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Maple Leaf Foods (MFI)

Q3 2007 Earnings Call

October 25, 2007 2:30 PM ET

Executives

Michael McCain - President and CEO

Michael Vels - CFO

Analysts

Bob Gibson – Octagon Capital

Irene Nattel – RBC Capital Markets

Cherilyn Radbourne - Scotia Capital Markets

Operator

Welcome to the Maple Leaf Foods 2007 third quarter financial results conference call, hosted by Mr. Michael McCain, President and Chief Executive Officer. (Operator Instructions) I would now like to turn the meeting over to Mr. Michael McCain. Please go ahead, sir.

Michael McCain

Thank you and good afternoon, everyone. Thank you for standing by here today. On today's webcast we will discuss Maple Leaf's financial and operating results for the third quarter of 2007. The news release and presentation are available at Maple Leaf.com under in the investor section. We would encourage you, as always, to view the webcast on our website.

As a reminder, some of the statements made in this call may constitute forward-looking information and future results could differ materially from what we may discuss today. Please refer to the MD&A section of our 2006 annual report and other public filings for a broader description of our operations and factors that impact our financial results.

On today's call, I will discuss the operating results for the quarter and then I'll turn it over to Michael Vels, our Chief Financial Officer, to provide other financial information. I will wrap it up and open the line up for questions following Michael's comments.

If I could begin by turning your attention to page 3 and a summary of the third quarter of 2007 for Maple Leaf. This is a very complex and unprecedented environment that Maple Leaf is operating within today. There are factors that are driving that outside our organization and inside our organization.

Outside the walls, we have uncharted territory in things like the currency, which has increased by over 21% in the last seven months alone; things like the wheat markets, which have increased by 75% in the last four months alone; things like a lean hog market that increased in middle of June by 21% in the following 30 days, and then subsequently declined by 26% in the next two-and-a-half months. This type of environmental volatility is unprecedented in our industry and our business, and creates tremendous demands on the organization.

In the context of inside our business or inside our walls, we are in a state of massive change as we reposition our business to address these opportunities and focus on the structural changes to reposition the business in what we describe as Destination 2010.

So I'm going to make some comments both on the quarter in this business, but I'd always ask our shareholders and analysts to maintain the focus on what we are trying to do to reposition our company for the long term over the course of the next two or three years.

In the face of all this, we increased our operating earnings by 14% in continuing operations in the quarter and 17% on a year-to-date basis which quite frankly, we're very well satisfied with. We now have a balance sheet that is stronger than ever. In fact, one could argue under-levered -- which we have no intention of sustaining -- and our progress with respect to the repositioning of our business is on track and progressing well.

Some of the highlights for the quarter include improved bakery results, mostly driven by improved performance in our frozen bakery and the UK bakery as a result of successive acquisitions in that market. But also, our meat group benefited from manufacturing improvements and very effective price management to maintain margins, despite the volatility and input cost increases that we faced in the external environment.

These were materially offset by significant losses in hog production operations which pressured earnings both as a result of currency shift as well as the rapid rise in feed costs, and the currency shift that negatively affects the broader protein business model outside of hog production as well.

We have made excellent progress in our protein reorganization, as I'll comment in a moment, and have met or exceeded all of the objectives that we set for ourselves in 2007 in implementing that strategy. We are increasing our investment in our core value-added food businesses to increase our efficiency, add capacity and accelerate new product activity in the value-added segments of our business.

Turning to page 4, the financial summary is captured here. The operating earnings increase of 14% to $39 million. A $0.01 year-over-year comparable increase in earnings per share from $0.05 to $0.06. It is important to note for those financial modelers on the call, to build in the effects of delevering the balance sheet following the sale of Maple Leaf Animal Nutrition. So an apples-to-apples comparison is $0.05 to $0.06 and the 14% increase in operating earnings; and a year-to-date increase of $0.06 per share from $0.25 to $0.31 on an apples-to-apples basis.

Again, this is in the context of unprecedented volatility, significant market headwinds, no material benefits in the quarter or year-to-date as a result of our strategic activity. In fact on the contrary -- some very high costs of implementation in the short term.

Turning to page 5, in the meat products group our sales declined due to the sale or exiting of non-core global businesses. That notwithstanding, we had a 25% increase in operating earnings, notably driven by our ability to offset higher fresh meat input costs in our processed meats business through price increases, as well as very strong fresh poultry markets, largely driven by the manufacturing efficiencies due to the plant closure in Atlantic Canada.

These were offset by the headwinds of market conditions, currency, implementation costs in our change initiatives, and the investment in new innovation for product lines such as Maple Leaf Simply Fresh.

