Premium Brands Holdings Corp.: Over-The-Top Valuation
- "A good company is not always a good stock" is true for Premium Brands Holdings which faces disconnect between fundamentals and valuation despite an impressive track record of increasing shareholder wealth.
- Trades at a steep premium to its sector and the broader market as investors love the growth promise of a consumer staple safe haven ignoring the risk of overvaluation.
- The stock price implies unrealistically high future growth expectations beyond the completion of a major capacity expansion project.
- We suggest to SELL the stock ahead of a downward re-rating of stock price after new sandwich plant completion.
Premium Brands Holdings (OTCPK:PRBZF) is a Canadian-listed specialty food products manufacturer headquartered in Richmond, BC, with operations in Canada and the US. It had annual sales of around USD1.4 billion in 2016. Sandwiches is the largest product line with 21.9% revenue contribution, followed by processed meats (17.1%) and beef (16.2%).
Revenue by Product (2016)
Source: Annual Information Form, 2016
The company reports its performance under two segments, Specialty Foods (mainly sandwiches, processed meats, snacks and deli products comprising 59.7% of revenue) and Premium Food Distribution (mainly beef, seafood, pork and poultry comprising 40.3% of revenue) with most of its sales in Canada and a smaller presence in the US.
Revenue by Geography (2016)
Source: Annual Information Form, 2016
Good company but not a good stock
We have tremendous respect for the management of PBH as it has delivered on its growth plans, successfully integrated newly acquired businesses and exercised efficient capital allocation over the years. Key persons like the CEO and CFO have had long tenures with the company and they have held their positions for over 15 years now. PBH has managed its investor relations very well by communicating with the investors via investor presentations, MD&A and conference calls. Corporate financial disclosures have consistently provided ample details to make a decent analysis. Management has set measurable targets for itself like:
- Organic growth rate of 4%-6%pa in revenue
- Long-term RONA (return on net assets) of 15%
- Minimum hurdle rate of 15% for all acquisitions and project capital investments
- Short-term EBITDA margin target of 8.5%-9% for 2017 and
- Target range of 4.0-4.5x for total debt to EBITDA ratio
Having said all of this, we have to ask ourselves whether this amazing company is still a good stock to own at prevailing valuations. We believe investors are paying too much here for owing a piece of this good company.
Source: Corporate Presentation, AGM May 2017
A very risky safe haven
Consumer staples stocks have been traditionally viewed as a safe haven in turbulent market periods. PBH has several attributes which have made it a darling of safe-haven seekers:
- Unlike many consumer staple companies, it has lot of growth initiatives
- Being in the specialty food segment, it has some pricing power and ability to generate stronger margins as it does not compete on cost
All of this has led to herd-behavior by investors which has bid up the valuation beyond levels that can be justified by fundamentals. PBH trades at a steep premium to its sector as well as the broader market on a number of valuation metrics s shown in the table below.
Source: Morningstar Canada
We are not proposing that this safe-haven perception is going to change any time soon as analysts are reluctant to downgrade a company which is about to deliver massive earnings growth next year. However, at this juncture, we do not think the company is such a good safe haven as there is a bigger risk of losing your shirt (if valuation starts adjusting towards fundamentals) than the probability of being safe from market turbulence.
Unrealistic Growth Expectations
The company is loved by investors as it has clocked double-digit growth in revenues and bottom line for the past five years. However, investors are forgetting that such growth does not continue forever.
The next leg of organic growth will occur in 2018/2019 when the Phoenix, AZ sandwich plant becomes fully operational adding between $200-300 million incremental revenues. We do not know what will be the next driver of organic growth beyond 2019 as management has not made any announcement yet.
PBH could continue its sandwich business expansion spree by building another plant as it is a fast growing business where the company had a 5-10% market share of the US sandwich market in 2014 with its two US-based plants in Reno, NV and Columbus, OH. The company may take a couple of years’ breather (like it did after completing Columbus, OH sandwich plant) before embarking on the next expansion phase. However, this cycle of expansions cannot continue forever.
Let us see what growth trend the market is expecting from the company. When we back-out the growth expectations embedded in the current stock price, we see another picture. The implied terminal growth in cash flows is an astounding 6% which is not only unsustainable but also unrealistic.
