Description

Del Monte Food Company (NYSE: DLM) may be purchased for 10x earnings, about half the valuation of its peers, yet it is well positioned with the growth customers (Wal-Mart and Costco) of the packaged food industry. Furthermore, DLM recently acquired four valuable but underperforming businesses from Heinz.

Market Dynamics
On December 20, 2002 DLM acquired four businesses from Heinz (HNZ): Tuna, Pet Products, Soup and Baby Food. The acquisition was structured as a reverse merger in which HNZ shareholders received shares in a newly capitalized DLM. For every $34.50 worth of Heinz shares, owners received $3.45 of Del Monte. As a result, it is likely the there were a number of HNZ shareholders who wound-up owning shares of DLM which they didn’t want; the happy outcome of this is that DLM shares have been under pressure for the last 10 months, contributing to DLM’s current low share price.

Legacy Del Monte
DLM is the largest producer and distributor of processed fruits and vegetables in the U.S. The average grocery store carries over 100 branded Del Monte items. DLM brands include Del Monte, Contidina, Sun Fresh, and Fruit Cups. DLM's market share in processed vegetables is larger than the market share of its four largest branded competitors combined. The company’s market share of processed fruit is larger than all other branded competitors combined. DLM's market share for solid tomato products is about twice that of its nearest competitor. The company has a record of being the low cost producer in its segments. In a real sense, DLM has won the branding battles in it’s legacy businesses: its products compete primarily with private label products, not other branded products. DLM’s efficiency has positioned it well with mass merchants and warehouse clubs: Wal-Mart represented 24% of FY ’03 revenue and is DLM’s largest customer.

New Del Monte
As a result of the acquisition of the HNZ businesses, DLM’s revenue more than doubled. The following is a list of DLM’s approximate revenue by business, post acquisition.

DLM Legacy (44% of revenue going forward)
Tomato and specialty: 11% of revenue
Canned fruit: 18% of revenue
Canned vegetables: 15% of revenue

Businesses purchase from HNZ (56% of revenue going forward)
Tuna: 18% of revenue
Pet products: 28% of revenue
Soup and baby food: 10% of revenue

The HNZ businesses acquired included the following brands: Starkist Tuna (the largest tuna fish brand in the US), 9Lives cat food (of Morris fame, number one share of dry cat food), Kibbles n’ Bits dog food, PupPeroni dog snacks and College Inn broth.


Going forward, it is reasonable to expect that DLM management will meet its FY ’04 objectives of 2% - 4% revenue growth given their strong position with the growth customers in the food business (Wal-Mart, Costco, BJs). For instance, Wal-Mart, which represented 24% of DLM FY ’03 revenue, has increased its Supercenter (a Wal-Mart combined + a grocery store) count from 564 in January, 1999 to 1,358 in January of this year.


DLM’s fastest growing businesses (pouch tuna, pet snacks, dry pet food, private label soup, value-added tomatoes and College Inn) represented 30% of DLM’s FY ’03 revenue and are growing at 7% per year. Note that these businesses enjoy a 35% gross margin while DLM’s overall gross margin is about 26%. As a result, the growth businesses are likely to disproportionately augment the company’s earnings.


DLM management is projecting earnings per share of $0.88 ($190 million) and free cash flow (before merger related expenses) of $200 million: both are attainable. The company’s maintenance capital expenditures are running about $35 million per year; the capital budget for new projects is $25 million per year and the company has budgeted $50 million over the course of 24 months for integration of the HNZ businesses. With depreciation and amortization costs of $85 million, the company is likely to generate more free cash flow than the earnings would indicate. This is particularly interesting in light of the company’s heavy debt load. DLM management is committed to using all free cash flow to pay down debt. As the company pays down debt, it will reduce interest expense which will boost earnings, even if revenue doesn’t grow. For instance, during the period from 12/20/02 to 4/27/03, the company reduced net debt by $183 million which will add $13 million of earnings (annualized); this represents a 12% increase to FY ‘03’ GAAP earnings and 7.3% increase in FY’03 adjusted earnings.

There are at least five reasons that the businesses purchased from HNZ will benefit DLM shareholders:

1. The market capitalization of DLM nearly quadrupled from $550 million to $2 billion as a result of the acquisition of the HNZ businesses. The larger capitalization raises DLM’s profile among institutional investors and makes it easier for large investors to buy shares in the company. There is also speculation that DLM may be included in the S&P 400 mid-cap index. Prior to the acquisition of the HNZ brands, Texas Pacific Group (TPG), a private equity firm, owned 46% of the company’s shares. As a result of the merger, TPG’s holdings have been reduced to 11.7% and all management agreements between DLM and TPG have been terminated. DLM is now a public company in all respects.