An example of that new innovation -- which is always important to us and always at the top of our radar screen -- is new products update, as illustrated on page 6. Maple Leaf Simply Fresh continues to perform well in the marketplace, particularly in their single-serve entrees, which is a category that is growing as well in the double-digits. We have continued strong growth with a 39% market share in single-serve fresh entrees today and 25% across the chilled meals category.

We continue to innovate inside that space with five new entrees and one new meal kit to be launched in October, but this is a great example of our vision to expand not just in value-added meat, but value-added meat and meals.

On page 7, the agri business group is a very difficult story. We have all of our hog production assets included in this business segment, and those hog production assets were badly hurt by the currency shift of 21% in the last seven months, as well as the rapidly rising feed cost.

It is important also to note that in Western Canada, the basis of the feed diet is wheat-driven and not corn-driven, so the basis difference between wheat and corn markets is an incremental hurt for the hog production assets.

This is offset by the rendering business, which is somewhat the beneficiary of rising commodity markets, but the net is a significant decline in our operating earnings in the agri business group.

As far as the protein reorganization update on page 8 is concerned, as I said earlier, we are accomplishing all of our objectives stated for 2007, either on track or exceeding our goals for the year. That said, we have many, many things left to do over the course of the next two years. Things such as the sale of the Burlington facility, the sale of our hog production assets in Alberta and Ontario, completion of the ESI restructuring, the second shift at our Brandon facility, the implementation of our shared service organization, plus all of the elements of our innovation agenda. So a great year, a great start, lots of work left to do.

Turning to our bakery group, on page 9, I would characterize the story as wheat, wheat, and more wheat. A 75% increase from what was trading in the $5 range as early as June of 2007. Closing the third quarter in excess of $9 is just virtually uncharted territory in the worldwide wheat market and challenges our ability to advance prices rapidly enough to offset that increase.

Embedded below the bakery products group performance, which had a healthy operating earnings increase of 31% in the quarter, is a significant improvement in performance in our frozen bakery business and our UK business, offset with a very marginal decline in profitability in our Canadian fresh bakery operations driven by this wheat cost increase.

I would make a quick spotlight on the UK operation, which continues to go from strength to strength, as demonstrated on page 10. We've had both high levels of organic growth and contribution from acquisitions that continue to derive the results in the UK bakery business.

The most recent acquisitions are the French Croissant company, which gives us a leading market share in the ambient croissant market. Our continued high level of double-digit growth rates in the bagel market, which we are a leading participant in; and most recently the acquisition of a specialty bread producer called La Fornaia in August 2007, which we're very excited about. So our UK bakery business continues to strengthen in specialty bakery categories that we can lead in and has performed very well and continues to perform very well for the company.

Turning now to various market factors that underpin all elements of our business, the first on Page 12 is the corn market, which has stabilized in the high $3 range, but continues to be a precarious market driven by the dynamics of food for fuel and the trends that are attached to that. This has an effect on feed prices and hog production costs, which obviously flow all the way through to fresh meat prices and processed meat costs, and also relate to the higher wheat and dairy costs that affect our bakery and fresh pasta operations.

Page 13, you can see that 75% increase in the last four months, in wheat prices. They have climbed 49% year over year, 75% in the last four months, so significant volatility. It affects the flour cost in our fresh and frozen bakery business, the pasta business, but also affects feed costs as the Canadian producers lose the wheat cost advantage over corn in the near term.

Page 14 illustrates the poultry processor spread, which is down 6% quarter over quarter, largely declining as a result of feed costs that flow through to the live bird price. Our improvement in poultry market performance is largely driven by manufacturing efficiencies from the closure of the Atlantic Canadian operation, as I said earlier.

The pork processor margin is down 55% as well in the quarter. Although we expect some strengthening in the fourth quarter of that processor margin, certainly in Q3, particularly the first half of the quarter, was under some degree of pressure.

At this point, prudent to turn it over to Michael Vels, the Chief Financial Officer for Maple Leaf, for some financial highlights and then I will return with a summary and wrap-up.

Michael Vels

Thank you, Michael. There are a variety of financially-related impacts in our quarter ended September. Michael already mentioned the acquisition of the La Fornaia business in the UK, but we also finalized and accounted for the sale of our animal nutrition business in this quarter, I would remind you we netted $525 million for that business. We'll pay relatively few cash taxes on the business and most of the proceeds went to pay down debt. That business was sold for a significant multiple of earnings and has significantly improved our balance sheet position.

On the capital spending side on page 17, our capital spend consistent with prior quarters was up significantly for the third quarter and for the year-to-date. The reason for that is tracking our prior explanations. It's a mix capital related to restructuring of the protein business.

