acquire this and slowly scale it. And I thought it was interesting, Vince, on the call that you mentioned, the CEO of General Mills mentioned that pet food is not that different to manufacture than human food. Who knew?
Shen: General Mills currently has four operating segments. Those are North American Retail, which is by far the largest, Convenience Stores & Foodservice, Europe and Australia, and then Asia and Latin America. Blue Buffalo is going to be tacked on as its own operating segment. The headquarters and manufacturing facilities, like you mentioned, will be left intact.
Some other parts of the deal that were mentioned in the press release, during the call, General Mills and Blue Buffalo are hoping to see about $50 million in annual cost saving synergies. Those won't come in until about two years after the deal closes. A big part of that is the fact that General Mills, with its footprint and scale, will see benefits in sourcing, manufacturing, logistics and also some reductions in their SG&A expenses. They mentioned revenue synergies, but they do not quantify them. I think that was a bit of a sticking point for some of the analysts who were trying to figure out the earnings and what kind of impact this will ultimately have on General Mills' business.
The deal is expected to close by summer 2018. The big story here, I think, that we've mentioned a few times, is the growth potential. That's why this deal came together. Blue Buffalo has been growing at that low double-digit pace for several years running, and that's really something that General Mills wants to get a piece of.
They're funding the deal with cash, debt, and equity. General Mills has actually paid a dividend pretty consistently since 1994. They've been increasing that payout for the past 14 years, but they're going to suspend their share repurchases until the company reduces its debt balance following this acquisition. The company previously reduced its share count about 10% over five years' time.
I think it's important to consider some of the risks and issues in terms of the pricing for this deal, too, that I know you mentioned. Do you want to speak to that, Asit?
Sharma: Absolutely. Let's use two taps in this conversation about purchase price. Let's use a cold water tap and a hot water tap. I want to throw some cold water on this deal to begin, and then we'll increase the temperature to give them their fair due. This deal, I calculate that the purchase price is about 25x trailing 12-month EBITDA. That's earnings before interest, tax, depreciation, and amortization. It's a pretty common way to look at a deal, what is the multiple of EBITDA here? 25x EBITDA is a high purchase price. If you were to look at the recent financial statements of Blue Buffalo, you would see that their book value is only about $300 million. So you're looking at a purchase price of $8 billion vs. tangible assets of about $300 million. There's a lot of goodwill that General Mills will book in this deal, so it's an expensive purchase.
And to complete the purchase, as Vince told you, it's a mix of cash, equity, and debt. The company is going to leverage its balance sheet up to 4.2x EBITDA. Again, I'm using a lot of jargon here. This is basically a high leverage ratio. When your debt to your earnings is in the 4x to 5x range, that's getting pretty leveraged on your balance sheet. It means you borrowed a lot of money, and you're going to have to use some of that cash flow now to service the debt you've taken on.
By that measure, the deal is very expensive. And as Vince mentioned, we don't really know -- I said that this is going to be double-digit growth going forward for Blue Buffalo, and the company can probably scale that. But General Mills didn't tell analysts on the call, is it low double digits? Is it high double digits? What will General Mills be able to do with this revenue stream? How far can they grow it? That's the real question, because if you look at the relative revenue, over $15 billion for General Mills and $1.2 billion for Blue Buffalo, it takes a lot of growth to move that needle. What are your thoughts on the valuation, Vince?
Shen: I was looking at this, trying to figure out, they don't quantify those revenue synergies like we've talked about. The interesting thing is, on one hand, Blue Buffalo has stated previously that their ultimate goal was to increase their market share and also to expand internationally, whereas General Mills, during the call, spoke to the potential for international growth, but that was not something in the near-term that they consider. I think it's important for General Mills, to consider some of the context here. They announced the deal last Friday, and they also had a presentation during a consumer products conference where they talked about what they consider to be some of the key drivers and parts of their strategy to deliver more consistent revenue growth. The past few years, their top line has declined in the mid single digits.
