Post Holdings (NYSE:POST) began trading as an independent company in February 2012 after it was spun out of Ralcorp, shortly before Ralcorp was acquired by ConAgra. At the time of the spin out, Post sold branded cereals, with annual sales just shy of $1 billion. However, over the past two and a half years, Post has undergone radical change. Led by then CEO (and current Executive Chairman) William P. "Bill" Stiritz, Post has spent approximately $4.2 billion to acquire nine companies with anticipated annual revenues of nearly $3.2 billion. By far, the most significant of these acquisitions was the $2.5 billion purchase of Michael Foods Inc. (NASDAQ:MFI) from private equity firms GS Capital Partners (GSCP) and Thomas H. Lee Partners (THL) in June 2014. As the price tag for MFI accounts for over 40% of Post's current enterprise value (EV), the importance of this acquisition to the future of Post cannot be understated. As a result, this article will focus on MFI's underlying business as well as the returns Post can expect based on the $2.5 billion purchase price.
MFI is a leading producer and distributor of food products in three main segments: egg products, refrigerated potato products, and cheese and other dairy products. In 2013, egg products accounted for over 73% of MFI's revenue compared to 9% for potatoes and 18% for cheese. The egg products division is MFI's crown jewel and the primary reason Post acquired it. For 2013, revenue and EBITDA totaled $1.95 billion and $255 million, respectively. MFI's two largest customers are Sysco Corporation and US Foods, which accounted for 18% and 13%, respectively, of 2013 sales.
Egg Products Division
According to MFI's 2013 10-K, the egg products division is the largest producer of processed egg products in North America. The company makes egg-white based, hardcooked and precooked egg, and organic and cage-free egg products; however its largest product line is ultrapasteurized, extended shelf-life liquid eggs. According to the investor presentation released by Post when the transaction was announced, MFI has the #1 market share in value-added processed egg products, with share 3x greater than the nearest competitor. It has a 49% overall market share in processed egg products. Approximately 3% of divisional revenue comes from the sale of shell eggs. While certain products such as basic shell eggs, short shelf-life liquid and certain dried and frozen egg products are commoditized, prices for value-added products such as low/no cholesterol, pre-cooked, and extended shelf-life liquid eggs are less dependent on the price of the underlying commodity. Approximately 65% of MFI's egg division's sales come from such higher value-added products, as MFI has emphasized these products in order to gain some degree of control over pricing.
The egg products division has a number of processing plants located primarily in the Midwest, with some of these plants being fully integrated. MFI produces 25% of its annual egg needs from its own flocks, with the balance being purchased under third-party egg procurement contracts and on the spot market. Egg division customers include the large foodservice distributors and national restaurant chains. In its 2005 10-K (and prior years), MFI listed major restaurant customers including Burger King, International House of Pancakes, Sonic Corp., and Dunkin Donuts. On the March 2014 conference call, CEO Jim Dwyer, while declining to mention specific foodservice customers, said that MFI works with "virtually everybody" across the breakfast segment. Only 11% of egg product sales are made in the retail channel, including the "Papetti's," "All Whites," and "Better'n Eggs" brands.
Because in the past, the production of shell eggs has been largely based on feed costs, MFI partially hedges these costs for its internal flocks. According to the 2013 10-K, "additionally, for an increasing portion of eggs purchased under third-party procurement contracts, egg cost is determined by the cost of feed, as the contracts are priced using a formula based upon underlying feed costs." This is an important point because currently spot egg prices are very high, yet grain costs such as corn and soybean meal have fallen sharply in recent months. The 2013 10-K goes on to say that "in addition, the division attempts to match market-affected egg sourcing with the production of egg products whose selling prices are also market-affected, and cost-affected egg sourcing, with higher value-added products priced over longer terms, generally 6 to 12 months. This typically allows the division to realize a modest processing margin on such sales, even though there are notable commodity influences on both egg sourcing costs and egg products pricing, which change frequently."
Post mentioned MFI's "grain-based pass through pricing model" as a positive factor insulating it from input cost volatility in its acquisition presentation. It is unclear what percentage of MFI's annual egg needs are procured via grain or cost-based contracts versus purchased on the spot market. However, the company clearly attempts to hedge its production costs by aligning variable cost with variable selling prices in order to earn a steady processing margin. Page 18 of the 2013 10-K states that "although we have variable pass-through pricing contracts in place with many of our customers, the delay in the reset mechanisms (typically 1 to 3 months) dictates the timing of pass-through price increases."
MFI's pricing model has allowed it to produce steady profit margins over the past decade. For example, the egg product division's adjusted operating margin (gross margins are not reported by division) has been relatively steady over time averaging 9.1% during the past eleven years and ranging from a low of 7.4% in 2007 to a high of 12.7% the following year. The relative steadiness of MFI's margins over a long period of time in many different pricing environments for both eggs and grains indicates that it is not just a seller of commodities. MFI has also been very adept at controlling operating costs.