Based on our analysis of company’s expansion plans and earnings guidance, we have modeled growth over the next five years as:
- Revenue forecast assuming ramp-up of Phoenix plant, recent acquisitions of Leadbetter and Skilcor as well as management guidance of 4% to 6% organic growth
- EBITDA margin expansion towards 10% (slightly higher than management 2017 guidance of 8.5% to 9%)
Combining the above five-year cash flow forecast with a terminal growth of 2% in our DCF valuation, we get a target price of CAD54.5/share which is far short of the prevailing CAD104.49/share market price.
DCF valuation is usually most sensitive to terminal growth and EBITDA margin assumptions. Going back to the question of market expectations, the table below shows that either the investors expect EBITDA margin to double from present levels of 9% towards 18% or the cash flows to keep growing in perpetuity at 6%. Both situations are unattainable and therefore the stock is overvalued.
Valuation from a portfolio perspective
PBH is a consolidator and it is achieving inorganic growth by acquiring family-held private food processing companies and integrating them into its value chain. Analyzing the price that PBH pays for its acquisition targets will give us an insight into the valuation that PBH should be able to command for itself as a portfolio of protein-processing companies.
PBH has made several acquisitions over the past few years but we restrict our analysis to companies with revenue larger than CAD10million, purchased in the last three years. We find that most of these acquisitions were at 0.6x Revenue and 5-6x EBITDA. As these were mostly privately held companies, this valuation will be at a slight discount to public companies (approximately 25% discount) due to illiquidity and other factors. If these transaction multiples present a fair valuation of privately held companies, then the valuation of a publicly listed food processing company should be around 0.8x Revenue and 8x EBITDA.
Source: Company Press Releases and Estimates
However, when we look at PBH trading at 14x 2018 EBITDA and 1.4x 2018 Revenue we conclude that there is overvaluation which creates an opportunity to short the stock.
A deep dive into growth drivers
How has PBH achieved its stellar topline growth? Not surprisingly for a consolidator, it has bought its way through it. Our analysis shows that 2/3rd of the revenue growth from 2009 to 2016 came from acquisitions and roughly 1/3rd of the growth came from organic initiatives. The single largest contributor to organic growth was the Columbus, OH sandwich plant, which delivered approximately 40% of the organic growth ($200million incremental revenue). The next big chunk of organic growth will come from Phoenix, AZ plant (approximately $200-300mln incremental revenue) over the next two years. Looking ahead, in the years beyond 2019, organic growth is likely to be around 5%pa (mid-point of management guidance range) until it stabilizes to a more normal level when the company matures.
Source: Management Discussion & Analysis reports
Our analysis shows that organic growth is less capital intensive, at least in the sandwich business where an investment outlay of around CAD30 million on a sandwich plant generates over CAD200million in revenues (7x) and EBITDA of CAD20 million (assuming 10% margin). An average acquisition worth CAD30 million brings in revenues of CAD48million (inverse of EV to Revenue of 0.6x) and EBITDA of CAD4.8million (assuming 10% margin). However, organic expansion is relatively more risky as there is a lead time to build new capacity during which market situation can change.
All about the sandwich business
Many people now identify PBH as a key player in the North American sandwich business. However, this was not always the case. PBH made forays into the sandwich market by acquiring Seattle, WA based SK Food Group Inc. in Oct 2010 for approximately USD42.5 million. SK Food Group had a 150,000 square foot facility in Reno, NV with annualized sales of approximately USD90 million and EBITDA run rate of USD8.1 million (9% EBITDA margin). This turned out to be a game changer for PBH as SK Food was a supplier to Starbuck Coffee which allowed PBH to ride the new trend of serving breakfast sandwiches to busy professionals. In quick succession, PBH set up two new sandwich plants in Columbus, OH (8 lines/180,000 sq feet/Completed Aug 2014) and Phoenix, AZ (12 lines/212,000 sq feet/Completion 3Q2017). Sandwich sales are expected to touch CAD700 million in 2019 once the new plan becomes fully operational compared to only CAD31 million in 2009.
