Investors had been agitating for Smithfield (NYSE:SFD) management to “do something” to increase the value of their shares, and their wishes were answered in spades on Wednesday. The largest pork producer in the U.S. announced that it had accepted a bid to be acquired by China's Shanghui International in an all-cash deal that awards a pretty hefty multiple to this protein producer.
The Deal To Be...
If the deal goes through as announced, Smithfield investors will receive $34 in cash for each share they own. That works out to a 31% premium relative to Tuesday's close and just barely less than the all-time high for the stock.
Shanghui is not getting this company for a song. With an enterprise value of $7.1 billion for the deal, Smithfield is selling for almost 9x trailing EBITDA, 7x normalized EBITDA, and about 8.5x sell-side estimates for 2014 EBITDA. This deal also represents a premium of nearly 2x to tangible book value – not bad for a business that almost never produced returns on invested capital above 5%.
SEE: Analyzing An Acquisition Announcement
...Or Not To Be?
Investors will note that, at least as of midday Wednesday, the share of Smithfield were trading almost 5% below the announced deal price. While it's normal for there to be some arbitrage opportunity in deals, this a wider margin than normal and I believe this reflects some potential obstacles to closing the deal.
For starters, Smithfield did not mention whether its largest disgruntled shareholder (Continental Grain) was on board with this deal. Given that Continental Grain has proposed various break-up and restructuring scenarios that assigned a $40 value to Smithfield, they may agitate for an even higher price.
Regulatory clearance could also be a problem. Shanghui is a large Hong Kong-based holding company with majority ownership in the largest meat processor in China. Even so, it's almost always controversial when a large foreign (especially Chinese) firm proposes to acquire a leading American company (and Smithfield accounts for about 30% of U.S. pork production).
Making matters worse is China's dodgy history in food safety. From bird flu to melamine-contaminated milk to the antibiotics-laced chickens that have crushed Yum! Brands (NYSE:YUM) in China to recent reports of Chinese farms dumping diseased pigs in rivers, China has a bad history here. Now, it's well worth noting that it's not as though Shanghui is going to box up all of Smithfield's pigs and move them to China – Smithfield will still operate in the U.S. and under U.S. laws (and inspections). Still, public outrage often has only a tenuous tie to facts and I don't think its unreasonable to think that there could be an outcry against this deal on the basis that lax management standards would eventually threaten the safety of the U.S. pork supply.
SEE: Evaluating A Company’s Management
Will This Deal Really Change Much?
I would be surprised if a rival bidder stepped into the picture. Brazilian companies like JBS and Brasil Foods (NYSE:BRFS) have spoken of wanting to expand their U.S. exposure, but JBS is already quite familiar with Smithfield (having bought Smithfield's beef business and operating Swift, the third-largest pork processor in the U.S.) and Brasil Foods has been concentrating on building its branded business (where Smithfield isn't that strong). Likewise, the rich valuation of the deal as is would make it hard to imagine a rival strategic bidder going higher and still earning a worthwhile return on the deal.
All told, I don't expect this deal to change much for the industry. Investors may argue that companies like Tyson (NYSE:TSN) and Seaboard (AMEX:SEB) (and maybe others like Hormel (NYSE:HRL) and Hillshire (NYSE:HSH)) merit higher multiples on the basis of this deal, but I think that will prove difficult to support once the bull market in food stocks subsides.
On the other hand, this could be an incremental positive for restaurant operators in China like Yum! Brands and McDonald's (NYSE:MCD). Both operators are much more oriented towards chicken in their menus (despite pork being a very popular protein in China), but moves to further localize the menu could bring more pork onto the menu and the ability to source Smithfield pork through Shanghui could reduce the risks of relying on local suppliers and the attendant contamination issues.
SEE: Top 6 Factors That Drive Investment In China
The Bottom Line
Smithfield wanted a bigger presence in China, and it looks like that's certainly going to happen now. Assuming the deal goes through unmodified, I'm admittedly surprised that Shanghui would pay so much for this asset, particularly given the historical returns of the business. That said, pork consumption is growing rapidly in China and having access to a high-quality source of supply could make Smithfield more valuable to this buyer than others. While I'm bullish on the prospects for protein and branded food consumption growth in emerging markets, this deal reflects how expensive many of these companies are getting.
At the time of writing, Stephen D. Simpson owned shares of Brasil Foods.
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