Over the past 3, 5, and 7 year periods as of December 31, 2013, compound annual growth in egg product unit sales is 2.1%, 0.1%, and 0.6%, respectively. However, over those same periods, egg product revenue has compounded at 10.0%, 2.5%, and 7.6%, respectively. In addition, unit volume has picked up in the past two years at 4.6% growth in 2012 and 2.8% growth in 2013 (this excludes acquired volume). And volume growth announced in Post's recent FY Q4 results was a very strong 7.9%. As a comparison, per capita US egg consumption increased 1.2% in 2012 and 0.2% in 2013. Given the fact that MFI has increased revenue at a much higher rate than volume over a number of years, it has some measure of pricing power. This is what I would expect to see from a company in a growing industry with 60% market share.
Refrigerated Potato Products Division
MFI's refrigerated potato products include shredded hash browns and sliced, mashed, and other specialty potato products which are sold into the foodservice (54% of sales) and retail (46% of sales) markets. According to Post, MFI is #1 in both the foodservice and the retail refrigerated potato markets, with a 60%-65% market share in foodservice. Most products are sold under the "Simply Potatoes" brand. As the demand for convenience food has grown in recent years, MFI's potato sales have grown 8.4% annually over the past decade. Unit sales growth has been very impressive in the low double digits in both 2012 and 2013. MFI has successfully leveraged relationships with customers of the egg products division in order to expand potato distribution. The division's operating profit margin has averaged 10.2% since 2003. Excluding 2009 and 2010, years which include costs associated with a product recall and the start-up of a new manufacturing facility, operating margins have averaged 12.8%.
MFI claims to have been the first company in the US to introduce nationally branded refrigerated potato products, having done so in the late 1980's. While the potato business is small, its growth and profitability are impressive. As it has benefited the potato division, Post seems to believe that MFI's platform can be used to help grow other of its businesses. For example, Post recently announced that Dakota Growers Pasta (NYSEARCA:DGP), which is a pasta company Post acquired in January 2014, would be integrated into MFI. As DGP operates in the Upper Midwest and has 70% of its sales into the foodservice channel, it should do well as part of MFI.
Cheese and Other Dairy Products Division
The cheese and other dairy products division (cheese division) sells cheese (84% of revenue) and other refrigerated grocery products (such as butter) to grocery stores and wholesalers. The primary cheese brand, Crystal Farms, is positioned as a "mid-tier" brand with prices below national brands such as Kraft and Sargento but above private label store brands. This division does not manufacture products, but processes and packages Crystal Farms and private label cheese products at a facility in Wisconsin. According to Post, Crystal Farms is the #3 branded cheese in the US and is #1 in certain regional markets in the Midwest.
Given that the cheese division sells a mid-tier brand into the retail channel, it is not surprising that it has the lowest margins among MFI's three divisions. Over the past eleven years, operating margins have averaged only 5.9%. The cheese division has struggled in recent years. After reaching a high of $414 million in 2008, sales have since fallen to $346 million in 2013. Cheese sales were high in 2008 due to price increases taken to offset rising input costs. In recent years, the cheese division has struggled with fluctuating costs for cheese and butter as well as increased competition. Revenue fell by 10.5% and volume declined by 11.4% in 2013 due to "significant competitive pricing activity in branded cheese and reduced distribution in our private label cheese and butter businesses." In the first quarter of 2014, the struggles continued with revenues falling 15% year-over-year primarily due to "reduced distribution in our private-label cheese and butter businesses." In its Q1 2014 10-Q, MFI also noted that the business struggled as commodity cheese costs increased 35% from the previous year. Interestingly, margins for the cheese division have risen in recent years through 2013. It appears that MFI has been willing to lose market share for the sake of maintaining profit margins. Given that the cheese division has the lowest margins and primarily sells a commodity product, it makes sense for MFI to turn away unprofitable business even if it means that this division continues to shrink. As long as dairy commodity costs remain high, the cheese division will more than likely continue to struggle. However, somewhat surprisingly, cheese sales rose 19.6% on volume growth of 4.3% as reported in Post's FY Q4 earnings. Based on these numbers, it appears price hikes were taken across the industry.
During the conference call to discuss the acquisition, Bill Stiritz referred to MFI as a "Renoir," meaning that he equated the opportunity to buy MFI along the same lines as the opportunity to purchase a rare and valuable painting. He stated, "You keep looking for these things, (but) they come along so rarely. And this has all the characteristics of this being a superb business. [It has] a great management team and a unique category, and it was offered at a fair price." Given the track record of Mr. Stiritz, I'm inclined to take him at his word; however, I believe the analysis confirms his sentiment.
