Ralcorp Spin-Off Could Post Big Gains

| About: ConAgra Brands, (CAG)
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The specific circumstances underlying a spinoff transaction are as myriad as the number of businesses undertaking spinoffs, but the motivation is always the same - to increase returns for shareholders. As such, spinoffs can be a great place for investors to look in their search for alpha. On Friday, February 3, Ralcorp (RAH) will complete a spinoff of Post Holdings (NYSE:POST). After the spinoff, Ralcorp will produce and sell a variety of private-label grocery products, and Post will produce and sell branded ready-to-eat cereals. The spinoff will be two-for-one, which means shareholders will receive one share of Post for every two shares of Ralcorp they own. 80% of the shares of Post will be distributed to shareholders, while Ralcorp will retain the other 20%.

Spinoffs can unlock value for shareholders in several ways. Often, when a company is made up of two dissimilar divisions, it will trade with a suppressed P/E ratio, because many investors prefer to invest in "pure-play" companies. Separating the company into two distinct businesses allows investors to evaluate each business on its own merits, and can lead to increased P/E ratios over time. Ralcorp and Post may not look extremely dissimilar at first glance, with each making grocery products, but the distinction of Ralcorp making private label products and Post making brand name products is an important one. Going back to Econ 101, private label products can be thought of as an "inferior good," which is not a commentary on their quality, but simply means a good that consumers demand more of when incomes fall. Post's brand name products are "normal goods," which means that consumers will demand more of them when incomes rise. By now you should be able to see the difficulty this poses for the business. Whether the economy is weak or strong, one division is likely to do well, while the other is likely to do poorly, which leads to middling performance in any economy. Separating the companies will allow investors to choose which business they want to own a part of - branded cereals if they expect a strong economy, private label products if they expect the economy to be weak, and could lead to higher P/E ratios for each business.

Another reason spinoffs perform well relates to management incentives. Under the combined company, executives for Post would have received a portion of their compensation in the form of options on Ralcorp stock. This meant that much of their compensation was determined by events outside their control. If excellent performance by Post was overshadowed by poor performance from the rest of Ralcorp, Post managers would not be fully compensated for their excellent performance and could grow disillusioned. On the other hand, if Post were performing poorly, but the other divisions of Ralcorp were doing well, Post managers would still benefit from their Ralcorp options and have little incentive to improve the operations of Post. As an independent company, Post will be able to use options on its own stock to better align managers' interests with those of shareholders, and the company should benefit as a result.

Parent companies can also perform well after a spinoff for the reasons mentioned above, along with another advantage - the ability to load up the company being spun off with debt. The Post spinoff is no exception. Post will take on $950M in new debt as part of this deal, with $900M of that going to Ralcorp.

Academic studies support these theories - in an article published in 1993 in an issue of The Journal of Financial Economics, Patrick Cusatis, James Miles and J. Randall Woolridge found that parent companies and spinoffs beat the S&P 500 by an average of 18% and 30% respectively during the first three years after the spinoff. This does not mean, however, that it is a good idea to go around blindly investing in any company that undertakes a spinoff. It is still important to look at the specific details of the transaction, which we can do by examining the form 10, which is the document that explains the specifics of the transaction, and presents pro-forma financial data - Post management's best estimate of what operating results would have been in the past had Post been operating as an independent company.

The figures for Post do not look great. The company earned $101.1M in 2009, $92M in 2010, and lost $361.3M in 2011. The loss in 2011 was due to a $451.1M impairment charge. Earnings excluding this charge would have been $89.8M. Certainly, earnings are not moving in the right direction. Market share also declined from a level of 12.2% in 2009 to 11.2% in 2011. However, these poor numbers may allow those of us who are not already Ralcorp shareholders a chance to purchase shares of Post at an attractive price. Spinoffs often face selling pressure when they first start trading. Shareholders of Ralcorp own the stock because it fits either a specific investment mandate, or an investment thesis. If Post is not a fit for those investors, they will likely sell it immediately, without bothering to evaluate the merits of the company. In the case of index funds, they may be required to sell. The poor numbers should only serve to exacerbate this effect.

However, Post has identified the source of its problems, and has a turnaround plan in place. Until 2008, Post was actually a part of Kraft (KFT), and utilized Kraft's in-house sales force as well as a proprietary tool for managing trade spending. Under Ralcorp, Post lost the use of these resources, and results suffered. Post also increased prices faster than competitors while reducing spending on advertising, leading to decreased perceptions of product value by consumers. Going forward, Post plans to upgrade sales coverage for its largest accounts, implement the use of new analytical products to increase ROI on trade spending, and implement a new pricing strategy that will provide an improved value proposition for consumers. Certainly, if you decide to invest in Post, it is not because the current numbers are extremely attractive, but rather because you expect the company to be able to execute on its turnaround plan.

I believe Post will be able to execute, and a couple details about the terms of the spinoff help lead me to this conclusion. First is Ralcorp's decision to hold on to 20% of the Post stock. The form 10 states that Ralcorp plans to dispose of the Post stock at a later date through one or more exchanges for Ralcorp stock. Ralcorp management's motivation behind structuring the transaction this way is clearly that they believe Post stock will increase in value. The second reason is the new Post Chairman and CEO, William Stiritz. Stiritz is leaving his position as Chairman of Ralcorp's board to take the job at Post. He is obviously confident in the potential for success at Post to make this move. Stiritz will own over 370,000 shares of Post, so his interests are certainly aligned with shareholders.

The fact that Post has taken-on a lot of debt in this transaction could also be beneficial, if the company is able to execute on the turnaround plan. With this leverage, a small increase in the value of the company assets will lead to a large increase in the value of equity. However, the reverse is also true, increasing the risk, and potential shareholder losses, if the turnaround plan fails.

If you believe in the turnaround story, the next step is to determine an attractive price at which to purchase Post. In order to maintain a margin of safety, I am going to assume that Post's earnings stay close to $90M for 2012. Based on an expected 34.5M shares outstanding, earnings could be close to $2.60 per share. Post's two largest competitors in the branded cereal space, General Mills (NYSE:GIS) and Kellogg (NYSE:K), trade at P/E ratios of 17.0 and 15.6, respectively. However, these companies pay solid dividends and are expected to grow earnings. Given the risk associated with the turnaround, we would probably look to purchase Post with a P/E closer to the range of 10-12, which would imply a price between $26 and $31. When-issued shares closed Thursday at 27.85, so they do appear to be close to the right price. If selling pressure after the spinoff is executed drives the price down, shares could become a true bargain, and that is the scenario I will look for before buying.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.