A Chinese Perspective On The Shuanghui And Smithfield Deal

| About: Smithfield Foods (SFD)


On May 29, 2013, Smithfield Foods Inc. (NYSE:SFD), one of the biggest pork producers in the world, agreed to be bought by Shuanghui International Holding Ltd. (from here on, "Shuanghui International"), the majority holder in China's biggest pork producer, for a total of $7.1 billion including debt, a 31% premium over the pre-announcement stock price.

Because this is so far the largest buyout deal of an American company by a Chinese related entity, the news generated a lot of buzz among the public in both the United States and China.

Who is Shuanghui International?

As I was driving my car and NPR radio was reporting the deal, even the reputable NPR reporters mispronounced the name of the purchasing entity: "Shuanghui International" became "Shanghai International". Even more convoluted, as pointed out by Peter Fuhrman in Seeking Alpha, the purchasing entity (Shuanghui International) is not technically a Chinese company, but a majority shareholder of the largest meat producer in mainland China, Henan Shuanghui Investment & Development Co. Ltd. (from here on, "Henan Shuanghui").

Shuanghui International is a shell company based in Cayman Islands. Its majority owners are China-focused PE firms CDH Investments and Heroic Zone Investments Ltd. (a shell company controlled primarily by Henan Shuanghui's senior management) along with some smaller shareholders ranging from Goldman Sachs, Singapore's Temasek Holdings and New Horizon Fund.

Henan Shuanghui itself is listed on the Shenzhen Stock Exchange in mainland China with a market cap of $160 billion and P/E around 25.8.

Why does Shuanghui International want to buy Smithfield Foods?

We think the reasons behind the deal are very different for these two entities: Shuanghui International and Henan Shuanghui. For Shuanghui International, its biggest shareholder, CDH Investments, has been invested in the company for over seven years, which is considered to be a very long time for Chinese-focus PE firms. Same is also true for other investors: Goldman Sachs started to invest in Shuanghui International in 2006 and Singapore's Temasek Holdings in 2009.

The deal with Smithfield Foods could pave the way for the biggest IPO in pork industry in Hong Kong Stock Exchange, thus allowing the shareholders from Shuanghui International to exit from Henan Shuanghui. For comparison, current P/E for Smithfield Foods is 16.80 while P/E for Henan Shuanghui is 25.8. A combined IPO of those two pork giants could further increase the value of Shuanghui International shareholders.

For Henan Shuanghui, the actual entity of the pork producer, its primary purpose could be focused on the brand reputation and technology from Smithfield Foods. In recent years, food safety has become a major concern for Chinese consumers. There are numerous "creative" but outrageous food scandals in various fields. Some high visibility scandals in the last two years include: melamine-contaminated baby formula, antibiotic contaminated chicken meat, and most recently clenbuterol contaminated pork.

There is huge potential in the safe and prestigious high-end food market among the middle to upper class in China. For example, Hong Kong recently had to impose a purchase limit of two cans of baby formula for anyone from mainland China due to the mistrust of domestically produced baby formula in mainland China.

With the recent scandals in the Chinese food industry, major food companies want to be associated with prestigious American food companies for an image refresh. The deal could develop into a huge PR asset and a competitive advantage for Henan Shuanghui.

More importantly, pork is the most consumed meat in China and the pork supply is considered to be a national security issue. There is no high end pork brand in China and Chinese consumers have grown tired of the numerous scandals from domestic producers. After merging with Smithfield Foods, Henan Shuanghui could leverage Smithfield Foods' brands, technologies and supplies to build the high-end pork market in China.

Also the management claims that the merger will open the door for more pork imports to China due to rising demand.

There is a wider perspective

There is a wider perspective: China has over $3,440 billion in foreign reserves and most of this is in dollar-related assets. There is strong demand to diversify some of the dollar reserves into hard assets.

In the long run, more and more of those large buyout deals could be expected inside the United States. Furthermore, due to the sensitivity in national security in areas like technology and energy, the most likely deals in the foreseeable future will be focused on low barrier technologies or non-core asset area, such as the pork produce business.

There is also a wave of reverse leverage buyout deals (LBO) of Chinese companies from the American capital market (NYSE or NASDAQ). Most recently, the largest ever reverse buyout deal, Focus Media (NASDAQ:FMCN), was completed last month. Another Chinese pork producer Zhongpin Inc. (NASDAQ:HOGS) will close the LBO deal at the end of this month. There are abundant of capitals in Chinese market looking for good assets, both foreign and domestic business. Another potential LBO target is New Oriental Education & Technology Inc. (NYSE:EDU), which is the largest private educational service in China. We will write a separate article to discuss the perspective on New Oriental .

How to play for the profit

As of today, the close price of Smithfield Foods is $32.82, representing a 3.6% spread to the buyout price at $34.

Investors see the biggest risk coming from the approval process of the United States Committee on Foreign Investment as funding for the deal has already been secured from Chinese banks.

There is a 30 day go-shopping window and after that the breakup fee will be increased from $75 million to $175 million.

We think the deal will most likely go through with some further concessions from Shuanghui International. We suggest a put spread between $32 (Jan 2014) and $26 (Jan 2014) or $28 (Jan 2014). This will provide some downside protection with a decent profit. We expect the 3.6% spread to narrow once the United States Committee on Foreign Investment is done with the review process. The committee might come up with certain restrictions but is expected to approve the deal.

Disclosure: I am long SFD, HOGS, EDU.

Business relationship disclosure: Business relationship disclosure: The article has been written by Crouching Tiger's two co-founders. Crouching Tiger is not receiving compensation for it (other than from Seeking Alpha). Crouching Tiger has no business relationship with any company whose stock is mentioned in this article.