Spotting an Awful Deal
The red flags that point to capital destruction
“I’m not single; I’m independently committed to personal growth.”
-George Costanza
Recent news of JM Smucker’s plans to acquire Hostess Brands and Campbell Soup’s proposed deal to purchase Sovos Brands remind us of the never-ending game food companies play by trading assets back and forth. Brands are passed around like baseball cards with one company paying a big multiple to pick up brands and making glowing promises of growth and synergy to its shareholders. However, results are often disappointing, and the company later “strategically” unloads the assets on another company which then promises its shareholders massive value creation which never seems to materialize. Investors feel the pain when the stock gets crushed, but the lawyers and bankers earn their fees and management often gets bonuses resulting from short-term growth that the acquisition may generate before things go bad.
While the industry is full of companies that have experienced this at one time or another, one that stands out to us is ConAgra Foods (CAG). Its comical history is well worth exploring as a real-world example of what happens when clear warnings are ignored and of how rapidly shareholder capital can disappear after a deal goes south.
If you want a great example of a company putting a positive spin on deal gone bad, just navigate to CAG’s “Company Milestones.” page on its website and scroll down to 2013. There you will find the following entry:
“ConAgra Foods acquires Ralcorp, the leading producer of private label foods. The private label operations are later divested to sharpen the company’s focus on building value for shareholders.”
“Divesting operations to sharpen the company’s focus” sounds positive, purposeful, and even downright proactive. However, a more accurate account would be “we jettisoned that dumpster fire before it got any more out of hand.”
Let’s throw a few numbers in here that will bring things into focus. CAG paid $6.8 billion for Ralcorp in 2013 to create its Private Label business. When it was purchased, CAG cheered the deal saying it was well-positioned for future growth. It promised margin expansion with better procurement and better supply chain utilization. Concerns about how well the company could support private label products and its own stable of brands were all dismissed. It didn’t take long after the deal closed for the cracks to start showing. There were impairment charges on the acquired assets of $602 million in 2014 and $1.59 billion in 2015. In 2016, less than three years later, the company admitted defeat and sold the Private Label business for $2.7 billion.
We are not sure what was more amazing- the jaw-dropping 60% loss in just three years, or the fact that by 2018, the company was back out touting another major deal in the form of its proposed acquisition of Pinnacle Foods- and investors were buying it! That deal blew up as well- and in less time than it took to watch The Godfather trilogy with commercials on AMC. So how could investors be so quick to trust a company that had taken a match to shareholder capital just two years earlier?
Studies have shown that 60%-65% of mergers fail to produce the predicted results. Many of these turn out to be complete stinkers and end up producing impairments, poor stock performance, and perhaps causing the company to take drastic changes such as cutting dividends, reworking debt, and ending share repurchase programs. Yet people still love them. Why? Well, as we noted above, deals generate fees for bankers, advisors, and lawyers and often result in bonuses for management. Early on, many people are captivated by all the glowing promises made by managment. Even journalists stay busy reporting on the deal. However, being a skeptic can help you avoid some of the clunkers and perhaps find the 35% of proposed mergers that make sense. A good deal should have one or more of these characteristics:
The price is so cheap, even if it came with some operating problems, some integration hurdles arise, or it was bought during a down cycle – the acquiring company may still see a solid return on capital. If the headline return on investment of an acquisition of a company with problems is 15% but the price is low, the ultimate ROI may rise to the high 20s with just a few problems correcting.
There is so much in fat and duplicate costs that can be eliminated quickly with very minimal effort that earnings and cash flow grow rapidly. Think about duplicate real estate in the same locations that can be closed, using fewer employees in overlapping areas, or combining more products on the same delivery truck.
The target company is growing rapidly and if that continues, the deal may look cheaper and see a rising ROI based on modest forecasts.
We believe a careful post-mortem of the Pinnacle Foods deal is a valuable opportunity for investors to learn how to assess the risk of an acquisition as there were clear indications going in that the proposed merger violated all three of the basic requirements for a good deal.
Let’s get “Behind the Numbers.”