In August 2011, Ralcorp Holdings Inc. (RAH) received a letter from ConAgra (NYSE:CAG) with a non-binding proposal to combine the two companies at $94 per share in cash. This offer follows a $82 per share in March 2011 which was subsequently revised to $86 in cash per RAH share.
Following the rejection of CAG’s offer, RAH not only recently acquired Sara Lee’s (SLE) North American Refrigerated Dough business for $545M, but also announced a spinoff of Post Foods (also known as Post Cereals) into a separate company.
Ralcorp Holdings Inc. (RAH) currently trades at $82.00. We recommend shorting RAH “right now” and going long Post Foods (POST) “after” the spinoff happens.
- Potential Upside: $20 a share
- Base Case: RAH goes from $83 to $55 while Post Foods, after the spinoff, rises due to good fundamentals - base minimum valuation of $21.
- My Spinoff Ratio Calculation: 1 POST share for 3 to 4 RAH shares.
- Market Capitalization: $5.0B.
- Cash: $51M.
- Upcoming debt: $300M.
- Shares Outstanding: Approximately 55M.
- Industry: Consumer/Non-Cyclical Industry: Food Processing.
- Situation: Spinoff and M&A play.
- Trading timeline: 15 to 18 months.
Main Event: Probability of failure takeover offer from ConAgra (CAG) and spinoff of Post Foods.
What Are The Catalysts For Shorting RAH?
(From $83 to $60)
It might seem strange that I am making a case for shorting RAH, but here is why:
Firstly, RAH stock has gone up by approximately $20 since the takeover offer announcement by CAG in March 2011 of $82. The most recent CAG offer that was made was of $94 a share, while the stock still lingers around $84. Various industry reports speculate that CAG’s may intend to go hostile with a higher offer in the range of $95 to $100,
However - there is a catch: The catch is that RAH is domiciled in the State of Missouri. The acquisition laws in the state gives the Board of Directors enough power to reject the bid, if they deem so. The relevant statutes are the "Control share acquisition statute", the "Business combination statute" and the "Constituency statute". Especially important is the “Business combination statue” which states that Missouri prohibits ConAgra from engaging in a merger with Ralcorp for five years if it acquires 20 percent or more of Ralcorp without first meeting one of three conditions: (a) The acquisition is preapproved by Ralcorp’s board of directors, (b) preapproved by the other shareholders, or (c) is at a fair price. Additionally the “Constituency statute” allows Ralcorp board to consider interests other than shareholders in deciding whether to accept or reject a takeover offer.
Furthermore, RAH recently adopted a shareholder rights plan against anyone acquiring more than 10% of RAH equity. Additionally, Ralcorp also has a staggered board, meaning that it might take another two years to take control of the board and remove this poison pill if CAG wants to remove. The RAH board, which has consistently refused to consider a potential sale, has decided on the spinoff instead. The spinoff does not require shareholder approval. As soon as there is a perception that CAG completely withdraws, the potential downside for RAH stock is $20 to $65 a share, which is where the stock traded prior to the takeover rumor.
Secondly, in addition to assuming that the CAG takeover does not go through due to the RAH board's refusal, the spinoff will provide further $10 downside to RAH - and here is why: Of the 5 segments, namely Cereals, Other Cereals, Snacks, Sauces & Spreads, Frozen Bakery and Pasta, only Branded Cereals (a.k.a Post Foods) reported 23% operating margins, with the rest of the segments in mid-teens (9% to 16%). Pasta which has only been in business for the past 3 quarters and constitutes only 12% of the total revenue as of March 2011, also reported a 22% operating margin.
Furthermore, fundamentally performing a sum of the parts analysis (SOTP) leads me to believe that Post Cereals constitutes approximately 50% of RAH's EBITDA. Industry estimates value the company at an average multiple of 8.5x. Assuming that RAH will receive a $1.1B dividend from POST after the spinoff, and that this dividend will be used to pay down the debt, RAH can be valued at $63 a share. This assumes a 8.5x EV/EBITDA multiple. Performing a competitive analysis, RAH should be valued at $75 a share, including a $21 a share value for Post Foods.
This brings an approximate value for RAH - without POST - to approximately $55 to $60 a share. Moreover, declining consumer spend into 2012 will continue to pressurize margins, putting downward pressure on the stock. Spinning off a business that not only makes up for 50% of RAH EBITDA but also generates highest operating margins for the company does not bode well for the firm in the medium term.
A positive might be a potential sale buyback from the special dividend that RAH will get from POST after the spinoff. With only USD 300m of debt coming due in another year, it still leaves approximately USD 800m cash on hand. Even though it’s highly unlikely, if RAH deploys the entire special dividend of $1.1B to potentially buyback shares at $80 a share, 10m shares or 18% of a float can be bought back, providing some floor to the declining share price.
What Are The Catalysts For Going Long Post Foods After The Spinoff?
(Base value of approximately $21/share)
Spinoff entities, in this case Post Foods, are sold out by funds who are not allowed to hold special situations in their portfolio but hold the parent company instead - in this case RAH. This automatic sale will lead POST shares lower, creating buying opportunities for investors. Is it the only reason to go long, after they go below their fundamental value? No! However there are few reasons as to why it’s a stock worth going long on.
Firstly, POST enjoys the third largest market share in the US in the Branded Cereals category and has been able to maintain its sales and operating margins throughout the past three years. Additionally, POST generates the highest operating margins of all the segments (23% over the last 10 quarters) and produces 50% of the EBITDA for RAH. Assuming a 7.5x EV/EBITDA multiple, POST’s equity can be valued at between $1B to $1.2B after the spinoff, or $21 a share after calculating a 3:1 share distribution ratio.
Secondly, POST's high EBITDA and operating margins compared to other segments may entice potential acquirers after the separation, including CAG, which has been repeatedly rebuffed by RAH board. Industry reports state that CAG has been recently focusing on its branded portfolio due to its high margins.
Furthermore, a point seldom given importance by investors is the management. After the spinoff, POST will be lead by Mr. William Stiritz, the current chairman of RAH, who will take over the management of Post Foods. Mr. Stiritz has had extensive experience with spinoffs and has been chairman of RAH for 17 years. Additionally, he has been a private equity investor and sat on various other boards such as those of Energizer Holdings and Reliance Bancshares. He may catalyze a sale of Post Foods post-spinoff, generating larger than expected returns for Post Foods shareholders.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.