On Friday, integrated poultry producer Pilgrim?s Pride (PPC) publicized its offer to acquire smaller rival Gold Kist (GKIS) for $20 per share. The offer values Gold Kist at roughly $1.16 billion including the assumption of $144 million in debt. The $20 a share cash offer represented a nearly 55% premium over Friday?s closing price of $12.93.

Since the offer was made public, the market price of Gold Kist?s shares has risen to $19.88.

Going Public

On Friday, Pilgrim?s Pride put out a press release that included the text of a letter delivered to Gold Kist?s board (that same day). In the release, Pilgrim?s Pride claimed it has ?substantial current liquidity? and that its financial advisors have given the company ?further assurances? that Pilgrim?s Pride has the ability to finance the transaction.

The release also suggested the transaction would be accretive to EPS in the first full year following the merger; the combined company would enjoy approximately $50 million in anticipated synergies. During 2005, Gold Kist had sales of over $2.3 billion while incurring Selling, General, and Administrative costs (SG&A) of just $112.2 million. So, these anticipated synergies would likely come from the cost of goods sold line. Pilgrim?s Pride suggested as much in the release by stating such synergies were ?expected to come primarily from the optimization of production and distribution facilities and cost savings in purchasing, production, logistics, and SG&A?.

A Fair Price?

The letter to Gold Kist?s board is generally unremarkable, being full of the usual platitudes such as ?value creation for our respective shareholders, employees, business partners and other constituencies?. Considering the price at which Gold Kist currently trades, the limited expected synergies, and the fact that the current proposal is for an all cash deal, it seems far more likely Pilgrim?s Pride is looking to create value for its shareholders by capturing the wide spread between the market price of Gold Kist and the company?s value to a 100% owner.

Pilgrim?s Pride shouldn?t be faulted for trying to exploit such an opportunity. However, investors shouldn?t view the deal as a value creating combination when it is clearly an opportunistic attempt to buy something for less than its worth.

The letter did state that Pilgrim?s Pride is ?willing to discuss alternative forms of consideration, including a mix of cash and Pilgrim?s Pride common stock?. We?ll see what this means in the days ahead.

I suspect it means some small amount of stock as a sweetener rather than a radically different mix of cash and stock. The reason for this is obvious. Shares of Pilgrim?s Pride are probably worth a lot more than their quoted price; so, a deal consisting of a large amount of stock in place of cash would actually be a big step up in the true amount of economic consideration given in exchange for Gold Kist?s operations.

Valuation

Now, some may argue that this deal is aimed in large part at capturing synergies rather than exploiting a difference between the price and value of a competitor. If you look at chicken producers Pilgrim?s Pride, Gold Kist, and Sanderson Farms (SAFM), you?ll see that the current price-to-sales and price-to-book ratios aren?t that low relative to where these stocks have traded in the past.

That?s true. But, they?ve been quite cheap in the past. Over the last ten years, these stocks have strongly outperformed the S&P 500. For the most part, this outperformance has not been the result of multiple expansion in terms of either price-to-sales or price-to-book. Today, both Pilgrim?s Pride and Sanderson Farms trade at roughly the same price-to-sales and price-to-book ratios as they did from 1996-1998. Yet, they?ve strongly outperformed the S&P 500 since then.

There?s a case to be made that the chicken producers actually deserve to trade at higher price-to-sales and price-to-book ratios than they have in the past. If you buy that argument, then the fact that Gold Kist is already trading at or above the kind of price-to-book and price-to-sales multiples chicken stocks have often traded at, doesn?t mean Pilgrim?s Pride isn?t getting a bargain at $20 a share.

Cash vs. Stock

For Gold Kist shareholders there?s a simple solution to the problem of getting a raw deal. While Gold Kist may be cheap, it?s no longer cheap relative to the other chicken stocks ? including Pilgrim?s Pride.

So, the easiest way to ensure a good deal would be to insist Pilgrim?s Pride puts its stock where its mouth is. If both Pilgrim?s Pride and Gold Kist are undervalued, paying for Gold Kist in stock would require the swapping of one undervalued asset for another. That would make for a true combination. Of course, it also might make the deal a lot less attractive for Pilgrim?s Pride.

If I were a Gold Kist shareholder, I?d want the deal to be all stock. There?s nothing wrong with swapping part ownership of one poultry producer for part ownership of a new, larger poultry producer. But, there is potentially something very wrong with swapping part ownership of a poultry producer for cash.

Copyright 2006 Geoff Gannon