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Company: Hillshire Brands Company (HSH)

Rating: Rating change from buy to neutral

Price: $34.77

Target Price Range: $34.08 - $55.26

Market Cap: $4,468

52 Week High/Low: $24.31 - $36.18

COMPANY OVERVIEW

Hillshire Brands Company

Hillshire Brands Company was formerly known as Sara Lee Corporation and changed its name in June 2012. The Company's products are primarily offered under the brand names of Jimmy Dean, Ball Park, Hillshire Farm, State Fair, Sara Lee and Chef Pierre. Two prominent artisanal brands are Aidells and Gallo Salome. The Company manufactures and markets meat centric food products for retail and food service markets in the United States. These products include; hot dogs, corn dogs, breakfast sausages, breakfast sandwiches, dinner sausages, deli meats, hams, pies, and cakes. The meat products consist of beef and turkey. The Company currently sales their products to supermarkets, national chains, warehouse clubs, foodservice wholesalers, healthcare institutions, educational institutions and restaurants. The problem Hillshire Brands is looking to solve is convenience without giving up taste. They seek to do this by making their products accessible and desirable.

STRENGTHS

  1. Brand names and leadership positions: Jimmy Dean breakfast sausage, Ballpark hot dogs, and Hillshire smoked sausage currently rank number one in market share and Hillshire lunch meat is currently number three in market share. Eighty-eight percent of revenue comes from branded sales (source: June investor day 2012, information provided for by Symphony IRI Group Total US FDMX data).
  2. Value added products that target non-price conscious consumers and command a premium price. Aidells sausage is an example of this type of product. The sausage is made with all-natural chicken, real fruit, and real vegetables. These ingredients provide a taste that traditional sausage has a hard time competing with. These sausages tend to appeal to consumers that are both health conscious and taste driven. According to Hillshire Brands, Aidells consumers tend to be highly educated and higher income (source: June investor day 2012). Products such as Aidells have higher margins that tend to be relatively more consistent over time and less determined by commodity prices. Also, Aidells has allowed Hillshire to expand into "organic" food outlets such as Whole Foods (WFM) which current competitors Smithfield Foods (SFD), Hormel (HRL), and Tyson (TSN) do not participate in.
  3. Increased regulatory cost burdens have provided a government made barrier to entry into the food segment. Due to Hillshire's size, they as well as other large competitors will be able to absorb these higher prices while smaller competitors and new entrants will struggle to survive.
  4. Hillshire Brands is vertically integrated in their turkey segment and not in other segments (pork and beef). This is strategically done because they only use trims in their beef and pork segments. Also, turkey has low capital intensity and low market availability. This helps Hillshire Brands to have lower volatility in earnings relative to competitors who are vertically integrated in segments such as pork. Specifically, Smithfield Foods.

WEAKNESSES

  1. Hillshire Brands does not have an international presence while their top competitors do. For example, Tyson has been promoting healthy chicken consumption in China and investing large sums of money in production facilities there. Although most of Tyson's revenue currently comes from the U.S. these facilities along with the current chicken scare at YUM will provide a tailwind for Tyson. They are also located in a total of 130 countries worldwide.
  2. Currently, 25% of all sales come from Wal-Mart (WMT). This exposes Hillshire Brands to potential problems stemming from Wal-Mart.
  3. Hillshire Brands can not pass through 100% of input price inflation to customers. Part of the reason being is that switching costs are low. Branded products are already priced at a premium so price conscious consumers are willing to purchase cheaper store brand products. This especially holds true in recessions.
  4. Supermarkets have recently seen a large amount of consolidation resulting in larger but fewer number of grocers. This leads to increased buyer power which allows them to negotiate lower prices for products from suppliers such as Hillshire Brands.
  5. Shelf space is always at a premium again giving more power to the buyer.

COMPETITORS

The competition within the food industry is competitive. The advantage of barriers to entry is shared by many of the larger constituents as well as the weaknesses such as passing through inflation to input costs, consolidating grocery stores and limited shelf space. The top competitors in packaged foods (meats) are Hormel, Smithfield Foods, Tyson, Pilgrim's Pride (PPC), Sanderson Farms (SAFM), Oscar Meyer (Kraft Foods), Cargill, Seaboard, and Foster Farms.

