Michael Foods Q3 2007 Debtholders Call Transcript

Michael Foods, Inc. (MIKL)

Q3 2007 Debtholders Call

November 14, 2007 10:00 am ET

Executives

Mark Witmer – Treasurer

Dave Johnson – President, COO, CEO-Elect

Gregg Ostrander – Chairman, CEO

Mark Westphal – SVP, Finance

John Reedy- CFO

Analysts

Christian Hoffman - Lehman Brothers

Presentation

Operator

Welcome to the Michael Foods 2007 third quarter debtholders conference call. (Operator Instructions) At this time I would like to turn the presentation over to Treasurer Mark Witmer. Please go ahead.

Mark Witmer

Thank you, Andrew, and good morning, everyone. Thanks for joining us again for our quarterly debtholders conference call event. We appreciate your interest in Michael Foods. We have a roomful of people here. We have Dave Johnson, our President, COO, CEO-Elect with us; Gregg Ostrander, our Chairman and Chief Executive Officer; Mark Westphal is with us, our senior VP of Finance; and John Reedy, our EVP and CFO. As you would expect, Gregg will make some comments a little bit later in the call.

The agenda is as follows: we will start out by reviewing third quarter net sales and EBITDA both in total and by division. We will then share some divisional operating comments with you. We will talk about the tone of business a little bit here in the fourth quarter and then Gregg will make his comments. We will wrap up by trying to answer your questions. These prepared comments are also available in text format on our website if you would like to go there at some point and review them.

Turning to the news release, you probably noticed that the 8-K and the 10-Q were both filed late yesterday so the audience has probably committed all these numbers to memory, but let me just recap the third quarter for you.

Net sales came in at $381.1 million versus $308.9 million. That was an increase of 23%. The third quarter EBITDA was $45.9 million versus $47.7 million, a decrease of 4%.

The nine month figures are as follows: EBITDA came in at $124.4 million versus $130.1 million. That was down 4%. Had a lot of big cost headwinds through the first nine months. They are still with us here obviously in the fourth quarter, so all in all we felt pretty good about the EBITDA results through the first nine months.

Let's go then to the divisional results for the third quarter. Egg Products came in with external net sales of $266.5 million versus $216.6 million, an increase of 23% with EBITDA at $38.8 million versus $36.3 million, an increase of 7%.

Crystal Farms third quarter external net sales were $84.5 million versus $63.2 million, an increase of 33% with EBITDA of $2.8 million versus $5.6 million, a decrease of 50%.

Potato Products division third quarter external net sales were $30 million versus $29.2 million, an increase of 3%. EBITDA was $6 million versus $6.6 million, down 9%.

Divisional third quarter operating comments, leading off with the largest division, Egg Products. Given the very high egg and grain markets we faced, we were fairly pleased with the EBITDA level for the Egg Products division in the third quarter.

On the sale side the 23% dollars sales increase reflects notable inflation, and that was caused by very high egg markets. Urner Berry (UB) egg pricing was up over 100% year-on-year in the first nine months of this year. What was an historically low, depressed egg market just over a year ago has turned into quite a robust market in recent months. We are now setting new historic highs on almost a daily basis.

UB graded large eggs, this is graded large eggs by the dozen, went over the $1.50 mark yesterday. That market is typically in the $0.60 to $0.80 range. If you go back just 17 months ago it was $0.62. It hardly seems possible that the market has nearly tripled at this point in just under a year-and-a-half.

Also affecting egg cost is the high cost of grains. Beans are now over $10, think $10.50 or $10.60 was a recent quote. Corn is pushing $4 a bushel. Those are both at the top end of historical ranges. Corn has risen in price here even in the recent weeks despite a strong harvest that is nearly done. As a result of all of this, our feed costs rose nearly 50% in the nine-month period of this year versus the comparable period in 2006. Both externally sourced and internally grown eggs were up sharply in cost for both the quarter and the nine month period.

Now thankfully the food ingredient side of egg products saw pricing as quoted mainly in the UB daily and weekly markets that rose and this pushed our pricing for dried, frozen and short shelf life liquid items up along with it. Better pricing was caused by a combination of high egg costs and a much better products balance in terms of supply and demand, particularly in the food ingredient sector. There has actually been noticeable tightness seen in parts of the dried egg products market.