General Mills says they want to compete effectively on all brands across all markets, that they want to accelerate their differential growth platform -- that includes their Haagen-Dazs ice cream brand, their snack bars business, the Old El Paso brand, and their natural organic foods. The third one is, they want to reshape their portfolio via both acquisitions and divestitures, and we're seeing the first example of that here.
Even though the company has had weaker top line performance, it has instituted a lot of changes and cost-cutting initiatives to improve its profitability, try and optimize the brand portfolio. In the prior fiscal year, General Mills changed their global organizational structure. They continue to restructure their supply chain. They have this established goal of consistent, low single-digit revenue growth. Management wants to target returning 90% of free cash flow to shareholders. With this holistic margin management they've been talking about, ultimately they have a goal of finding about $4 billion of cost savings over a decade.
With all of that in mind, it has me thinking about some of the strategies and changes that I think General Mills will implement as part of the integration for Blue Buffalo. They're going to outfit it, for example, with their marketing apparatus, their sales apparatus. They have a lot of resources, for example, for R&D, product innovation. General Mills divested its Green Giant brand in fiscal 2016. That's about 5% of the top line. But as you mentioned, they added brands like Annie's and EPIC to their portfolio, more similar to Blue Buffalo in terms of this natural foods niche, so they have some experience with integrating those natural food businesses.
What else do you think General Mills can do to leverage and expand the Blue Buffalo business?
Sharma: They can probably push into other areas of the pet food industry, which itself is very big. The company has mentioned more distribution in Food, Drug and Mass, which is a segment basically getting into drug stores. There's a hint there that the company could potentially move into pet health, which is another phenomenally growing category. I think scaling this would be in their interest and also opens up the opportunity for them to help this smaller company with innovation. That's one thing that General Mills has been very good at, as you mentioned, is taking brands -- for example, let's look at Yoplait, a very traditional brand of theirs -- and adding on new labels that have seen much faster growth. Oui yogurt is one example. I was thinking, when you were talking about snacks, Lärabar is yet another example of brand innovation on this company. Either through acquisition or creating new brands. So management has some muscle in being able to laterally move into new segments of markets. I think that's to the good.
One more bit of cold water here, and then I want to turn on the warm water tap. I really don't like that the company is telling investors that the deal won't be accretive to earnings, and that, too, on a cash earnings per share basis, until 2020. The reason is, when you tell investors, "We will be able to add to our bottom line from this acquisition in 2020 on a cash EPS basis," what you're saying is, "We sort of overpaid for this." There's a lot of goodwill in this transaction that will be amortized every quarter going forward. That's why the company can't say, "This will hit our bottom line and spruce earnings next year." It's going to be two years before we see the first true positive bottom line hit for General Mills, and that, too, after you pull away things like amortization and interest expense for the debt. So it's going to take a while for this to really take hold and make a meaningful impact on General Mills' income statement.
On the other hand, the hot water, why is this so intriguing. This company is very millennial friendly, Blue Buffalo Pet Products. This is the segment of the consumer universe that is causing retail disruption. The very consumers that make it harder for General Mills to sell its traditional cereals in grocery stores are the kinds of consumers that buy products that Blue Buffalo manufactures. So, over the very long-term, there's an enormous potential to grow within the pet category.
Having said that, there are some large players in this industry. There's Mars, which is privately held, one of the world's largest consumer goods companies, they have a pet division. Nestle has a gigantic pet division, you're familiar with names like Purina. So it's not like there isn't any entrenched competition that exists out there. But the smart thing that I think General Mills has done is to purchase a company in a market which is expanding at a much faster growth rate than, say, cereals, which is something that you mentioned at the outset, Vince. There's space in an expanding market to take share from bigger rivals. If you look past those first few years that I'm quibbling about, I think there's some growth potential here. And that's what's more exciting about this deal, for those who want to hold General Mills stock for, let's say, a five or seven or 10-year period.
