I remember my high school Economics teacher always quoting an old adage "there's no such thing as a free lunch in this world." There may not be free lunches, but every once in a while, Mr. Market will present highly irrational market quotations on businesses for which astute investors can take advantage of. We believe this is the case with WH Group Limited ("WH Group" or the "Company") where Mr. Market is providing an opportunity to buy the parent for less than the market value of its subsidiary.
WH Group was founded in 1958. It is the largest pork company in the world with operations in China, US and Europe. It is fully integrated with operations in hog production, fresh pork and packaged pork products. WH Group is comprised of two principal subsidiaries. WH Group owns 73.4% of Henan Shuanghui Investment & Development Co.,Ltd. (“Shuanghui” and “SZSE:000895”), which is the largest pork company in China. Shuanghui is listed on the Shenzhen Stock Exchange in China. In 2013, WH Group acquired Smithfield Foods Inc. (“Smithfield”) for $4.7 B USD. Smithfield is the largest pork company in the US and the producer of a variety of pork products including “Lunchmeat”, a line of deli meat products in reseal-able plastic tubs. The lion’s share of WH Group’s revenues are derived from its packaged pork products and its fresh pork products.
Figure 1 - Smithfield Lunch Meat
Source: Company Data.
WH Group currently has a market capitalization of $13.1 B USD, which is comprised of its 100% shareholding of Smithfield and 73.4% shareholding of Shuanghui. The market capitalization of Shuanghui can be determined based on its share price on the Shenzhen Stock Exchange, which is $19.2 B USD. Therefore, WH Group's shareholding of 73.4% would be worth $14.1 B USD on a pro-rata basis, which is greater than the entire market capitalization of WH Group. This brings the question of whether we have uncovered an opportunity where the market has significantly mispriced WH Group. Is WH Group actually significantly undervalued based on the sum of its parts?
If the market did not misprice WH Group, we believe there are four possibilities that could explain why the market values WH Group at less than its subsidiary as discussed below. However, we believe none of the possibilities are plausible in explaining this mispricing. The possible explanations and our reasoning in refuting each of the explanations are as follows:
Based on the above analysis, if Shuanghui is indeed worth $19.2 B USD and WH Group is worth $13.1 B USD, simple arithmetic would imply that WH Group's Smithfield business is valued at negative $1.0 B USD. How can a business have a negative value? This can be the case if the Smithfield business actually represents a liability to WH Group.
However, we would argue that this is highly implausible. Based on our review of WH Group's December 31, 2019 financial statements and Shuanghui's March 31, 2020 financial statements, we estimate that WH Group has approximately $4 B USD of debt and $853.6 M of cash while Shuanghui has $632.2 M of debt and $752.8 M of cash. This would imply that Smithfield has net debt of approximately $3.3 B USD. If Smithfield has an equity value of negative $1.0 B USD, this would imply that it has an enterprise value of $2.3 B USD today. Based on CPI numbers provided by the U.S Bureau of Labor Statistics, a US dollar in 2013 is worth $1.11 today. If we convert the $2.3 B USD back into 2013 dollars to account for inflationary growth during this time period, Smithfield would be worth $2.1 B USD in 2013 dollars. WH Group acquired 100% of Smithfield for an equity value of $4.7 B USD and an enterprise value of $7.1 B USD in 2013. Since acquiring Smithfield, WH Group's US operations has become its largest business segment generating the majority of WH Group's revenues. Revenues from WH Group's US segment has remained relatively stable since, but operating income has almost doubled. Smithfield generated operating income of $496.2 M USD (as reported) in 2013, but WH Group's US segment generated $932 M USD (as reported) in operating income in 2019. Assuming no change in the enterprise value of Smithfield since 2013 and using WH Group's 2019 EBIT, this would imply an EV/EBIT multiple of 7.6x for Smithfield, which appears to be on the low end of comparable US public companies. Given that Smithfield has generated stable revenues, become more profitable and has a history of positive operating cash flows since its acquisition, this would suggest that even if WH Group grossly overpaid for Smithfield in 2013, it would be highly unlikely for Smithfield to have lost $5.0 B in enterprise value ($7.1 B - $2.1 B).
Figure 2 - WH Group 2019 Revenue Composition by Geography (as reported)
Source: Company Data.
Figure 3 - US Operating Results from 2013 to 2019 (as reported)
Source: Company Data.
Figure 4 - US Comparable Analysis
Sources: Company Data, Prevalence Value Capital estimates.
