(MEAT&POULTRY, August 1, 2006)
by MEAT&POULTRY Staff
By Christopher Huisinga
While protein markets are usually dynamic and demanding, the environment in late 2005 and early 2006 was especially challenging for many beef and poultry processors. At the March 2006 Stephens Consumer Conference, C.E.O.s from some of the largest meat and poultry companies acknowledged headwinds, including animal issues, import/export restrictions, and supply/demand imbalances.
According to executives, better times are ahead. Attractive markets should return and exposure to difficulties should not overburden most meat and poultry processors, particularly larger, efficient companies capable of maintaining strong niches or those preserving strong cash flows and balance sheets. While noting challenges, the same C.E.O.s expressed confidence in building their core businesses through operational improvements and strategic acquisitions.
Mergers and acquisitions in the protein sector historically heat up during tough markets. In the past few years, relatively weak beef conditions resulted in a flurry of deals. Poultry conditions softened in late 2005 and early 2006, yet little deal flow has occurred to date. Poultry companies have sustained their businesses, backed by strong profitability captured in 2004-2005. However, if markets remain taxing in the near to medium term, expect an increase in poultry sector M&A activity.
Beef sector activity
Fallout from bovine spongiform encephalopathy has pressured U.S. beef processors, squeezing companies on both the import and export fronts. The United States closed its border to Canadian live cattle imports in May 2003, thereby reducing live cattle supplies and boosting live cattle prices. In July 2005, the United States eased the two-year old import restrictions, yet live cattle imports to the United States from Canada remain below pre-B.S.E. levels. Meanwhile,
U.S. domestic live cattle supplies experienced cyclical lows, further pressuring live cattle prices. The silver lining is analysts and U.S. Dept. of Agriculture representatives expect an increase in U.S. live cattle supplies moving forward, from both domestic and Canadian producers.
In December 2003, the United States discovered a B.S.E.-infected cow, which further exacerbated the situation with Canada and caused many foreign countries to close their ports to U.S. processed meat. The Japanese market opened briefly in late 2005, then reinstituted its U.S. beef ban. South Korea, which many expected to reopen to U.S. beef in early spring 2006, is still closed. Fortunately, Taiwan reopened its market to U.S. beef in early 2006; and in June, China agreed to ease its ban on U.S. beef, accepting certain types of processed beef. Albeit slow, progress is being made with respect to Japan and South Korea, traditionally the first and second largest customers for U.S. beef exports, respectively. Besides difficult markets, factors driving beef sector M&A activity include: the importance of size and scale in achieving low-cost production, focus on value-added and branded products, food retailer consolidation, and the increasing importance of foodservice.
Beef sector M&A activity persists, including the 2002 acquisition of Swift & Co., Greeley, Colo., by Hicks, Muse, Tate and Furst and Booth Creek Management; the 2003 acquisition of National Beef (Farmland), Kansas City, Mo., by U.S. Premium Beef; the 2005 merger of Rosen’s Diversified, Alexandria, Minn., and American Foods Group, Green Bay, Wis.; and more recently, the 2006 acquisition of Brawley Beef, Brawley, Calif., by U.S. Premium Beef, Kansas City, Mo. Expect beef sec
tor consolidation to continue as companies maneuver through strong macro influences and company-specific developments. Also, look for more crossborder activity, principally U.S. players looking abroad, but also selected international players hoping to establish a U.S. foothold.
Poultry activity
From 2003 through 2005, aggregate net income for Tyson Foods, Pilgrim’s Pride, Gold Kist and Sanderson Farms grew from $294 million to $843 million, a compounded annual growth rate of 69.4 percent. Organic growth and acquisitions fueled this escalation. The aggregate earnings before interest, taxes, depreciation and amortization (EBITDA) margin for these companies increased from 5.4 percent in 2003 to more than 10.2 percent in 2005, a significant upswing.
As a result, poultry valuations increased substantially during this same time period, as evidenced by the Stephens Poultry Stock Index, which posted an average annual return of 27.8 percent, outperforming both the S&P Food and S&P 500 indices. Given such strong profitability, most poultry companies were able to substantially reduce debt levels, increase cash positions and significantly strengthen balance sheets.
Unfortunately, the poultry market took a quick turn for the worse in late 2005 and into 2006, substantially affected by global fear of avian flu and decreased export demand. Poultry operating margins and stock prices dropped; EBITDA margins for the same peer group decreased from 10.9 percent in 2004 to approximately 5.5 percent for the most recent 12 months.
However, the poultry sector is exhibiting some signs of strengthening. Analysts have commented on a correction in the chicken oversupply situation; and in May 2006, chicken and parts prices began to rally, as boneless, skinless breast meat and leg quarters showed solid gains. In addition, Russia (one of the top importers of U.S. broilers) continues to accept product from the U.S. despite the fact that import permits were pulled in late April 2006. Demand from Russia remains solid. These developments appear to signal improving market conditions, yet not all industry sources are in full agreement.
Divergent views on the health of the poultry market have had some effect on the industry’s confidence, precipitating M&A discussions. The most likely sale candidates will be processors already facing succession or competitive issues, further prodded into action by tenuous or uncertain markets.
For example, in April, Montgomery, Ala.-based Sylvest Farms filed a petition for relief and reorganization under Chapter 11 bankruptcy and announced its plan to sell its assets to Koch Foods, Chicago. In a company statement, Sylvest Farms officials blamed the "unforeseen and prolonged impacts of bird flu fears" and "reduced export demand" for putting the company in a financial crunch. The company also said it endured severe losses because of "softness" in commodity prices.
Potential poultry sector acquirers may include some of the largest companies in the industry, including Tyson Foods, Pilgrim’s Pride, Gold Kist, Perdue Farms, Sanderson Farms, Wayne Farms and Foster Farms, who are all jockeying for market positions. Many have already expressed interest in further consolidating the industry. The top three poultry processors — Tyson, Pilgram’s Pride and Perdue — represent nearly 50 percent of all poultry sales, but in general would not confront antitrust concerns in securing acquisitions. A wide range of midsize players are also well-positioned to make acquisitions, looking to strengthen geographic reach, customer relationships and value-added product capabilities.
To appropriately value poultry processors acquirers generally acknowledge they must look beyond today’s market, instead relying on three- to five-year rolling average operating results incorporating both historical and projected results. Poultry sector deals have often occurred in the 5.5 to 7.5 times EBITDA range, depending on the targets expected earnings growth, size, asset base, value-added capabilities, brand strength and profitability margins. Expect this valuation range to remain relevant for future M&A deals in the poultry sector.
Current indications point to the possibility of an increase in poultry sector M&A activity. The size of the expected uptick will be determined by how quickly market conditions improve, and the resulting effects on operating margins, balance sheet strength and general confidence levels, for both potential sellers and buyers.
Christopher Huisinga is a managing director at Stephens, Inc., where he heads the Food, Beverage & Agribusiness Group. Stephens Inc. is a full-service investment banking firm headquartered in Little Rock, Ark.