I wrote in August how MDLZ appeared overvalued with little room for upside, and how Ackman's stake posed a long term fundamental threat. Since then, the company's performance has been flat, plus $.68 in dividends. Amid record highs for stocks, I believe the company's bid for Hershey represents a peak in the stock and the company is poised for downside.
The Deal Itself
MDLZ bid $107 a share, below Friday's closing price of $109. Hershey's board quickly rejected the offer, which was not a great surprise given their history of spurning takeover offers. However, there may be more to develop in this story, as Hershey may be vying for a higher offer price. Analysts at Stifel believe the final offer price could range from $120-$130 a share.
First, the Pros
The deal sounds great on paper. MDLZ, an international powerhouse of snack foods, would combine its operations with Hershey, a domestic giant in the industry. The Cadbury brand, now owned by two different companies across continents, would be reunited under one umbrella. Cost synergies in management and distribution would drive returns in the combined new entity, while the Hershey's name would encompass the worldwide company.
Unfortunately, just because something makes sense from a business perspective, it doesn't always make sense from a cost perspective.
It's not exactly the IRS I'm concerned about, but you get the point.
To start off, the actual target of the deal is a little ridiculous. Hershey, though a logical target, has a history of spurning takeover offers (See: Wrigley, 2002). The Hershey Charitable Trust, though only owning 21% of shares outstanding, has 81% of the share voting power. Given the obvious importance of the company to the Trust, especially following the wake of both the 2002 attempted takeover and the initial rejection of the MDLZ offer, it seems unlikely the Board of Hershey would approve a takeover.
Additionally, one must consider the political implications of a deal. The Pennsylvania Attorney General's office is required to approve any deal, and can shut it down if they believe the deal would threaten the long-term viability of the company. Don't forget, the AG's office is politically incentivized to keep Hershey a Pennsylvania company. While MDLZ has promised to move their headquarters to Hershey, PA and rebrand themselves as Hershey, a MDLZ could threaten Hershey's status as a PA company.
On the physical purchasing end of the deal, MDLZ's bankers advised them to do a mix of half stock, half cash. That's the equivalent of: Your company is overvalued, but we also don't mind paying record low interest rates on half the acquisition price. Keep in mind, a company's equity is as much currency as pure cash is. When a company is overvalued, bankers advise using equity to compensate acquisition target because the market values it more than cash, aka, it would be more accretive to the deal. I will elaborate on this further in the short thesis later in the article.
Half cash speaks to the controlling shareholder: Hershey would be unlikely to consider any deal that wouldn't yield it enough cash to start up some sort of investment fund. However, it also points to a key roadblock for Hershey: The Charitable Trust already has a sweet gig lined up. They own 21% of a company, meaning they could theoretically take 1/5 of all profits/cash flows. However, they completely control the company by a long shot (81% voting power). No deal could match that. Indeed, if this deal were to go through, the Hershey Trust would just end up a wealthy minority stakeholder in some far larger entity. It sacrifices control of its brand and company. And the job of those on the Charitable Trust's Board goes from being the "managers of the managers" of a major corporation to just being a steward of capital. Personally speaking, I'd rather have the corporate control.
And coincidentally, the bankers advising this deal would collect a legendary tombstone for their team/firm, and collect a nice bonus on top of that.
On the physical purchasing end of the deal, MDLZ's bankers advised them to do a mix of half stock, half cash. That's the equivalent of: Your company is overvalued, but we also don't mind paying record low interest rates on half the acquisition price. Keep in mind, a company's equity is as much currency as pure cash is. When a company is overvalued, bankers advise using equity to compensate acquisition target because the market values it more than cash, aka, it would be more accretive to the deal. A bundle of cash
From a cost perspective, the deal makes even less sense. Here's what Hershey currently trades for:
TTM P/E: 26.54x
2016 P/E: 25.73x
2017 P/E: 23.82x
2018 P/E: 22.18x
The company rejected a takeover offer at these levels, which are incredibly generous given the limited growth potential of the company. If MDLZ wants to make another offer, it's going to have to pay up even more, which further calls into question how accretive the deal can be for MDLZ shareholders.
No Room to Run for Mondelez
While I have previously highlighted my short thesis in MDLZ in this article, I believe the risks to the company are still significant and offer little upside to the stock. The move to acquire Hershey proves that management is out of ideas on how to drive returns.
There seems to be little room to cut operating expenses after a serious push in 2013 by activist Nelson Peltz, an experienced cost-cutter. This is much to the chagrin of Bill Ackman, another activist who seems to be a little late to the game on MDLZ.
The company has already employed zero-based budgeting, which is one of the most aggressive approaches to cost-cutting. Instead of using a prior year budget to determine the next year's budget, the company starts from scratch every year to determine what is and isn't necessary.
Further gains in the stock are unlikely to be propelled by decreasing operating expenses, especially if the company is still trying to push growth overseas. If anything, Ackman's involvement and war to cut costs are a distraction for management.
The snack food industry is not known for its staggering growth figures, though management has done an excellent job pushing growth internationally. This stable revenue source is one of the reasons a company like MDLZ can trade for such high multiples, but is a double-edged sword. At a certain point, investors are no longer willing to pay such a hefty premium for the "safety" of MDLZ.
MDLZ is known for its operating prowess overseas. Though the company has seen some strong growth internationally, it has also suffered from a strong increase in the dollar. A continuously strong dollar poses a macro threat for MDLZ, as they will recognize less benefit from international sales with a higher dollar.
The Hershey Deal: Bringing It All Together
Imagine this: MDLZ wants to know how to boost returns, so they call up their friendly local investment banker. But what is a banker to do if there are few growth opportunities and little room for cost cutting? One word: Synergies.
The deal is filled with potential synergies, from sales synergies to distribution synergies to management synergies. But while all of them sound great, it proves one thing: There really aren't other ways for management to boost returns. A mega-merger doesn't come because a company is uncorking the champagne on a great quarter, it comes because it needs to do something drastic to prove its shareholders it can still outperform the market.
If the deal goes through, investors are betting that the amount of synergies is worth the hefty premium being paid. If not, investors are stuck with a company that has few outlets for EPS growth.
Disclosure: I/we 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.