As the global financial crisis went full throttle in 2008 and 2009, the credit markets dried up extremely quickly. This caused corporate finance activity of all types, especially mergers and acquisitions, to fall off a cliff. Fast-forward to today, and it's a completely different environment. Interest rates are still near historic lows, the stock market is at a record high, and credit markets are once again open. This means that the spigot of easy money has been turned back on, and nowhere is this more evident than in the world of mergers and acquisitions.
The latest big buyout involves food giant Hillshire Brands (NYSE:HSH.DL) announcing a takeover of smaller rival Pinnacle Foods (NYSE: PF). But while it's understandable for companies to attempt the growth-through-acquisition approach, it's important for management teams to exercise discipline as well. In this case, Hillshire Brands may be paying too steep a price for Pinnacle Foods.
Food companies hungry for growth
Companies of all shapes and sizes are devouring one another as a means of generating growth. Since economic growth remains sluggish in many parts of the world, including the United States, companies are essentially trying to buy growth any way they can.
These conditions are particularly ripe in the foods sector because of the saturation of the industry in general. The food industry is extremely stable, which ultimately serves as a double-edged sword. After all, people will always need to eat, which means profits stay afloat during recessions. However, the downside is that when the economy starts to recover, food companies don't enjoy huge growth.
Buying smaller competitors is often a quick way to restore growth for conglomerates with few new avenues for growth at their disposal. This was the impetus for Sysco buying out US Foods for $3.5 billion in stock and cash last year. That deal made a lot of sense for Sysco. For one thing, Sysco needed to find a way to reengineer growth once again since profits had flatlined for several years despite the steady economic recovery in the United States. For instance, Sysco earned more than $1 billion in fiscal 2009, but its profits clocked in at just $992 million in fiscal 2013.
Hillshire's takeover of Pinnacle makes sense strategically as well. Once the deal is finalized, Hillshire will control 10 brands that hold the No. 1 or No. 2 position in their respective categories. Those brands will diversify Hillshire's product offerings, which were primarily frozen foods. With Pinnacle's portfolio in tow, Hillshire's products will be spread throughout your local supermarket.
However, there remains one major difference with Hillshire's acquisition: the price paid.
Growth at an unreasonable price?
A key difference between Sysco's acquisition and Hillshire's deal is the price tag involved. Sysco didn't pay too high a price for its acquisition. It paid 8.8 times enterprise value to earnings before interest, taxes, depreciation, and amortization, which measures a company's market value plus net debt compared to its cash flow. As a result, Sysco absorbed US Foods' assets at a fairly attractive price.
Hillshire's $6.6 billion offer, including debt, values Pinnacle at about $36.48 per share. From a valuation perspective, that would mean Hillshire is paying about 14 times Pinnacle's trailing EBITDA and about 23 times trailing earnings. This represents a roughly 59% premium to Sysco's buyout based on the EV/EBITDA metric.
Of course, it's possible Hillshire is expecting rapid growth from Pinnacle, which would make its takeover premium more palatable. This doesn't seem likely, however, given the saturated nature of the food industry. This is evidenced by the fact that Pinnacle grew sales by less than 1% in fiscal 2013.
Food for thought
The packaged-food industry in the United States is struggling to produce growth, which is why many large companies are buying up smaller ones. The latest deal involves Hillshire Brands eating up Pinnacle Foods, which will both diversify Hillshire's product portfolio and provide instant growth.
Meanwhile, Hillshire appears to be paying a very high price for these benefits. The deal's price tag is much higher on a relative valuation basis than Sysco paid for US Foods last year. In addition, because Pinnacle's top line has leveled off recently, it's unclear how accretive the acquisition will be to Hillshire shareholders. As a result, if you're a Hillshire investor, this deal shouldn't whet your appetite.