Smithfield Foods Inc. (NYSE: SFD) has formally and legally agreed to marry Hong Kong-based Shuanghui International. Interestingly, however, there still were two other serious suitors for Smithfield when the matched pair came to terms and the indications are that they may not have been given sufficient time to make their strongest case. That's not all, a matchmaker of sorts -- a Mr. Smith, clearly not one to be confused with cupid -- has walked onto the stage, hoping to find a better match for the betrothed, certainly one bearing more valuable gifts. As things now stand, stockholders in Smithfield have the proverbial bird in hand, but may have the option of trading that in for the two in the bush once bagged. In other words, although nearing the end game, this drama still offers investors the rare combination of a relatively attractive arbitrage opportunity and the potential of perhaps much more. In this article, we detail the merger agreement that's already been signed and assess the free call option as represented by the possibility of a superior offer. We think the opportunity looks particularly attractive in the prevailing low interest rate, high stock-market volatility environment.
The Merger Agreement
On May 29th, Virginia-based Smithfield Foods, the world's biggest pork processor and hog farmer, announced that it had entered into a definitive merger agreement to be acquired by Shuanghui, China's top pork producer, in a transaction valued at $7.1 billion, including debt. This equates to $34 a share in cash, which represents a premium of approximately 31% over the closing price on May 28th, the last trading day prior to the deal's announcement. Consummation of the merger is subject to shareholder approval, antitrust clearance, and other customary closing conditions. It's also subject to a CFIUS (Committee on Foreign Investments in the United States) review. The agreement does not contain a financing condition and the two marriage partners expect to close before 2013 concludes. Smithfield is entitled to a termination penalty payment of $275 million if Shuanghui decides to walk away. On the other hand, it has to pay Shuanghui a penalty of either $75 million or $175 million, depending on the exact reason (detailed below), if it decides to terminate the deal.
Door Not Shut on the Other Two Suitors
According to the proxy statement filed by Smithfield on June 18th, it was still in serious negotiations with two other suitors -- described as Company A and Company B -- in late May when Shuanghui announced its intention to abandon the pursuit of the Virginia-based meat products concern if a merger agreement were not executed by May 28th. Interpreting this as a firm deadline, and in view of its assessment that Company A and B, identified by various media sources as Charoen Pokphand Foods Pcl of Thailand and JBS SA of Brazil, were proceeding in "deliberate fashion," with B indicating that it couldn't execute and announce a transaction until at least June 13th, Smithfield did, in fact, sign the merger agreement with Shuanghui on May 28, 2013.
That said, pursuant to the terms of a limited "go-shop" provision in the agreement, Smithfield and its representatives "may initiate, solicit and encourage any alternative acquisition proposals from two third parties who provided acquisition proposals to the Company or its representatives during a specified period prior to the date of the Merger Agreement (the "Pre-Existing Bidders"), provide nonpublic information to such Pre-Existing Bidders and participate in discussions and negotiations with such Pre-Existing Bidders regarding alternative acquisition proposals." Moreover, prior to approval of the merger proposal by Smithfield shareholders, the company may, upon terms and subject to the conditions set forth in the merger agreement, provide information to and engage in discussions or negotiations with a third party (other than the pre-existing bidders) if that party has made a bona fide written acquisition proposal that has not been solicited after the date of the merger agreement and the Smithfield board determines that such acquisition proposal would reasonably be expected to constitute, result in, or lead to, a superior proposal and that failure to take such action would be inconsistent with the board fiduciary duties. The termination penalty stemming from a deal with the pre-existing bidders would be $75 million, whereas a deal with another third party would cost $175 million.
The agreement gives Shuanghui as many as seven business days to counter a superior proposal, and its chairman Wan Long said on May 31st that it may raise its offer to meet other bids, if necessary.