For example, the construction and commissioning of the second shift in Brandon, but also driven at the same time by some very significant growth capitals. For example, the investment in our new Brampton, Ontario plant which is supporting the Simply Fresh launch, and very significant capital expansion in the UK, where we're adding bagel capacity, bagel storage capacity and also croissant capacity to meet customer demand.

We do anticipate, consistent with our prior estimates, a very significant fourth quarter capital spend, and believe that our full year of capital could approach approximately $260 million.

On page 19 for the quarter, we had a relatively low level this quarter of restructuring costs, no significantly new initiatives to talk about in that number, and mostly that number is a continuation of the costs previously announced initiatives.

Turning to page 18 and looking at the total restructuring costs in terms of what we have charged to earnings already in 2006, and then for the nine months to-date in the third quarter, we are approximately 70% to 80% through the total estimate of restructuring costs at the lower end of our range of $165 million to $215 million. We estimate, depending on the outcome of the sale and closure of certain facilities, relatively small further charges in respect to cash earnings, and anticipate by next year that most of the restructuring charges should have been charged to earnings.

Finally on page 20, we provide a snapshot of one of our key lending ratios, which shows the band in which it has traded over the past several years to 2.5X to 3.5X on a net debt to EBITDA basis. Based on the underlying cash flows of our business, we've tended to target in the 2.5X to 3.5X range.

As you can see after the sale of the animal nutrition business, it's trading significantly below that range at just over 2X earnings. As Michael said, we anticipate with our increased earnings over the timeframe of the protein restructuring and the significant reduction in debt as a result of the animal nutrition sale, that our balance sheet will ultimately be significantly under-levered.

With those few comments, I will hand it back to Michael and then we can take some questions.

Michael McCain

Thank you, Mike. So in the context of unprecedented turbulence in the external environment, which we are -- I think -- managing effectively and as best we can in delivering a solid operating performance in the midst of that, our focus continues to be on the ultimate destination in 2010 of an entirely repositioned organization to move forward beyond that time.

We're managing structural change and repositioning in the context of this turbulence and delivering solid operating performance, in the face of rising input costs. We had major capital projects underway, but a strong balance sheet which will both carry us through these turbulent periods and also position us well beyond 2010 in looking for future opportunities.

So all in, actually, we are quite pleased with the performance in the quarter and look forward to continuing on our journey of restructuring and transforming the business as has been outlined over the past year.

With that, I'll turn it over to questions from the participants on the call.

Question-and-Answer Session

Operator

(Operator Instructions) The first question is from Bob Gibson – Octagon Capital.

Bob Gibson – Octagon Capital

66,000 hogs, was that as of the end of the quarter?

Michael Vels

I'm sorry, Bob. Can you just give me a little more context to that question?

Bob Gibson – Octagon Capital

You said you had effective ownership of 66,000 hogs.

Michael Vels

You're talking about the number of sows under management?

Bob Gibson – Octagon Capital

Yes.

Michael Vels

Yes. that was at the end of the quarter.

Bob Gibson – Octagon Capital

Just a conceptual question, how are these farmers going to make any money?

Michael McCain

A conceptual question. We have many cost adjustments and structural changes underway. The feed costs, we hope actually that the basis between wheat and corn will restore to more normal levels over the course of the next six months to a year.

We believe that the lower cost of the vertically-integrated model that we're in the process of implementing will significantly contribute to cost reduction. We have a number of elements of our operating costs which we're looking for improvement. Many of our inputs, as the currency is rising, we're working those costs down. Everything from veterinary supplies to capital costs. So we're hoping and optimistic that we can adjust, but it does take some time.

Bob Gibson – Octagon Capital

It sounded like you were going to be spending a lot of money in this current fourth quarter. Is this a new direction, or was this planned? Just give us some color.

Michael Vels

It was planned, Bob. The estimate of 260 for the total year is something we've held to all year. Many of the investments that we're making are back ended. We only recently started on the construction, for example, of our distribution warehouses out west and so we currently have the floors in place and the walls up in Vancouver and Saskatoon. A lot of that spending will be coming in the fourth quarter.

Secondly, much of the capacity investment in the UK began construction in the third quarter, it will be paid for in the fourth. A fairly significant amount of the first shift at Brandon will be finalized and paid in the fourth quarter as well.

So there are several back-ended projects, just in terms of payment flows, but that is what we planned and it is within our estimate we provided at the beginning of the year. And, I may add, no new projects over and above what we had anticipated at that point.

