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November 3, 2015

TreeHouse’s acquisition of ConAgra private brands – 10 things to learn 

TreeHouse Foods confirmed what many suspected yesterday (2 November) when it announced a deal to acquire ConAgra's private brands business for US$2.7bn. The acquisition will almost double TreeHouse's size, creating an enlarged business with sales of around $7bn spanning more than 20 categories. Here are ten key points to take away from the deal.

TreeHouse Foods confirmed what many suspected yesterday (2 November) when it announced a deal to acquire ConAgra’s private brands business for US$2.7bn. The acquisition will almost double TreeHouse’s size, creating an enlarged business with sales of around $7bn spanning more than 20 categories. 

TreeHouse CEO Sam Reed suggested that the combined capabilities will allow the TreeHouse to “reach all classes of trade” with value-added own label products. However, in the near-term TreeHouse faces a number of challenges, not least of which will be turning around the performance of ConAgra’s private brands unit. 

Here are some key takeaways from the news. 

Private brands hit TreeHouse’s sweet spot

The ConAgra private brands business is clearly an excellent fit with TreeHouse’s existing operations. Key product categories within private brands are: bars, with sales of around $400m; cereal, with sales at $450m; condiments, which generate $250m; pasta sales that total $500m; $650m in retail bakery sales; and $1.3bn in snack sales. “You can see from the categories that we will be adding a lot of business in our key strength of shelf-stable food categories,” CFO Dennis Riordan observed. Riordan will take control of the private brands business as chief operating officer after the deal completes. 

TreeHouse becomes private label powerhouse 

The acquisition will make TreeHouse the largest player in the highly fragmented US private label market. According to Athlos Research analyst Jonathan Feeney, this leaves the group well-placed to expand further and capitalise on the potential of the market by acting as a consolidator in the field. “It’s no secret that the low-margin private label industry has long needed consolidation, and this merger of the two leading players makes TreeHouse the only feasible remaining consolidator of upwards of $10bn in potential center-store acquisitions,” he wrote in a note to investors. 

Financing structure keeps door open for M&A

Acquisitive TreeHouse has made a number of acquisitions in the North American private-label space in recent years, including Bay Valley Foods and Flagstone Foods. The ConAgra deal is TreeHouse’s largest move in the arena – but management indicated that the group has financed the acquisition in a way that keeps further M&A on the radar. The company will raise $1.8bn in new debt and $1bn via a private equity issue. Post acquisition, TreeHouse’s debt to EBITDA ratio will rise to around 4.5x, which is above the group’s current ratio of approximately 4.2x and above its historic average. However, Riordan said that the “much larger” TreeHouse will generate strong cashflow, enabling it to paydown debt at a rate of 0.6x per year. “We will remain active in the M&A market for additional bolt-on acquisitions should they arise,” he insisted.  

TreeHouse earnings will be hit next year

TreeHouse said that the acquisition will dampen its earnings outlook by 20-35 cents per share in fiscal 2016. This is the first time that TreeHouse has made an acquisition that will result in year one dilution. Riordan said one of the main reasons for the earnings hit was the cost associated with its transition services agreement with ConAgra. The agreement, which will run for two years, is necessary because the acquired unit is a ‘carve-out’ of ConAgra and the purchase price does not include many of the functional support capabilities you would expect to gain if acquiring a standalone business. The cost of the TSA will stand at around US$50m in the first year, Riordan revealed. Financing expense will also weigh. “These costs will result in the transaction being dilutive to our earnings in the near term…. But this is also a fundamentally transformative transaction that we believe will provide significant future earnings opportunities,” he commented. 

TreeHouse expects to turn a profit by year two

While the acquisition will dent profitability next year, the company expects to reverse this situation relatively quickly. Speaking during an analyst call, Riordan explained: “In the years following we expect synergies will ramp up while integration costs will wind down. Our estimate is that we return to an accretive earnings base in about six quarters and we will be accretive on a full-year basis in year two. Our current estimate is that we should see earnings accretion in year two of 55-70 cents… in year three we expect to see accretion increase to a range of $1.50-1.65.”

