Eyeing Ralcorp Hungrily

Okay, so Ralcorp (RAH) hasn't delivered big returns just yet. In fact, the stock has traded roughly breakeven over the last year. Yet, in a year where the S&P 500 drops 40%, that’s not too bad. So, what is this company that has fared so well in such a bad market?

Investment Thesis
Ralcorp is a private label manufacturer of a variety of food products ranging from cereals to snacks to frozen bakery products. In an economy where consumers are constrained and food costs have risen, people have increasingly traded down to so-called “knock off” store brands, a.k.a. private labels. Grocery retailers like these products as well as they often can push them through at higher margin than branded products. In fact, recent earnings calls with Costco (COST), Kroger (KR), and SuperValu (SVU) have confirmed that retailers industry wide intend to focus on promoting private label share.

As if trends for private label weren’t positive enough, Ralcorp is not resting on its laurels. In the last quarter of 2008, Ralcorp closed its purchase of Kraft’s Post Cereals business. This transaction is expected to be accretive of net income by 40 cents per share by the end of the year and already added 16 cents per share in Q4 2008. This to a baseline business which made $3.57 per share last year ($3.73 in total). Thus, even without growth in its base business, Ralcorp is likely to grow earnings by over 11% per share. While there is execution and integration risk with this acquisition, Ralcorp’s addition of a legitimate branded product line to its portfolio will allow the company to maintain earnings should the shift to private label turn out to merely be a transient counter-cyclical trend.

Valuation

Ralcorp added nearly $1 billion in long term debt to fund its acquisition of Post Cereals. AS a result, enterprise valuation may seem inflated (12x EV/EBITDA) versus 8-9x at other similar businesses (General Mills (GIS), Kraft (KFT), Kellogg (K), Treehouse Foods (THS)). Further, the company issued another $1.6 billion in shares which, to some degree, “diluted” share value. While EPS grew despite the issuance, valuation is now dependent upon continued performance in the Post brand. Without Post, organic EPS would actually look more like $3.21 per share on a run rate basis.

Obviously, this is unlikely given the fact that Post Cereals is a $1 billion in revenue business, but any destruction in value as a result of the transition could severly hamper value delivered.

Caveat noted, if you include management’s forecast for Post’s contribution this year, Ralcorp is actually trading at just about 8x EV/forward EBITDA which is generally in line with its peers. Thus, while it’s arguable whether or not debt pay down will serve to leverage equity returns at its current valuation, Ralcorp offers reasonable value and a very impressive growth trajectory should all synergies of acquiring the Post business be achieved. If Ralcorp can use Post to leverage distribution of its private label line or even expand Post’s market penetration more successfully than Kraft could, you could be looking at a legitimate food distribution powerhouse.

Is Ralcorp a buy, then? For most growth stocks, price to earnings is an easier proxy for value. That's provided that debt levels are manageable, since its earnings growth-- and not EBITDA growth-- that will ultimately be delivered to shareholders. In these terms, Ralcorp seems to be trading at roughly fair value to its expected earnings power - average industry P/E of 14x expected earnings of $4.16 = $58.24 - which does not leave a significant margin of safety. But, given the recession resistant nature of this business’ product and the significant potential growth trajectory, this could be a compelling buy should the share price correct close to or below $50.

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Full Disclosure: Author does not have positions in any stock mentioned in this article though positions can change at any time.

Comments

[Jim Regan:]

This is a nice article, but I fear that you are missing the big picture. Namely, how the heck does a private label get away with acquiring Post, an underperformer in the past that fits as a direct opposite to everything that Ralcorp stands for.

If private label is going to outperform, their entire portfolio is now diluted 20% by Post products that according to the thesis... nobody should be buying. If, however, you want to make the argument that they are positioning for a rebound... why wouldn't you simply want to hold a more premium brand that has none of the private label on their books (i.e. Kellog, Gen Mills).

Seems like a play to be made in January of 2008 to me, and we might be over-extending ourselves to find a new reason to hold this name through a rebound. People like that status symbol that tracks along with premium brands... and may not want to opt for the big ugly private labels once they can afford better.

Your thoughts?

Mar 26 05:43 PM

[DVZ:]

Jim

There is a certain percentage of the population that will buy brand names only until their last penny is gone. There are also those who never purchased a Private Label item until recent economic turmoil forced their hands.

Whether those customers will return to a branded product once their financial circumstances (or perceptions) change is really predicated on their experience with the PL products they buy. Having worked for a maufacturer of OTC drugs, I know that often they are made in the same factories as the branded product.

As a consumer, I know the quality of PL food products is often indiscernable from branded items. It is not the lowest quality item in a can with a white label and black print saying "Green Beans" any longer.

With grocery chains staking their brand image on satisfying customers with their private/control labels, they have every reason to make sure they are the highest quality. Every time stores reset their shelves there is more focus on PL, both in quantity of SKU's and in placement preference on the shelf.

All things being equal, the retailer can buy equivalent (or better) quality at up to 80% lower cost than the National Brand. Margins on an OTC Private label might be 250% vs. 35% on a National Brand and still have dramatically lower retails (while generating bigger penny profits). The spreads are not quite as high with food but the principles remain.

So National Brands will continue to decline as a percentage of the overall Market Basket. That still does not mean that Ralcorp can not grow their share of that business and using those branded items to leverage PL distribution would then be a win/win for them.

Mar 27 11:50 AM

[Yedidya:]

Still, would it not make sense for Ralcorp to purchase a better Brand Name company? Or is the idea to fix Post's problems and make it profitable again, therefore increasing Ralcorp's profits?

Mar 30 01:46 AM