Bob Gibson – Octagon Capital

Last quarter you said if the Canadian dollar was above par, you might have to reevaluate your supply chain. Any comments?

Michael McCain

That's, something we will constantly be looking at. We're 2% higher or 3% higher than above par today. Certainly would rather be $0.90 than parity and we would rather be at $0.80 than $0.90. But I don't think we're materially above par at this stage. I would tell you that responding to the currency environment that we face today is something that is just requiring all of our organization's attention and the response mechanism is about cost, cost and cost. We're just scrubbing every corner of our business looking for opportunities to readjust, to realign our business, to compete in the North American market at a parity dollar.

If the currency goes to $1.10, we'll look for new opportunities. If it goes to $1.20, we'll look for new opportunities. Do we have a plan for every eventuality of where this currency goes? The answer is no. Do we have confidence that whatever comes our way, we're going to react to it in a very aggressive way? Certainly as the currency grows, the primary mechanism is cost reduction.

Operator

Your next question comes from Irene Nattel – RBC Capital Markets.

Irene Nattel – RBC Capital Markets

Both of you mentioned in your prepared remarks that the balance sheet gearing levels are lower than where they have been historically and probably a little bit lower than your target levels.

In the past, or in the recent past, you've indicated that you don't really want to make any big acquisitions right now, given everything that's underway. Would you care to comment on how you're thinking at this point in time about acquisitions?

Michael Vels

Our perspective on acquisitions hasn't changed. We're not looking for big acquisitions. Actually we're not even looking for small acquisitions in our protein business. All of the focus in the protein business is around completing our capital spend and the restructuring that's required in that business to reposition it with the new consumer product space direction.

On the bakery side, however, we do continue to scan for acquisitions, particularly in Europe. We continue to look for new growth platforms, even in our mature Canadian business, and as we've said before, we do think there are acquisition opportunities in the frozen/par-baked bakery business in the U.S.

So we haven't slowed down our activity or our point of view on acquisitions in the bakery business, but we're not out actively looking for acquisitions in protein at this point. We believe that will change as our protein business comes in line. We'll more and more need to look outside of Canada in our protein business for growth, and that will likely come from acquisitions.

Michael McCain

I think it would be fair to say, Irene, that over the course of the next couple years, our first priority and 98% of our time is based on getting the foundation of our repositioning the business right and executing what we have on the plate today as opposed to acquiring larger acquisitions. So that's clearly where our focus of effort is in the next couple of years, and that's the appropriate place.

You could probably safely expect that we'll have an under-levered balance sheet for 18 to 24 months at least, but we would not expect to sustain that situation into the long term. Once we get our restructuring complete, we'll have the balance sheet to look at some game-changing strategies for the organization going forward.

At the end of the day, it's a nice place to be through this position of change, but we'll look for game changes in a couple of years.

Irene Nattel – RBC Capital Markets

If we could just stay with the protein segment for a moment, how is the startup in Brandon coming along, the second shift?

Michael McCain

We started in the front end of that second shift on September 4th and it's gone phenomenally well. The startup occurred with great precision and we've been on plan, on track almost to the day in the ramp-up so far this fall. We're not yet complete through the ramp-up, and keep in mind that's only in the front end portion of that process. The more complex back end startup won't occur until the fall of 2008. So all I can tell you today, is absolutely on track and so far, doing exceptionally well.

Irene Nattel – RBC Capital Markets

One final question, if I may. In the bakery segment, you had announced price increases for Q4, but clearly wheat prices have continued to go up. So I'm wondering whether the price increases you've already announced are going to cover the incremental input costs, or do you think you're going to have to take more early next year?

Michael McCain

I think it's highly likely that we'll have to take more next year, but we're studying that very carefully. I'd say the balance of probability is that we would have to take more, but there are two observations I would make.

More recently, if you track it on a day-by-day basis as we do, more recently it has come off a bit, actually down to the $8 mark. Where that trend unfolds is an important consideration.

Also, what the wheat futures is saying is that there's actually an inverted curve here. So it peaks and then declines in the back half of next year. All of which is to say it's a very volatile situation. We're monitoring it very carefully and we haven't made a final decision yet as to whether or not we absolutely do need to take further price adjustments in the first quarter of 2008.

It is uncharted waters for us in that respect, so we're looking at it very carefully and we would hope to make a decision on that sometime over the next 30 or 60 days.

Operator

Your next question comes from Cherilyn Radbourne - Scotia Capital Markets.

Cherilyn Radbourne - Scotia Capital Markets

I was hoping you could speak about, for each of the three business segments, the sequential change in your earnings from Q2 to Q3? Because there's been a lot of change in the commodity market since 3Q06 and so I think it would be more helpful for me to have a discussion about the sequential change in earnings as opposed to the year-over-year change.

