Hillshire's Pinnacle Buyout Should Pressure Shares And Credit Ratings

| About: Hillshire Brands (HSH)
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Hillshire Brands recently announced plans to buy Pinnacle Foods for $6.6 billion, merging two mid-cap food companies into one larger entity.

The deal is expected to have significant synergies, but also comes with significant debt. This debt and the overall price may be too much for what Hillshire will get.

After Hillshire completes the needed financing and issues probable equity, credit ratings agencies will likely downgrade HSH debt, possibly into junk status.

The Hillshire Brands Company (NYSE:HSH) announced on Monday, May 12, that it has agreed to acquire Pinnacle Foods Inc. (NYSE:PF) in a cash and stock deal valued at approximately $6.6 billion, including debt. Under the deal, Pinnacle shareholders would receive $18.00 in cash and 0.50 shares of Hillshire stock for each share. Pinnacle Foods shareholders will own around 33% of the combined company. Blackstone is Pinnacle Foods' largest shareholder, owing 51% of the company.

Pinnacle's brands include Birds Eye frozen vegetables, Duncan Hines cake mixes, Log Cabin syrups, Vlasic pickles and Wish-Bone salad dressing, among others. Hillshire's brands are largely meat-related, including its namesake Hillshire Farm brand, Ball Park hot dogs and Jimmy Dean sausages.

The combined company's scale, and distribution should result in cost synergies that may improve the profit margins of either on its own. Hillshire expects the deal to be immediately accretive to earnings, with $140 million in cost synergies to be realized over a three-year period, largely through supply chain integration. Additionally, Hillshire expects the resulting product mix's increased diversification to be beneficial, by reducing the company's sensitivity to meat pricing.

Hillshire Brands intends to fund the transaction with $2.1 billion of equity and through raising $4.8 billion in debt. The company will suspend its share repurchase program to focus on paying down this debt, and plans on maintaining its annual dividend payout of 70 cents per share. Hillshire received a term loan from Goldman Sachs (NYSE:GS), but it is likely that the company will attempt to refinance that loan by issuing long-term debt.

Hillshire's credit rating is BBB, or a mere two levels above junk, and that could be lowered because of the significant increase in debt that will result from the deal. The company last reported holding about $1 billion in debt, so adding $4.8 billion to it is a substantial change. Standard & Poor's rating agency indicated that the debt would increase HSH's leverage to nearly 5x EBITDA, and also that it expects HSH to issue $2.1 billion of equity. The Pinnacle buyout includes around $2.5 billion in debt at an S&P rating of B+, or four levels below investment grade.

It is likely that Hillshire entered the deal already knowing that it would probably lower HSH's credit rating to below investment grade. Hillshire's plan to delay share repurchasing for at least two years in order to pay down debt acknowledges the importance placed on deleveraging. Nonetheless, this $4.8 billion in debt is significant, and it should be noted that with such funding, and at current market pricing, Hillshire could have bought all its outstanding shares at nearly a 10% premium.

Another issue to note is that Hillshire previously appeared to be a probable takeover target, and that this deal will make any such deal far more difficult, expensive and unlikely. Pinnacle and Hillshire are relatively small players in a business that is dominated by bigger players like Kraft (KRFT) and ConAgra (NYSE:CAG). The combined Hillshire and Pinnacle would make a buyout by their larger competitors more expensive and less likely. Alternatively, such competitors may look to acquire a smaller entity such as B&G Foods (NYSE:BGS). In the meanwhile, to the extent that some investors were holding HSH in anticipation of a buyout, those investors may now move elsewhere.

There can be no doubt that Pinnacle's business makes strategic sense for Hillshire by expanding its suite of supermarket brands and diversifying its sensitivity to any singe commodity cost or scarcity, as well as dietary fads. The real question, though, is whether this is too high of a price to be paid. It does indeed seem quite high, and it appears unlikely that the planned two-year suspension of HSH's share repurchase plan will pay down a sufficient level of debt to where the company will be able to both reinstate the plan and increase the dividend. Alternatively, reinstating the share repurchase plan or raising the dividend too quickly would probably be even further credit negative.

All of this indicates that there Hillshire shares will likely suffer increased near-term share pressure, including possible Wall Street revisions that will follow probable credit rating reductions, once the forthcoming financing and equity issuance is finalized. As a result, interested investors may want to wait for some of this impending negativity to arrive before buying, as better pricing appears likely.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.