Wall Street has been worried about the impact of weight loss drugs on companies that make sweets, but that didn't stop J.M. Smucker (SJM -0.27%) from buying Hostess Brands. And there are compelling reasons to support the $5.6 billion deal. In fact, if there's one thing that investors should be worried about (and watching closely), it isn't sweet snacks. It is the new debt that has been created from the acquisition. Smucker knows it and has made an important promise.
Smucker is adding more than sweets to its portfolio
The big draw of Hostess Brands is most obviously its collection of well-known brands. The list includes icons like Twinkies, Ding Dongs, and HoHos. That makes sense, given that consumer staples companies like Smucker live and die by their brands. And while the acquisition of Hostess is a bit contrarian at a time when Wall Street is worried about the changes that might be caused by new weight loss drugs, the long-term benefit of adding recognizable brands seems likely to win out in the end.
That said, there are other reasons to like the deal. For example, it expands Smucker's business in the snacking space. Snacking has been an increasingly important consumer trend in recent years. Hostess also has extensive distribution in the convenience channel, where Smucker isn't quite as strong. Smucker can now plug some of its other products into that distribution channel with greater ease. And Hostess has an innovation pipeline that will allow Smucker to bring out more "new" and "improved" products. Those two words are big draws for consumers and retailers alike to partner with companies that get consumers in their doors with "new" and "improved" product offerings.
The purchase price for Hostess was $34.25 per share. The deal was a mixture of cash and stock, with an enterprise value of $5.6 billion, including the assumption of debt. That's not a small figure, noting that Smucker's market cap is just around $14 billion. There are going to be many lingering impacts.
Smucker has a three-year plan
The biggest immediate impact of the deal, however, shows up on Smucker's balance sheet. The company's debt-to-equity ratio rose from around 0.6 times to nearly 1.1 times thanks to the debt it took on to close the Hostess transaction. That's a massive uptick in a worrying direction. Management isn't ignoring the problem.
SJM Debt to Equity Ratio data by YCharts
It has set a goal of paying off $500 million worth of debt each year for the next three years. That's a lot of cash going out the door, and investors need to think about the implications. For starters, stock buybacks are coming to a halt because debt reduction will take priority. This shouldn't bother investors in the least, as it makes complete sense.
However, with 26 years of annual dividend increases behind it, the dividend is a bigger question. One of the quickest ways to raise cash is to cut the dividend. Yet, management explicitly stated that it would continue to support its current dividend policy. That suggests that a dividend cut is off the table. However, the company went on to specify its policy, which is to pay out between "40% to 45% of our annual adjusted earnings per share to shareholders." Assuming that the Hostess deal works as well as hoped (the company believes it will be accretive in the first full fiscal year of ownership), that actually leaves the door open for dividend increases. But, given the leverage situation, investors should probably expect just token increases for the next few years.
Smucker is doing the right thing
The Hostess acquisition has opened up new avenues for growth at Smucker, but it comes with a caveat. The food maker now has a pile of debt to pay down before it can really say this deal has been fully integrated. Investors should appreciate the company's commitment to do just that while at the same time standing firm on the dividend, even if it means Smucker's dividend growth is less exciting for a little while. That said, the 3.2% dividend yield is near the high end of the stock's historical yield range, suggesting that the debt overhang from the Hostess deal, which management has plans to fix, has put this stock on the sale rack.