FINANCIAL OVERVIEW

Although meat consumption in terms of pounds has been declining, meat eating occasions has grown by an average of one percent from 2002 to 2012 (source: June investor day 2012, provided by NPD Group/National eating trends). This is important for Hillshire because this leads to an increase in value added products. Also, I believe a trend that will be seen in the future is the need for quicker meals as more people are required to have longer work days. This will also benefit Hillshire and their ready meal products. I initially issued a buy rating on July 17th, 2012. A key contributor to this rating was my belief that Hillshire had been grossly mismanaged while it was under the Sara Lee umbrella and the new management team would be able to unlock more value. I believe Hillshire Brands will experience increasing revenue with margin expansion (I expect operating margins to be between 7-8% per year, managements stated goal is 10% in three years). The industry as a whole has been shifting from commoditized products to value added products which have higher margins. Company management has stated four goals which need to constantly monitored: 1) to strengthen core brands through increased MAP spend and better product packaging 2) Extend trademarks into adjacent categories 3) cost efficiencies (save $100mn in three years) 4) acquire on-trend businesses. Management has stated they see potential growth in the meat centric meals market, meat centric snack market and the meat breakfast market.

PROJECTED FINANCIAL METRICS

I have stated since my initial report last year that in my opinion Hillshire will be managed to make it an attractive takeover target in three to four years. To derive the value of Hillshire, potential acquirers were examined to determine what they may potentially pay for Hillshire. Metrics used to help determine value were; price to free cash flow multiples, price to sales multiples and price to EBITDA multiples. Key assumptions are listed below (all market share data, current penetration rate data, and current size were provided by Hillshire in their CAGNY presentation. Information was supplied to Hillshire by Symphony IRI Group, national consumer panel 12/30/2013);

  1. As previously stated, I believe Hillshire was mismanaged while part of Sara Lee. I have modeled Hillshire to start with a twenty-eight percent market share in lunchmeats with this market share declining in the first year due to supply chain issues stated in their third quarter conference call. I then model the Company to increase market share through 2017. Overall market penetration is estimated at eighty percent. I believe this is a mature market and modeled a minimal increase in overall market penetration.
  2. Hotdogs market share is modeled to start at thirty-one percent and slightly increase through 2017. Current overall penetration rate is estimated to be seventy-nine percent and slightly decreasing through 2017. I have modeled a slight decrease in overall penetration rate because I believe the trend towards healthier products will negatively affect the hot dog industry as a whole.
  3. Smoked sausages are currently estimated to have a sixty percent overall penetration rate with Hillshire having a thirty percent market share. I have modeled Hillshire to have increasing market share in this category with gains coming mostly from Aidells expansion into national markets. I have modeled modest growth in penetration rates because these products tend to be purchased more in raising economies and I believe we will continue to see modest economic growth at best.
  4. Breakfast sausage is estimated to have a sixty-one percent overall market penetration with Hillshire's current market share at twenty-eight percent. Both overall market penetration and Hillshire's market share have been modeled to show modest growth.
  5. Frozen Breakfast is currently estimated to have an overall penetration rate of thirty-six percent with Hillshire having a current market share of twenty-one percent. I have modeled market penetration to grow aggressively because it is my belief that as the economy continues to drag consumers will be working longer hours. Therefore, there will be an increased need for faster breakfast items. Also, I believe breakfast items as a whole will increase as consumers become increasingly educated on the benefits of breakfast. Hillshire's market share has been modeled to slightly increase.
  6. Pricing for the retail segment has been modeled to show zero percent growth in FY13 with extremely low and consistent increases thereafter. Pricing for the foodservice segment has been modeled to be negative in FY13 with extremely low and consistent increases thereafter.
  7. In my July report, the main margin expansion driver was driven from my opinion that Cost of Goods would have a sharp decline. We have since seen the cost of commodities decline (mainly animal feed products such as corn). I am now neutral on commodity prices. Therefore, COGS has been modeled to show a decline in FY13 and be stable thereafter.
  8. SG&A has been modeled to slightly decrease for FY13 and stay consistent through FY15. This slight decrease is from cost reductions but are partially offset from increased MAP spend. In my original report I overestimated corporate expenses. I have revised this number down. It is my belief that the Company will be purchased at the end of FY15 and will be integrated into the acquiring company through FY17. Therefore, I have modeled SG&A to decline during these two years as Hillshire is integrated with the acquiring company.
  9. Operating leases have been subtracted from operating expenses and capitalized. The capitalized expense has been taken into account in as additional interest payment and the capitalized lease has been added to long-term debt. Also added to long-term debt is unfunded pension liabilities. As a note regarding their pension plan. I do not view the unfunded status as a detriment to value. In my opinion Hillshire uses a conservative rate of return and discount rate assumptions to project the plan status. They also use a liability driven strategy which is considered relatively more conservative than other methods. I view the current unfunded status as a result of the current interest rate environment and should correct as rates increase.
  10. Management's target for operating margins is eight to ten percent. The assumptions in my model have lead to what I believe is a conservative estimate of operating margins (roughly eight percent).
  11. The FY13 earnings per share estimate does not include the sale of the Australian bakery segment. Thus my estimate will be lower than the reported GAAP numbers at the end of the year.
  12. Two companies presented below have been identified as potential buyers, Tyson and Hormel. I used valuation multiples from previous purchases to generate a value for Hillshire Brands. However, Tyson has not made a large scale purchase since 2001 and although Hormel has been active in acquiring companies, they have all been less than a billion dollar acquisitions. For these reasons, I decided to supplement this analysis with a DCF model and apply purchase premiums ranging from twenty percent to fifty percent. The terminal Price to Free Cash Flow multiple used is 6.5 which is the median projection of my comp. set. A discount rate of 9.6% was used. Value obtained ranges from $34.08 to $42.60.

