When you think of mergers and acquisitions, a number of sectors come to mind. The food industry probably isn't one of them. Food companies are typically the slow-and-steady types, which is indicative of the business they operate in. That being said, one of the merits of investing in giant food producers is the stability of their business models.
But suddenly, the food industry is proving to be far more exciting than you'd ever imagine. Just two weeks ago, Hillshire Brands (UNKNOWN:HSH.DL) offered to buy smaller rival Pinnacle Foods (NYSE:PF) for $6.6 billion including debt. Now, both Pilgrim's Pride (NASDAQ:PPC) and Tyson Foods, (NYSE:TSN) have tossed their hats into the ring by each making offers to buy Hillshire. Pilgrim's Pride is offering to buy Hillshire in an all-cash deal valued at $6.4 billion. For its part, Tyson is one-upping Pilgrim's Pride with a $6.8 billion offer.
Keeping it simple by consolidating
If all this craziness seems overwhelming, there's actually a simple strategy employed by these companies: Produce growth by buying it. Organic growth is hard to come by in the food industry. Mature markets like North America are saturated, and as a result growth is more or less limited to population growth. But buying out other companies can produce instant growth as well as future benefits from cost synergies.
After news of the offer from Hillshire to acquire Pinnacle Foods, I wrote against the idea, saying the deal too richly valued Pinnacle. Apparently, both Pilgrim's Pride and Tyson feel the same way and will each force Hillshire to drop its bid for Pinnacle as part of their offers. Here's why Hillshire would be wise to take the offer from Tyson, and cut Pinnacle Foods loose.
Hillshire should walk away from the table
Hillshire's proposal to buy Pinnacle Foods makes strategic sense but is problematic financially. It's true that the diversity offered by Pinnacle Foods' product portfolio would allow Hillshire to extend its reach to nearly every aisle of the grocery store. If Hillshire acquires Pinnacle Foods, it will control a total of 10 brands that hold the No. 1 or No. 2 position in their respective categories.
Still, the deal poses a problem from a financial perspective. Hillshire's offer pegs Pinnacle's value at $4.3 billion excluding debt. This values Pinnacle at about 14 times trailing earnings before interest, taxes, depreciation, and amortization and about 23 times trailing earnings. That's a fairly rich earnings multiple for Pinnacle, which produced revenue growth of less than 1% last year.
Overvaluation is now someone else's problem
Fortunately for Hillshire shareholders, they might not have to worry about their company undertaking a large, potentially dilutive deal now that Pilgrim's Pride and Tyson have come along. Pilgrim's offer alone sent shares of Hillshire up 22% in a single day. Pilgrim's Pride is offering about $45 per share for Hillshire.
Tyson is offering even more, roughly $50 per share for Hillshire. That would value Hillshire for about 29 times trailing earnings.
Hillshire investors should breathe a sigh of relief that their company didn't take them on an ill-fated acquisition campaign. Pilgrim's Pride and Tyson are better suitors for Hillshire than Hillshire is for Pinnacle. That's because Pilgrim's Pride, Tyson, and Hillshire hold primarily meat brands. It makes more sense for Hillshire to team up with a larger protein producer in the same industry than it does to buy a frozen-vegetables company like Pinnacle.
Still, paying 29 times trailing earnings for Hillshire represents a lofty multiple for a company with a fairly unimpressive growth profile. Hillshire reported a 1% drop in sales in fiscal 2013 after just a 2% increase in sales in the previous fiscal year.
The U.S. food industry is inevitably marked by slow growth. People always need to eat, which means profits stay afloat when the economy takes a nosedive. But the opposite is true as well. When the economy recovers, food companies generally miss out on huge growth.
That means food companies are turning to acquisitions as a way to generate growth. Hillshire Brands was on the cusp of an expensive takeover pursuit of Pinnacle Foods, but that's in doubt now that it has its own potential buyer. Pilgrim's Pride and Tyson have each stepped in with offers for Hillshire and they both would require Hillshire to drop its bid for Pinnacle as part of the takeover. Whether it's Pilgrim's Pride or Tyson that scoops up Hillshire, Hillshire would be wise to take the offer and cut Pinnacle Foods loose.