It has now been almost a year since ConAgra (CAG) agreed to purchase Ralcorp Holdings Inc. for $90 per share, a 28% premium to where Ralcorp stock was trading at the time, representing an aggregate purchase price of $6.8 billion, including debt. ConAgra has now run the Ralcorp business for almost eight months since the transaction closed in late January 2013.
The Ralcorp acquisition was a long-term bet on growth in the private label market. It's too early to say whether that was a good bet, but we can look at how things are getting along so far.
FY 2014 Ralcorp EPS Accretion Re-Affirmed
In its first quarter conference call, ConAgra reaffirmed its expectation of $0.25 of EPS accretion from the Ralcorp acquisition during fiscal year ending May 2014, and is expecting around $400 million of EBIT from the Ralcorp businesses during that period. With long-term debt now at $8.8 billion, an increase of $6 billion over the prior year, many ConAgra shareholders may consider these results not to compensate for the additional leverage and associated risks that were taken on to finance the acquisition.
ConAgra management says the biggest savings from the Ralcorp acquisition will come down the road, and they have targeted $300 million per year in Ralcorp cost synergies in 2017. Management is also confident that they can drive private brand top line growth by installing sales teams organized by client (rather than branded or private label product) that can cross-sell across product. Management also believes that there are opportunities to focus the Ralcop business on organic growth and innovation rather than growth by acquisition.
The Ralcorp acquisition undoubtedly presents attractive long-term possibilities, particularly if the private label business takes share from branded products over time as management expects. But there have already been some bumps in the road, and that is concerning.
Management has alluded to several problems with Ralcorp that investors should keep a close eye on. The first was Ralcorp pricing problems that management discussed on the fourth quarter call. Ralcorp had gotten "upside-down" on a few commodities, but presumably management is well on its way to working through that by now. Management has also on several occasions characterized the Ralcorp business as an acquisition-focused business and implied that the organization itself was lacking in terms of organizational capabilities, including the capacity for organic growth.
Most concerning is management's references to Ralcorp's internal restructuring prior to its acquisition. On the fourth quarter conference call, the CEO said:
"Ralcorp's own restructuring efforts that started maybe 6 months or so before the acquisition frankly cut the organization too deeply, particularly on the sales front."
Management then followed up on the first quarter call with:
"Rebuilding the leadership team and the sales force from the Ralcorp restructuring that took place a year ago, several months before the transaction, is part of this work, and we are getting those customer-facing positions in place as we speak."
"And Gary hit on the organizational changes that were executed prior to the acquisition, but it really consolidated a big part of the portfolio under one general manager. And our diversity of products and categories, as well as the customer diversity, just really translates into a different org design that will enable far deeper focus. As Gary said, customer by customer, category by category, it's not a one-size-fits-all and breaking the business down into those business units to enable the focus, from our perspective, will have a significant impact and really help us in the customer execution. And we'd lost some of that. And I believe that the execution, not only from the customer facing but also the total operations, will improve as we get things set up and rolling forward."
Is Management Setting the Stage?
All in all, these issues seem surmountable, but it is nevertheless concerning and somewhat unusual that management speaks so negatively of the Ralcorp organization and management decisions. At the risk of exaggerating the point, Ralcorp is being characterized as an acquisition shop that did not have the organizational capabilities to achieve organic growth or innovation, had made commodity pricing mistakes and had cut its leadership team and sales force too deeply to have adequate customer coverage.
A skeptical take would be that management is laying the foundation for an explanation for any future disappointments in the Ralcorp business or failure to achieve the expected synergies. A less skeptical interpretation is that these are all significant near-term issues that can be dealt with. But if that's the case, given these hiccups and the general sluggishness in the private label business right now, one may question whether ConAgra overpaid for Ralcorp or, at least, could have purchased the company for a lower purchase price if they had waited and some of these pricing, management and sales coverage issued had affected Ralcorp's results.
I believe that the private label business offers attractive long-term opportunities, although I am not yet convinced that the combined branded and private label business is the right model. Although ConAgra shares may seem cheap if they can achieve the earnings growth that management has guided for, it appears that there are some issues with the Ralcorp business that investors should stay focused on.
With future earnings guidance so dependent upon the performance of the Ralcorp business and achieving the ambitious synergies from integrating the Ralcorp business, I would steer clear of purchasing the shares at these levels until management is able to tell investors that the near-term issues in the Ralcorp business have been resolved.