The following are companies which have been identified as potential acquirers of Hillshire Brands. I have also included names of companies that have previously been mentioned as potential suitors and explain why I left them off the list of potential acquirers. I continue to look for potential buyers and will update this report if necessary if any are identified.

  1. Hormel Foods: Hormel consist of five segments; the grocery segment, the refrigerated foods segment, the Jennie-O-Turkey Store segment, the specialty foods segment, and their international operations segment. Hormel is fundamentally strong and would be able to finance the acquisition of Hillshire Brands. The acquisition would make Hormel's leadership position that much stronger and they should be able to integrate Hillshire with their current operations. Hormel's most recent purchase was Skippy peanut butter. The reported purchase price had a Price to Sales ratio of 1.89. Applying this ratio to my estimated figures provides an estimated purchase price of $48.72.
  2. Tyson Foods: Tyson is the second largest food production company in the Fortune 500. Their three operational segments of chicken, beef, and pork should allow them to integrate the purchase of Hillshire Brands. The last acquisition made by Tyson was in 2001 of IBP. They purchased IBP at an EBITDA multiple of 6.94. Applying this ratio to my estimated figures provides an estimated purchase price of $55.26.
  3. Kraft Foods (KRFT): I have heard rumors that a major conglomerate such as Kraft would be interested in purchasing Hillshire. I have looked in this potential and believe Kraft would not be interested in acquiring this Company. The number one reason being that Kraft is already extremely competitive in this field by owning Oscar Meyer. I am continuing to look into other conglomerates as well and will update this report if I come to the conclusion that one of them may show interest in acquiring Hillshire.
  4. JBS (JBS.SA): JBS is one of the largest meat companies in the world and is based in Brazil. They were in negotiations to buy Hillshire before they were spun off from Sara Lee. JBS is quoted as saying they backed out of a potential deal because they viewed the price as being too steep. I decided to evaluate a price that JBS may be willing to buy Hillshire Brands. I examined four previous purchases made by JBS; SFD Beef, Swift, PPC, and National Beef. Based on various ratios paid for these companies I estimated that JBS was targeting a purchase price between $12.50 and $14.00 a share. For this reason I believe they will show no interest in acquiring Hillshire Brands in the future.

VALUATION CONCLUSION

Taking the median value of my five valuation estimates gives a target value per share of $42.60 or a 22.53% discount to current market price. Combining the low and high estimate gives a range of $34.08 to $55.26. I view this valuation of having relatively low risk and moderate potential returns.