2. Shuanghui is significantly overvalued by the market.
Another possibility for this mispricing is that it is Shuanghui that is actually overvalued while WH Group is fairly valued. This could be due to the closely held shareholding in Shuanghui (73.4% owned by WH Group) resulting in demand for Shuanghui shares largely exceeding the amount available for the public float. However, we believe this is not the case. Based on our analysis of comparable public companies in China, Shuanghui appears to be undervalued, if not fairly valued. Shuanghui's EBITDA multiple is 16.4x, which appears to be on the low end of its peers.
Figure 5 - China Comparable Analysis
3. WH Group has liabilities equal to $1.0 B USD plus the value of its Smithfield business.
Another possibility that could explain the potential mispricing is that WH Group may have other liabilities unrelated to Shuanghui that brings down its value. The value of the liabilities would have to be equal to the equity value of Smithfield plus $1.0 B USD. However, we have based our analysis on the market capitalization of the respective companies, which should already incorporate on-balance sheet liabilities. Therefore, this explanation would only be plausible if WH Group has significant off-balance sheet liabilities. Based on our review of WH Group's annual report, management has indicated that it has no material contingent liabilities.
4. A significant portfolio discount is being applied to WH Group.
Portfolio discounts are typically assigned to companies with largely unrelated operations. The underlying theory is that investors can achieve diversification on their own and will therefore value companies with unrelated operations at a discount. However, we feel that this explanation is unlikely to explain the mispricing because the majority of WH Group's businesses are hog and pork product related. Both Smithfield and Shuanghui are in the pork business. If a portfolio discount were assigned, we believe it would be unwarranted and, in our opinion, lead to an undervaluation of WH Group.
This leaves us with the possibility that WH Group is actually mispriced by the market and significantly undervalued. Buying WH Group at its current share price would allow an investor to pick up Shuanghui shares at a lower price than buying Shuanghui shares directly on the Shenzhen Stock Exchange. In addition, they would get the Smithfield business essentially for free.
If WH Group is actually undervalued, the following options could be pursued by management to unlock the hidden value:
Based on our review, Shuanghui is relatively under levered as compared to its peers. The median Debt to Total Capitalization ratio in our selected group of Shuanghui's Chinese peers is 20.58% while its own ratio is only 3.2%. Given that WH Group has control of Shuanghui, it can direct Shuanghui to take on additional debt. The funds obtained from the debt financing can be used to pay dividends, which can be passed on to WH Group shareholders in the form of dividends or share repurchases.
An additional alternative to unlock value for shareholders is to take the parent company, WH Group, private. Given WH Group's leverage ratios relative to its peers, we believe the Company has room to take on additional debt for a privatization deal.
A third option to unlock value is for a potential spin-off of WH Group's Smithfield business. Given that the market does not appear to be properly assigning value to WH Group's Smithfield business, a spin-off of Smithfield could potentially highlight the value of Smithfield.
In addition to the apparent mispricing, we believe the following tailwinds are present for WH Group's business:
1. Domestic Supply Shortage
Pork is the most popular meat in China being a consumer staple during holiday season. The Chinese pork market is the largest domestic market in the world with 1.3 billion people and annual per capital consumption at 40 kg cwe. Due to the African Swine Fever outbreak in China, over 100 million pigs have been lost since August 2018. As a result, Chinese pork production is expected to be reduced by 20 million tons cwe in 2020. In addition, Chinese pork is much more expensive than imports. In October 2019, pork prices in China were double prices of US imports after tariffs at over $3/lbs. We believe this would suggest an increase in demand for pork imports in the short to medium term. Evidence of this can be seen in the trade negotiations between the US and China. In Phase 1 of the US-China trade deal, China agreed to purchase $200 B USD of goods from the US where 16% is comprised of pork. Pork has also been one of the commodities that have been subject to tariff reductions and exemptions from additional tariffs in the trade talks between US and China. WH Group, with its global operations in the US and Europe, is well positioned to take advantage of this price gap and demand.
2. Demographic Shift
The typical traditional Chinese household pork consumption pattern involves housewives going to local wet markets to purchase fresh pork meat to cook traditional recipes. However, as the country's population increasingly becomes more developed, this consumption pattern is beginning to change to more closely resemble those seen in Western countries. The next generation of families may see more than one income earner with more emphasis on convenience when it comes to food preparation. The purchase of meat products will likely shift from traditional wet markets to more modern retail channels. With its acquisition of Smithfield, we believe WH Group is uniquely positioned to benefit from the change in demographics in China.
3. Supply Chain Consolidation
The Chinese government has stated that part of its objective for pig production from 2016 to 2020 is to increase farm scale and efficiency as well as waste treatment and utilization in its National Pig Production Development Plan (2016-2020). They seek to increase the percentage of pig slaughtering volume of scale pig farms from 68% in 2014 to 75% by 2020. Scale pig farms are farms that have an annual slaughtering volume of 20,000+ heads. Increased regulations due to environmental and food safety concerns are resulting in closures of small and uncertified slaughterhouses. As the largest pork company in China and with a vertically integrated pork operation, Shuanghui is well positioned to benefit from this supply chain consolidation trend.
