Hillshire Hit for Picking Veggies Over Buybacks: Real M&A

Shareholders are balking at Hillshire Brands Co. for buying a company with slow-growth brands that will stand in the way of stock buybacks.

In a period when acquirers have been rewarded for dealmaking, Hillshire dropped as much 7.4 percent yesterday after it announced a $6.6 billion purchase of Pinnacle Foods Inc. It’s gaining brands such as Birds Eye frozen vegetables and Wish-Bone salad dressings and a business that’s projected to grow at half the industry’s average pace. Hillshire says the deal will increase its leverage ratio to about 5, at the high end for U.S. food companies, according to data compiled by Bloomberg. As a result, it’s suspending share repurchases.

Even though investors aren’t thrilled, there are strategic benefits to the transaction, such as selling Hillshire’s meats with Pinnacle’s vegetables, Morningstar Inc. said. The deal also helps Jimmy Dean sausage-maker Hillshire diversify amid high input costs for its own business, according to Bloomberg Industries. Valuations for similar transactions show that while Hillshire isn’t getting Pinnacle on the cheap, it isn’t overpaying either.

“There’s been kind of a ho-hum reaction to the brands Hillshire is getting, and the debt is a red flag,” Ken Shea, an analyst for Bloomberg Industries, said in a phone interview from Skillman, New Jersey. “Every stock analyst likes the potential for buybacks or increased dividends, but when you’re up to your eyeballs in debt, those things are unlikely. There are positives and negatives to this deal.”

Pure Play

Another reason Hillshire shares fell is because the potential for it to be acquired may be diminished now that it will no longer be a “pure-play” meat company, according to Ken Goldman, a New York-based analyst at JPMorgan Chase & Co. Hillshire has been considered an appealing target for Tyson Foods Inc., Hormel Foods Corp. and BRF SA.

Mike Cummins, a spokesman for Chicago-based Hillshire, declined to comment. Thuy-An Wilkins, a spokeswoman for Parsippany, New Jersey-based Pinnacle, didn’t respond to a phone call or e-mail.

The meat company agreed to pay $18 in cash and half a share for each Pinnacle share. Based on Hillshire’s May 12 closing price, the offer was valued at $35.88 a share, or about $6.6 billion including net debt.

Hillshire said that after the deal closes, it will have five times more debt than earnings before interest, taxes, depreciation and amortization on a trailing 12-month basis. That will leave it with the third-highest debt-to-Ebitda ratio among U.S. foodmakers valued at more than $1 billion, according to data compiled by Bloomberg.

Possible Downgrade

Moody’s Investors Service said yesterday that it’s now reviewing the company for a downgrade. Hillshire is currently rated Baa2 by Moody’s, just two levels above junk status, and the deal may push it below investment grade. Still, Chief Financial Officer Maria Henry told analysts yesterday that she expects to have an investment-grade rating again within three years.

“We don’t expect to do any share buybacks for the next two years, so we’ll continue to manage the overall capital allocation of the business to maximize shareholder returns,” Henry said on a conference call. “But with the level of debt that we will have, which will be about $5.7 billion, we clearly will be focused on delevering the company over the next few years.”

Hillshire said in February that it expected to repurchase $200 million of shares through fiscal 2015.

Stock Drop

The stock ended yesterday with a 3.2 percent drop, its biggest retreat since Aug. 9. The decline is a divergence from the recent trend of acquirers’ stocks rallying after making a purchase. Actavis Plc, Facebook Inc. and Zimmer Holdings Inc. are among buyers this year that rose on takeover announcements.

Hillshire climbed 2.2 percent to $36.56 today.

Despite the negative reaction among shareholders, Hillshire may be on the right path, given Pinnacle’s portfolio of brands, said Ken Perkins, a Chicago-based analyst for Morningstar. The Birds Eye line generated $1.1 billion of Pinnacle’s sales in 2013, about 45 percent of its total revenue. The unit that includes Duncan Hines cake mix and Mrs. Butterworth’s syrup generated $1 billion. Pinnacle acquired Unilever’s Wish-Bone salad dressing business last year for $580 million.

“Hillshire’s getting several large brands in categories that they’re not operating in,” Perkins said in a phone interview. “If you think about selling meat-based products and then you throw on something like vegetables, there’s definitely a complement there. It helps improve their relationship and negotiating position with retailers.”

Selling Everywhere

A supply chain analysis by Bloomberg shows Pinnacle doesn’t sell products at Costco Wholesale Corp., one of Hillshire’s biggest customers. That could present an opportunity for it to increase exposure at those stores.

Food products, which previously have been found mainly at grocers, are now also being sold everywhere from convenience stores to mass merchants and dollar stores. As a result, food manufacturers need to have a broad portfolio to capitalize on the fragmented market, said Shea of Bloomberg Industries.

Hillshire forecast $140 million of annual cost savings that will come from supply-chain enhancements and cuts in overhead expenses. Under that assumption, its earnings will climb more than 40 percent next year, data compiled by Bloomberg show.

Lackluster Sales

That said, some of the lack of excitement about the acquisition may be because of Pinnacle’s growth prospects, said Perkins of Morningstar. Pinnacle’s revenue will climb 10 percent through 2016, while the average U.S. foodmaker will grow at more than twice that rate, according to analysts’ estimates compiled by Bloomberg.

Part of Hillshire’s rationale for the deal could be, “‘if we don’t acquire, we may get acquired ourselves,’” Shea said. “I’m not sure how much that weighed in their decision because this deal does make strategic sense, so I wouldn’t go as far as to say that was the reason. But they could probably be in the sights of someone like a Tyson at some point.”

Cummins, the Hillshire spokesman, declined to comment on speculation that the company is in play.

Spinoff Anniversary

As JPMorgan’s Goldman pointed out, next month marks two years since Sara Lee was renamed as Hillshire and split off its coffee and tea division to become a meat company. It would have been “tricky” for a suitor to buy Hillshire so soon after the Sara Lee breakup because of rules imposed by the U.S. Internal Revenue Service regarding spinoffs, though those potential tax implications “largely dissipate” after June, he wrote in a note yesterday.

Hillshire Chief Executive Officer Sean Connolly said in an interview on CNBC that the two-year anniversary of the Sara Lee spinoff “never entered my mind” as a reason for the Pinnacle deal and that his company had been speaking with Pinnacle for a while.

Hillshire’s valuation of about 11 times Ebitda may not leave enough upside for a buyer to step in now, unless it could extract significant synergies and tax benefits, said Sachin Shah, a special situations and merger arbitrage strategist at Albert Fried & Co. in New York.

“There are some that might be convinced that Hillshire should be sold, rather than them acquiring Pinnacle,” Shah said. “But it might be too early to know if this is not such a good deal or not.”

Before it's here, it's on the Bloomberg Terminal.