WH Group Limited provides meat processing services, supplies chilled meat, meat products, and other related products. WH was formed in January of 2014 when Shuanghui International changed its name after it acquired Smithfield Foods, a U.S. competitor.
WH Group Ltd.’s operating profit growth should outpace sales gains in coming years as it focuses more on higher-margin premium-priced branded sausages, deli meats and ready-meals.
Nathan’s hot dogs and Healthy Ones deli meats will likely help it capitalize on China’s growing appetite for beef, turkey and other animal proteins. Its U.S. subsidiary will likely boost pork exports to China over the next one to two years to capitalize on the country’s higher prices.
WH Group LTD (0288.HK)
East Meets West
The company’s acquisition of Smithfield was a watershed moment for WH. The strategic acquisition was not without risk, and the price tag of almost $7 billion, inclusive of Smithfield’s assumed debt, saddled WH with a heavy burden. However, it also gave the company an opportunity to expand into the U.S.
At home in China, WH is known as the “number one butcher”, and has almost 19% market share in the packaged meat segment. The company is a clear beneficiary of the country’s burgeoning middle class, and has secular tailwinds in terms of consumers’ increasing appetite for proteins, not to mention the convenience of packaged products like those WH offers.
While the combined company benefits from operational efficiencies, it also benefits from portfolio diversification. It is able to opportunistically shift imports and exports based on price differentials between China and the U.S., as well as target certain products that may have limited appeal in the U.S. for export to China.
The Chinese Use the Same Word For Crisis and Opportunity
Crisitunity? We cannot talk about a company with trade ties to the U.S. without delving into conjecture on tariffs. The stock fell in January after Morgan Stanley noted its outsized U.S. exposure. However, consistent with conversations we have had with other companies, it seems like there are other more likely targets in any trade war than pork. WH’s Wan Long stated, “In the scenario of a trade war, the first to be targeted should be steel and machinery manufacturers.” He also noted the relative inelasticity of pork demand.
There are other near-term challenges faced by both the stock and the company. One is firm ownership. We love insider ownership, and Rise Grand Group, controlled by WH senior management, owns almost 40%. However, there is a PE overhang, as CDH Group, may continue to reduce its holdings, which it has historically done at a 4%-6% discount to the market. This has kept the stock range-bound, though it did leap 9% on its latest earnings report, so perhaps the market has lost its fixation.
Finally, although the company has looked to position itself as a value-added provider of consumer goods, and does have the aforementioned import/export optionality, it can be difficult to pass through higher costs to consumers.
Despite these challenges, we think the opportunities for this company are massive.
Year of the Pig
WH not only assumed Smithfield’s debt, it also financed the acquisition of the shares by issuing debt. Accordingly, WH saw its debt/capital spike from under 10% to over 75%. Fortunately, the company generates significant free cash flow, with an average free cash flow yield of around 12% since the acquisition. They have used this cash to pay down the debt, which now sits at a more modest 31%.
This creates flexibility to raise dividends or make additional strategic acquisitions. To that end, WH has started a further build-out of its U.S. portfolio with the much smaller acquisition of Clougherty Park from Hormel (HRL) in early 2017.
However, the company has a grander vision, as the company’s chairman, Luis Chein, stated in late 2016, ”We are already the largest pork packaged meat producer in the world, and we aim to become the leader in other meat markets.” He went on to state, “We will consider bigger scale acquisitions when our debt level drops further.”
Analysts estimate WH Group will pay down an additional US$400-500 million of debt and refinance the Smithfield debt with lower interest rates, given the rating agencies have upgraded the company to investment grade. As this occurs, we look for the company to opportunistically add to its portfolio.
Also, with strong cash flow and lower debt, the company plans to raise its dividend in 2017.
Year of the Rooster
The company has a clear and likely path to growth for 2017, the year of the rooster in the Chinese zodiac. Although the stock could be volatile based on hog pricing, trade issues with Trump, and currency in the short run, the longer term prospects are outstanding. Management is likely to increase the dividend and generate double-digit organic earnings growth over next few years. With the market fixated on the near-term, valuation versus peers is attractive:
With recent headlines regarding tainted beef imports from Brazil, perhaps Chinese consumers will eschew imported beef and look for more trusted domestic brands, like those WH offers.
The kicker for WH is its acquisition strategy. The Smithfield acquisition provides a template for continued expansion, as it has executed superbly. A shift to more packaged products and the successful integration of Smithfield’s operations has boosted margins significantly. Further opportunities to expand its Chinese distribution through the restaurant vertical, currently only about 5% of Chinese sales versus 35% in the U.S., are another avenue for growth.
With the flexibility provided by its cleaner balance sheet, the company will look not only to return capital to shareholders but also will consider further strategic acquisitions in its quest to become a market leader in other areas. Its focus on packaged products fits well with changing consumer preferences both in the U.S. and in China, and has also boosted margins. Accordingly, we think another acquisition would be well received by the market and with it being the year of the rooster, perhaps WH, like Newman, has a taste for chicken?
Article by Adam T. Eagleston, CFA & John A. Ferguson, CFA – Opus Capital Management
See the full PDF below.