Ralcorp Holding Inc.: Boring business, Big returns
Ralcorp is a private label manufacturer of a variety of food products ranging from cereals to snacks to frozen bakery products. In an economy where consumers are constrained and food costs have risen, people have increasingly traded down to so-called “knock off” store brands, a.k.a. private labels. Grocery retailers like these products as well as they often can push them through at higher margin than branded products. In fact, recent earnings calls with Costco, Kroger, and SuperValu have confirmed that retailers industry wide intend to focus on promoting private label share.
As if trends for private label weren’t positive enough, Ralcorp is not resting on its laurels. In the last quarter of 2008, Ralcorp closed its purchase of Kraft’s Post Cereals business. This transaction is expected to be accretive of net income by 40 cents per share by the end of the year and added 16 cents per share in Q4 2008 to a baseline business which made $3.57 per share last year ($3.73 in total). Thus, even without growth in its base business, Ralcorp is likely to grow earnings by over 11% per share. While there is execution and integration risk with this acquisition, Ralcorp’s addition of a legitimate branded product line to its portfolio will allow the Company to maintain earnings should the shift private label turn out to merely be a transient counter cyclical trend.
Ralcorp added nearly $1 billion in long term debt to fund its acquisition of Post Cereals. AS a result, enterprise valuation may seem inflated (12x EV/EBITDA) versus 8-9x at other similar businesses (General Mills, Kraft, Kellogg, Treehouse Foods). Further, it issued another $1.6 billion in shares which, to some degree, “diluted” share value. While EPS remained grew despite the issuance, valuation is now dependent on continued performance in the Post brand. Without Post, organic EPS would actually look more like $3.21 per share on a run rate basis. Obviously, this is unlikely given the fact that Post Cereals is a $1 billion in revenue business, but any destruction in value as a result of the transition could severly hamper value delivered.
Caveat noted, if you include management’s forecast for Post’s contribution this year, Ralcorp is actually trading at just about 8x EV/forward EBITDA which is generally in line with its peers. Thus, while it’s arguable whether or not debt pay down will serve to leverage equity returns at its current valuation, Ralcorp offers reasonable value and a very impressive growth trajectory should all synergies of acquiring the Post business be achieved. If Ralcorp can use Post to leverage distribution of its private label line or even expand Post’s market penetration more successfully than Kraft could, you could be looking at a legitimate food distribution powerhouse.
Is Ralcorp a buy, then? For most growth stocks, price to earnings is an easier proxy for value provided that debt levels are manageable since its earnings growth and not EBITDA growth that will ultimately be delivered to shareholders. In these terms, Ralcorp seems to be trading at roughly fair value to its expected earnings power - average industry P/E of 14x expected earnings of $4.16 = $58.24 - which does not leave a significant margin of safety. But, given the recession resistant nature of this business’ product and the significant potential growth trajectory, this could be a compelling buy should share price correct close to or below $50.
Full Disclosure: Author does not have positions in any stock mentioned in this article though positions can change at any time.