Companies that make large acquisitions often bear great risks for their shareholders. Destruction of shareholder value often results from various acquisition related issues, such as overpaying, over leverage, poor management execution, acquiring legal liabilities, dilution, overly optimistic synergy assumptions and departures from core management competency.
Diamond Foods’ (NASDAQ:DMND) acquisition of the Pringles unit of Procter & Gamble (NYSE:PG) poses serious risk for current shareholders, from all of the aforementioned potential acquisition-related issues.
When Diamond agreed to acquire Pringles, P&G agreed to sell the unit, after some hard bargaining, for $1.5 billion in Diamond equity, consisting of 29.1 million shares at $52, plus $850 million in cash, for a total consideration of $2.35 billion. At Diamond’s current share price around $70, Diamond is giving up $2.05 billion in equity and approximately $850 million in cash ($700 million in cash plus a $150 million restructuring charge), for a total cost of $3.05 billion. Since the deal was struck six months ago, the cost of Pringles to current Diamond shareholders has gone up about 25%.
According to P&G, Pringles has earned about $150 million in income on $1.45 billion in revenue last year. However, that net income excludes the cost of debt interest, which could cost Diamond about $50 million a year on the $850 million in debt taken on for the deal. This interest expense would reduce Pringles income by a third, to $100 million, and would give Pringles a P/E of about 22 when consolidated into Diamond’s earnings. Pringles has shown a 2% top-line annual growth rate for the last three years of data disclosed by P&G.
Often when companies take over other companies, they acquire existing stand-alone entities, including working capital and clear historical performance. Pringles’ financials have been “carved out” of P&G’s and reflect assumptions and allocations (evaluations of the deal involve assumptions of assumptions). Diamond Foods will receive no cash and at least $850 million in debt. Diamond currently has only $6 million in cash and marketable securities on its balance sheet, and post acquisition, this company will have one of the highest debt to cash ratios in the Russell 2000. Without taking on more debt for working capital, Diamond will have about $1.4 billion in total debt.
Also problematic is that Pringles earns well over half its income abroad, a non-issue for P&G, but Diamond will likely struggle with cash balances without repatriating some cash. This repatriation would lead to a heavy tax burden unless the tax law changes.
Overly Optimistic Synergy Assumptions
Diamond management believes that Pringles’ distribution channels, including sales in 140 countries, will open opportunities to market Diamond’s entire product portfolio in a greatly expanded reach. They could very well be correct in their assessment, and Diamond’s complementary products could get a material sales boost from this strategy. However, I would point out that P&G is a marketing and distribution machine, and I would imagine that all strategies to expand Pringles have been explored and exhausted by P&G. And if marketing and distributing complimentary products was easily accomplished in a synergistic way, P&G would likely be an acquirer.
This doesn’t imply that it is not possible for management to execute this strategy effectively, but it is clearly not a no-brainer and fraught with execution risks.
Management Execution Challenges
For starters, Diamond management must create a new system for the distribution and sale of Pringles products to replace the P&G direct sales force, one of the most successful direct sales forces in business history.
Management will also need to integrate information, purchasing, accounting, finance, sales, billing, payroll and regulatory compliance systems. It is possible that Diamond may not be able to successfully or cost-effectively integrate Pringles.
In fact, P&G states that Pringles has been able to receive benefits and services from P&G and has benefited from P&G’s financial strength and extensive business relationships. P&G also states that it sold Pringles because of the relative sales, earnings and cash flow of the Pringles business relative to P&G’s other businesses; and the effect of the divestiture on its future earnings per share.
Diamond will issue an additional 1.32 shares for each share outstanding. P&G shareholders will own 57% of the future company. The dilution from the mass issuance of 29 million shares, to likely weak P&G shareholder hands, will lead to near-term Diamond investor confusion. The once thinly traded shares, often subject to short squeezes due to a high short ratio, will be much more actively traded with arbitrageurs playing the deal.
Legal Liability Risks
Two issues present with this deal, albeit unlikely.
- The process of producing Pringles creates a naturally forming compound called acrylamide. Acrylamide is a potential carcinogen, and future research on this compound could pose consumer and regulatory issues.
- P&G’s tax lawyers believe that the sale of Pringles is tax-free. However, Diamond must fulfill certain obligations over the next two years to ensure the tax-free status. Yet the IRS may still rule that P&G’s tax analysis was incorrect and impose taxes, penalties and interest on P&G. In this case, Diamond must indemnify P&G of this liability, which would pose a material obligation for Diamond.
Aside from the obvious short-term risks to Diamond Foods’ shareholders from 29.1 million shares entering the market in potentially weak P&G shareholder hands, longer-term risks to Diamond shareholder value abound. Diamond’s management in the past has shown an ability to execute acquisitions successfully. However, in the acquisition of Pringles, Diamond is paying an inflated price, in a leveraged bet, on optimistic assumptions for synergies.
In addition, for those investors thinking Diamond will make for an attractive takeover target: The completion of the Pringles merger has a prohibition from Diamond being acquired for a full two years. Diamond is also limited, during the two-year period, in its ability to pursue strategic transactions, equity or convertible debt financings, or other transactions that may maximize shareholder value.
Disclosure: I am long DMND puts.