Michael McCain

The problem with that analysis, Cherilyn, is that there's such extraordinary seasonality in our business. If you look at the year-over-year change, the actual progression from quarter to quarter kind of cracks and last year, reasonably well, and reflects the normal seasonality of the various businesses in the portfolio. You can do bridging in this business from one quarter to the adjacent quarter, but I would respectfully suggest that it's much less meaningful than the quarter over quarter because of that seasonality.

Cherilyn Radbourne - Scotia Capital Markets

So just thinking about the meat products group, for example, you've had a movement in your earnings in that sector from $21 million in the first quarter to $15 million in the second quarter, to $11 million this quarter. Would that be primarily just a seasonal pattern, or could you reflect for us some of the underlying movements in the businesses?

Michael McCain

There is a combination of both of those, but the most significant, I think, you get much closer symmetry to the year-over-year percentage changes quarter to quarter than you would the actual quarter results because, for example, in primary processing, which is embedded today in our portfolio -- significantly embedded -- you have a large exposure today and haven't materially adjusted that in the fresh business. There's very, very material shift in the profitability of that fresh business seasonally.

By way of an example, July and August are historically the absolute two worst months of the year in our primary fresh pork operations and they have been for a decade, as long as I've been involved. That's just a short form version of there's a combination of changes within the portfolio and the mix of businesses in it, but the seasonality is so defined and pronounced in the business that I really think that the quarter over quarter is a better analysis.

Cherilyn Radbourne - Scotia Capital Markets

Could you give us some commentary then on how the processed meat and meals business has performed year-to-date?

Michael McCain

In general, the processed meat and meals business in terms of its profitability is down on a year-to-date basis and the fresh performance is up, largely reflecting the first half of the year, and our ability as raw materials costs ramped up dramatically and food inflation, primarily affecting the value-added portion of the business, and our ability to pass on prices from a lag time perspective.

So the lion's share driving that is the lag effect in pricing on the further value-added processed meats and meals business. Our volumes are strong. They continue to be strong. Through to the end of the third quarter, both our margins and volumes are in good shape, so there's nothing fundamental but positive news in our value-added meats and meals business. There's always some puts and takes there along the way, but in general terms, the only material factor here is the lag time in prices.

Cherilyn Radbourne - Scotia Capital Markets

Any further thoughts on when we might see some enhanced disclosure, separating the fresh versus the further processed businesses?

Michael McCain

I think it's going to become increasingly difficult to accomplish that as we integrate these businesses, Cherilyn, so I don't know that we'll be able to accommodate that.

Cherilyn Radbourne - Scotia Capital Markets

Last question for me, if I could. The notes to your financial statements indicate that there was an award of 1.5 million restricted share units in October. Could you just tell us what that relates to?

Michael Vels

It relates to our long-term stock incentive program, Cherilyn. The company today mostly issues restricted share units as opposed to options. Every year in the early fall, we make our annual awards and that's what that would have represented. The way that is currently financed by the company is the restricted stock units are awarded to employees, but they are deferred and the vesting of those stock units depends on the stock price performance compared to the performance of the S&P Food Index; very similar to the performance vesting that we had on our options.

The difference is that the company trust now purchases those shares over time and holds them until such time as they vest. So you will see that payment coming through in our cash flow statements under the purchase of treasury shares as well.

Operator

Your next question comes from Irene Nattel – RBC Capital Markets.

Irene Nattel – RBC Capital Markets

You did note the significant losses in hog production. Is it fair to say that the year-over-year decline in contribution from the agri business group is all attributable to the losses from hog production?

Michael Vels

Yes, that would be correct. Because of the discontinued operations disclosures, there are no animal feed results in either this year. The rendering business, as Michael said, is better this year because of increased commodity prices, so the net differential – in fact, slightly more than the net differential -- would be all attributable to hog production losses.

Irene Nattel – RBC Capital Markets

Yes, that's what I was wondering. So in fact, the losses were greater than the year-over-year decline?

Michael Vels

Yes, that's correct.

Operator

There are no further questions registered at this time. I would now like to turn the call back to Mr. McCain.

Michael McCain

Thank you very much. I appreciate your patience. We have our work cut out for us in the next two years as we just finished our first anniversary of our new direction and new vision for Maple Leaf Foods. We are finishing this first year full of optimism for Destination 2010, in spite of the short-term challenges of some pretty volatile and challenging market conditions in the greater marketplace.

Thank you for your patience, and we look forward to the next quarter.

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