Early Tuesday morning, ConAgra (click ticker for report: ) announced that it will acquire Ralcorp for $5 billion, or $90 per share in cash, a cool 28.2% premium from yesterday’s closing price. This deal is slightly surprising, given that Ralcorp rebuffed the firm’s previous $94 per share offer in 2011, as it opted to spin-off its Post Cereal (POST) business instead. However, given Post’s share performance, and the $90 per share buyout offer, we think Ralcorp shareholders came out slightly ahead.
If we use Ralcorp’s fiscal year 2012 adjusted earnings per share from continuing operations ($2.97), the deal certainly doesn’t look cheap at 30 times this year’s earnings. Even when that figure is adjusted for acquisition-related amortization, the company paid 24 times earnings. More importantly, the acquisition price greatly exceeded our fair value estimate for the generic food maker. Therefore, we think the hurdle for a strong return on investment for ConAgra could be too high to consider this deal value-creative. However, we think the newly-combined private-label food business will have improved negotiating power and a number of cost-savings opportunities that could potentially make the deal look less pricey. Management estimates that at least $225 million in annual savings will accrue four years after the deal.
Strategically, the transaction makes sense as the firm attempts to capture growth in the private-label food market. Consumers have become more comfortable shifting away from brand names in the wake of the recent recession, and we see no evidence of this trend reversing. Since these private-label brands don’t require the same amount of marketing investments, operating margins tend to be fairly strong, leading to strong cash flow generation.
ConAgra intends on paying for the deal by issuing $350 million in new equity, stalling its share repurchase program, tapping some new credit facilities, and using existing cash. Importantly, the company will not reduce its $1 per share annual dividend, and it intends to use free cash flow to eliminate financial leverage—generally a wise use of cash, in our view. All things considered, we think ConAgra overpaid for Ralcorp, but synergies could be better than expected. We plan to make a modest downward revision in our fair value estimate for ConAgra as a result of the deal, but we believe shares remain fairly valued at this time.