The Pros and Cons Of Hillshire Brands’ Pinnacle Deal

Hillshire Brands (NYSE:HSH) recently announced plans to acquire Pinnacle Foods (NYSE:PF) for $4.3 billion in a cash and stock transaction. Pinnacle Foods manufactures, markets, and distributes frozen vegetables, seafood, pizza, and bagels. It also sells cake mixes, salad dressings, table syrup, and pastry fruit fillings. The company generates annual sales revenue of around $2.5 billion.

Pinnacle estimates that more than 85% of American households buy at least one of its products. The company also flaunts holding one of the top 2 brands in 10 out of the 13 product categories it operates in. However, many Hillshire Brands investors including Eminence Capital LLC, one of the meat company’s 20 largest shareholders, have questioned the deal. Here, we take a look at some of the pros and cons of Hillshire Brands’ Pinnacle Acquisition. ^[1]

Formerly known as Sara Lee Corporation, Hillshire Brands began trading under the “HSH” symbol on June 29, 2012, following the spin-off of its international coffee and tea business. It sells a variety of packaged meat products including hot dogs, corn dogs, breakfast sausages, dinner sausages and deli meats, as well as a variety of frozen baked products. These products are sold through the retail channel to supermarkets, warehouse clubs and national chains in North America. The company also sells a variety of meat and bakery products to foodservice customers in North America.

We currently have a $42 price estimate for Hillshire Brands, which we will soon update based on the recent announcement.

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Pros:

• Increased Diversification: Hillshire Brands’ current product portfolio is highly meat-centric. Some of the company’s key product categories include hot dogs, breakfast sausages, premium deli and luncheon meats. Therefore, meat commodities such as pork, beef, and poultry are some of its key raw materials. Wholesale prices of these commodities are very volatile, which increases Hillshire Brands’ operating risk. For example, wholesale beef and pork prices have been soaring higher this year on supply side constraints. In order to reduce the margin impact of higher input costs, the company has already taken pricing measures in some categories and plans to extend it further. However, price increases generally erode volume market share, which is not easily regained and requires investments in advertising and marketing later on. Therefore, we believe that a broader product portfolio that includes Bird’s Eye frozen vegetables and Vlasic pickles would reduce Hillshire Brands’ sensitivity to the volatility in meat commodity prices and help it sustain more stable margins.

• Higher Bargaining Power: The bargaining power of a food and beverage company with supermarkets and other retailers largely depends on the amount of shelf space it covers. With the acquisition of Pinnacle Foods, Hillshire Brands’ shelf space will expand because of a broader product portfolio. Therefore, apart from diversifying its sales, the acquisition of Pinnacle Foods will also help improve Hillshire Brands’ bargaining power with supermarkets, grocery wholesalers and other distributors. This is expected to result in better price realizations for the company.

• Lower Unit Fixed Costs: Hillshire Brands would also capture value from lower per unit costs of the combined company, compared to the two companies operating separately. Consolidation of procurement, manufacturing, and supply chain operations results in lower per unit costs, as some personnel and machinery are rendered redundant. In a three-year period, Hillshire Brands expects to realize cost savings of about a $140 million annually from the Pinnacle acquisition. ^[2]

Cons:

• Higher Debt Load: Hillshire Brands’ debt load is expected to increase significantly after the deal. This is because the cash that it is supposed to pay to Pinnacle shareholders (around $2.1 billion) will be mostly financed through a term loan from Goldman Sachs since its ending cash balance was just over $200 million at the end of the last quarter. Moreover, its own long-term debt was around $1 billion in March and on top of that, it will also inherit ~$2.5 billion of Pinnacle’s debt. This implies that the combined company will have a total debt of over $5.5 billion. Standard & Poor’s rating agency indicated that the debt load would increase Hillshire Brands’ leverage to nearly 5x EBITDA. This compares to a debt/EBITDA ratio of just over 2 in 2013. A higher debt load weighs on the company’s credit ratings, which results in higher yields, and it also increases the required rate of return on equity. This is because there is higher risk involved for equity-holders in a company with higher debt. Hillshire Brands has already indicated that it will be suspending its current share repurchase program in order to reduce leverage. Therefore, Pinnacle acquisition could make it a less attractive equity investment. ^[3]

• Increased Competition: Some of the categories that Pinnacle Foods operates in, such as salad dressings, are marred with intense price-based competition from private label brands. The penetration of private label brands in some grocery categories continues to grow, while in the frozen protein breakfast, hot dogs, and smoked sausage categories, in which Hillshire Brands currently specializes, it continues to remain relatively low. Last year, Kraft Foods Group’s (NASDAQ:KRFT) grocery sales fell by ~3% y-o-y due to increased private label competition in salad dressings and gelatin desserts. This could potentially lead to a negative volume-mix effect and offset some of the gains Hillshire Brands expects to realize from the acquisition of Pinnacle Foods. ^[4]

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1. Hillshire Investor Eminence Will Vote Against Pinnacle Deal, businessweek.com [↩]
2. Hillshire Brands To Buy Pinnacle Foods For $4.3 billion, wsj.com [↩]
3. Pinnacle Foods SEC Filings, sec.gov [↩]
4. CAGNY 2014, hillshirebrands.com [↩]