Post's Weetabix Deal: Great Grains Or Shredded Wheat?

Summary

• The $1.8 billion Weetabix acquisition is a very different kind of deal for POST.
• That's made POST stockholders more than a bit ambivalent.
• Here's "Honey Bunches of Notes" on the deal and prospects for POST's debt and equity.

Post Holdings Inc. (NYSE:POST) is adding international flavor to its cereal. On Tuesday, the St. Louis, Missouri, based consumer packaged goods company announced it will pay £1.40 billion (or $1.79 billion) to buy UK-based whole grain cereal maker Weetabix Ltd. The Weetabix ready-to-eat (or RTE) cereal brand is the number one ready-to-eat (or RTE) cereal brand in the UK and Alpen is the number one muesli brand in the UK. Weetabix also makes the Barbara's, Weetos and Ready Brek cereals.

The transaction is a significant geographic expansion for POST which is best known in financial circles as the 3rd largest cereal maker in the US behind General Mills (GIS) and Kellogg Co. (K) and, to US consumers, as the maker of Honey Bunches of Oats, Honeycomb, Pebbles and Malt-O-Meal cereals. Weetabix has an existing North American business which sells natural and organic RTE cereal and snacks, both branded and private label, including Barbara's and the Puffins sub-brand. It serves leading US natural, specialty channel and conventional retailers. Weetabix does extensive international business, with operations in Africa through two joint ventures and a distribution export business to over 90 countries. The sellers in this transaction - Bright Food Group Co Ltd and Baring Private Equity Asia - have owned Weetabix since FY'12. POST has agreed in principle to establish a JV with Bright Food Group and Baring Private Equity Asia to manage the Weetabix China operations.

The deal announcement came as no surprise since rumors about a pending transaction had circulated in the market for months beforehand. The Telegraph reported in early January that there were multiple bids for Weetabix and then reported in March that POST was the most likely buyer. However, the price paid by POST to beat the other bidders, including GIS, looks high. On its face, paying £1.4 billion for £120 million Adjusted EBITDA translates to an 11.67x valuation multiple. An unadjusted EBITDA multiple would be up near 13.0x but if you believe in management's estimate of the cost synergies, it slides back down to 10.0x. Regardless, that's still high versus a 7.55x median EBITDA multiple for comparable international packaged food transactions and versus what POST's paid on average for its other disclosed transactions. Second, as shown in the table below, POST's previous cereal and snack food company acquisitions were predominantly US-based businesses even if they sold some of their products into foreign markets. Third, Weetabix's home market is very competitive. The British RTE cereal market sees significant discounting and aggressively priced private label alternatives to branded products like Weetabix:

POST management claims the Weetabix deal will be immediately accretive to Adjusted EBITDA margins once it closes and additive to free cash flow if one-time transaction related expenses are excluded. Specifically, management expects Weetabix to contribute £120 million ($154 million) Adjusted EBITDA annually, a figure which rises as cost synergies are realized over time. Management expects cost synergies to be £20 million ($25.7 million) annually by the third full fiscal year post-closing and that these will be realized from achieving benefits of scale, sharing administrative services, optimizing infrastructure and rationalizing the business.

To put this latest deal in perspective, per the Summary Financial Information table below, the $154 million Adjusted EBITDA from Weetabix would boost POST's $928 million LTM Adjusted EBITDA by 16.6%. The Company is scheduled to report its Q2'17 (ending March) results on May 4th. In conjunction with the release of the deal news, management also released March quarter guidance. The guidance calls for net sales of $1.25 billion and Adjusted EBITDA of $228 million. The consensus estimates are right in line with those figures (net sales of $1.26 billion and Adjusted EBITDA of $226 million). Since the Weetabix transaction isn't expected to close until the September quarter, management has left full FY'17 (ending September) Adjusted EBITDA guidance unchanged at its range of $920-950 million:

The announcement of the Weetabix transaction wasn't met with a round of cheers by POST equity investors. While Tuesday wasn't a great day for stocks generally - the S&P was off 0.26% as health care and financials took a powder - concerns about the Weetabix deal cited above helped send POST Common Stock down 3.74% on the day.

The initial thumbs down response (and the bounce back on Wednesday) should be put in historical perspective. Regardless of equity investors' immediate reaction to the deal news, POST's common stock has significantly outperformed GIS and K common shares since the middle of last year. In fact, if you normalized the price history graph below, you'd see a 270% increase over the past 5 years for POST common stock versus 149% for GIS common stock and 135% for K common stock:

The equity outperformance by POST seems odd when you consider that the Company has underperformed on certain key margin metrics. Indeed, one of the main reasons for pursuing the Weetabix transaction is management's desire to increase POST's margins. The Company may indeed be paying too much to acquire Weetabix, but there can be no doubt that POST needs to improve on its LTM gross margin of 30.3% and Adjusted EBITDA margin of 18.3%.