A Matchmaker Enters the Mix
On June 17th, Starboard Value LP, a New York-based investment advisor that has a history of pushing for changes at companies in which it has an equity interest, sent a long letter to Smithfield Foods announcing a roughly 5.7% stake and expressing its opinion that the $34 takeover price vastly undervalued the company's worth. The letter outlined in considerable detail a sum-of-the-parts assessment that suggested that Smithfield's three major businesses -- hog production, international, and pork -- were conservatively worth between $9 billion and $10.8 billion after tax, or $44 to $55 per share, representing a 29%-62% premium to the Shuanghui deal. Significantly, too, in a television appearance that morning, Jeffrey Smith, Starboard's managing member, indicated that he essentially wanted to serve as an unofficial facilitator of a sum-of-the-parts transaction. Mr. Smith further noted that he had already had conversations with several interested parties. The activist shareholder took yet another step forward on July 12th, announcing that it had hired two financial advisers, Moelis & Co. and BDA Advisors Inc., to explore alternative deals.
Earlier this year, in March, another shareholder, Continental Grain Co., had pressed Smithfield to break up the company, stating that the three businesses would achieve a stock price of $40. Around that time, six Wall Street analysts estimated a post-breakup value of $26 to $48 a share.
An Arbitrage Opportunity…
Shuanghui International Holdings has already secured binding financial commitments for the transaction, with the New York branch of the Bank of China providing a $4 billion term loan and Morgan Stanley (MS), which is advising the buyer on the takeover, providing $3.9 billion. Funding will not be a problem. The two intended partners notified the Federal Trade Commission and the Antitrust Division of the Department of Justice of the proposed merger in early June and the applicable waiting period expired at midnight on July 11, 2013. Antitrust considerations should not be an issue either. A little more challenging, perhaps, could be the requisite CFIUS (the Committee on Foreign Investment in the United States) review, which is focused on assessing takeovers by foreign entities for national security implications.
Under most circumstances, the acquisition of a meat products company would probably barely raise an eyebrow, but the potential largest takeover of a U.S. company by a Chinese buyer will undoubtedly trigger some opposition in the nation's capital. Indeed, some senators have already raised the specter of food safety as a national security concern. Politicians will probably take this opportunity to rail and grandstand about China's uneven playing field with respect to protecting its companies against foreign takeovers, but the government is unlikely to block the deal. A joint voluntary notice was filed with CFIUS on June 18th, and a review and investigation (if necessary) shouldn't take nearly the maximum of 75 days. Even assuming the deal closes around year-end, investors stand to earn a low-risk 3.3% (from July 12th's closing price of $32.91) over the next roughly five months, which annualizes to about 7.9%. A closing in September or October seems likelier, though.
…With Additional Upside Potential
Smithfield Foods' stock price reflects Wall Street's obvious skepticism that a superior takeover price will materialize, with the shares trading little changed from before Mr. Smith joined the party. The price did rise in reaction to the revelation of an activist investor but subsequently receded, probably reflecting both the skepticism and the protectionist noise emanating from Washington, D.C. The stock also reflects the expectation that the deal now on the table will be consummated, trading very close to the buyout price. That said, the existence of the two "pre-existing bidders," the allowances made in the merger agreement, and the possibilities afforded by Starboard Value's presence inject some speculative appeal to SFD. Important, too, the implied call option comes at virtually no cost.
The simplest alternative would be the purchase of Smithfield stock, with 100 shares at Friday's closing price of $32.91 costing $3,291. Assuming the deal with Shuanghui closes, the investor will earn a relatively low-risk 3.3%, which annualizes to 13.2% if payment is received within three months and 7.9% if received around year's end. An investor looking to make a smaller capital outlay might consider buying a call option. Options would generate a very handsome return if a superior offer materialized in relatively short order. The holder could also exercise his option to buy the stock if it were determined that additional time is necessary. The modest time premium in SFD options makes this alternative reasonably attractive. Moreover, the small capital outlay dramatically limits the downside risk, which may be particularly important in the current environment.
Arbitrage plays are never completely risk free, underscoring the old maxim that there is no such thing as a free lunch; there is always the risk that the Smithfield/Shuanghui pact unravels even without a superior alternative. The termination penalty of $275 million, or about $2 a share, which is in escrow, would provide a cushion, though. That said, we think the probability of Smithfield still being an independent concern at year-end is very low. All in all, we fully expect investors in the stock to earn a minimum of 3.3%, and perhaps considerably more.