Synergies to come from packaging, logistics

TreeHouse based its earnings expectations on some “conservative” synergy assumptions, management revealed. TreeHouse is confident of delivering 100 basis points margin improvement by year three but implied that if the integration process goes well this could add up to 300 bps or more. The majority of cost synergies will be found from more effective packaging purchasing and lower transport costs, CEO Reed revealed. “The biggest part of the synergy is not raw materials, wheat and soya and such, it is really on the packaging side. The scale of the two companies together is going to give us additional leverage. We did a pretty good deep dive in terms of looking at what their purchasing prices were and what ours are and between the two of us we know what the sweet spot is. We will also have transportation synergies coming through, not just in shipments out but also the raw materials coming in. Even though your broad price may be consistent – soya bean oil is soya bean oil – the cost to get it from a processor to your plants comes down as you gain scale in your distribution network. Those will be the key areas that we focus on.”

Space for margin improvement

ConAgra’s private brands business currently operates an EBITDA margin of a little over 8%. This compares to TreeHouse’s group average of around 12%. Gross margins at ConAgra private brands stand at under 14%, “well below” TreeHouse’s gross margin of 20%. Riordan said that this means there is plenty of scope to bring ConAgra private brands in-line with TreeHouse’s margin profile. “Although the categories and product mix are different between private brands and TreeHouse we will still see great opportunities to improve private brands margins through purchasing synergies and implementation of the product line simplification actions that our foods business utilises with great success.”

Impact of scale on customers

While enhanced scale might afford TreeHouse some benefits when it comes to synergies, Reed said that it will have minimal implications on the group’s customer relationships. He commented: “With regard to the effective scale in the transaction of the business it is really quite muted because our customers manage their businesses by individual product category grouping or segment and the test there is for us to be able to provide a strategically sound and competitively appealing program that is a result of committing ourselves to steadfast partnerships to these brands. It will be largely business as usual not on a larger scale in a monolithic way but more activities in concert.” He did, however, suggest that the company would be able to leverage its scale to strengthen its “customer interface” and put more resource behind innovation and customer understanding. 

Re-building customer relationships key

According to TreeHouse’s assessment, rebuilding customer relationships and trust will be a crucial element as it works to stem the decline of the ConAgra private brands business. TreeHouse suggested that underinvestment and poor customer service had driven a wedge between private brands and the retailers the business serves.  “Therein lies the great challenge… to regain the trust of the customer-retailer base,” Reed noted. Management said that ConAgra is already seeing improvements in its customer service metrics thanks to changes made at private brands over the summer. “They are still not where they should be, where they want to be, or where customers expect them to be. But we can see that coming around,” Riordan suggested. TreeHouse plans to accelerate this process by putting more resource behind the private brands customer service function through the creation of “key customer stewards” that will have a direct line to the group’s largest accounts. 

Making private brands relevant 

TreeHouse also intends to invest in innovation to make the ConAgra private brands business relevant to consumer trends. TreeHouse suggested that here too the business had been hurt by under-investment as it competed for resource with ConAgra’s higher margin branded business. Reed explained: “The key for us is to go back to reinvesting in innovation and formulation for these [centre-store] categories. Part of the challenge that we have been able to take on in our business is reinventing, reinvigorating, these centre store categories to contemporise them and make them more on trend with cleaner labels, organic offerings and so on. My belief is that innovation investment has not taken place at the level it should have. It is always challenging to be private label in a branded world because the margin structure is inherently lower and in the fight for capital a low margin category generally loses. With us, we understand private label.”

BB&T Capital Markets analyst Brett Hundley said that these initiatives should result in a stronger partnership between the private label supplier and its retail customers. “We see a clear strategic vision for becoming the go-to partner in private label at a time where retail customers are increasingly looking to build their own brands and create consumer allegiance,” he noted. 

These initiatives have given TreeHouse confidence that ConAgra private brands will prove to be a business that has “hit the bottom” and can now be returned to growth. In a sector where product lifecycles average 9-12 months, TreeHouse believes it will start to turn positive in a year and “really take off” in two years.

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