Starboard Value's letter to Smithfield Foods arguing that Smithfield is selling itself too cheaply to Shuanghui International makes for tough reading if you think pigs are cute. The 16-page letter does a pretty detailed sum-of-the-parts valuation of Smithfield at, like, a pig-by-pig level, and it doesn't end well for the pigs. Sum-of-the-parts value has a disturbingly literal meaning, for them.
How did this letter come about? I imagine it as something like this:
- Earlier this year, Starboard analyst recommends Smithfield on the basis of a long well-reasoned report about how it'd be worth 2x its current price if it were broken up.
- Portfolio manager is persuaded and buys a chunk of shares starting in March, at an average price of around $27, planning to mount an activist campaign to break up the company.
- Smithfield announces merger at $34 a share on May 29.
- Starboard makes several million dollars on paper.
- Starboard celebrates, congratulates analyst, etc.
- Some spoilsport interrupts celebration saying, "well, but really the thesis was that Smithfield could break itself up and we'd make even more money."
- "Really, analyst, this counts as a loss."
- "Go back to your desk and repurpose your original report into a letter that we can mail to Smithfield."1
That's a little too glib, though, because they actually went and bought a ton more shares, and at-the-money-ish options, in the weeks since the deal was announced. So this isn't just a matter of sending an already-written letter to Smithfield and seeing if they can't bump the price a little; they're actually pretty levered to getting a price improvement. By my rough math2 Starboard makes about $12 million if the Shuanghui deal goes through, on an (at this point) $64 million investment; every dollar of additional value they can capture by October (when a lot of their options expire) is worth an extra $8 million. So their money really is where their letter is. And their letter argues that the company is worth $44-$55 broken up.
You can see why this would be a good place to put more money to work on their original breakup thesis. Getting a company to split itself up is hard - especially when you only own about 1.4% of the shares, as Starboard does. The 5.7% ownership reported in its 13D and news accounts includes shares subject to options, which Starboard has bought for an average price of around $2 a share, versus the current $33ish share price - actually exercising them and buying 5.7% of the votes would cost almost another $200 million on top of its $64 million current cost.
And even if you get there, Smithfield could always just ignore you: generally speaking boards can do whatever they want, re: not breaking up their companies, and shareholders mostly get to complain ineffectually. Or run proxy fights, but that's not much better: Harvard Business Review's blog today had an item about a 2012 study suggesting that activist campaigns that end in proxy fights have an average cost of about $10.71 million, which would more or less wipe out Starboard's gains so far.
But an already-announced merger is in some sense the perfect place for this sort of activism. You've already got shareholder attention, and they've gotta vote anyway, so you're not mounting a campaign from scratch. You've already got an announced merger and, thus, the attention of potential buyers for the bits of Smithfield: Starboard is more likely to get its calls to, I dunno, Hormel returned if they're already well aware that Smithfield is in play.
And, crucially, when a company is selling itself for cash, the board is obligated to maximize value - specifically unlike in the case where it's just bopping along and you come to the board with a proposal to break up the company, where the board is free to ignore you unless you can convince everyone else to vote them out. Similarly, complaining that the board has not considered every option to maximize shareholder value always sounds a little whiny for an independent company: nobody can consider everything, and there's no a priori reason for anyone to think that your 16-page letter contains a better idea than whatever the board is currently doing. But a merger tends to focus shareholders' attention on the paths not taken. Especially if you can throw a higher dollar value on those paths.
And especially when the value you've identified, rather than just being a figment of your imagination, seems to be what the acquirer is paying for. Starboard says:
Lending further credence to our views, we note that on the day the deal with Shuanghui was announced, the market capitalization of Henan Shuanghui, China’s largest meat processing company majority owned by Shuangui International, increased by approximately $1.2 billion.
I love this argument! It basically says: when public companies do mergers, they're supposed to destroy value, so the fact that this deal seems to be creating value is itself a sign that Smithfield's board screwed up. "More than 100% of the value of any merger is supposed to go to the target," is the gist here. As an argument for Smithfield to seek greater value - by actually pursuing a breakup3 or just by trying to negotiate a higher price with Shuanghui - it's ... umm, it's got the weight of tradition on its side anyway. As a general rule for activist investors, though, it seems a little suspect: if you succeed in always making acquisitions unprofitable for acquirers, how will you find anyone to buy the companies you invest in?
Smithfield Pressed to Carve Itself Up [WSJ]
Activist Investor Calls for Breakup of Smithfield Foods [DealBook]
Starboard Value - Schedule 13D and letter to the board [EDGAR]
1.Generally speaking, if I had to pick one thing that separates the excellent financial services employee from the average one, this would probably be the thing. Some people say "oh, sweet, we won, let's celebrate." Those people are crushed under the boot of people who are like "okay, fine, but now how do we optimize this more?" It's exhausting.
2.Here's a hideous spreadsheet [Update: now shared!]. It's an approximation because I'm just eyeballing the purchase price of the options (and, thus, the split between $30 and $34 strike options) but, whatever, it's close enough. You could re-do it with the actual numbers from Schedule B to the 13D, if you wanted. Also with formatting and stuff.
3.Smithfield's merger agreement contains a no-shop provision forbidding Smithfield from seeking competing acquisition proposals for over 25% of the company. But I guess it doesn't forbid Starboard from doing that; as their letter says:
We fully understand that under the Merger Agreement, Smithfield is contractually prohibited from seeking superior offers for the Company or from contacting third parties who may be interested in acquiring certain of the Company's operating divisions. In light of this limitation, Starboard is seeking to identify and connect any strategic or financial buyers for the Company's individual business units to determine if it would be possible to structure a sum-of-the-parts transaction that could deliver greater value for shareholders than the Proposed Merger. We hope that our efforts will lead to the submission of a Superior Proposal under the terms of the Merger Agreement.