Deal frenzy in aisle 4

December 16, 2010: 3:09 PM ET

Mergers and buyouts among food manufacturers are gaining steam, but there is one complicating factor: brands are fading, and the biggest consumer food companies are built on brands.

By Dan Mitchell, contributor

food dealsWith improved access to credit and mountains of capital ready to deploy, private-equity and strategic buyers are hot to snap up food companies. Thanks to their stable cash flows, food firms are generally safe bets, especially for highly leveraged private-equity deals where debt repayment is a priority.

There is one complicating factor, however: brands are fading, and the biggest consumer food companies are built on brands. So while there has been buzz about possible buyouts of, for example, Sara Lee (SLE), ConAgra (CAG), and J.M. Smucker (SJM), there has been no reported movement toward a deal for any of them.

Even before the recession, private-label (or store brand) products were ascending, taking market share away from branded products. The downturn has only made things better for private labels and worse for many brands as consumers have sought out cheaper fare.

In many cases, those consumers have discovered that private-label products are just as good as the branded ones, or at least close enough. For that reason, some analysts believe that private labels -- which according to the research firm Packaged Facts now make up nearly a fifth of the grocery market, up from just 14% in 2005 -- will continue to eat away at certain brands even after the economy picks up. Once viewed as commodities, private-label products are developing a "brand" of their own. They represent an $87 billion market, Packaged Facts says.

This raises several questions for both strategic and private-equity investors. Should would-be acquirers wait to see how the recovery might affect sales of private-label products? Which brands are most vulnerable to the rise of private labels? Not all brands are the same – many will remain strong for years to come.

Finding value on the shelves

In general, mid-tier brands are the most vulnerable. Just look at Bumble Bee, the once-venerable tuna brand that has lost its luster over the years. Last month, Centre Partners Management, the tuna company's private-equity owner, sold Bumble Bee to Lion Capital, another PE shop. The price was a reported $980 million, or only about 7.5 times earnings before interest, taxes, depreciation, and amortization. That's well below the valuation of 9 to 11 times earnings that food companies are commanding on average.

In one sense, Centre Partners did well – it got a 250% return on its investment. But Centre could have gotten a better return elsewhere. And just compare this deal to the last time Centre bought and sold Bumble Bee. It purchased the company from ConAgra in 2003 and sold of the last of its stake in 2005. That series of deals netted Centre an 850% return. But the brand has faded since then, and so has the valuation.

Consumers tend to be more brand-loyal to bigger names. And grocers, overwhelmed by the variety of products on their shelves, are more likely to trade out mid-tier brands for their own brands than to stop stocking the best-known products.

Those crowded shelves also have implications on the deal front. Expect more consolidation among makers of private-label products. For retailers, buying products from dozens of private-label suppliers is highly inefficient and costly. Buying from just a handful allows grocers to get the full benefit of making thin-margin private-label products available.

That consolidation has already begun. TreeHouse Foods (THS) and Ralcorp (RAH) are the two biggest publicly held makers of private-label products, and both are in acquisition mode. TreeHouse in September announced the purchase of ST Specialty Foods from Windjammer Capital for $125 million. In March, TreeHouse closed on its acquisition of Sturm Foods for $660 million.

In June, Ralcorp bought American Italian Pasta Company, which had been the third big, publicly traded private-label company, for $1.2 billion. At the same time, Ralcorp snapped up two privately held makers of private-label products -- North American Baking and JT Bakeries -- for undisclosed amounts.

Not everyone's a private label believer. Kraft (KFT) CEO Irene Rosenfeld said in August that private labels had peaked. But a month later came the news of TreeHouse's acquisition of ST Specialty Foods, whose chief product is a private-label rival to Kraft's iconic mac'n'cheese brand. If prices tick down on Kraft's product relative to ST's, that will be a sign that the store-branded stuff is stealing market share from Kraft.

Private equity interest

Consolidation is also happening in private-equity deals. Fieldbrook Foods recently agreed to be acquired by Arbor Investments, which specializes in food and beverage companies. Terms weren't disclosed, but Fieldbrook is the largest supplier of private-label ice cream east of the Mississippi. It got that way by spending the past decade snapping up other companies.

Meanwhile, private equity and strategic buyers are wondering what to do with brands that are being hurt by the rise of private labels. In October, shares of Sara Lee spiked after reports that private-equity firms including Kohlberg Kravis Roberts and Apollo Global Management, perhaps smelling blood in the water, were eyeing the struggling company. But there has been no reported movement on a deal (and Sara Lee says it no longer wants to sell). The stock has continued to rise.

Last month, Sara Lee sold its North American bakery unit to Mexico's increasingly gargantuan Grupo Bimbo for a bargain-basement price of $959 million (it was reportedly hoping for something more like $1.5 billion), signaling that it no longer wanted to compete with private-label bakers.

Bimbo, which has snapped up brands such as Entenmann's and Thomas' English Muffins, is on a mission to get most of its sales from the United States. Through acquisitions, it's getting close.

Whether or not Sara Lee is bought out in whole, such spinoffs of particular units might become a trend if wholesale deals can't be struck. Analysts have said that companies like Sara Lee and ConAgra might not be attractive, but some of their parts surely are.

None of which is to say that brands are dead. Far from it. Sara Lee's desserts continue to do well, for example. Companies like Nestle and Unilever have worked hard to support their brands, and have faced relatively little serious competition from private labels. And acquirers, including private equity shops, are still buying brands as well – Kohlberg Kravis Roberts (KKR) announced last month that it would pick up Del Monte Foods (DLM) for $4 billion. In June, C. Dean Metropoulos & Co. bought Pabst Brewing Co. for a reported $25 million.

But that just makes shopping more difficult for would-be acquirers. Brands that are strong today might, like Bumble Bee, start fading tomorrow. On the other hand, the recovery might send shoppers flocking back to their favorite brands, making some private-label deals less valuable. It will likely be a few years before we know who is making the smartest bets in the grocery store.

Also on Fortune.com:

The reconditioning of Atkins Nutritional

The return of J.W. Childs?

Big buyout anti-portfolios

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