The overall impact of pricing in this sector are rising more rapidly than costs was helpful to the division's margins and EBITDA contribution for the quarter. You might recall we saw the same thing in the second quarter.

Margin expansion in food ingredient egg products was able to more than offset weakness seen in the margins for foodservice and retail items, where pricing relief happens much more grudgingly. As the audience I think knows, the food ingredients part of our business is really a key part of the Egg Products portfolio here at Michael Foods as the world's biggest and best egg products firm and it helps us keep a good balance in that business. It is a nice offset, so when you have periods such as now when the foodservice and retail margins are weaker, the food ingredient side oftentimes comes through with stronger margins and vice versa the opposite often is the case.

Looking over the past many years, there have been very many days when we wished we didn't have to sell another pound of frozen or dried egg products here. Last quarter that was clearly not the case. For foodservice and retail we continue to take pricing actions where we can. That involves competitors in some cases moving on price and it also involves waiting in some cases for contracts to reach expiration.

Now we turn to Crystal Farms. Crystal Farms had a tough EBITDA period in the third quarter despite it being a very strong sales period. First the sales side. The sales were up one-third in the quarter due to both volume growth and higher market pricing but mostly due to the pricing side. The volume side showed branded cheese units up 3% year over year with private-label units up a whole bunch. That means more than 100%. That was due to the addition of a very substantial new national account. Distributed products, which as we define it, excludes shell eggs, rose 11% for units in the 2007 period versus '06, and that is quite strong growth.

On the inflation front we saw cheese pricing rise notably. This was driven by the sharp spike in the cheese market during the quarter. Cheese is typically $1.20 to $1.50 per pound. You look at the block market but it has been either side of $2 since mid-spring. The third quarter year-over-year rise for block cheese was 59%. That has taken our cheese costs up dramatically. We effected, as a result, two midyear price increases to the retail trade -- our customers -- with the second bigger one taking effect in mid-August.

However, this has not been enough to offset the raw material pressures and cheese remains stubbornly high given the market fundamentals. A rise in cows and milk production is yet to be seen or felt in the cheese market. It feels as if cheese needs to come down; we would have told you the same thing, however, three months ago.

With this high block cheese environment our cheese business is in terms of margin, struggling. As a data point, gross margins for cheese in the third quarter were about one-half of what prevailed a year prior. As I think you recognize, as goes the cheese business, so goes Crystal Farms. That does not go well for the current period. We do have some cheese hedging activities, but they have not been enough to stem the tide of the rapid, dramatic rise of the cheese market.

Potato Products, the smallest of our three divisions, Potato Products third quarter results were much like the second quarter, quite mixed with sales up a bit and EBITDA down a bit. Within the results it is worth noting that sales volumes were up slightly year over year in the quarter with foodservice up 2% and retail about flat. Retail refrigerated Potato Products as a category continue to grow, but that growth has slowed. The category is up 6.6% for the most recent 52-week measurement and 1% for the most recent 13-week data that we've seen. The growth leader in that category the past two years, which is Shedd's Country Crock is experiencing 8% declines with distribution losses.

Our operating earnings and EBITDA for the foodservice piece of the business in the quarter were down with retail off slightly. Gross margins were depressed by a drop in processing yields, with lesser raw material quality than a year earlier and also due to some production inefficiencies.

A few other items to mention, that I think the audience would like to be cognizant of, we did make a mention in the news release that we took a charge in the third quarter related to the equipment writedowns for egg processing equipment at a plant we closed in Ontario at the end of March. That charge was $1.3 million. We now have all those plant closing impacts behind us, a combination of severance and equipment impairment charges.

Also worth mention is that the new mechanical wastewater treatment plant in Wakefield, Nebraska is expected to be operational around the turn of the year. That has been roughly a $16 million project for us, funded largely by industrial revenue bonds that were issued by the City of Wakefield but are guaranteed by us and paid for by us via our waste water treatment charges.

Our cash flows remain healthy. The invested cash position today is over $62 million, though I know we will be paying nearly $15 million of interest by the middle of next week. Capital, there's always interest in that, I know. Capital for the year is still pegged at $41 million and regarding our September 30 balance sheet, you've got that now in front of you per the 10-Q filing late yesterday afternoon.

