Sara Lee - Will Spin-Off End The Conglomerate Discount?

| About: Hillshire Brands (HSH)
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Sara Lee (SLE) rose 7% on the last trading day of the week after announcing its intention to divest its subsidiary DE International, which is known for its coffee and tea operations. The decision was made as pressure on the board of the company grew after two failed takeover attempts.

Conglomerate discount
Sara Lee has failed to provide investors with satisfactory returns over the last decade. Shares, which traded $25 as recent as 2005, have seen lows of under $10 per share in 2009. Shares have recovered somewhat after current management has sold some divisions over the last couple of years.
In 2009 the company sold its global body care to Unilever (NYSE:UL) for $1.8 billion. Last year it sold the North American bakery unit for close to $1 billion to Mexican's Grupo Bimbo (OTCPK:GRBMF).
The announcement to spin-off the international coffee and tea operations is the final step in breaking up the company, which is only comprised out of its U.S.-based meat operations after completion of the spin-off.
A recent study from the Boston Consulting Group showed the average conglomerate discount for U.S. companies was 7% in 2009 as investors favor focus over conglomerate risk diversification. This final spin-off marks the end of Sara Lee as a conglomerate company.

DE Spin-off
Sara Lee's Douwe Egberts coffee has applied to get a listing on the NYSE in Amsterdam.
In 2011 the division reported $3.5 billion in revenue, which was up 10% on the year. The division was responsible for 41% of 2011's corporate revenue, which came in at $8.6 billion.
DE generated $452 million in operating income before corporate overhead. On a revenue basis some $70 million in corporate overhead costs could be attributed to the beverage business indicating that stand-alone operating income should be comfortably above $380 million per year.

Existing business
The remaining assets of Sara Lee are focused on the North American market. Brands like Hillshire Farm, Jimmy Dean, Ball Park and Sara Lee leave the company exclusively focused on meat products.
Sara Lee's U.S. operations, which are North American Retail and Food Service, generate $4.4 billion in revenue, which was up 2% compared with 2010. The division generated $385 million in operating income before corporate overhead.

Dismantled Sara Lee
This last spin-off will mark the completion of the divestiture strategy, which the company engaged in over the last years. In 2012 shareholders are still to receive a $3 special dividend from the proceeds of the sale of the bakery unit. Sara Lee, which will only be include North America's U.S. meat operations, will support a net debt position of $1.4 billion.

Investment thesis
Returns to Sara Lee's shareholders in the short term will be driven by the success of DE's IPO. Dutch bank Rabobank estimates the value of Douwe Egberts around EUR 4 billion.
At the moment the market values Sara Lee at $13 billion. If we subtract the $2 billion special dividend and a $5.5 billion valuation of DE's business this implies a valuation of $6.5 billion for Sara Lee's North American activities. At such a valuation the meat businesses are valued at 1.5 times revenue and 17 times operating income.

After Friday's jump in Sara Lee's stock investors have priced in the benefits of the spin-off. Unless the IPO of Douwe Egberts is going to raise significantly more than EUR 4 billion, shares are not interesting at this point in time, until a larger food producer is willing to go after the U.S. meat operations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.