Margins from Del Montes consumer-foods business are lower than its pet business

Margins from Del Monte's consumer-foods business are lower than its pet business

After weeks of speculation, the senior management at Del Monte Foods said yes last week to a takeover bid for the company.

On Thanksgiving Day (25 November), a private-equity consortium, led by KKR, secured agreement from Del Monte on an offer worth US$5.3bn, which according to estimates is the largest leveraged buy-out in the US this year.

The Del Monte brand is one of the most well-known in the food sector but, in the immediate aftermath of the deal being announced, analysts have suggested that KKR, Vestar Capital Partners and Centerview Partners have signed this hefty cheque to get their hands on Del Monte's pet products.

Aside from selling canned fruit and vegetables, Del Monte is one of the largest players in pet food in the US; alongside Mars and Nestle, the company is one of the three biggest branded suppliers of pet food in the country. Pet food is among the fastest-growing sectors in the FMCG space and Del Monte's most recent annual figures demonstrated its importance to the business.

In the year to 2 May, almost 70% of Del Monte's operating income came from pet products. The fact that pet products account for less than half of Del Monte's turnover emphasises the profits that are to be earned from selling dog biscuits and the like.

Speaking to analysts at the Barclays Back-to-School Conference in September, chairman and CEO Rick Wolford described pet products as an "earnings accelerator" for Del Monte. That side of the company's business, he said, enjoyed "strong margins" of "20%-plus". Del Monte's consumer-foods business, by contrast, was a "solid cash-flow generator" and earned "dependable" margins of 11%, Wolford said.

The Del Monte chief described the business thus: "This is a diversified portfolio that combines a very solid foundation in the consumer business with a higher margin, higher growth driver in our pet category."

As such, gaining a foothold in a fast-growing, high margin category was likely to have been a key consideration for KKR and its partners. However, where does Del Monte's consumer-foods business fit into KKR's pet project?

On 2 September, Del Monte reported a 1.1% fall in first-quarter net sales for the three months to 1 August. The company grew sales of its pet products by 4% but sales of its consumer foods fell 6%. Del Monte said its consumer-foods business had been hit by "reduced government bid sales" within its non-retail channel, while grocery sales had been affected by promotions by competitors.

Speaking to the Barclays Back-to-School Conference five days later, Wolford pointed to higher margins and operating income from its consumer-foods business.

He said the "softness" in the non-retail channel would not mean a change to the "underlying strengths and drivers" of the category. Wolford explained that Del Monte's grocery sales had been affected by consumers "destocking their pantries" and competitors ramping up promotions to reduce their higher inventories.

However, Wolford said the consumer-foods business would "continue to drive consistent growth" and pointed to plans for more innovation behind the "huge franchise" of the Del Monte brand.

The Del Monte consumer-foods business, then, is navigating through a changed landscape in its "non-retail" business and a fiercely competitive environment in grocery stores. Like other food manufacturers (Campbell Soup Co. being an example), Del Monte is pinning its hopes on innovation to revitalise grocery sales but, as we all know, innovation carries with it the significant risk of failure. Del Monte was due to issue its second-quarter results tomorrow but there are now no plans to report to the market following the announcement of a deal with KKR.

In any case, the prospective private-equity owners face a Del Monte consumer-foods business under pressure. Given the growth prospects for Del Monte's pet foods are stronger, could KKR et al, at some point down the line, look to spin off the consumer-foods unit?

Morningstar analyst Jeremy Cohen says it is a possibility but believes the new owners would be unlikely to want to offload a business that is still profitable and accounts for half Del Monte's turnover.

"Could the investor partners spin-off this unit? Sure, and there is recent precedent in the food manufacturing industry with Sara Lee spinning off its baking business, Cohen tells just-food.

"However, with the premium KKR and partners offered for the company, it might not want to do away with half the business, especially since the Del Monte name for canned vegetables and fruits are still ever-present in the marketplace - though, if they did, they could use proceeds to boost its pets business or venture elsewhere."

Cohen adds: "The consumer foods segment is still a profitable business for Del Monte (though operating margins fall below those of the average packaged food firm) and the firm holds either the number one or number two brands in roughly 80% of the categories it partakes in. So the firm was clearly doing something right, but it did not always translate on the bottom line because, the fact is, its food goods are commodity products where the difference is slight. The consortium is going to need to be creative in attacking private-label goods and even other branded goods to make sure its own brand does not deteriorate because Del Monte is well known in the food aisle."

The transaction is expected to close by the end of March. Between now and then, under the terms of the agreement, Del Monte's board is allowed to solicit for alternative offers. Moreover, since the proposed deal was announced, a slew of law firms have issued statements to say they are investigating the agreement and potential claims that Del Monte's board breached its fiduciary duty.

Nonetheless, Morningstar's Cohen argues the KKR-led offer was a "pretty good deal for shareholders".

"The stock was trading just south of $15 before rumours hit the street and now those investors are going to get $19 per share, a nice premium," Cohen says. "We think the business as a public entity would have been somewhat constrained by its leverage and would have needed organic growth to pave the way. With the purchase, the company's debt is assumed for by the investor group, giving the company greater financial flexibility."

Cohen acknowledges there could be a "downside" for long-term investors under private-equity ownership with the end of a dividend but he insists the "premium" on the KKR-led offer compensates for that.

"The downside for long-term investors is that the firm had more than doubled its dividend since early 2009 (however, the dividend was yielding less than 2.5% prior to the announcement) and may have continued to return higher quantities of capital to investors but we think the purchase premium more than makes up for that," Cohen explains.

For all the issues at Del Monte's consumer-foods division, KKR, Vestar and Centerview clearly believe the company is worth that premium and, while the pet business offers greater potential, the canned fruit and veg could provide a stable cash cow with which to invest.