In this video devoted to General Mills' (NYSE:GIS) purchase of Blue Buffalo Pet Products (NASDAQ:BUFF), the Industry Focus cast takes a look at the deal's valuation. At $8 billion, the price tag for General Mills to enter the pet food industry is steep, and our hosts discuss the pros, cons, and long-term implications for shareholders.

A full transcript follows the video.

This video was recorded on Feb. 27, 2018.

Vincent Shen: 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?

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.

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.