Let's then turn to the fourth quarter and share some comments on the tone of business here midway through the fourth quarter. Please note that these are clearly forward-looking comments, inherently making any comments that are forward-looking in nature is just full of risk, and we do list those risk factors in the Form 10-K, we like to keep our creditors up at night. Therefore, please note that these comments are clearly governed by the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Egg Products, the fourth quarter should bring roughly more of the same as the first nine months did. The higher value-added lines may improve their margin contribution in the months ahead as we effect more price increases, but we will still be under pressure due to high grain and braking stock costs.

The food ingredients business may continue to help us on the upside if this egg market continues to hold this very high ground. The weak U.S. dollar seems to be supporting a strong export business for us and for other domestic egg products producers. At the same time our European competitors are seeing their cost advantage in the global egg products market shrink as their egg markets rise.

On the cost side, grains continue to be higher than our operating plan calls for. We are seeing the rise in the energy complex impact a number of costs including diesel, natural gas and even packaging. There are a lot of interesting crosswinds in the Egg Products business these days, to say the least.

Turning then to Crystal, as noted Crystal Farms has cheese market challenges still here in the fourth quarter. We can't see matching year-ago EBITDA for this division in the current quarter given where the cheese market is. The cheese market is clearly above our forecasted level. We have taken cheese pricing up as already noted, but still have a distance to go given the high block prices and some of what we can do on the pricing front is clearly in the context of what competitive actions are. Our cheese margins will remain under pressure until the cheese market corrects.

Also noteworthy is that with the high cheese market consumers are gravitating more to private label cheese, which is up nearly 2% in the past 26 weeks, while the total cheese category is off by 2.4% with the Crystal Farms brand off slightly more than that based upon competitive factors.

I would no that new account activity at Crystal Farms remains good. Three key account additions in the past month or so include Mitchell Grocery down in Alabama. That is over 150 stores with initially four cheese units placed. Then Associated Grocers of Florida was added, 150 stores with 13 cheese SKUs. And then Cleveland-based Drug Mart, that is a 60 store chain carrying 25 of our Crystal Farms cheese items. We also added a small chain in Medford, Oregon called Sherm's. It is only four stores, but they are quite high-volume units, and we placed 30 SKUs there.

There are number of new items being introduced by Crystal Farms, the modus operandi there, they keep expanding the products offering. They include here recently the Tuscan Herb Bagels sold under the David's Deli line and a white cheddar with jalapeno peppers cold cut, that is a spreadable cheese in a cup. We also introduced sliced baby Swiss cheese. We also have a Crystal Farms cracker cut cheese tray for the deli which is being introduced here in time for the holidays.

Potato Products is showing higher sales on the foodservice side and lower sales year-over-year on the retail side. The latter seems related to a softer market and reduced share. We recently added a major new foodservice account. I can't name that name on this call but it is a large buyer of what we call large red cuts; the volume is upwards of 2 million pounds on an annual basis, that clearly qualifies as a big account.

The reported upper Midwest potato harvest situation is quite good. That harvest is basically done. The field data shows that it looks to be an above-average crop for us in the upper Midwest. It is also noted that the Idaho crop, which is the big part of a national crop, is somewhat below average and our guys are calling the national crop in total then at about average. We expect processing yields to have an opportunity to uptick now after a year of a slight downtick.

With that, I'd like to turn to our CEO Gregg Ostrander, and he will share some thoughts.

Gregg Ostrander

Thank you, Mark. Just a couple of comments relative to the quarter and the year end outlook. Unit volume growth in our key value added products continues to indicate that our core business strategy around providing value-added solutions to our customers is working. So we are quite pleased that our value-added volume growth in the quarter continued, really the trends that were established in the first six months of this year.

I think as we look at cost headwinds, they are certainly here to stay. We have grains at historical highs. We have energy at historical highs and cheese costs have stayed at historically high levels for a lot longer than certainly we had anticipated. They continue to remain high here in the fourth quarter.

I think when you net through all that, we are clearly in a period of sustained food inflation. I believe it will take us well into fiscal '08 before we are able to pass through appropriate pricing to get our margins back to where we would like to target them, well into fiscal '08. Clearly this inflation is here to stay. We are going to have to work hard to get pricing taken wherever we get the opportunity to do that.

