The news this morning (17 November) that Irish ready-made meals supplier Greencore and Fox’s biscuits group Northern Foods are to merge has been applauded by the City.

News of the deal sent Northern Foods’ share price soaring 24.31% to GBP56.25 (US$89.42) at 13.14 GMT – a major improvement on the 45.50p value it slid to when it announced a raft of job cuts only last month. Greencore shares surged 30%.

The merge, which will create new business Essenta, is expected to lead to annual cost savings of GBP40m within three years, both firms said today, as well as increase their bargaining power with supermarkets.

The enlarged business will have strong market positions in sandwiches and ready meals, sales of which grew 9.8% and 7.7%, respectively, in the UK last year, the companies said. Great news for both companies who have faced a difficult couple of years navigating their way through the recession.

The future direction of Northern Foods, in particular, was looking questionable only last month when the Goodfella’s pizza maker confirmed job cuts at top management level as part of its restructuring programme.

The company has experienced a somewhat problematic year to date. In August, Northern sold loss-making Dalepak Frozen Foods for GBP6.4m (US$10.2m). And a month earlier, the group booked a 1.6% decrease in like-for-like sales for its fiscal first quarter, on the back of a 25% drop in revenues from frozen food, a division that has continued to be a problem for the firm.

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For Greencore, 2008/2009 proved to be a challenging time, as the prepared foods market suffered and shoppers increasingly looked to save money by cooking from scratch.

The world’s largest sandwich maker has no doubt faced some of the toughest conditions it has seen in the convenience sector, but it has successfully navigated its way out of the downturn, despite selling its malt business in February to pay down debt and disposing of its bottled water division in November 2009 and its Dutch convenience foods business in July this year.

Nonetheless, the new entity will provide both firms with a complementary customer base from both businesses. Greencore has significant sales with Asda, Sainsbury’s and Morrisons, while Northern Foods’ key customer is Marks & Spencer.

“A more diverse customer base and greater scale ought to provide Essenta relatively more leverage when dealing with the retailers going forward,” Evolution Securities analyst Alex Sloane said.

However, he added that there might be some risk that those customers where there is an overlap, ie Tesco, seek to “rebalance” their supplier base to avoid overexposure to the enlarged group.

Panmure Gordon analyst Graham Jones, echoed this sentiment, despite applauding the proposal and raising his recommendation to ‘Buy’.

“The proposal would take capacity out of the chilled convenience food market where suppliers have struggled to get supermarket customers to pay them enough to be able to make a sensible economic return,” Jones said. “The key question will be whether the new group, Essenta Foods, will lose any significant volume from retailers ‘rebalancing’ their supply.”

He added that the key area of overlap between the two will be in chilled convenience, an area where Jones says Northern Foods has been more “disciplined” in the past few years at trying to deliver “a sensible economic return on assets”, but one where supermarkets have seemed “reluctant to pay the price to give a fair economic return to their suppliers”, and where Northern has closed a number of factories as a result.

“The key question here is how much ‘rebalancing’ the supermarkets will do if they feel overexposed to the new combination. Hopefully this will have been realistically estimated by the two boards,” Jones said.

The proposed merger is expected to complete in the second quarter of 2011, subject to regulatory and shareholder approval, and it is hoped that longer term there could be “significant” revenue synergies as the group leverages Greencore’s direct to store distribution platform in the UK and brands are stretched across a broader set of categories.

Indeed, the creation of Essenta is expected to lead to annual cost savings of GBP40m within three years of the deal completing. Around GBP5m of that is expected to be achieved from lower tax and financing fees that can be achieved through “combination and a more secure balance sheet”, Sloane said.

“We suspect the prudent forecasts reflect the fact major retail customers are likely to seek their ‘share’ of savings,” he added.

Essenta will be created by giving 0.4479 of new Greencore shares to every shareholder of Northern Foods. Upon completion of the merger, shareholders of both firms will each hold 50% of the equity in the new group. Essenta will have its head office in Dublin and be tax domiciled in Ireland, but have its primary list in London and report its results in sterling with a March year end.

At first glance, Jones says the merger looks like “a deal with a lot of logic”, while Sloane said the deal makes “strong strategic sense”.

“With Northern only modestly rated we raise our recommendation from ‘Hold’ to ‘Buy’,” Jones said. “We place our price target under review until we have had time to consider the proposals in more detail.”

Sloane added: “[The deal is] creating a group with a diverse blue chip customer base with which it ought to have relatively more leverage. We estimate the dividend yield of the new group could be circa 5% (post the share price rallies of both companies) excluding the synergies.

“Assuming the synergies are fully retained the yield could be closer to 8% and given more certainty on pensions, lower finance and cash tax charges now looks much more sustainable. As a result we upgrade to ‘neutral’ with a price target of 55p,” he added.

Click here to view the full announcement of the deal.