Investors in TreeHouse Foods (NYSE:THS) are reacting with caution to the announced acquisition of Flagstone Foods which will give the company access to the fast growing private label healthy snacks industry.
The deal looks fine, given the expected accretion and the very strong acquisition track record. The increase in debt, the high valuation and the discrepancy between GAAP and non-GAAP earnings prevent me from making an investment at current levels.
TreeHouse Foods announced that it will acquire Flagstone Foods, a provider of private label healthy snacks. The company furthermore sells trail mixes, dried nuts, wholesome snacks and nuts. These items are more healthy than "traditional" snacks, being appealing to more health conscious consumers.
Under terms of the deal, TreeHouse will pay $860 million in cash which is subject to working capital adjustments. Flagstone was previously owned by Gryphon Investors, among others.
The company employs about 1,365 workers in two manufacturing facilities in the US. If all goes well the deal might close as soon as the third quarter of this year.
Strategic And Financial Rationale Behind The Deal
With the deal, TreeHouse will capitalize on one of the fastest growing trends within the food industry. Flagstone is a large manufacturer and distributor of healthy snacks, holding the #1 private label position in trail mix and dried fruits. According to TreeHouse the company will gain a strong platform in a fast growing $7.1 billion market for healthy snacks.
CEO Sam Reed is very enthusiastic about the deal commenting that "Flagstone Foods is ideally situated at the intersection of health and wellness, snacking and the perimeter of the store." The company has furthermore demonstrated the ability to broaden its product offering while expanding into new categories.
Reed was also impressed with the 24% average growth in sales per annum over the last three years, as well as the meaningful margin expansion seen over this time period. For the past fiscal year, Flagstone posted sales of $697 million.
The deal will impact 2014's earnings by $0.05 to $0.08 per share thanks to one-time charges related to the acquisition. Accretion is seen between $0.24 and $0.28 per share in the first full year after closing.
The deal values TreeHouse at 1.2 times annual sales while accretion is seen around $10 million per annum in actual dollar terms by next year. This comes after the dilutive effect of the issuance of new stock and profit impact from the issue of new debt.
This implies that Flagstone is quite profitable at the moment. On top of the $10 million expected accretion based on anticipated earnings accretion of $0.24 to $0.28 per share, TreeHouse will incur roughly $530 million in new debt which could result in incremental pre-tax interest expenses of about $25 million. This assumes TreeHouse will borrow at a rate of around 5% per annum, consistent with its current effective yield paid on debt.
Another $10 million in after-tax incremental earnings are required to avoid dilution on the new shares being issued to pay for Flagstone as will be discussed below.
As such I estimate that Flagstone earns about $35-$40 million per annum on an after-tax basis. At the midpoint of this calculation it would imply that TreeHouse paid a 23 times earnings multiple which is certainly no bargain.
Back in May, TreeHouse reported its first quarter results. The company holds just $24 million in cash and equivalents while total debt stood around $900 million. To finance the $860 million deal, TreeHouse will issue some $530 million in new debt, pushing its net debt position to a little over $1.4 billion.
Some $325 million will be financed through the issuance of new shares. At current prices, this implies that the diluted share base will increase by about 4 million shares to roughly 41 million shares.
On a trailing basis, TreeHouse reported revenues of $2.4 billion which included with the deal push revenues to $3.1 billion. Trailing earnings came in at $78 million. Given the expected accretion and the new outstanding shares, earnings are expected to improve towards a $100 million.
With roughly 40 million shares outstanding, the equity in TreeHouse will be valued at $3.2 billion after factoring in the dilution from the deal. This values equity in the business at approximately 1.0 times sales and roughly 30 times earnings.
Note that in the press release the company even anticipated forward sales of $3.5 billion thanks to a string of acquisitions in recent times. At the release of the first quarter outlook, TreeHouse guided for adjusted earnings of $3.50 to $3.60 per share this year which values the company at 22-23 times adjusted earnings. The discrepancy between GAAP and non-GAAP earnings is driven by debt extinguishment costs in recent times.
Given the aggressive growth plans, TreeHouse does not pay a dividend currently.
TreeHouse has embarked on an aggressive growth trajectory over the past decade. Back in 2004 sales totaled just $695 million, while pro-forma sales are seen around $3.5 billion at the moment, representing a five-fold increase in annual sales.
Earnings have grown rapidly as well while total dilution has been limited to about 20% over this time period. Growth is important as shareholders have not received any dividends over this time period.
Still investors have seen solid returns. Shares traded in a $20-$30 price range between 2005 and 2009 and have steadily moved upwards to current levels in their low $80s.
Investors reacted cautiously to the deal after shares were trading up to 5% higher in pre-market trading on Monday. Shares are trading flat or with very modest gains, as investors are digesting the impact of the deal at the start of the week.
This reserved reaction is kind of remarkable given the expected accretion and strong track record of TreeHouse in making deals. The company already acquired 6 companies in recent years including the $150 million deal to acquire Protenergy Natural Foods which closed just last month. These acquisitions have been very successful and have pushed up shares in recent times.
While FlagStone will add further diversification and growth prospects, the deal is no obvious bargain given the calculation above which implies that TreeHouse probably paid an earnings multiple in the low twenties.
This causes me to be reserved about the deal as well. While TreeHouse has an excellent track record, the latest deal pushes the debt load to relatively high levels. I am furthermore cautious given the premium valuation, especially in relation to GAAP earnings after shares have seen a very strong performance in recent times.
At levels around 20 times adjusted earnings, which would translate into a $70 price target based on the company's outlook, I would potentially reconsider my investment stance. I continue to keep a close eye on the gap between GAAP and non-GAAP earnings as I believe investors in general place too much emphasis on adjusted earnings. As long as most of the discrepancy is based in non-cash charges and are not stock-based compensation, I am willing to allow non-GAAP earnings as they don't result in actual cash outlays or create real dilution.
Investors should be aware that the run-up in debt limits the potential to make near term deals, unless the company will finance the majority of the purchase price in equity.
Given that I expect a period with a focus on execution and reduction of leverage, a consolidation in the share price might be anticipated as well in the medium term.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.