2. The brands that DLM acquired from HNZ are valuable and complementary to DLM’s traditional lines of business. First, consider that these brands contributed to 19% of HNZ’s revenue and 22% of HNZ’s profits during fiscal year 2002 (the last full year HNZ owned them). HNZ shareholders paid 24x earnings for these businesses; today they are available at 11x earnings when one purchases DLM. Better yet, these brands were orphans at HNZ. At DLM, the acquired HNZ brands represent 56% of DLM revenue, so the newly acquired brands are going to get full attention from DLM’s management. What does this mean in terms of specific actions? DLM management is tripling advertising and promotion of the HNZ brands, e.g., reinforcing brands including 9Lives (Morris has been on sabbatical for a decade) and Starkist (remember Charlie, the tuna with good taste).

3. The HNZ product lines are complementary to DLM’s legacy business. The products are sold to the same customers (grocers, mass merchants, wholesale club stores) and make use of DLM’s existing distribution infrastructure. The HNZ businesses also have similar manufacturing and packaging processes as DLM’s legacy business and are managed using similar metrics.

4. The brands DLM acquired from HNZ are well established. For example, Starkist is the number one tuna brand in the US, with a 43% market share. College Inn commands 15% of the US broth market and a whopping 43% of the broth market in the northeastern US. The private label soup business purchased from HNZ is the largest private label soup manufacturer in the US. 9Lives, Kibble n’ Bits and PupPerroni all lead their respective markets.

5. The businesses purchased from HNZ have opportunities for improvement. HNZ is known to have mediocre systems. Also, HNZ was not focusing management attention on product lines that they were divesting. DLM, on the other hand, is the low cost leader in its legacy businesses e.g., DLM legacy businesses measured against Green Giant and Dole. Historically, Pillsbury broke-out Green Giant’s performance statistics; since Pillsbury was acquired by General Mills, these data are no longer available. Also, Dole was taken private in May 2003. When the data were available, they showed that DLM had more efficient operations than Green Giant and Dole.

6. The following table compares DLM’s operating metrics (since the acquisition of the HNZ product lines) to those of other packaged goods companies (CPB, CAG, GIS, HNZ, KFT).



Metric Del Monte Peers
Revenue / employee $241 k $290 k
Gross margin 26% 36%
Days receivable 26 33
Inventory turns 3 5
Earnings / assets 5% 6%
Earnings / net assets 9% 12%
EBITDA / assets 12% 14%
EBITDA / net assets 21% 28%


DLM lags in most of these metrics, hence the opportunities for operational improvement.

Recent Declines
At first glance, DLM’s revenue and earnings are falling. For instance, FY ’03 sales were $3.059 billion compared to FY ’02 sales of $3.185 billon.(DLM FY ‘03 and FY ’02 revenues used here are GAAP figures, adjusted as if the merger happened at the beginning of FY ’02).
There are two reasons why revenue declined, both owing to the HNZ brands and both transient:

• DLM is exiting most of the HNZ private label pet food business. It will continue to make private label pet food for Wal-Mart (Ol’ Roy and Special Kitty).

• Tuna prices were depressed.

Earnings also fell during FY’03 due to merger related costs and falling tuna prices. Falling tuna prices hurt DLM’s Starkist business because they get stuck with higher priced work-in-process inventory while customers expect price concessions due to the falling wholesale prices. The merger related costs will decline over time. This trend has reversed itself; according to Infofish Trade News, wholesale canned tuna prices have increased from $12.50 per case in June to $15.50 per case recently. Tuna prices vary with the quantity of the catch. Weather patterns since June of this year have made it more difficult for tuna fishing boats to find and catch tuna, so prices are increasing.

One more comment regarding the tuna business. DLM management is ramping-up the pouch tuna initiative started by Heinz. Pouch tuna consists of packaging tuna in a foil container which includes almost no water. The tuna industry has spent the last ten years reducing the quality of canned tuna; the pouch initiative is reversing this trend. For instance, a three ounce pouch of tuna contains three ounces of tuna, compared to a six ounce can of tuna, which contains about 3 ½ ounces of tuna (the balance is water). Starkist is the leading provider of pouch tuna (20% of Starkist revenue) and is currently commanding a premium for the product.

Catalyst

1.Debt pay-down from substantial free cash flow, boosting earnings (annualized earnings increase of 7% from debt pay-down).
2. Faster growing businesses enjoy fatter margins which will augment earnings growth.
3. Integration of HNZ brands plus modest operational improvements.
4. Revenue growth from mass merchants and wholesale clubs e.g., Wal-Mart, Costco.
5. Simplified comparisons after the issuance of DLM’s FY 2004 10-K.
6.Increased investor interest due to larger market capitalization and greater liquidity.