Starboard Value LP yesterday delivered and made public a letter to Smithfield Foods, Inc. (NYSE:SFD)’s board of directors. In this letter, Starboard argued that by agreeing to sell the entire company rather than its disparate parts, Smithfield likely left money on the table. Starboard believes fair value in a breakup is $44-55, rather than the $34 price at which Smithfield agreed to sell. Ken Goldman of JPMorgan notes in a new letter that Starboard owns relatively little of the actual stock—most of its value is in options—and thus has minimal voting power at the moment. Therefore, though Goldman ‘found Starboard’s letter interesting’, He still believes the most probable outcome is the one Smithfield agreed upon: selling the whole company to Shuanghui Group for $34. Below we highlight Goldman’s comments where he analyzes each piece of Starboard’s argument.

starboard value

Starboard believes Smithfield’s Hog Production segment should be worth $1.35B in a liquidation value analysis alone.

We note the following regarding this discussion. First, we would not necessarily use current market hog prices here (as Starboard did) because a sale of the largest hog farm operation in the country probably would lead to a sudden over-supply of product and thus dramatically reduced prices. Second, we would not value small pigs on the same dollar-per-hundredweight measure as fully-sized hogs because market pigs have different $/cwt values than market hogs. Third, and perhaps most importantly, we would not use Lean Hog Futures when pricing live hogs (or pigs for that matter) as Starboard seems to do. Lean hogs are dressed hogs; that is, they have already been slaughtered and processed and thus are more value-added and expensive than live hogs. Smithfield’s Hog Production segment by and large sells the live variety.

The Starboard letter implies Hog Production should trade at a premium valuation

Starboard believes that putting all of the parts together, Hog Production should be worth between $1.9B and $2.3B. This range seems like a stretch to us on an EV/EBITDA basis. Keep in mind that Hog Production a) lost $119MM in FY13 EBITDA, b) lost money in three of its last five years, and c) has not made more than $205MM in EBITDA in any of the last six years (FY11). Even if we valued Hog Production off this peak FY11 figure, the midpoint of Starboard’s range would imply an EBITDA multiple of 10.5x. Smithfield Foods, Inc. (NYSE:SFD) peers Tyson (TSN), Sanderson Farms (SAFM), and Pilgrim’s Pride (PPC) are trading at 5.4x, 4.9x, and 6.0x, respectively. One of the problems with a liquidation analysis is that it looks at hogs and sows that, to some extent, already have been fed. Future hogs and sows that still need to be fed $5-6/bushel corn are worth less.

International Segment valuation: some of the companies used as comparisons are not truly comparable

Starboard cites a number of European companies in its valuation of Smithfield Foods, Inc. (NYSE:SFD)’s international business; however, we do not necessarily see all of these companies as similar to Smithfield Foods, Inc. (NYSE:SFD)’s meat business. The comparison includes Danone (one of the biggest, most diversified packaged food companies in the world), Associated British Foods (another global diversified company), Glanbia (dairy and sports nutrition), Deoleo (olive oil, rice, condiments), Artyza (specialty bakery products), and Ebro (rice, pasta, and sauces). There are reasons not to mix packaged food and protein sectors when determining comps, especially as packaged food is generally a much higher margin, more stable business than meat processing. Using only meat companies such as Hilton Food Group for comparisons, the valuation multiple for Smithfield Foods, Inc. (NYSE:SFD)’s International segment would come out lower than what the letter suggested.

Pork Segment: all of the recent top-line growth came from pricing, not volume.

Starboard’s letter says, “We believe a multiple [for Pork] of only half that of Hormel’s and Hillshire’s completely ignores the importance of Smithfield’s Pork division for the global pork industry and its growth potential, already demonstrated with top line growth of approximately 20% over the last three years.” True, Pork grew by 19% between FY09 and FY13; however, it actually shrunk a small amount in FY13. And over 100% of the gains over the last three years were driven by higher prices, which in turn were driven by higher input costs, not necessarily greater demand for product. We are not suggesting that pork demand is shrinking—indeed it is growing—we merely observe that higher global volumes are not necessarily visible in Smithfield’s Pork segment growth at this time.

Smithfield Foods, Inc. (NYSE:SFD)’s Fresh Pork sub-segment is worth more to the Chinese buyer as part of a vertically integrated company than on its own

One of the letter’s positions is that on its own, Fresh Pork would be able to “leverage its size and bargaining power to contractually secure a steady supply of high quality, genetically consistent, and traceable hogs similar to the arrangements employed by other leading meat processing companies that are not vertically integrated.” Though this is largely true, we believe a fully vertically integrated supply chain, one in which hogs and pork are only in one owner’s hands until delivery to a customer, has superior traceability to one in which the animal and its meat are handled by two or three owners before the sale. This is especially true for buyers in China, a nation that has had meat quality issues and would benefit from touting full and clear traceability of product.

Starboard: We found many parts of the letter interesting, especially the section on Fresh Pork efficiency

Starboard laid out a case for Smithfield’s Pork margins to have much better capacity utilization. We found this section creative (in a good way) and convincing. We would observe, though, that these efficiencies can be gained no matter who owns Smithfield and whether the company is whole or not. In other words, as useful as this section of the letter may be, it does not necessarily advance the case for a breakup. Starboard does not yet carry a large vote (though it could someday). Of the 8.0MM shares effectively controlled by the investor, 6.1MM are call options. Starboard, of course, can exercise these options if it so chooses.

Conclusion: We are comfortable with our previous sum-of-the-parts analysis that suggests SFD should be worth roughly $30 broken up. Perhaps this figure should be higher now that the company has drawn interest from strategic buyers, but we are not comfortable suggesting it is worth the $44-55/share suggested by Starboard.