Shen: Thanks, Asit! Last couple of points from me, then. I think it's interesting, also, to speak to how, you mentioned the Food, Drug, and Mass channel, that's definitely a space that General Mills is very familiar with, very strong in. Blue Buffalo has already begun pushing into that FDM channel as of 2017. This includes the biggest grocery stores and retailers. That's away from where Blue Buffalo was previously focused, which was with specialty retailers. Because General Mills has a lot of that experience in the FDM channel, I think that's a really important part of the opportunity that the two companies, their management team, spoke to during the investor call.
Specialty channels accounted for about 40% of U.S. pet food sales, and the remainder of that was made up by the FDM channel. But growth has historically been much stronger in the Specialty channel. But because of that, in terms of FDM making up the majority of that space, the entry, I think, for Blue Buffalo is really important. And now that they've gotten started in 2017, it's only a matter of time until they're accelerated with the integration with General Mills.
On the other side of that, Blue Buffalo stated there's an international opportunity, whereas General Mills is saying it's a little bit farther off. But it's still worth looking at in that Blue Buffalo currently only sells in the U.S., Canada, Japan, and Mexico. Only 4% of its sales were outside of the United States. While the U.S. pet food market is about $30 billion, the global market is about $80 billion. Because of General Mills' global footprint, again, I think it's another important opportunity longer-term that they could consider in terms of how they market that and how they roll that out into their other geographic regions.
I want to leave a few minutes here for you, Asit. Any final thoughts on the deal before we close out the discussion?
Sharma: Two things. One, just to add to your comment on the international expansion, especially in Asia where birth rates are declining, and populations are aging, the pet business is booming, I think China and Japan in particular. In Japan, there's a very worthy competitor in a company called Unicharm, which has seen a lot of success in selling pet food to families. They've enjoyed a lot of growth. I think there's some persuasive opportunity there.
The last point I want to make about this is, this deal is very similar to a deal that we saw last year, which is McCormick & Company, the spice company, buying Reckitt Benckiser's, a British company, portfolio of foods, which included French's mustard and Frank's Red Hot hot sauce. Again, another big deal versus the company's balance sheet. They took on a lot of debt, they also suspended share repurchases.
When companies do this, there's two things that we see. They are saying that it's really hard to develop innovation internally, and acquisition may help in this slow-growth consumer goods market. No. 2, we want to add a lot of debt to our balance sheets so that Kraft Heinz, who we talk about a lot, Vince, won't come and purchase us. And I think General Mills was thinking about that when they made this deal. "Hey, if we add a lot of debt to our balance sheet in this acquisition, we're not as attractive to that big behemoth that's over here that may be sniffing around trying to acquire us." So it's a defensive move as well.
All in all, I'll put these two taps together, I think the water runs a little warm for me. I have skepticism about that purchase price, but over time, it should work itself out.
Shen: Thanks, Asit! Last thing for me, I forgot to mention with the channels, which I thought was interesting, especially with the premium pet foods, an important channel for Blue Buffalo that they mentioned has been their e-commerce. That's something else that General Mills has been working on. Blue Buffalo sold $250 million via e-commerce in 2017. That was 75% growth year over year, about 20% of their total top line. It makes Blue Buffalo the No. 1 selling pet food brand online and also one of the most searched on Google overall.
If you compare that to General Mills' U.S. e-commerce business, they said it was up 82% in the first half of its current fiscal year, so very impressive, but that's from a very small base, only about 2% of their total sales, which they hope will be closer to 5% by 2020. But I think it's interesting how, with the younger demographic, in terms of consumers, how popular Blue Buffalo is among them. And their penetration in terms of that online market, again, something else that can help for both sides of the company in terms of these synergies there.
Thanks again, Asit, for joining us today as part of this discussion.
Sharma: Absolutely! This was fun.
Shen: Thanks for listening, Fools! Austin Morgan is our man behind the glass. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!