Conagra Brands finally reached a deal this week to acquire Pinnacle Foods, creating a leading player in the US frozen food category with combined sales of US$11bn. Yet the market reaction was less than positive, with some analysts questioning whether the merger puts too much faith in demand for frozen foods holding up in the longer term and the inherent risk should it not. Simon Harvey takes a look.
Stock investors hit the sell button on Wednesday (27 June) after Conagra Brands secured a long-awaited deal to acquire Pinnacle Foods in fear the latest acquisition has taken the company a step too far down the frozen food aisle.
Shares in Illinois-based Conagra Brands closed down more than 7% on the New York Stock Exchange on Wednesday after the owner of the Healthy Choice, Slim Jim and Orville Redenbacher’s brands said it had paid US$10.9bn to acquire fellow US food manufacturer Pinnacle Foods, whose portfolio includes Earth Balance and Hawaiian Kettle Style Potato Chips.
While Conagra’s annual sales far outstrip those of Pinnacle, the latter generates double the revenues of its peer from its frozen food category, which is dominated by the Birds Eye brand. But the deal raised eyebrows among some industry watchers amid concerns the merger places too much emphasis on that segment and exposes the company to the ever-changing whims of consumers and shifts in eating habits.
And for a company that has largely rested its strategy on acquisitions and margin expansion under the three-year tutelage of chief executive Sean Connolly, the merger brings into question the risks of taking on too many brands that do not always fit into the high-growth, high-demand category. And then there is the small factor of competition.
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However, that said, Conagra outlined the merger with Pinnacle as being a “complementary portfolio of iconic brands” that will give the newly-combined entity an “enhanced ability to capitalise on trends in frozen foods”. The acquisition will “serve as a catalyst to accelerate value creation for shareholders”.
Sonia Vora, an equity analyst at Chicago-based Morningstar, said in a research note: “From a strategic perspective, we can appreciate the rationale behind the deal, which will make Conagra the number two player in the domestic frozen food category.
“While we contend Pinnacle lacks a competitive edge on a standalone business, given its presence in categories that face limited differentiation (like frozen vegetables), heightened competition, and/or unfavourable category dynamics, many of these challenges have already been incorporated into our view of Conagra’s prospects (particularly within its refrigerated and frozen business).”
Still, the Pinnacle tie-up comes at a price in terms of leverage. Conagra will inherit $2.7bn in outstanding debt, which it intends to re-finance, adding to its own $3.8bn.
With that, the debt-to-EBITDA ratio will rise to 5X, although Conagra is targeting to bring that down to 3.5X by the end of fiscal 2021.
Alexia Howard, a US food analyst with New York-based securities firm Sanford Bernstein, has some reservations about the deal, particularly with regard to the heightened leverage and uncertainty about the prospects for continued growth in the frozen food category.
“Overall, we believe the acquisition makes strategic sense, although remain cautious on the growth prospects for the frozen category,” Howard wrote in a research note. “While the frozen category has been supported by product innovation led by Conagra and Pinnacle recently, it is unclear if there is enough demand to support the growth of frozen foods over the long term.
“This [debt-to-leverage ratio] makes Conagra one of the most leveraged companies within our US food coverage and could potentially pose risks to the business if the growth in the frozen category starts to slow down.”
Conagra has become a brand-focused business since November 2015, when what was then ConAgra Foods sold its private-label assets to US group TreeHouse Foods. CEO Connolly has since built up the portfolio with a number of acquisitions and indicated on a conference call with investors and analysts on Wednesday that more could be on the cards. But at the same time, he pointed to the likelihood for some unit disposals too.
The company is in the midst of a five-year plan focused on cost structure and “adding on-trend brands through acquisitions”, the CEO said.
Morningstar’s Vora added: “We think the firm will keep an eye out for opportunities to divest underperforming assets as it continues to skew its portfolio towards more differentiated, higher-margin offerings.”
Connolly said he has done some “heavy lifting” over the past three years with a focus on the long-term goal of margin expansion within a “value-over-volume strategy”.
