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Food Stocks May Be Poised For New Round of M&A

Is Warren Buffett thinking about mixing some Oreo cookies in with his Dairy Queen?

Last week, Kraft Foods shares went on a wild ride driven by market chatter that Buffett's Berkshire Hathaway was eying an investment in the food company. The maker of Oscar Mayer meats, DiGiornio pizza and Oreo cookies isn't the only food company at the center of such speculation. Pittsburgh ketchup maker H.J. Heinz was recently rumored to be in talks with a private equity buyer, but CEO Bill Johnson tried to dispel that talk in a recent interview on CNBC.

The recent wave of M&A and private equity has missed the larger packaged food manufacturers, but the sector remains on the radar screen of private equity players, who could be poised to begin a new round of deal-making. After all, the group has long been prized for its stable profile and reliable cash generation.

“Private equity has been making larger and larger deals,” said Steve Davis, head of the Food & Beverage Group at Barrington Associates, which provides merger and acquisition advice to companies with revenue between $25 million and $1 billion. “I think that will ultimately manifest itself with private equity making a play for a larger food company.”

U.S. Food Industry Merger & Acquisition Activity

Year
Number of U.S. Food Mergers & Acquisitions
Total Deal Values (in billions)
2003 70 $6.76
2004 83 $8.22
2005 90 $4.11
2006 120 $16.40
2007 YTD 52 $11.91
* 2007 data through June 5, 2007.  Source: Barrington Associates

According to Davis, private equity has tended to favor food companies as a way to diversify other investments. The number of deals in the food industry, and their value, has been on the rise, but most of these transactions have been made in the middle market.

At the same time, investors also have begun to realize that some of the companies in the group are now armed with a substantial war chest that could be used to fund further consolidation in the industry. What companies will do with this growing pile of cash still remains to be seen.

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Mergers among the top-tier food companies have been virtually non-existent over the past three to five years. That’s because a series of transactions, which included Kraft’s acquisition of Nabisco, Kellogg’s purchase of Keebler, and Unilever’s tie-up with Best Foods, had left the group busy paying down debt and integrating operations.

The track record for these deals has been mixed. Some of the deals, such as General Mills’ acquisition of Pillsbury, have had trouble delivering on the promised cost savings and benefits. And Wm. Wrigley Jr.’s recent experience buying the Lifesavers and Altoids brands from Kraft was a reminder that it is easy to get burned by an acquisition.

Touching Off The Next Wave

But acquisitions can be beneficial, and it just may be that the group is waiting for one company to boldly head back into the waters and touch off a new round of consolidation.

At moment, one of the most likely targets is Cadbury. The British company, which is expected to announce plans to separate its U.S. beverages business later this month, is restructuring its confectionery business. These activities could make the company easier to digest.

Kraft, for example, could purchase Cadbury at a premium and still have it be “significantly accretive,” according to Palmer. He estimates there is a 80% market overlap between Kraft and Cadbury, which should allow for substantial cost savings. The acquisition of Cadbury would expand Kraft's chocolate business and improve its international presence.

Palmer expects the next wave of consolidation in the food sector will play out over the next two to three years. He expects four or five large global players will emerge at the end of the period, most likely Nestle, Unilever, Kraft and PepsiCo. The others will become likely targets.

According to Sanford Bernstein analyst Alexia Howard, General Mills could fit the criteria of a private equity buyer because it stands to benefit the most from improved management focus and it is not in the middle of a restructuring program. (Kraft, Sara Lee, Heinz and Hershey are all in the midst of restructuring programs at the moment.)

Howard expects a private equity buyer would likely consider Campbell Soup and Kellogg to be running well, which would make it difficult to scale up revenue and profit from their current level.

Sector Values Easing

As for the possibility that an investor like Buffett might put a stake in the ground. Howard has been growing more positive about the group’s stock values, but still has a market weight rating on the sector.

The group enjoyed a big run-up in the first half of 2006, helped by a combination of macroeconomic factors and interest from activist investors such as Nelson Peltz. Although valuations remain lofty, they are not as sky-high as they once were.

Heinz ketchup.
Keith Srakocic
Heinz ketchup.

Still, over the last ten years, the average premium paid for a food stock was a 3% discount to the average valuation of the Standard & Poor’s 500 Index. However, right now, food stocks are trading at 22% premium.

Kraft may be one of the laggards. According to Palmer, Kraft is “modestly less expensive” than its peers.

“EPS expectations are quite low,” Howard said. She expects with dairy prices on the rise they will remain that way.

Still, Howard rates the stock and outperform because she expects the Northfield, Ill., company will see a pick-up in their sales in 2008. This run-up could push Kraft shares as high as $39 within the next 12 months, she said.

Howard and Palmer do not own shares of the stocks that they cover. However, UBS has an investment banking relationship with many companies in the sector, including Kraft, General Mills and Heinz. Sanford Bernstein owns more than 1% of the outstanding stock of General Mills, Hershey, Kellogg, Sara Lee, and Wrigley. The company also has performed non-investment banking services for many of the companies she covers.

Christina Cheddar Berk is a News Editor at CNBC.com. She can be reached at christina.cheddar-berk@nbcuni.com.

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