The graph below should make the point clear. The top half of the graph compares the rolling 12 months' gross margins of GIS, K and POST while the bottom half compares their rolling 12 months' adjusted EBITDA margins. For GIS, gross margin and adjusted EBITDA margin for the latest period ran 34.5% and 20.7%, respectively. For K, gross margin ran second to GIS at 31.5% but adjusted EBITDA margin was above GIS at 20.7%. But more striking is the consistent tendency of POST to pretty much underperform its peers on both metrics since the second half of FY'13. So, despite the fact that key margin metrics at POST underperformed for the past two and a half years, its common stock outperformed during the past two and half years as well as during the past five years. Hmmm. That seems like a very curious dynamic:

More curious is that POST's net earnings should be more highly valued than the earnings of its most direct comparables. POST common stock trades at a 32.7x P/E multiple based on this year's consensus estimated earnings and a 27.7x P/E multiple based on next year's estimated earnings. That's higher than GIS (18.9x and 17.9x) or K (18.5x and 16.9x). However, this is likely a reflection of public equity investors' willingness to pay for higher revenue growth in what has been a zero to negative growth segment. POST's compound annual revenue growth rate between FY'12 and FY'16 was 38%, largely on M&A activity. GIS's 5-year revenue CAGR was flat for the period and K's was -1.8%. Although GIS bought Annie's in FY'14, it sold B&G Foods for nearly the same dollar amount one year later. K has actually been more consistently acquiring businesses since FY'12, but not enough to materially improve its total sales.

The table below provides an additional set of comparisons between the enterprise valuation multiples of EBITDA for POST and its peers (including K, GIS, Snyder-Lance (LNCE), and J&J Snack Foods (JJSF)). The table also includes a comparison of those multiples to the broader S&P 500 consumer packaged goods sector index. POST's Enterprise Value to EBITDA multiple for this year and next are 9.7x and 9.4x, respectively. Viewed from this perspective, POST's valuation multiple is at a 25% to 26% discount to its cereal/snack food peers and at an even steeper 29% discount to the consumer packaged goods sector index:

In brief, the equity market is exhibiting a high degree of ambivalence in its assessment of the Company, overvaluing its net earnings reduced on costs related to acquisitions that grow the top line, but also undervaluing its EBITDA as margins trail behind those of the peer group. The undervaluation of EBITDA raises the question of why POST's margins have been trailing behind GIS and K up through the end of last year. In order to answer that question, I took a look at a breakdown of POST's segment results, to see where the margin problems are appearing.

See the Segment Information table below. You will notice that Michael Foods, POST's largest segment by revenue, wasn't doing too well over the past four quarters. The segment, which accounted for 43% of Q1'17 revenue, produces and sells eggs, potatoes, cheese, and pasta. The decline in the segment's adjusted EBITDA from $122 million in Q2'16 to $92 million in Q1'17 was largely due to the avian flu epidemic that damaged egg products producers. In addition, low shell egg market prices deferred sales of value-added egg products to certain customers. The good news is that the situation is reversing itself as market egg supply rises back up toward pre-outbreak levels and while the numbers aren't impressive, Michael Foods actually performed about as expected during Q1'17. Meantime, POST's 2nd largest segment, Consumer Brands, has been seeing sequential improvements in operating margin:

What do POST's fixed income investors think of the Company and its latest acquisition…? POST has $4.6 billion of total debt and two series of perpetual convertible preferred. Nearly all of the outstanding debt is in the form of senior unsecured notes as there are only $12 million Letters of Credit outstanding under the Company's $800 million L+175 1st Lien Secured Revolving Credit Facility. Net leverage, per the Financial Summary table above ran 4.0x through the LTM period ended March.

POST's senior note holders have some reasons to be ambivalent about the Weetabix deal too. On the one hand, the entity they've extended credit to is about to become larger and more diversified. Management is forecasting the combined company's pro forma revenue to run $5.5 billion, pro forma Adjusted EBITDA to increase $175 million to $1.1 billion, and pro forma Free Cash Flow to go up $96 million to roughly $435 million. On the other hand, pro forma leverage at this enlarged enterprise is about to spike upwards to an estimated 5.3x. POST expects to fund half the £1.4 billion acquisition cost with £700 million secured debt borrowed in the UK (which also defuses half the currency exchange rate risk). The balance will come from cash on hand or borrowed via the existing Revolving Credit Facility. On balance, POST note holders have expressed greater optimism than its equity holders. As shown in the graph below, prices for POST's existing senior unsecured notes improved and their yields fell after the deal announcement (top half of graph), a mirror image of POST's convertible preferred and common stock price activity (bottom half of graph). That happened even before Moody's chimed in with news that it was affirming the Company's ratings and leaving the outlook stable:

How to trade POST securities post-deal…? The Company is paying a big multiple for the better margins at Weetabix, even if you assume cost synergies have been underestimated. Equity holders are clearly leery about paying more for POST shares without additional proof that margins are improving. That may hamper the equity's upside for the next 3-6 months. On the credit side, POST's senior notes are facing a rise in leverage, but the Company has a history of leveraging up to acquire companies and de-leveraging shortly thereafter. Also, note holders know that this time the leverage increase will not hit the credit until after the Weetabix deal closes near the end of the Company's fiscal year. All of that has helped the notes increase in value but I suspect that there's little further upside. While the senior notes are around 225 basis points wider than comparable GIS or K bonds of the same tenor, none of the POST senior unsecured notes is particularly cheap to similarly rated high yield bond comparables. On average, single B notes in the consumer packaged goods sector yield about 50 basis points more than the POST notes do. Also, there's virtually no correlation between POST senior notes and the POST common stock which would allow investors to position one versus the other.

Since it's more likely that POST's margin problems are lapsing, it's more likely that the EBITDA multiple discount versus peers will lapse too. One can envision a scenario in which over the next 6 to 12 months POST proves its profitability is increasing and the multiple goes up. Harder to envision for the next 6 to 12 months is a scenario in which POST senior note holders get a credit rating increase or benefit from a general decline in interest rates. On balance, investors should favor the POST equity over the POST debt at current prices.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.