In March, Conagra snapped up US business Thanasi Foods, which produces meat- and seed-based snacks under the Duke’s and Bigs brands. And in December, it bought Sandwich Bros., a maker of frozen breakfast and flatbread sandwiches, on the heels of the September purchase of Angie’s Artisan Treats, the owner of Angie’s Boomchickapop popcorn.
“After three years of transformative work to create a pure-play, branded food company, we are well-positioned to accelerate the next wave of change,” Connolly said in a statement announcing the latest deal. “The addition of Pinnacle Foods’ leading brands in the attractive frozen foods and snacks categories will create a tremendous opportunity for us to further leverage our proven innovation approach, brand-building capabilities, and deep customer relationships.”
With the Conagra-Pinnacle transaction not expected to clear until later in the year, and still subject to shareholder and regulatory approvals, it remains to be seen what impact the merger will have on financial performance.
Conagra generated net sales of $7.83bn in the year to 27 May, a 1.4% increase from a year earlier, but down 0.2% on an organic basis. Meanwhile, Pinnacle booked annual sales of $3.14bn through to 31 December, a rise of just 0.5%.
By category, sales from Conagra’s refrigerated and frozen division rose 7.9% last year to $691m, well below the $1.3bn generated by Pinnacle’s frozen segment, which represented a 0.4% drop from a year earlier.
The company said the $10.9bn purchase price reflects an adjusted EBITDA multiple of 15.8x, based on Pinnacle Foods’ estimated fiscal year 2018 results excluding synergies, and 12.1x adjusted EBITDA including run-rate cost synergies.
Bernstein’s Howard added: “The acquisition was widely anticipated and Conagra seems to have paid a fair price, especially in light of the elevated multiples paid by packaged food companies recently.
“While we don’t expect major anti-trust issues here, the merger agreement includes a $300m provision for divestments, which may mean something needs to be given up. And if the closing process drags on for several months, it begs the question of whether Pinnacle will be able to maintain its current sales momentum given the uncertainty hanging over employees as they await the change of ownership.”
Given the amount of cash generated from Pinnacle’s US frozen division vis-a-vis that of Conagra and the latter’s desire to acquire the business, one has to wonder why the Birds Eye owner found itself under pressure to sell the division from activist investor Jana Partners, which acquired a 9% stake in April.
And Pinnacle shareholders will still own approximately 16% of the combined business. Further, Morningstar’s analyst Vora said the company plans to raise its valuation for Pinnacle to about $66 from $57 to “reflect the discounted value of the offer”, assuming the deal is closed at the end of the year.
Pinnacle CEO Mark Clouse said the “transaction provides Pinnacle Foods shareholders with substantial and immediate value, as well as the opportunity to participate in the significant upside potential of the combined company. The portfolios and capabilities of both enterprises are impressive and complementary.”
In terms of financing, Conagra secured a $9bn bridge loan from affiliates of Goldman Sachs Group. The purchase price is expected to be financed with $3bn of Conagra’s equity issued to Pinnacle Foods shareholders and $7.9bn in cash consideration funded with $7.3bn of transaction debt and approximately $600m of incremental cash proceeds from a “public equity offering and/or divestitures”.
Conagra said the deal will lead to $215m in annual run-rate cost synergies by fiscal 2022, while the company is expected to incur a one-time charge of around $355m, inclusive of expected capital expenditures of about $150m.
It intends to maintain its quarterly dividend at the current annual rate of $0.85 a share in the current fiscal year, while Pinnacle will continue to pay its quarterly dividend of $1.30 until the transaction is completed.
Morningstar’s Vora concluded: “This valuation strikes us as reasonable given our more favourable top-line outlook for Pinnacle (with net sales averaging 2%-3% growth the next few years, versus slightly above 1% for Conagra) and its modestly higher adjusted operating margin (standing at 18% in its latest fiscal year, versus 16% for Conagra).
“While Conagra’s shares eroded around 7% [closed at $35.43 on Wednesday], we don’t anticipate a material revision to our $34 fair value estimate and now view the stock as fairly valued.”