A list of the characteristics that constitute a good business could fill pages. However, the measurement of return on invested capital (ROIC) is a good way to distill "business quality" into a single metric. As a quality business is one that earns sufficient returns relative to the capital invested in it, ROIC specifically measures business returns relative to the capital necessary to generate those returns. On this metric, MFI is a quality business. For example, over the past eleven years, ROIC has averaged 18.5% and, in 2013, it measured 22.1%. (In this case, in measuring invested capital I exclude intangible assets as they represent various private equity transactions in the company over the years rather than past acquisitions as is the case with most companies). Returns are measured in terms of net operating profit after taxes (NOPAT).
Another hallmark of a good business is being able to increase profits without having to retain significant earnings. A great example of this type of business is See's Candies, about which Warren Buffett has written extensively in his annual letters. Over many years See's has paid a growing stream of cash to Berkshire Hathaway without Berkshire having added any capital into the business. Because See's has a "moat," it is able to steadily grow profits while only needing to retain a minimal amount of its annual profits to maintain its competitive position. Like Charlie Munger has said, the best business to own is one that can write you a check at the end of the year. MFI fits this description. In each of the past eleven years (I only went back eleven years in order to calculate CAGRs for a decade), MFI has produced substantial free cash flow to equity (FCFE, defined as operating cash flow less capital expenditures), in spite of the fact that it has carried substantial leverage. In addition, since 2003, MFI has been able to grow with minimal additions to capital; and, on the capital it has invested, it has earned an incremental ROIC of over 147%. As growth has accelerated, operating assets has increased somewhat ($91.3 million) over the past five years relative to the five years prior, yet the ROIC on incremental capital investments has still been nearly 40% during this period as NOPAT has increased by $36.1 million. It is possible that the company has been under-invested in by its private equity owners; however, the nature of MFI's business seems not to be too capital intensive.
MFI's managers have proven to be capable operators. In spite of the fact that per capita egg consumption in the US has declined marginally over the past ten years, MFI has managed to grow egg product division revenue at 5.7% annually during that time. In addition, despite the fact that MFI operates in an industry subject to significant price volatility, management has put into place the previously discussed pricing strategies to largely mitigate this volatility, as evidenced by relatively stable gross profit margins. Management has also done a good job of containing costs. For example, MFI's total employees fell from 3,897 in 2004 to 3,675 in 2013 even though revenue increased by nearly 50% during this period. As a result, during this period revenue per employee increased 57%, SG&A per employee increased 22.4% and operating profit per employee increased 73%. SG&A expenses as a percent of sales have been trending downward for several years. In addition, working capital has been well managed. Granted, MFI's current CEO has only been with the company since 2009; however, these positive trends have only accelerated under his leadership.
In addition to being a quality company run by competent management, MFI operates in an industry with relatively bright prospects. After Post announced its acquisition of MFI, it released an investor presentation in which it emphasized its focus on secular growth themes including "increased consumption of protein" and "away from home breakfast occasions." In addition to several other acquisitions, (e.g. Dymatize, Premier Protein, Golden Boy Foods) in buying MFI, Post is attempting to capitalize on these trends. Post's presentation pointed out the fact that breakfast revenue at quick-service restaurants has grown at a CAGR of 4.1% over the past five years. Since McDonald's first introduced its egg-white mcmuffin to great success in 2013, other restaurant chains have quickly followed. Some restaurants, including Subway and Taco Bell, have recently begun serving breakfast for the first time. Demand for refrigerated and frozen breakfast sandwiches has also been growing rapidly. A recent Wall Street Journal article indicates that demand for frozen hand-held breakfast sandwiches such as Jimmy Dean biscuit sandwiches and ham-egg-and-cheese Hot Pockets has surged 29% over the past two years. As the leading supplier of value-added processed egg products, MFI is well positioned to capitalize on consumers' growing demand for convenient and high-protein breakfasts.
It is no secret that general demand for protein-rich foods is growing rapidly. Demand for items from greek yogurt to protein powders has surged in recent years as more Americans have focused on eating healthier and consuming fewer carbohydrates. According to market research firm Euromonitor, US protein supplement sales have risen 40% over the past five years and are predicted to rise another 40% by 2018. While some believe the recent protein craze is a temporary fad, I think the trend has staying power primarily because the health benefits of consuming healthy proteins are real. Numerous studies have confirmed the benefits of protein consumption including assisting in weight loss and muscle gain as well as avoidance of age-related muscle loss. Increased protein consumption is easier for consumers to stick with because it encourages eating, rather than avoiding, certain foods as compared to the typical diet. Also, the fact that eggs are loaded with high-quality protein (not to mention vital amino acids and antioxidants) for a very low cost in terms of dollar/grams should continue to benefit MFI. Interestingly, two of the cheapest sources of natural protein are eggs and peanut butter, which is another market segment in which Post has invested.
