Is Hillshire Worth the Meaty Price?

 Hillshire Brands  announced on June 1 that Pilgrim's Pride has increased its offer, proposing to acquire Hillshire for $55 per share in cash (enterprise value of $7.4 billion). We have increased Hillshire's fair value estimate to $55 per share as a result of the updated offer, and we will adjust our fair value accordingly in response to any future bids.

After years of operating inside a diversified consumer product firm, Hillshire Brands (the domestic meat business of the former Sara Lee) became an independent entity in 2012. We think the added focus inherent in operating as a meat-centric food business should ultimately serve the company and its shareholders well. Despite fierce competition, we think Hillshire's portfolio of branded items, and its Jimmy Dean brand in particular, should help Hillshire differentiate its products enough to generate solid returns on capital over time.

Pilgrim's Pride's updated offer represents an approximate 14.5 times enterprise value to 2014 EBITDA multiple (including the $163 million break-up fee that would be paid to Pinnacle), a 10% premium over  Tyson's (TSN) offer of $50 per share, and a 72% premium over our stand-alone $32 fair value. Hillshire's management has provided limited commentary on the bids so far, but the firm announced that its board of directors will provide information to, and enter separate discussions with, both Pilgrim and Tyson to discuss their offers. From our view, Hillshire's shareholders are already receiving an extremely rich price for their shares, so there is a very high probability that Hillshire will eventually terminate the transaction with Pinnacle to accept one of the acquisition bids.

Hillshire's shares are already trading at a 5% premium to Pilgrim's offer, with the expectation that Tyson will return with a counteroffer. Tyson's management has provided very positive commentary on the potential combination, and has said that it would be willing to issue equity to get the deal done. However, while we agree that Hillshire would be an attractive complementary piece in Tyson's meat portfolio and see room to identify cost synergies, we think it will be extremely difficult for either Tyson or Pilgrim's Pride to generate enough synergies to make the deal attractive at these prices. In fact, if Tyson participates in another round of the bidding war, we think there is a strong likelihood that the firm would overpay, and this could negatively affect Tyson's $30 fair value estimate.

Hillshire Focuses on Value and Complementary Products
Value, of which price is an important component, remains among the top purchase considerations for products in many of Hillshire's categories. To deliver such value, the company has focused on the sale of convenient products, most notably in the breakfast category with its Jimmy Dean products. When combined with the facts that Hillshire's breakfast and lunch products typically have higher turnover and that private-label share is relatively low in many of Hillshire's categories, we think the firm should be able to generate profit margins that are more similar to those of other consumer packaged goods companies than of meat processing firms. However, some of Hillshire's smaller brands have faced increasing competition, and this could continue in the future. A category that remains particularly competitive is lunch meat, while the firm's State Fair brand has also faced elevated competition. It could be very challenging for Hillshire to charge a significant premium to peers for these products.

In May 2014, Hillshire announced its intention to acquire Pinnacle Foods for $6.6 billion. Through this acquisition, Hillshire will add the Birds Eye, Duncan Hines, Vlasic, and Wish-Bone brands to its portfolio. While the acquisition of Pinnacle does not directly increase sales from meat-based products, it could prove complementary to Hillshire's existing portfolio. Hillshire will nearly double frozen food sales to $3 billion, giving it a broad presence across grocery categories. In addition, Hillshire can strategically market complementary products, such as convenient meat-based products and frozen vegetables, and diversify its commodity exposure.

Fair Value Estimate of $55 per Share Is Dependent on Current Offers
Our fair value estimate of $55 per share for Hillshire Brands is tied to Pilgrim's Pride's increased offer, which countered Tyson's $50 bid. Including Pinnacle Foods' $163 million breakup fee, the transaction values Hillshire Brands at over 14.5 times our projected 2014 enterprise value/EBITDA ratio. From our view, Hillshire's shareholders would receive an extremely rich price for their shares in either bid, so there is a very high probability that Hillshire will eventually terminate the transaction with Pinnacle to accept one of the acquisition bids. Tyson could return with a counteroffer, but we believe it will be very difficult for either bidder to generate enough synergies at these prices to make the deal attractive. The $55 offer already looks very rich, in our view, so it is uncertain how much higher either bidder would be willing to go.

