Smithfield Foods Should Split Apart

Mar.26.13 | About: Smithfield Foods (SFD)

Davenport believes that Smithfield Foods (NYSE:SFD) can create value for shareholders by breaking up into three segments: Pork, Hogs, and International. Davenport believes that the company's parts are worth more than the share price, which they are correct on based on a fair value approach. Currently, Davenport gets a break-up value of $48/share to which I agree with based on the valuation methods described below. The following chart is the data from SFD's most recent fiscal year end (Source: Capital IQ):

There were 3 methods I used to figure out the value of SFD on a sum-of-the-parts basis: P/FCF, P/E, and a DCF. Some assumptions used were an 11% cost of capital, 152.1M shares outstanding, and the following debt values for each of the three segments based on the percentage of interest expense in total:

P/FCF

In 2012, SFD's Pork, Hogs, and International segments earned approximately $579M, $252M, and $26M in FCF. SFD's current P/FCF multiple is 9.6. The Pork segment is worth more based on the brands it has, higher margins, and higher sales. For example, competitor Hormel Foods (NYSE:HRL) trades at much higher multiples than SFD as it does not have the Hogs aspect to it. The P/FCF multiples used for Pork were 10, 10.5, and 11. Hogs and International were valued at 6, 7, and 8 due to the higher risk, lower quality, and volatility.

P/E

Pork is the clear driver of earnings for SFD. It is worth more than the other two segments. Based on the operating profits listed above, tax rates of 32% for Pork and Hogs and 25% for International, Pork multiples of 16, 16.5, and 17x earnings, and Hogs and International multiples of 9.5, 10, and 10.5, the following value was obtained:

The multiples are justified based on competitors' multiples. SFD is trading at an earnings discount due to the drag of earnings growth from the latter two segments. SFD's Pork competition trades at over a 60% premium on a multiples basis compared to SFD as a whole.

DCF

On a DCF basis, there are similar results to the previous two. An 11% discount rate was used and the last FCF divided by the 11% cost of capital to get the terminal values for each segment. Bear, Base, and Bull growth rates used for Pork were 3%, 6%, and 9%. Pork has grown much faster than the other two segments, to which I applied growth rates of 0%, 3%, and 6%. The terminal values for the Pork, Hogs, and International on a Base case scenario were more than the current enterprise value, signaling even further potential evidence that a breakup creates value. The values were $6.6B, $2.58B, and $270M, respectively for each segment.

Conclusion

SFD is clearly worth more separately but only because the Hogs segment is really driving down value. The Hogs segment is much more volatile due to the inputs and maintenance of keeping up a farm. The move was done for backwards integration which keeps Pork costs lower. By dividing up the company, the Pork segment could experience higher costs as the companies will be treated separately. The charts below are the value of each segment separately based on these three approaches:

By combining the values for each, the $48 value is obtained:

In other words, Davenport is right. The fact that SFD has hired Goldman as an advisor for this potential split goes to show that the company will most likely be split up. It would be a detriment to the current shareholder if it is not the case. SFD could almost double its share price by breaking up, as the Pork segment is worth the greatest part of the business. It would create a healthier Pork company with less leverage and higher growth. This would demand higher multiples and create value for the shareholder. The Hogs segment could be broken off and actually sold to another Hogs company or be kept separately. Either way it would be smarter for SFD to break-up and focus on the core pork business.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.