It is clear that the US faces an obesity epidemic which has led to a host of illnesses ranging from heart disease to diabetes. Given this unbearable burden placed upon society by obesity, something has to give. I agree with Post's management in that increased protein consumption will play a leading role in combatting this problem for the foreseeable future.
Prior to Post's purchase, MFI had previously been acquired in 2010 by GSCP from THL, with THL retaining a 20% interest. This transaction implied a total value of $1.7 billion, or 7.5x 2009 adjusted EBITDA and 1.1x EV/revenue. Various media outlets reported that in addition to Post, others bidding on MFI in 2014 included TreeHouse Foods (THS), Tyson Foods (TSN), Golden Gate Capital Management, Clayton Dubilier & Rice LLC and Oak Tree Capital. Unfortunately for Post, it faced competitive bidding.
At a deal price of $2.5 billion, Post paid nearly 10x 2013 EBITDA (which was $255 million). EBITDA adjusted for non-recurring expenses was approximately $270 million representing a multiple closer to 9.3x. Based on 2013 revenues of $1.95 billion, Post paid approximately 1.3x EV/revenue. These metrics are higher than GSCP paid in 2010; however, the 2014 capital markets were much more accommodative to sellers than those of 2010. MFI's unleveraged free cash flow (which is the free cash the company would produce if it had no debt) in 2013 was approximately $168 million, which represents a free cash flow yield of 6.7% on the purchase price. While these metrics do not scream out "bargain purchase," they seem, as Bill Stiritz described, "fair," especially for a company experiencing impressive growth with steady cash flows.
Based on my discount cash flow analysis, I believe MFI's intrinsic value is in a range of $2.65 to $2.85 billion. In valuing MFI, I primarily used its historical SEC filings as well as industry data. I did not include any synergies with Post. The primary assumptions used in the analysis are as follows:
- Initial annual revenue growth of 5.3% falling to 2.1% by 2020 - I'm factoring in no growth for the cheese and other dairy products division compared to 2013 and falling growth rates for eggs and potatoes
- Gross profit margin of 17.3%, which is the average of the past decade (in order to smooth out the ups and downs of various pricing environments)
- SG&A expenses at 8.6% of revenue, which is the average of the past five years and higher than the 8.1% of 2013
- Projected depreciation similar to past levels in terms of % of revenue and % of net PPE
- Tax rate of 38%
- Capital expenditure and net working capital requirements similar to the past in terms of % of revenue
- Capital structure consisting of 60% debt and 40% equity (This is the capital structure put in place by Post so I am assuming it is optimal)
- Weighted average cost of capital of 7.9% based a 14% cost of equity, 6.3% pre-tax cost of debt (which is the current BofA Merrill Lynch US High Yield "B" effective yield - Post actually issued 6% debt to purchase MFI).
- Long-term growth rate ranging from 2% to 2.5%
The capital structure assumption of 60% debt may be somewhat aggressive; however it is not far off from what MFI has successfully handled in the past and it is the actual debt ratio put on MFI by Post. Total debt of $1.515 billion represents a (proforma) net debt/EBITDA ratio of 5.1x and EBIT/interest expense of approximately 2.5x in the first year. MFI should be able to deleverage by $100 million annually, which will result in quickly falling leverage ratios. Based on the amount of leverage used and MFI's steady cash flows, the deal price of $2.5 billion implies a low (and growing) double digit yield on the equity used in the transaction.
By turning my valuation model in a back-of-the-napkin LBO model and assuming that Post exited MFI at the end of 2020 at 10x EBITDA with $100 million in annual deleveraging between now and then, then Post would earn an IRR of 14% over a seven year period. Based on this math, I can see why the private equity firms interested in MFI would not be willing to outbid Post. More than likely, their IRR hurdles could not be met at a purchase price much higher than $2.2 billion. In addition, Tyson may have wanted to keep its powder dry in case someone came calling on Hillshire. Regardless, based on the leverage involved and the price paid, Post can earn double digit returns on equity on its investment in MFI without exposing itself to excessive risk.
I believe Post paid a very fair price for MFI and, given the leverage involved, the deal provides a double digit return on equity for Post shareholders under conservative assumptions. Given declining consumption of ready-to-eat cereal, the acquisition of MFI provides Post with diversification into a growing category which is directly benefitting from cereal's decline. While it did not specifically say this, I had the sense after listening to the acquisition conference call that Post management felt that MFI may not have taken advantage of all opportunities available to it while under private equity ownership. While not explicitly factoring this into my valuation, if under Post ownership, MFI is able to better capitalize on opportunities and/or produce financial performance above expectations, then the equity returns could be very lucrative. However, even if MFI continues to perform as it has and growth even slows a bit, returns will still be satisfactory. As a shareholder in Post, I'm very pleased with the acquisition.
Disclosure: The author is long POST.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.