Hillshire is acquiring Pinnacle Food at premium prices in a deal which involves a lot of leverage, with most of the expected synergies expected to cover the anticipated cost synergies.
I would be very cautious, and believe that shares might have further room to fall in the short term as people work out the implications of the deal.
Hillshire To Acquire Pinnacle Foods
Hillshire announced that it has reached a definitive agreement to acquire Pinnacle Foods in a deal reported to have a value of $6.6 billion.
Investors in Pinnacle stand to receive $18 per share in cash and another 0.5 share in Hillshire for every share they currently own. The reported $6.6 billion deal tag, values Pinnacle at 9.6 times adjusted EBITDA, creating a company with leading position in frozen, refrigerated and other store grocery categories with a total revenues of $6.6 billion.
Blackstone and affiliates which combined own 51% of Pinnacle Foods' stock have already agreed to vote in favor of the deal. The deal is subject to shareholder and regulatory approval, expected to close in September of this year.
What's The Rationale?
Hillshire stresses a strategic rationale behind the deal, as the new food company will have greater scale, reach and capabilities which can result in margin expansion. The new combination with have ten #1 or #2 brands in its portfolio including names like Jimmy Dean, Hillshire Farm, Birds Eye, Ball Park, Duncan, Mrs. Butterworth's and Log Cabin, among others. The first three of these brands generate a billion or more in annual revenues.
Greater diversification should furthermore allow for stronger and more consistent cash flows in order to deliver shareholder value according to the company's press release.
While strategic benefits are nice, investors care a lot about potential cost savings and immediate accretion. By year three, Hillshire anticipates $140 million in annual cost synergies which could result in 15% earnings per share accretion.
The 9.6 times adjusted EBITDA multiple as reported in the headline report includes the realization of the Wish-Bone acquisition and the expected present value of $390 million related to Pinnacle's tax assets.
Pro Forma Calculations
Hillshire reported revenues of $3.93 billion over the past four quarters on which it net earned $220 million excluding one-time items. With some 123 million shares outstanding, the company is valued at $4.4 billion which excludes roughly $550 million in net debt.
Pinnacle Foods reported revenues of $2.64 billion over the past year, while reporting earnings of $89 million. The company has roughly 117 million shares outstanding, valuing the business at $4.0 billion, excluding $2.4 billion in net debt.
To finance the $6.6 billion deal, Hillshire will issue $2.1 billion worth of shares and take on $4.8 billion in new debt. The new company will therefore be valued at roughly $6.5 billion for its equity, while the net debt position will be a very sizable $5.3 billion.
The $2.5 billion incremental debt will undoubtedly cost $100 million orso per annum, which actually approaches the expected synergies of $140 million by year three. Note that this will result in a one-time charge of roughly $180 million, necessary to achieve the synergy estimates.
Combined, both companies will generate revenues of $6.6 billion on which it earns $310 million on a pro-forma basis. If we add to that $140 million in pre-tax cost synergies and subtract interest payment of let's say $100 million per annum, I foresee earnings of $350 million.
This back of the envelope calculation confirms the projection of 15% earnings per share growth accretion. With normalized earnings of $1.50 over the past year, accretion of $0.20-$0.25 per share is required projected. This results in additional earnings of $35 to $45 million based on roughly 180 million shares outstanding. This is in line with my expected accretion of $40 million based on financing rates of 4%.
The new business with $6.6 billion in annual revenues creates the 7th largest US food company according to the company's presentation, trailing Campbell Soup (NYSE:CPB), but coming in just ahead of J.M. Smucker (NYSE:SJM). Within the frozen segment, the new combination will become number three behind Nestle and ConAgra Foods (NYSE:CAG).
While all this marketing talk looks nice, I believe Hillshire is making a rather expensive deal, with the enterprise vale of Pinnacle outpacing that of its own. This is despite the fact that Pinnacle has inferior earnings and revenues. On top of that comes the fact that some 70% of expected synergies three years down the road will be made undone by additional interest payments.
The new company will have a roughly $6.5 billion equity valuation, valuing equity at 18-19 times annual earnings. This of course excludes the integration risks and the very sizable debt position incurred following the deal which involves quite some leverage. To counter the build up in leverage, Hillshire has frozen its share repurchase program, while its annual dividend of $0.70 per share is left in place.
As such I remain very wary and will stay away from investing in Hillshire as Monday's negative reaction to the deal was more than warranted.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in HSH over 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.