Will Tyson Chicken Out of Its IBP Deal?


By Sam Jaffe These are hardly glory days for the cattle business. First came bovine spongiform encephalopathy, better known as mad-cow disease, which spread to the European continent last year. Then the February outbreak of hoof-and-mouth disease in Europe caused millions of animals to be incinerated out of fear of contamination. Meanwhile, in the U.S., beef consumption has been gradually declining as Americans try to eat more healthfully.

So, it should come as no surprise that the nation's largest beef producer, IBP Inc. (IBP), is the target of furious takeover activity. Two previous merger attempts were thwarted by IBP shareholders at the end of last year. The company's latest suitor is chicken processor Tyson Foods (TSN), which has a $3.2 billion cash and stock offer signed and sealed, to be completed on May 31.

But now even that deal is open to question. After taking a close look at IBP's books, including a letter from the Securities & Exchange Commission questioning the beef company's accounting methods, Tyson has changed the terms of the deal, and rumors are swirling that it could back out altogether. IBP's stock closed at 26 on Mar. 9, down 11 cents.

UPS AND DOWNS. IBP's problems start with high cattle prices. The beef business is based on a commodity whose price can fluctuate dramatically. In August of last year, the cost for 100 pounds of choice beef was $64.93. By December, it was up to $76.32 and hasn't fallen significantly since then. While that's good news for cattle ranchers, it's bad news for IBP, because it doesn't raise its own animals. It only buys, butchers, and processes cattle. As a result of the increasing prices, IBP's minuscule operating margin of about 3% is in danger of shrinking.

The solution to IBP's low-margin problem is to get into lines of business that have higher profit margins. And that's exactly what the company has been doing for the past two years. It has been purchasing processed-meat purveyors at the clip of two to three companies a year. "Rather than supply raw beef to processors, IBP is starting to walk down the road of adding value to its commodity product," says Prudential analyst John McMillin, who has a hold rating on the stock. "This is becoming a value-added world. People don't want to make the cake, they just want to put the candles on it."

And companies like IBP want to make higher profit margins, too. Its fresh-meat operation, which produces about 85% of the company's overall sales, manages an operating margin of only 3.2%, according to calculations I made from IBP's third-quarter earnings report. The fledgling FoodBrands division, consisting of the company's branded foods, is increasing revenue at a 24% annual clip and comes out with a 5.2% operating margin.

PROFITABLE MIDDLEMAN. If the value-added strategy sounds familiar, than you must be familiar with a little family-owned company in Arkansas called Tyson. The chicken processor started out as a single slaughtering house and transformed itself into the dominant brand name in white meat, without raising a single chick. By serving as the middleman between the capital-intensive business of poultry farming and the nearly profitless grocery business, Tyson can squeeze out a companywide operating profit margin of 4.1%. Few other agricultural companies can match that figure without growing tobacco.

IBP already has taken the first baby steps toward becoming the Tyson of the beef industry. The beef company bought a handful of food-preparation outfits over the past two years that gave it an entr? into the lucrative airline and institutional-food businesses. Last year, it ran a test launch of its new Thomas E. Wilson-branded shrink-wrapped packages, shipped directly from the slaughterhouse to grocery shelves. "They've done a good job of creating a name that consumers will eventually recognize," says Standard & Poor's analyst Maureen Carini, who nonetheless has an avoid rating on the stock.

But to mimic Tyson's success, IBP has to do more than brand its hamburger meat. "The key to Tyson's strategy was establishing confident relationships with the buyers, like McDonald's and the large food-service companies," says Prudential's McMillin. "IBP has just started that. It will take them another 10 years to finish it."

Unless Tyson follows through on its merger agreement with IBP. In that case, the same relationships Tyson has developed in the chicken business can be put to use in the beef business. The deal would immediately make Tyson the largest beef producer in the country, since IBP creates 29% of the beef that American's eat. Twenty percent of IBP's revenues come from pork slaughtering, another area Tyson wants to enter.

SECOND THOUGHTS? But Tyson is hesitating on finalizing the deal -- partly because it wants to make sure no more accounting skeletons are hiding in IBP's closet, like the SEC letter that didn't surface until after the deal was signed. But Tyson also may be having genuine second thoughts. "Part of me thinks they will chicken out," McMillin says. "They have to have a lot of guts to buy a beef company in the midst of mad cow, foot and mouth, and declining beef consumption."

Still, IBP is enthusiastic about the marriage. "We continue to join Tyson officials in affirming our desire to complete this transaction as promptly as possible," says company spokesperson Gary Mikelson.

And if the merger falls through? Shareholders will be left with a low-margin company with a cash position of only $35 million that's managing 4% earnings growth annually. That's not too tasty a morsel. Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

Questions or comments? Please visit our Ask Sam Jaffe interactive forum


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