Hillshire Brands (NYSE:HSH) recently entered into a definitive merger agreement with Tyson Foods (NYSE:TSN). The announcement came just a couple of days after Pinnacle Foods (NYSE:PF) terminated its merger agreement with Hillshire Brands. Announced on May 12, the $6.6 billion Hillshire – Pinnacle deal (including debt) was broadly criticized by analysts and investors alike. It also led to a fierce bidding war between two of the world’s largest meat processing companies that are riding high on surging meat prices for Hillshire Brands. 
Tyson Foods eventually won the bidding war against JBS-backed Pilgrim’s Pride (NASDAQ:PPC) as it offered to buy the maker of Jimmy Dean breakfast sausages for $63 per share in cash, beating Pilgrim’s Pride’s final offer by $8 per share. However, we believe that in the heat of the bidding war, Tyson Foods has significantly overpriced Hillshire Brands and could find it difficult to justify the valuation in the long run.
Formerly known as Sara Lee Corporation, Hillshire Brands began trading under the “HSH” symbol on June 29, 2012, following the spin-off of its international coffee and tea business. It sells a variety of packaged meat products including hot dogs, corn dogs, breakfast sausages, dinner sausages and deli meats, as well as a variety of frozen baked products. These products are sold through the retail channel to supermarkets, warehouse clubs and national chains in North America. The company also sells a variety of meat and bakery products to foodservice customers in North America.
We currently have a $41 price estimate for Hillshire Brands, which values it at around 11.5x our CY2014 adjusted EBITDA estimate for the company.
Springdale, Arkansas-based Tyson Foods is the world’s second largest meat processing company only behind Brazilian JBS S.A., which owns a majority (75%) stake in Pilgrim’s Pride. Tyson Foods derives 87% of its sales from highly commoditized beef, pork, and chicken products. The business is fraught with inherent problems such as volatile feed costs (mostly corn and soybeans) and negligible pricing power. Tyson Foods’ last twelve months operating margin stood at just around 4.5%, less than half of Hillshire Brands’. This is primarily because Hillshire Brands has significantly higher pricing power, which comes from the perceived value of its brands like Jimmy Dean and Ball Park. Therefore, Tyson Foods wants to increase the proportion of higher-margin sales in its portfolio and reduce its operational risk by acquiring Hillshire Brands. 
This year has been extremely good for meat processing companies so far because of higher pork, beef and chicken prices in the U.S. Beef prices are up because of the severe drought in the U.S. in 2012 that shrunk the nation’s cattle herd to its smallest size in over 60 years. On the other hand, pork prices are rising because of the growing spread of porcine epidemic diarrhea virus or PEDv, which has killed millions of piglets across 28 states since last spring. Rising red meat prices have also sent the demand for chicken, the cheaper meat, to its highest level in three years. Riding high on the surge in meat prices, two of the world’s largest meat processing companies, Tyson Foods and JBS-backed Pilgrim’s Pride, entered into a bidding war for Hillshire Brands. 
Tyson Foods eventually won the bidding war with an offer that valued Hillshire Brands’ equity at ~$8 billion, a 70% premium to its closing price on May 9, which was the last traded price just before Hillshire Brands announced its plans to acquire Pinnacle Foods on May 12. However, including the assumption of Hillshire Brands’ net outstanding long-term debt of $0.55 billion and the $163 million termination fee associated with the termination of Hillshire Brands’ merger agreement with Pinnacle Foods, the deal is valued at $8.71 billion. 
We believe that in the heat of the bidding war, Tyson Foods has overpriced Hillshire Brands. Even if the company is able to realize anticipated cost synergies from the deal, it could still find it difficult to justify the steep valuation in the long run. In a three-year period following the deal, Tyson Foods expects to realize annual cost savings of around $300 million from the Hillshire Brands’ acquisition. We can visualize the impact of this on Hillshire Brands’ valuation by adjusting our current forecast for the company’s Retail EBITDA Margin driver in our model to reach around 19% in the long run.
All else remaining constant, this would increase Hillshire Brands’ price estimate to around $57.5 per share, which is more than $5 per share below what Tyson Foods is paying for the company. Therefore, according to our estimates, Tyson Foods would also have to grow Hillshire Brands’ sales revenue at an average annual rate of at least 4.5% apart from realizing cost savings in order to justify the price it plans to pay for the company. Just to give some perspective, Hillshire Brands’ average annual sales revenue growth rate has been just around 0.7% for the past 3 years.Notes:
- Tyson Foods And Hillshire Brands Announce Definitive Merger Agreement, hillshirebrands.com [↩]
- Tyson Foods Investor Presentation, tyson.com [↩]
- Profit Tastes Like Chicken in Hunt for Cheaper U.S. Meat, bloomberg.com [↩]
- Tyson Foods Submits Unilaterally Binding Offer To Acquire Hillshire Brands For $8.55 Billion In Cash, tyson.com [↩]