Tasty Baking Is Tapped Out: Scenario Probabilities Show Downside for Stock

| About: Flowers Foods, (FLO)
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What's really important for Tasty Baking (TSTY) to survive is consistent high demand and consumption of its products. Its debtload is very ugly, but that can eventually be overcome if EBITDA is consistently positive. If revenues are growing and EBITDA is positive, it can find a way to restructure its debt, pay off principle inch by inch, and, possibly over decades, gradually pay down its debt. It could also be acquired or merge with another company that sees the potential in the product and willing to take over the enormous debtload.

From looking at the quarters 1-3 of 2010 (see conference call transcript here, here and here), we can assume that TSTY's revenues did NOT increase in Q4 2010.

TSTY won't report its financial results for Q4 2010, ending in December 26, 2010, until March, so to figure out the value of the stock it helps to predict what TSTY's financial results roughly will be. From the previous quarter, Q3 2010, gross revenue had dropped from $73,859,000 to $68,234,000. That's $5.5 million of less cakes being consumed. TSTY produced an EBITDA of around -$3.8M.

Q4 2010 was the holiday season so theoretically more cakes should have been sold. However I don't think that happened. Looking at previous years, gross sales for Q4 was never much different than the previous or following quarter. After Charles Pizzi, TSTY's CEO, saw Q4 2010 results, he immediately said they couldn't make January's debt payments. He says it's because the factory produced less cost savings than was expected. Not only could they not make their debt payments, which now get tacked onto next quarter's debt payments in addition to the extra interest expense, but they also had to borrow an extra $6.5M.

TSTY's management has clearly shown they tend to sweep their problems under the rug. They continued to pay dividends after posting losses up until their creditors ordered them to stop. They also have failed to look ahead by not hedging against commodity price increases. Higher oil prices impact cost of sales as well as sugar and cocoa, all at multi-year highs.

Because of their behaviors, it's safe to say that TSTY is completely tapped out. They have no money whatsoever in reserves. If they did, they wouldn't have taken the trouble to seek out the extra $6.5M of financing, they would've just asked for a delay in paying the debt for a quarter and ended their dividend payments. The new financing came at a high cost: the $3M from the government probably doesn't have a high interest charge, but the $3.5M from the group of accredited investors is a 12% interest charge, principle and interest all due by December 31, 2011.

These investors aren't loaning TSTY money out of the goodness of their hearts. Would TSTY have taken this extra $3.5M if they hadn't completely squeezed money out of every nook and cranny in their establishment? I don't think so. Come to think of it, it's very optimistic of TSTY to expect to pay back the $3.5M*1.12 = $3.92M in a lump sum at the end of the year, when TSTY can't even pay its regular debt payments now.

From this I predict that TSTY experienced another EBITDA loss in the quarter ended December 26, 2010. Keep in mind this is before their mounting interest expense payments, which by now is likely over $2M a quarter.

That said, there is evidence that the company has been getting an increase in sales since they reported their troubles and risk of going under in early January. I believe people have been buying more of the cakes lately because of all the press and spotlight that has been on TSTY, and also because the people of Philadelphia would be sad to see it go, so they're buying more cakes. I'm guessing this by my own logic and from what an independent TSTY representative, who goes by "tastysd", said on the Yahoo message boards here. Even if sales do remain higher, TSTY has such liquidity problems it will most likely not be good enough. The closing of some of the A&P grocery stores puts a further damper on current sales. What will generate TSTY's much needed high sales is loyal customers which requires a great product.

As I have a vested interest in the company's downfall (I'm short TSTY), part of my research was to taste their product. If I felt they were addictingly good, then I would have a hard time shorting it because I'd really believe in the product. If you, my fellow investor, are considering a long or short position in the stock, it's worth the small investment to try their product. You can order a box here.

After trying 4 different kinds, I felt they tasted low quality and a little stale. I was surprised being how the company started based on the idea of higher quality ingredients. Now this alone isn't conclusive evidence that the cakes aren't very good, maybe it's just my particular taste buds that don't mesh well with it. I know there are plenty of big fans who eat a Tastykake after every lunch meal. However, I have a theory as to why Tastykakes don't taste as good as they used to.

Ask any cook or bakery chef and they will tell you passion and thoroughness needs to be put into the making of a dish or else the food tastes like crap. Desserts I understand are more of a science than an art compared to main courses, but I digress. Pizzi is trying to do all he can to make the new factory profitable. He is trying very hard to max out its cost savings which ended up below his expectations. Also, this factory is built with the latest technology for making cakes efficiently. Lots of the company's factory workers got laid off because the machines are supposed to do more of the cake baking labor. Because of this there are lots of kinks that need to be worked out to make sure the machines are making the cakes correctly and the balance of ingredients are just right. To this day, TSTY is having a lot of trouble making cream filled cakes and they are often not able to deliver them when ordered.

Kinks in the new cake makers + desperate striving for minimum costs per cake = cakes that don't taste so great.

For TSTY to survive now, it needs to have cakes that are addictively good. So good that when people see one on the shelf of the grocery store, their mouth waters and they compulsively reach out and put it in their cart. I don't believe Tastykakes evoke this response.