The new Phoenix, AZ plant has had a soft-start already and it was operating five out of the 12 lines as of 2Q2017 with plans to reach 10 lines utilization by end-2017 and full 16 line capacity utilization in 3 to 3.5 years. We estimate that at full capacity, the Phoenix plant will have revenue of CAD300 million as it is larger than the Columbus plant which generates revenues of around CAD200 million. We expect new plant revenues to ramp up from CAD50 million in 2017 to CAD200 million in 2018 and ultimately CAD300 million in 2019.
According to the management, all the business at Phoenix plant is not new business as yet. Initially, some of the volumes have been moved to Phoenix from the two older plants (in Columbus and Reno), as those plants were running close to or over capacity. Once all of the plants are running at optimum levels as opposed to capacity levels, it should improve efficiencies by reducing over time and allowing for maintenance shutdowns and eventually it will improve profit margins. However, in the short term, profit margins will take a dip as the company will have to absorb the full amount of overheads for a new plant operating below capacity.
Our back of the envelope cash flow forecast for the company is presented below:
The forecast is based on the following assumptions:
- We have estimated the sales levels based on a combination of 5%pa organic growth, the ramp-up of Phoenix sandwich plant over the next two years towards a sales level of CAD300 million and acquisition of Leadbetter and Skilcor which will be adding in around CAD82 million of sales next year.
- We are assuming that EBITDA margin will be around 10% over the forecast horizon, which is slightly higher than management 2017 guidance of 8.5% to 9%. We are anticipating the new sandwich plant to provide some efficiency improvements like better sales planning and less overtime.
- We use an effective tax rate of 27.5% (equal to 2016 effective rate).
- We are forecasting capex of 2% of revenues which mainly comprises project/maintenance capex only. We are not factoring in any inorganic capex apart from Leadbetter and Skilcor acquisitions which were announced recently.
- We think working capital needs will be in line with last five years average.
- Our terminal value is based on a normalized year and we use a modest terminal growth rate of 2%.
We assign a target price of CAD54.5/share to the TSX listed PBH.TO shares and USD42.2/share for the NASDAQ OTC traded PRBZF based on a Discounted Cash Flow (DCF) valuation implying a downside of 48%. The DCF has been carried out with a terminal growth rate of 2% and WACC of 10%. We have used a cost of equity of 10.8% which includes a risk premium for less liquid small cap stock.
Our WACC of 10% comprises of the following elements:
Cost of equity of 10.8% is built up from:
- Risk-free rate of 1.97% from the latest yield on 10-year government of Canada benchmark bonds
- Equity market risk premium of 5.69% for Canada from Professor Aswath Damodaran's website
- Leveraged beta of 0.88 taken from Reuters, which is lower than the market beta owing to company's exposure to consumer staples
- Small cap risk premium of 4.33% based on risk adjusted excess returns earned by small cap stocks compared to the market from 1926 to 2014
- Cost of debt of 3.4% based on historical 2016 cost of debt adjusted for tax.
- We have calculated weight of equity based on market capitalization and for debt based on book value.
What Could Go Wrong?
The biggest risk to our negative thesis on PBH is the possibility of an aggressive share repurchase program by the company. The management has a lot of legroom to support its share price through aggressive buybacks as financial leverage (net debt to forward EBITDA) at 1.9x is low relative to historical five-year average of 3.2x. The company could borrow another CAD355 million by increasing its financial leverage towards historical average and use these funds to buy back approximately 10% of its outstanding shares. The company had unutilized credit facilities with banks to the tune of CAD187.6 million as of July 2017. This response can be expected in case share price declines far enough to make the management defensive.
The critical assumption for our investment thesis is the reasonableness of market expectations on terminal growth rate and EBITDA margin expansion. We have looked at the impact of changes in these two variables in the sensitivity table below, which indicates that the market is highly optimistic regarding the growth trajectory of the company.
We have converted the sensitivity table output to USD at current exchange rate for investors looking at NASDAQ OTC traded PRBZF.
We believe investors have anchored themselves to continuation of high growth trend for a far longer horizon than can be reasonably predicted. We respect the quality and successful track record of the management, however, this cannot justify the rich valuations being assigned to the stock. We anticipate long-term investors to cash out once the sandwich plant expansion ramps up leading to downward re-rating of the stock price over the coming 12 months towards our price target of CAD54.5 for PBH.TO and USD42.2 for PRBZF.
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