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Investors in Smithfield Foods (SFD) were pleasantly surprised by the aggressive offer for the company made on Wednesday. The largest Chinese pork producer, Shuanghui International Holdings, made an offer for Smithfield in an attempt to create the world's largest pork producer.

The proposed deal makes huge strategic sense for both companies involved and shareholders in Smithfield, which will receive a more than fair premium for their stake.

The Deal

Shuanghui International Holdings announced that it has entered into an agreement to acquire Smithfield Foods. The Chinese company, which is China's largest meat processing company, will pay $34 per share in cash for the company, offering shareholders a decent 31% premium for their shares.

The deal values Smithfield's equity around $4.7 billion. Including the assumption of debt, the deal values the US meat company at $7.1 billion.

With the acquisition, the Chinese company hopes to expand offerings of Smithfield's leading brands into China through its own distribution network. Shuanghui is able to offer competitive, high-quality meat in China, removing concerns about food and meat quality in general. The company hopes to learn from Smithfield's operational excellence as well.

Smithfield generated annual revenues of $13.09 billion over the past year, up 7.3% on the year before. Earnings fell by 30.7% to $361.3 million in the meantime.

The equity portion of the deal values the firm at 0.35 times annual revenues and 13 times annual earnings. The deal is of a highly strategic nature, with few cost synergies to be expected in the short term.

The deal is subject to shareholder approval, regulatory approval and other customary closing conditions. Most importantly will be to get approval from the Committee of Foreign Investments in the US given the sensitive trade relationships between the countries, and the importance of the business for the US economy. If all goes well both companies hope to close the deal in the second half of 2013.

A Sensitive Deal ...

Obviously such a mega-deal between a Chinese and American company, especially as Shuanghui is the acquiring party, is politically sensitive. This explains the rather large $275 million break-up fee of around $2 per share. It is important to note that this fee does not apply if the deal breaks down as a result of an unfavorable decision from the Committee on Foreign Investment in the US.

On Thursday, shares are still trading a full dollar below the offered value, indicating that some investors are still not sure about a swift process and a quick approval of the deal.

Some political backlash is to be expected as well, as undoubtedly politicians will raise the possibility that the company might import poor quality meat from China into the US.

As the companies already outlined, it is more likely that the US will export meat towards China given the rapidly increasing demand for protein. This will be good for the US agricultural sector and the trade balance, but could potentially lead to higher meat prices.

... Of A Highly Strategic Nature

I think the deal has a huge strategic nature. Smithfield's vertically integrated model as a low-price, high quality meat producer makes it an interesting target to combine with Shuanghui's operations, given the huge export opportunities.

First of all, the Chinese company can differentiate itself in its home market with branded premium products, and higher quality meat products. Shuanghui can use a boost to its reputation. In 2011, officials found that its meat lacked veterinary medicines. Earlier this year, thousands of unidentified pigs were floating in rivers near Shanghai, creating a lot of backlash as well.

The integrated model of Smithfield and its highly efficient operations will allow Shuanghui to increase the efficiency within China, as its extensive distribution network could boost production within the US.

Shareholders Should Be Happy

The premium which shareholders in Smithfield are receiving is very high, especially for a "boring" food company. The valuation levels are more than fair after the significant premium. The offer of $34 per share corresponds to all time highs set back in 2007.

Smithfield stresses that the board carefully considered the alternatives. This includes a scenario in which it could organically, or by means of a partnership, benefit from increased Chinese pork consumption. Yet the board concluded that this deal creates the most and instant value for shareholders.

For the daredevils among us, there remains a dollar premium left, or a potential of 3.3% at this moment. Note that shares could fall some $7 back toward $26 if a deal is somehow blocked. This seems exaggerated as well as the company still stands to receive a $2 break-up fee in such a scenario, and the company remains "in play."

For the retail guys out there, one should be happy to tender, or simply sell, their shares in the $33-$34 current price range.

Source: Smithfield Foods: Shareholders Receive A Fair Premium With A Politically-Sensitive Deal