Several of TSTY's management have left the company or have been fired. David Marberger, the former CFO, began working for TSTY in 2003 and left to work for Godiva Chocolates in 2008. Ironically, Joe Carboy, the former plant manager of both TSTY's old and new bakery, and a 25 year veteran of Tasty Baking, got let go sometime in mid to late 2010 because of continual problems with the machines and now also works for Godiva Chocolates. MikeyZman, a regular poster for the TSTY Yahoo message board, said that Marberger saw the writing on the wall and left before things got bad. MikeyZman worked for Tasty Baking for 23 years before leaving seven years ago. He says right now there is a shortage of cream filled cakes from TSTY because the machines have trouble making them, and this is confirmed by tastysd. This is part of the machinery incompetence that led to Carboy leaving the company.

Right now, it's do or die for TSTY. The banks are giving it this one reprieve until June 2011, and that's it. TSTY will either have to show considerable improvement by then in revenues and EBITDA, or it restructures its debt or finds a buyer. If none of these events happen, the banks will force TSTY into bankruptcy. Unfortunately for TSTY, fortunately for me, I believe this is the likely scenario.

The banks are not messing around, and have no sympathy for the company and its iconic history, they are only thinking about what's the best financial decision for them. From reading this SEC filing, you can see that the banks are ready to put TSTY out of its misery and not let them dig themselves a deeper hole.

To value TSTY, it's important to calculate the risks of each of these events happening, evaluate what the stock price would be based on those events, and get the average.

Lets start with the best case scenario for TSTY: My thesis is wrong and TSTY just needed a little more time to get everything running smoothly with the new factory and have all it's ducks in a row. It's somehow able to reach all of the banks' performance requirement covenants by the June deadline which you can find at that same SEC link here.

If this feat is accomplished and those high demands are met, then TSTY is back to profitability and blue skies are ahead. As these covenant requirements are very high, I'd give it a 3% chance for this outcome. The stock should rise to about $5 in this scenario.

The second outcome is if TSTY fulfills a little bit to most of the performance covenants, shows some hope, and can either pay off its debt owed so far or successfully negotiates with the banks for more reprieves. The stock will go to anywhere from $2.1 - $4.3 dollars, average $3.2. There's an 11% chance for this outcome.

The third outcome is if TSTY gets a major financing or raises capital in some way, possibly a share dilution. Stock should go to between $1.4-$3 a share, average $2.2. There's about a 7% chance of this happening.

The fourth outcome is if TSTY finds a buyer or merges with another company. This is what TSTY's management is really hoping for to save the share price. They are going to have a hard time finding a suitor. Companies are very careful in how they spend their cash in this market, and only want to make an acquisition if the upside is really big.

With TSTY, there's just too much risk and not enough upside. The new buyer would have a tough road ahead with TSTY's massive debt and needed factory improvements, so if there is a buyout, it would pay much less than the current share price. The debt for TSTY, based on 9/30/10 numbers and current estimates, is $112M, and the accrued pension liability is $23M. Add to this another $10M (my guesstimate) for company restructuring and changing/fixing of machines. That's $145M of debt an acquirer would have to take on.

Fellow Seeking Alpha reader Tiger01 alerted me to FLO, which is looking to expand to the PA and NJ area. FLO has an EBITDA margin of 11%, this isn't realistic for TSTY given the current high commodity prices and other challenges. TSTY's EBITDA margin has historically been around 8-10% in better times, so we can go with 8%.

Generously giving TSTY gross revenues of $180M a year, that's an EBITDA of: 180M*.08 = $14.4M.. FLO trades at a multiple of around 8x EBITDA so 8 x 14.4M = $115.2M EBITDA. From this TSTY's total valuation comes to: $115.2M - $145M = $-29.8M. Adding about $10M of debt that should be allowed for TSTY in this multiple (FLO's debt is about half its EBITDA) we come to: -$29.8M + $10M = $-19.8M, still a negative number. A buyer would have to be very optimistic that they could get TSTY's revenues way up to make any kind of acquisition worth it. Futhermore, if a potential buyer waits a little while and lets TSTY suffer more before making an offer, they may get a better deal. If TSTY does get bought out by an optimistic buyer, the stock will go to between $1.4 - $4 a share, average $2.6. 7% chance of this outcome.

The fifth outcome is if TSTY can't find a buyer or more financing, its performance isn't good enough for the banks to give it more reprieves, it can't make its payments, and is forced into bankruptcy. The stock goes to $0.2-$0.6, average $0.4. There's a 72% chance of this happening.

Current intrinsic value of TSTY based on the probabilities of these outcomes: .03*$5 + .11*$3.2 + .07*$2.2 + .07*$2.6 + .72*$0.4 = $1.126

I admit I have limited knowledge of chances of scenarios in a bankruptcy situation. After mulling over the different scenarios, likelihoods, and calculations, I came upon these numbers. If anyone thinks my reasoning is off in some way, (the market certainly does), please let me know in the comments or send me a private message. Thanks!

Disclosure: I am short TSTY.