Description

American Italian Pasta (PLB) is a misunderstood company with lots of hair on it. It is down 70% since April. I believe it is a compelling long and is, in essence, a publicly traded LBO. The market cap is $120 million and the enterprise value is approximately $387 million, for an equity to debt ratio of 31:69. Shares are about $6.00. They have cratered from about $10 at the beginning of October and the low $20s in August.

Someone has been selling a ton of this company in the last two weeks (and yesterday in particular). Given the performance of the stock, I imagine several of the mutual fund owners consider this toxic (all of the largest owners are mutual funds). Fidelity Low-Priced Stock Fund has an October fiscal quarter-end, so they may be a culprit, but that is total speculation on my part.

Background:
American Italian Pasta Company is the largest producer and marketer of dry pasta in North America. PLB produces more than 220 dry pasta shapes in five vertically integrated milling, production and distribution facilities (though the Wisconsin facility is currently not operating and represents excess capacity). The Missouri plant is among the most efficient and highly automated pasta facilities in North America. The South Carolina plant, which commenced operations in 1995, and the Arizona plant, which commenced operations in fiscal 2003, serves both retail and institutional customers. The Wisconsin plant, which commenced operations in 1999, is designed to produce pasta primarily for sale to food processors that use dry pasta in their products. The Italy plant, which commenced operations in 2001, serves private label, branded, foodservice, and industrial markets internationally and in the United States.

American Italian Pasta believes it is the low cost manufacturer of dry pasta.

PLB’s brands include the nation’s largest, Muellers, as well as several others. It manufactures private label pasta for a number of large grocery chains, is a primary dry pasta supplier to Sam’s Club (Wal-Mart writ large accounts for just under 20% of the sales), and is the exclusive dry pasta manufacturer for Sysco (another 10% of sales).

During its growth phase, PLB took on significant debt for a variety of reasons including paying out a big one time dividend, acquisitions, and expansion CapEx. That debt is both the problem and opportunity today.

After many years of rapid growth, PLB hit a buzz saw in the last two years. A confluence of several things has led to today’s opportunity. Pasta, after being touted as a wonder-food for much of the 90’s came to be considered the enemy by carb crazed dieters. This took a severe toll on a business that was used to growth and had spent ahead of itself to build out capacity in preparation for continued growth. PLB was not alone. As the pasta market shrank, significant overcapacity plagued the industry and compounded the problem of the shrinking top line by creating a pricing war. PLB made an additional misstep by spending on developing and marketing an expensive foray into low carb pasta that was ultimately a total write-off. Further, the business was managed by managers that knew one way to run a business: run it for growth. As a matter of fact, the first bullet of the company’s mission statement crafted by them still shows on the website: “Growth & Profits--Achieve short and long-term growth in sales and profits and maximize value to our shareholders.” Not exactly how I would write it. Those growth managers also may have obfuscated the financials by misreporting them. Finally, shipping costs have risen significantly as the cost of gas has increased. All of those problems, in tandem with violating covenants on its healthy debt load, have led to a hammering of PLB’s stock price as it has fallen from $30 to $6 in just five months. It has been the proverbial falling knife during the last week or two.

Opportunity:
What’s changed/why should we care:
- PLB shuttered one plant as did one of its competitors, taking capacity off line
- New World Pasta (a former spin-off of Hersheys), is working through Chapter 11 today and may emerge with a debt load nearly as big or bigger than PLB has today
- Atkins, the business, filed for bankruptcy just under two months ago. I take this as a sign that low carb is well past its peak
- PLB’s old management team was shown the door and turnaround specialists were brought in and given a strong incentive system (see the Management section below)
- G&A cost cutting potential (SG&A ballooned from $59 million to $73 million from FY 2002 - FY2004). The run-rate as of March 31 was around $55 million -$60 million
- The company has been GAAP profitable during this whole time
o Trough EBIT of $7 million expected in FY Q3
o D&A much higher than likely needed level of CapEx
o Have stayed current on interest payments throughout

Financials:
Liquidity: American Italian Pasta had, per an 8-K filed on September 28, 2005, total debt of $282 million, $8 million of cash, and $13 million of available credit on its credit line.

