In this segment from The Motley Fool's Industry Focus podcast, Vincent Shen and senior contributor Asit Sharma break down the surprising merger of consumer packaged goods titan General Mills (NYSE:GIS) and upstart pet food manufacturer Blue Buffalo Pet Products (NASDAQ:BUFF).

Tune in as they explore the deal basics and the rationale behind General Mills' $8 billion leap into the pet foods industry.

A full transcript follows the video.

This video was recorded on Feb. 27, 2018.

Vincet Shen: 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.

Asit Sharma has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool is short shares of General Mills. The Motley Fool has a disclosure policy.