Figure 6 - Valuation Summary
Sources: Company Data, Prevalence Value Capital estimates.
In arriving at a valuation for WH Group, there are various useful indicators of value that could be used to derive its implied value. Based on Shuanghui's current market capitalization of $19.2 B USD, a 73.4% shareholding would have a value of $14.1 B USD. If we take the acquisition enterprise value of Smithfield in 2013 of $7.1 B USD and adjusted it for inflationary growth to bring it to 2020 dollars, Smithfield would have an enterprise value of $7.9 B USD. After deducting net debt of$3.2 B USD, Smithfield would have an implied equity value of $4.7 B USD today. This represents a total equity value of $18.8 B USD for WH Group or a per share value of approximately $9.85 HKD. This would imply an upside of approximately 43.5% without accounting for the improvement in Smithfield's operations over the years.
After taking into account of the improvement in Smithfield's operations, we have arrived at our target price of $12.15 HKD per share. Our target price is based on the following methodologies:
■ Multiples from Comparable Public Companies: LTM EV/EBITDA multiples ranging from 16.4x (Shuanghui's trading multiple) to 17.5x (25th percentile multiple from Chinese peers in Figure 6) for WH Group's Chinese operations; LTM EV / EBITDA of 8.8x (25th percentile multiple from US peers in Figure 7) for WH Group's US operations, LTM EV / EBITDA of 7.9x (25th percentile multiple from European peers in Figure 8) for WH Group's European operations; In selecting multiples to value WH Group's various geographic segments, we have been conservative and selected the 25th percentile multiple. Given WH Group's industry positioning, size and operating margins relative to peer companies, this range is a relatively conservative estimate of value. Based on our comparable public company analysis, we believe WH Group can be worth up to $13.36 HKD per share or an upside of 94.7%.
■ Capitalized Cash Flow Analysis: In performing our Capitalized Cash Flow analysis, we assumed a conservative outlook to see what WH Group would be worth under pessimistic growth assumptions and to avoid biases from projections. Our analysis assumes 2.5% annual growth. With a capitalization rate in the range of 2.3% to 2.9%, the implied share price is in the range of $11.00 - $13.31 HKD/share for a midpoint of $12.15 HKD/share. This represents an upside of approximately 77.9%. The implied EBITDA multiple at this price is approximately in the range of 11.2x to 11.4x.
Public Companies Comparable Analysis
Figure 7 - Chinese Comparable Analysis
Figure 8 - US Comparable Analysis
Figure 9 - Europe Comparable Analysis
Capitalized Cash Flow Analysis
We calculated Maintainable EBITDA as follows:
Figure 11 - WH Group Implied Equity Value
Sources: Company Data, Prevalence Value Capital estimates.
■ Discount Rate - Low: 4.8%
■ Discount Rate - High: 5.4%
■ Annual Growth Rate: 2.5%
Sources: Capital IQ, Duff & Phelps, Company Data, Country Risk Premiums from Professor Aswath Damodaran, Prevalence Value Capital estimates.
The following represent the risks to our investment thesis:
■ Coronavirus Plant Closures: As a result of the COVID-19 pandemic, WH Group's businesses have experienced interruptions. Smithfield's plants have been hotbeds for transmission of the COVID-19 virus and were subjected to plant closures. Should the pandemic result in additional plant closures to WH Group's Chinese and US operations, this could be detrimental to the fundamental value of the Company in the short term.
■ Hog Epidemic and Food Safety Issues: Epidemics related to the hog population as well as food safety issues can negatively affect the general demand for pork products.
■ US-China Trade War: The US China trade war may result in tariffs or other trade restrictions that may negatively affect pork imports to China.
■ Shuanghui Overvaluation: The underlying assumption to our investment thesis is that Shuanghui is undervalued, if not fairly valued. If Shuanghui is actually overvalued, our investment thesis would be incorrect.
■ Lack of Action to Exploit the Mispricing: If management or market participants do not take action to exploit this mispricing, the divergence between our calculated value of WH Group and its market value can persist.
In conclusion, we believe WH Group is an interesting case of market mispricing. At its current valuation, an acquirer would be able to obtain Shuanghui shares at a lower price than what it trades for on the Shenzhen Stock Exchange. In addition, they would also be able to obtain WH Group's Smithfield business for free essentially. We believe this mispricing represents a 77.9% upside. In order to exploit this mispricing, WH Group can consider leverage recapitalization, privatization or a spin-off of its US operations to unlock value to its shareholders.
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Disclosure: I am/we are long SEHK: 288. 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.