If the acquisition offers are rejected, however, we still estimate Hillshire Brands' fair value at $32 per share, which incorporates the firm's pending acquisition of Pinnacle Foods. Our fair value implies a fiscal 2014 forward price/adjusted earnings ratio of 18 times, an enterprise value/EBITDA of 9, and a free cash flow yield of about 6%. Hillshire Brands is aiming for 4%-5% long-term revenue growth after 2015, driven by 2%-3% volume growth. We forecast organic revenue to increase in the low- to mid-single-digit range during the next five years, which reflects our expectation that operating conditions will remain challenging over the near term but improve over the medium to long term. Acquiring Pinnacle Foods would increase revenue by more than 50%, and we also see additional opportunities for Hillshire to cross-sell products in the future.

The company has also targeted 10% operating margins on its base business by 2015, hoping to leverage increased sales and the benefit from cost reduction programs. Pinnacle Foods also boasts higher operating margins than Hillshire, and the firm expects to generate $140 million in expected run-rate synergies by the third year after the acquisition closes. We forecast gross margins to average around 30% over the next five years, slightly above the firm's three-year historical average, reflecting favorable mix and the benefits of cost-cutting programs, and we forecast operating margins to reach nearly 15% over the next five years (in line with management's pro forma guidance for the combined company).  ​

Household-Name Brands Make for a Moat, but Competition Looms
We believe Hillshire Brands' competitive position warrants a narrow economic moat. Hillshire Brands has a portfolio of well-known brands in categories with fairly low private-label penetration, which gives the firm some clout with retailers looking to stock shelves with traffic-driving and profitable brands. We also think the company's new focus on brand investment is a step in the right direction and should allow Hillshire to generate solid returns on capital over time. 

Domestic consumers remain laser-focused on value, and consolidation has shifted power in the favor of retailers, but we believe Hillshire Brands possesses the brand equity to withstand these pressures and drive store traffic. We do not award Hillshire Brands a wide economic moat, however, primarily because we don't think it possesses the same degree of pricing power commanded by other wide-moat CPG firms. In addition, while the firm's distribution network and its research and development and MAP spending create high barriers for new entrants to overcome, Hillshire's large rivals have comparable scale and distribution networks.

We believe Hillshire Brands' moat trend is negative. Although we think Hillshire's portfolio of category leaders should help the firm generate solid returns over time, we don't believe it possesses the same degree of pricing power that other moaty CPG firms command, primarily because the firm faces significant competition from other branded players, as well as private labels, particularly in the lunch meat category. Retailers are demanding increasing support when price increases are proposed by packaged food companies, and if Hillshire attempts to raise prices faster than its competitors, it could face pushback in light of the number of substitute products on the market, potentially putting it at risk of losing shelf space at key distribution outlets or negatively affecting volume if consumers refuse to accept higher prices. The acquisition of Pinnacle Foods will add another $1 billion brand (Birds Eye) and several other market-leading brands to Hillshire's portfolio, all of which have the potential to improve Hillshire's negotiating position with a more consolidated customer base; while this is not enough to shift our trend rating at present, we intend to keep a close on eye on developments going forward.

New Management Is Committed to Bolstering Its Brands
A number of new faces joined Hillshire Brands upon the split-up of the former Sara Lee. Sean Connolly, named CEO in January 2012, worked in various roles at Campbell Soup and Procter & Gamble before joining Hillshire Brands. We think his previous tenure at leading branded consumer goods firms gives him ample experience to draw upon when working to strengthen Hillshire's brand portfolio, and his strategy thus far appears conducive to supporting the firm's moat. CFO Maria Henry joined the firm in July 2011 after working at both public and private equity firms. We think the new management group is appropriately focused on investing behind the firm's brands to drive growth and profitability, which has been lacking in the past, and we expect Hillshire will generate excess returns on invested capital. We award the firm a Standard stewardship rating as a result of these prudent capital-allocation decisions. Despite the optimistic future outlined by management, we still note that executing large-scale changes will take time. If up-front investments fail to drive sales growth higher, profit growth and shareholder returns could suffer.

For fiscal 2013, Connolly's base salary was set at $900,000 with a target bonus of 100% of base salary (150% in maximum). In addition, $1.8 million in performance stock options and stock units will be granted from fiscal 2012 to 2014, while another $3 million of long-term incentives (with the form of grant yet to be determined) will be awarded to Connolly from 2013 to 2015. We like that a majority of Connolly's compensation comes from incentive-based programs. However, Hillshire Brands' board is evaluating compensation programs for its new management team, and we plan to update our commentary as the details of these programs are made public.