Bidding war for Australian dairy processor worries Saputo’s investors

MONTREAL – For almost 60 years, Montreal-based Saputo has quietly built its business from a family of cheesemakers that once made deliveries by bicycle into the top ten of the world’s largest dairy empires.

But the company’s reputation as a disciplined acquirer is being put to the test in a very public battle for Warrnambool Cheese and Butter – Australia’s oldest dairy – that is making some of its investors a little nervous.

“I think it’s starting to get into that silly zone where the deal dynamics are driving this,” says John Stephenson, fund manager of Toronto-based First Asset Investment Management.

Since September, Saputo and Australian diary processors Murray Goulburn and Bega Cheese have all been jockeying for the win by raising bids to nearly double the initial offer.

Murray Goulburn has taken the lead with an all-cash conditional offer of AU$9.50 per share, surpassing Saputo’s latest offer of up to AU$9.20, assuming it wins majority control, and Bega’s lower cash and share submission.

Stephenson said Saputo can still top its rival, but anything above 10 cents would be a “bit of a worry.”

“They can probably make this work at $9.50 or maybe $9.60, but if they are going to chase this up to $10 I think that’s crazy,” he said in an interview.

Faced with intensified competition and limited growth opportunities in Canada, the company has focused on expansion in the United States, Latin America and into Asia Pacific.

Saputo (TSX:SAP) has been eyeing Australia for a decade as it sought ways to extend its reach into the Asia Pacific area and capitalize on growing global demand for dairy solids. The demand for milk powder used in baby formula, for example, has grown by 25 per cent annually since 2010.

Australia is the world’s third-largest exporter of milk products after the European Union and New Zealand, with about 10 per cent of the global market share.

Saputo’s expansion strategy makes sense, Stephenson said, but the bidding against two Australian companies has become political, with Murray Goulburn presenting itself as the country’s farmer-owned alternative.

“And that’s a little dangerous,” said Stephenson.

The Australian Takeovers Panel issued an interim order on Friday that prevents Saputo from boosting its 9.6 per cent stake in Warrnambool for two months, or until the panel examines the bid.

The order was issued after Murray Goulburn asked the board to intervene, claiming investors have been misinformed about the true value of Saputo’s offer. The move also buys the Australian company time, as its offer needs competition tribunal approval, which can take three to six months, while Saputo’s bid can close in December.

Mawer Investment Management, one of Saputo’s investors, agrees that the company’s expansion in Australia makes strategic sense.

But chairman and chief investment officer Jim Hall said he’s concerned that Saputo has changed its merger and acquisition strategy by looking at the bigger picture, instead of its usual practice of insisting that each deal makes economic sense.

“It’s a red flag. We’ve seen several other companies use this kind of logic to close high-priced acquisitions only to later regret them,” he wrote in an email.

Mark Toby, of Canaccord Genuity, says the bidding by Australia’s Murray Goulburn has become “irrational.”

The Melbourne-based analyst wrote in an email that he wouldn’t be surprised if Saputo eventually targets Bega, Warrnambool’s largest shareholder, which controls seven per cent of Australia’s dairy market.

Unlike its rivals, which have to issue equity to fund their offers, Saputo has deep pockets for the acquisition of a company that generated just C$25 million in pre-tax operating income on $477 million of revenues last fiscal year.

That hasn’t always been the case for Saputo, which started in 1954 when Lino Saputo and his father launched a small cheesemaking business in Montreal that, each day, produced about 12 kilograms of mozzarella and ricotta per day and was delivered to customers by bicycle.

Lina Saputo and his family now rank sixth on the list of richest Canadians, with a net worth of $5.24bn.

Saputo’s success was initially tied to the growth in pizzerias. A trained cheese maker in Sicily, the founder’s father developed a mozzarella crafted for pizza. For nearly a quarter century, the business catered primarily to the restaurant industry and developed a distribution system across Canada.

The company went public in 1997 with about $450 million of revenues and shortly after acquired Stella Foods, a large U.S. company more than twice its size, for $580 million.

The company has completed 21 more acquisitions, adding more than $7.1 billion of annual revenues. Last year’s $1.44 billion acquisition of U.S. dairy product company Morningstar Foods is the largest deal to date. Saputo is expected to earn about $1 billion in pre-tax operating income on more than $8.8 billion of revenues in fiscal 2014.

Canada’s largest dairy processor has about 36 per cent market share, is No. 3 in the United States and in the top three in Argentina.

Global competitors include branded companies such as Nestle, Danone and Kraft Foods and dairy firm Parmalat, as well as farmer co-operatives such as Quebec’s Agropur, New Zealand-based Fonterra and Dairy Farmers of America.

Unlike the branded firms that sell heavily processed products that require deep promotional spending, Saputo focuses mainly on commodity cheese, specialty cheeses and milk. Its Vachon bakery division, famous for its Jos. Louis and May West snack cakes, accounts for about two per cent of Saputo’s revenues.

Saputo’s focus on efficiently operating its manufacturing and distribution facilities has allowed it to generate lots of free cash flow, attractive returns on capital and raise its dividend for 13 consecutive years.

“I expect them to continue to excel at this ‘game of inches,’ continuing to build a world-class company over many decades to come,” said Hall.