INVESTMENT THESIS

In my initial report on July 17th, 2012, the current price was $26.22. The estimated valuation range was similar to what I am currently estimating. I issued a buy rating based on what I viewed as a relatively low risk high potential return. Due to the share price appreciation I have determined that the potential return is now relatively moderate and I am changing the buy recommendation to neutral. In my opinion there are three catalysts that can drive the share price higher. First, an announcement of an acquisition. Second, a dividend increase. Last, if I were to change my outlook on commodity prices (feed such as corn) from neutral to negative as it was last summer.

My recommendation on investing in Hillshire Brands consists of the following (please note that this recommendation is based on available information and may change with the release of new news): if you already hold shares continue to hold them and dispose of positions at opportune times such as on days of large share price increases. Look to add positions should the share price decline to the $27 range.

FINACIAL PROJECTIONS AND SUMMARY

Income Statement Hillshire Brands

($ in millions, except for EPS)

Fiscal year ending June

INCOME STATEMENT

2013P

2014P

2015P

2016P

2017P

Retail

$2,887

$3,078

$3,229

$3,403

$3,464

Foodservice/Other

$1,073

$1,145

$1,201

$1,265

$1,288

Total Sales

$3,960

$4,222

$4,430

$4,668

$4,752

Cost of Sales

2,705

2,892

3,034

3,197

3,255

Gross Profit

$1,255

$1,331

$1,396

$1,471

$1,498

Gross Margin

31.7%

31.5%

31.5%

31.5%

31.5%

SG&A

$912

$973

$1,026

$723

$153

Impairment charges

15

15

15

15

15

Operating Profits (loss)

$329

$343

$355

$733

$1,329

Operating Margin

8.3%

8.1%

8.0%

15.7%

28.0%

Interest Expense

$68

$43

$51

$34

$43

Interest Income

($3)

($6)

($12)

($13)

($26)

Income (loss) from cont. operations B4 income tax

$264

$305

$316

$712

$1,312

Income tax expense (benefit)

89

107

110

249

459

Net Income

$175

$199

$205

$463

$853

EBIT

$329

$343

$355

$733

$1,329

EBIT Margin

8.3%

8.1%

8.0%

15.7%

28.0%

EBITDA Reconciliation

Depreciation

$131

$136

$142

$148

$155

Amortization

12

10

8

7

9

EBITDA

$472

$488

$505

$888

$1,493

EBITDA Margin

11.9%

11.6%

11.4%

19.0%

31.4%

Pretax Income

$264

$305

$316

$712

$1,312

Taxes

$89

$107

$110

$249

$459

Tax Rate

33.6%

35.0%

35.0%

35.0%

35.0%

Net Income

$175

$199

$205

$463

$853

Net Margin

4.4%

4.7%

4.6%

9.9%

17.9%

Fully-Diluted Shares Outstanding

125

125

125

125

125

EPS

$1.40

$1.58

$1.64

$3.69

$6.80

Free Cash Flow Estimate Hillshire Brands

(in millions)

Fiscal Year Ending

6/30/2013

6/30/2014

6/30/2015

6/30/2016

6/30/2017

EBIT

$329

$343

$355

$733

$1,329

Less: Taxes

$89

$107

$110

$249

$459

EBI

$240

$236

$244

$484

$870

Plus: Depreciation & Amortization

$143

$146

$150

$155

$164

EBIDA (EBI + DA)

$383

$382

$395

$639

$1,034

Less: Changes in NOA

($104)

$12

($7)

($550)

($6)

Less: Capitalized Investments

($162)

($173)

($182)

($191)

($195)

Free Cash Flow

$117

$221

$206

-$102

$832

Discount Period (1)

0.16

1.18

2.19

3.21

4.22

Discount Factor @ 9.6%

0.99

0.90

0.82

0.75

0.68

PV of Cash Flows through 2014

$115

$198

$169

-$76

$566

Summary Of Implied Share Price

FY '17

FY '17

DCF Estimated

Premium

Today's

Acquirer

Previous Acquisition

Valuation Metric

EBITDA

Revenue

Value

Applied

Shares Outstanding

Implied Share Price

TSN

IBP

EBITDA

$1,493

125

$55.26

HRL

Skippy

P/S

$4,752

125

$48.72

FCFF Multiple

$28.40

20%

$34.08

FCFF Multiple

$28.40

35%

$38.34

FCFF Multiple

$28.40

50%

$42.60

Median

$42.60

Source: Valuation Report For Hillshire Brands