Tasty Baking Is a Tasty Short

| About: Flowers Foods, (FLO)

Although this is a great shorting opportunity, what's happening to Tasty Baking (TSTY) is actually a sad story. It's an iconic brand in Philadelphia that makes small cakes pre-wrapped at the bakery and sold at local grocery stores.

People around Philadelphia have grown up eating these delicious cakes. The business started with a couple guys in 1914 who went into business making baked pastries with quality ingredients. The cakes became so popular that the company began to expand and eventually became a huge corporation with over $180 million in annual revenues today. Now, Tasty Baking might be baking itself into oblivion.

TSTY has been losing money quarter after quarter, and has consistently paid dividends. This happened to the point where it has been carrying almost zero cash on its balance sheet, or just $5,000, since the fourth quarter of 2009. Below are numbers I picked from its quarterly SEC filings that illustrate the company's downward spiral. Note I didn't include Q4 because these are enough numbers to tell the story.

(in thousands $)

Quarter Net Income (loss) / Long Term Debt / SHE / Interest Exp

Q1 2008 / (959) / 36,778 / 45,442 / 456

Q2 2008 / 75 / 37,398 / 45,529 / 508

Q3 2008 / (1352) / 53,364 / 43,408 / 545

Q1 2009 / (70) / 67,561 / 32,300 / 604

Q2 2009 / 2345 / 80,093 / 33,368 / 545

Q3 2009 / (531) / 88,403 / 32,426 / 720

Q1 2010 / (3920) / 96,441 / 24,557 / 1319

Q2 2010 / (3334) / 98,580 / 20,962 / 1579

Q3 2010 / (4940) / 96,738 / 15,761 / 1823

Q4 2010 (We'll find out how bad in March)

Notice how debt has continually risen since Q1 2008, even when the company had a good quarter now and then, like in Q2 2009. Even though its long term debt stayed somewhat steady through 2010, the vast increases of its interest expense through that period shows that it's also piling up short term debt that it needs to pay interest on.

TSTY's management has a hard time earning more than it spends. Keep in mind it also has added to the slow crushing of the company by continuing to pay out $425,000 in dividends every single quarter. Since it didn't have cash flow to pay it, it borrowed from its credit facility. It's very irresponsible for a company to add to its already heavy debt load in order to pay dividends. Through 2010, shareholders' equity was dropping at an enormous pace.

Now TSTY is at the point where it can't pay off its debt at all without an extension. At the beginning of January, the stock dropped 40% when the company announced its debt problems and the stock has been gradually declining since then. On January 14 it got a reprieve, largely from a great show of support from the citizens in Philadelphia who show a lot of love for the brand. It got $6.5 million in loans to continue operating, $3.5 million from private investors and $3 million from the local government, secured by its assets.

TSTY also negotiated so it doesn't have to pay off any debt principle until the end of June. The banks stipulated some covenants, including that TSTY must not pay dividends. Unfortunately, TSTY still has to pay interest on the debt, which is a huge expense -- over $2 million this quarter.

It seems like TSTY's problems first developed from an ambitious building of a huge new "green" factory and closing down its old one. Like most ambitious development projects people undertake, there are often unpredicted problems and expenses that constantly come up. This management seems to look through glasses that are too rosy to realize this, and has a habit of sweeping its problems under the rug. Then, with the now-higher commodity prices for ingredients like sugar and cocoa, its cost of goods sold has increased. It was inevitable that the cookie batter would hit the fan.

As if things couldn't get any worse for TSTY, the UN's food and agriculture organization said food prices reached an all-time high in January. This is another reason why it's a safe short. TSTY has more of a chance of going bankrupt now than it did when food prices were lower. Sugar reached its 29-year high in November 2010 and has stayed consistently at those levels. Cocoa is also reaching similar highs, partially due to political unrest in West Africa, where they export cocoa. We haven't seen the effects on the income statement of November peak level commodity prices, but we will on TSTY's next income statement -- and it won't be pretty.

But the Tasty Baking tragedy is probably better explained by the management, which knows its company and business better than I do. Below are excerpts from TSTY's Q3 2010 earnings call on November 1, 2010. Charles Pizzi is the company's CEO, and Paul Ridder is its CFO. From this call it's clear to me that these guys are incompetent and dug the company in a hole too deep to dig themselves out of.

"We understand the stress that the challenges and significant complexity of the new bakery project has placed on our shareholders, our company, our independent sales distributors, and our retail partners. As with most things, great rewards require sacrifice. We have made great progress since the beginning of the third quarter. But there is work to be done to fully complete the transformation." -- Charles Pizzi

Not finished yet? Well, I think you're tapped out of things to sacrifice!

"For the quarter ended September 25, 2010, depreciation expense declined by more than $800,000 as compared to the third quarter of 2009 to $2.7 million, as the accelerated depreciation associated with the move from the company’s former facilities was completed." -- Paul Ridder

Okay, so the income losses are less about depreciation and more about losing cash.

"We expect the commodity costs in the near-term are going to continue to be a headwind. We’ll evaluate pricing action, promotional action that’s necessary to offset that." -- Ridder

Great. So to offset increasing costs, you're going to increase the price of your product and spend more money on advertising. TSTY's management hadn't thought to hedge at all for rising commodity prices. Ridder had mentioned that commodity costs are a "headwind" about three times in the earnings call. I think a 2x4 to the face is a better portrayal.

"For the third quarter of 2010, the company had capital expenditures of approximately $1.7 million, which included $800,000 in expenditures related to the new bakery project. As we move forward through 2011, we anticipate that capital expenditures will be less than $7 million and would primarily be used for a combination of future cost improvements and revenue enhancement projects." -- Ridder

So you're expecting capital expenditures in 2011 to be less than $7 million. $1.7 spent in Q3 2010 comes to $6.8 million, so it's safe to say capital expenditures aren't going to decrease. Like the CEO said, there's more work to be done ...

"We’re evaluating those options to ensure that we have the complete ability to repay and satisfy all our obligations as they come due. I don’t think we want to discuss particulars, but we are evaluating all of our options, including debt." -- Ridder

Guess you're gonna wait to discuss the particulars when you can no longer make your debt payments. Way to think ahead!

"$4 million annually is usually our true marketing number." -- Ridder

Doesn't seem like a lot for a company that has $180M a year in revenue.

What a mess. It's very unlikely TSTY will be able to make a comeback. Pizzi mentioned in the earnings call that TSTY hired an online marketing team to increase online sales. I checked it out and noticed you can buy the treats on the website and on various other sites like Amazon.com (NASDAQ:AMZN). On Amazon, there's only a few comments about the treats, and 90% of them are from 2008 and 2009. That makes me think online sales aren't increasing too much, if at all.

As far as trying to save costs by laying off workers, the management has done that already. The technology of the new plant can supposedly do the work that factory workers used to do, so it laid off hundreds of employees in the transition.

Now assuming TSTY won't make a comeback, the only option is to sell itself. The fact that it's in such a desperate position means it will have to offer itself cheap. It's definitely not worth more than its book value. It's currently trading at $3.10, and the book value is $1.84.

The brand is a popular brand, so it can get a few million for the name. The plant is having trouble generating a profit and has some kinks to work through, so it will be sold at a steep discount. If the company is sold quickly, the bondholders will be paid off and the shareholders will get at best $1 a share. The longer it takes TSTY to make a deal, the more frosting will leak, and the less it will be worth.

Disclosure: I am short TSTY.