Potential Take-out Candidate with Earning Upside
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On its earnings call on 9th August, Hillshire Brands (NYSE:HSH) only reported results down to the operating segment profit level. No 4Q12 results were given for corporate costs, discontinued operations, interest expense, tax rate or EPS. This absence of data was attributed to the ongoing investigation into accounting irregularities in the Brazilian operations of D.E. Master Blenders. The company expects this investigation to be completed by the end of August, such that Hillshire Brands can release its FY12 10-K. Although sales and EPS guidance was provided for FY13, quarterly results remain very hard to predict due to the absence of quarterly pro forma information at present. The company lowered its FY13 guidance to $1.40-$1.55 as compared to consensus estimates of $1.62.
We believe there is nothing wrong with lowering guidance in a tough environment like this. We believe Hillshire has the potential to beat what we see as conservative guidance for next year. We like the turnaround story, and we continue to see Hillshire as a legitimate potential takeout candidate. Moreover, Hillshire is not a commodity-oriented protein company. The company has good brands, so it can take pricing without either waiting for competitors to cut supply, or suffering excessive volume losses. We admit there are some near-term risks but we would rather be long the stock than the opposite. The following are some notable positives that make us bullish on the stock.
Investments are working
Innovation and marketing investments are going to be the key drivers of volume growth. 4Q results indicate that a lot of the investments are working. The Ball Park brand grew 4% and gained share behind the successful launch of a new pre-grilled hamburger. Jimmy Dean grew 12% behind the new line of "Meat Lovers" breakfast bowls. Hillshire lunchmeats also stabilized its market share declines.
Compelling margin expansion story
Despite the slow start, management maintained its guidance for 10% operating margins by FY15. The management has already identified $60 million of cost savings for FY13 and expects another $40 million to come. Moreover, the return to positive volume this fiscal year will improve gross margins through better capacity utilization.
Beatable FY13 Guidance
Investors are concerned about lowering FY13 guidance. However, we believe, the loss in management’s credibility could be regained quickly if they start beating and raising numbers. We believe there is good upside potential given FY13 as a whole is going to be a deflationary year for the company even if hog futures stay high in the second half.
Potential Take-out Candidate
It seems likely that several of the U.S. and Brazilian meat companies could be interested in acquiring Hillshire Brands. We believe, this will be a transformational deal with substantial cost synergies for whoever makes it.
- Substantial Cost synergies
Expected cost synergies from recent food and HPC acquisitions have averaged more than 8% of the target's sales over the past decade. Recently, Kraft Foods Inc (NASDAQ: KRFT) indicated that its cost synergies from both the Cadbury and Nabisco acquisitions came in higher than expected. Given $20 million in overhead reduction and potential for another $100 million in cost savings over the next three years, we believe the cost synergies from the acquisition of Hillshire Brands will amount to $300-400 million.
- An attractive sizeable downstream business
The downstream, branded end of the meat value chain is much more attractive than the upstream, more commoditized activity of meat-packing. This downstream segment is able to command consumer loyalty to brands especially in meats where the consumer is concerned about food safety and thus it offers higher margins than the upstream segment. Hillshire Brands and Oscar Mayer are the only two sizable downstream businesses in the U.S. meats category, and the Oscar Mayer business is still a part of Kraft North America Grocery business and is therefore not as easily available as a publicly-traded Hillshire Brands.
Hillshire Brands, with a market cap of $2.95 billion, is less than half the size of the others.
Of these companies, we suspect that Tyson Foods Inc (NYSE: TSN) and Hormel Foods Corp (NYSE: HRL) are the most obvious acquirers. Since Hillshire owns the strong Jimmy Dean brands, this acquisition will help Tyson to move from commodity lines to higher margin products. Tyson has the balance sheet strength to do it. Tyson only has 1.0x EBITDA in net debt. So, it would be able to finance a deal of this size almost entirely through debt financing without breaching 4.0x EBITDA in leverage. Strategically, Hormel is the most similar to Hillshire Brands with brands such as Hormel, Spam and Jennie-O Turkey Store and given its low leverage (-0.4x EBITDA in net debt), Hormel is likely to be interested in this acquisition.
Thus, we see the firm as a potential takeout candidate which will help the company attain a premium valuation. Although the company may face a stiffer cost headwind than initially expected, the firm is investing in itself in a way that will eventually lead to outsized EBITDA and EPS growth. Thus, despite lower than expected guidance we remain bullish on this stock.
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