I think another potential cloud on the horizon is that at least in our key foodservice business, demand is likely to be pressured in that trade channel as consumers opt to eat more at home in the face of very high gasoline and home heating costs. I think that is going to pressure the whole foodservice trade channel.

On the flip side of that is as consumers trade down and move more to QSR, quick serve restaurants, that could also help since we have such a large presence with breakfast in the QSR trade channel. I think there are some headwinds there and some tailwinds there that could help us but clearly I think foodservice demand is going to be affected going forward here.

On the plus side, I think as Mark talked about earlier, food ingredient business continues to build momentum both domestically and internationally as the high UB markets and the cheap dollar fuel earnings and sales volume momentum in this business, we expect that momentum clearly to continue to grow. I think it also points out the wonderful balance that we have in our Egg Products portfolio, where one trade channel that may be under pressure like foodservice is, is largely offset or bolstered by the strength we have in our food ingredient business. So it is just continues to show that our playing in every segment of egg products is a good overall strategy for the company.

Looking out, we will continue obviously to look for opportunities to pass price increases through on our foodservice and retail businesses. That is job one around here.

We continue to invest capital to improve the productivity in our facilities, taking FTEs out, which is basically automating our facilities to get lower cost structures. We are continuing to invest in getting those kinds of returns.

We continue to invest in new innovation platforms that we hopefully will drive growth in our core businesses over the '08 timeframe and beyond. I think as Mark alluded to, we are certainly going to be challenged in the fourth quarter relative to year-over-year comparisons given the very high inflationary market we are in around grains and energy and cheese costs. So clearly that headwind is out there.

I think to the plus side, the business is solid. Unit volume growth is solid. Our cash position continues to grow. We continue to generate strong cash flows and overall a tough market environment, but the business is holding up pretty well in that very tough cost environment.

I think with that as an overview, Mark, why don't we throw it back and open it up for questions?

Mark Witmer

Thank you, Gregg. Andrew, would you hop on please and explain the question-and-answer process?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Christian Hoffman - Lehman Brothers.

Christian Hoffman - Lehman Brothers

Good morning. You mentioned some pressure on the demand side in the foodservice segment. Is that something you've seen to date, or is that more of an outlook?

Gregg Ostrander

I think we are actually seeing pressure in certain segments of the foodservice channel. Obviously that is a tough channel to monitor, but if you look at the quarterly earnings reports for a lot of the family-style restaurant chains and so forth, they are clearly showing year-over-year declines in sales so there is some pressure out there particularly on the mid-scale family dining arena. Many of the QSRs continue to post some pretty nice growth at least at this point.

That is why I said I think you've got a headwind and a tailwind out there in the foodservice sector. But I think directionally as gas prices hold and sustain themselves above $3 a gallon and as we look at home heating coming into the winter season, that is going to pressure the average consumer in terms of where those dollars go. There is clearly a cloud out there and we are going to just have to maneuver our way through it and fortunately a good chunk of our business is in QSR, and that particular segment of the foodservice arena seems to be weathering through this pretty well.

Christian Hoffman - Lehman Brothers

What kind of volume impact is that having?

Gregg Ostrander

Right now our unit volume growth in our value-added products is still doing okay. We are showing low single-digits but there is pressure out there.

Christian Hoffman - Lehman Brothers

Just in terms of margins on an EBITDA level, do you expect improvement in the fourth quarter?

John Reedy

We don't expect significant improvements. As Mark mentioned, I think we will see much the same. I think we will see a little bit better margin on the egg side as he mentioned, as we continue to get through some of the contracts that are expiring and have the opportunity to pass some additional price increases through.

We will continue to see the margin pressure on Crystal again as long as this market stays at the level it is, which as Mark had mentioned is well in excess of where we would have seen it coming into the quarter.

Operator

Management, at this time we appear to have no additional questions in the queue, and I will turn the conference back to you for any closing remarks.

Mark Witmer

Thank you, Andrew. With that I think we will call it a call. Thank you again for joining us and we will look forward to discussing the fourth quarter with you in March of next year. Thank you.

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