Share price: $6.00
Net Debt per share: $14.35
EV per share: $20.35

Market Cap: $114 million
Net Debt (3/31/05): $273 million
Enterprise Value: $387 million
Trough Annualized Sales: $360 million
Trough Annualized EBIT: $28 million
Trough Annualized EBITDA: $57 million
Annualized Interest Expense: $18 million

Diluted Shares Out: ~19 million

Back of the envelope computations: The third quarter indicated income statement items (from the 8/9/05 press release) put EBIT at $7 million. This would be basically the worst quarter PLB has experienced. Even if that brutal quarter is annualized into perpetuity, I believe at today’s prices we will be amply rewarded. I think these are trough, trough numbers. The most likely soft spot to these estimates is CapEx, but even with more aggressive CapEx estimates, the cash flow is there to justify today’s prices. However, given that I am charging the business taxes when they will not pay taxes for a few years given the level of write-offs recent press releases have indicated (almost totally non-cash), there is some built in cushion.

Annualized EBIT: $28 million
Annualized D&A: $29 million
= EBITDA: $57 million
Must spend CapEx: $15 million
= EBITDA-CapEx: $42 million
Interest Expense: $18 million
Tax (40% EBIT-Int): $4 million
= Excess Cash Flow: $20 million or $1 per share

Bottom line, this business is capable of generating $1 per share of excess cash available to pay down debt even assuming the worst period it has ever gone through is the new norm. In each 2002 and 2003, PLB reported EBITDA of better than $80 million. If normalized EBITDA is actually $68 million (halfway between $80 and $57 million) with normalized CapEx of $20 million, we generate $22 million of excess cash or $1.10 per share. Of course, what maintenance CapEx is and what a reasonable normalized EBIT is are big variables, but I think I have been reasonable in both cases.

It seems to me that the company is trading for 6x FCF/market cap or just over 10x FCF/EV (using my excess cash flow number as a proxy for free cash flow). As excess cash is used to presumably pay down debt, I expect the equity value of the company will increase at least dollar for dollar.

Management:
At the end of September, American Italian Pasta retained turnaround specialist Alvarez & Marsal’s Jim Fogarty as Co-CEO. He will bring with him a few other A&M professionals to assist in his efforts. PLB paid a $500k retainer fee that will be credited against the hourly fees that A&M charges. I suspect annualized A&M comp will be in the $3.5 - $4 million range, which is expensive but not inordinately so, for a typical executive suite. Further, A&M can earn two different $1 million bonuses by achieving to be determined EBITDAR and cash flow targets during FY 06. Finally, A&M is receiving about 0.5 million stock options that will have a strike price based on the average share price starting a week before A&M was hired and concluding 40 trading days after the Sept. 28th announcement.

While the hourly rate is not cheap, I love the remaining incentives. Of course, I would not expect much positive news during the next month as it is clearly not in A&M’s interests to promote the stock price until its options prices are set (quite the opposite, in fact; they probably are doing a jig at the stock price's recent woes). If A&M accomplishes its mission, it clearly can make a small fortune in the options. In any case, they have clear incentives to generate lots of excess cash and to have valuable equity.

Risks:
- Default on its bank loans and subsequent foreclosure. Mitigated by the fact that PLB remains current with all its creditors and is generating excess cash even today.
- Further deterioration of the pasta business from a volume and/or competitive standpoint.
- The short thesis is that this is a fraud and that EBITDA margins should be 5-10%. There may have been some inappropriate accounting under old management, but given that they were gone when the $7mm of FYQ3 EBIT was announced, I view that as a post-fraud number. Also, the margin estimate doesn't make intuitive sense to me given that D&A is more than 5% of sales itself, but that is what I've been told and who am I to argue?

Catalyst

1) Excess cash is used to pay down debt, resulting in a 17% annualized return if the EV does not change and the business stays at trough levels;
2) Becoming current on SEC filings;
3) Stabilization or better of the dry pasta industry;
4) Huge short interest (40% of float) gets turned around;
5) Sale of the company (less than ideal at today’s prices); and/or
6) Return to earnings environment of two years ago (that would be a grand slam and is totally unnecessary).