Value Investors Club / Fresh Del Monte Produce Inc. (FDP)

Description

Executive summary

Fresh Del Monte is a vertically integrated fresh fruit company. Despite operating in an unattractive industry, it is an attractive investment at the current price because it is cheap on both an asset valuation and earnings basis (P/B 0.91x; P/E 8.6x (’08); ROE 12.2% ave. 98-07), and because the one third stake still held by management - bought for cash 12 years ago - should bring an owner mentality to inevitable operational challenges, and maintain a conservative balance sheet, thereby ensuring business safety.

Introduction

Just three months ago, this company could have been justifiably written up on the anti-site of VIC, where all things momentum and faddish get discussed in a frenzied atmosphere (if such a site exists, please don’t write and tell me, it would do me no good). This is because the very same company was being bought by people who had fallen in love with such “secular investment trends” as food inflation and a global agricultural boom. The stock sold for double its current quote. What happened next is a familiar story, which will be briefly discussed, but more importantly brings the company to its current audience: the value investor.

Business description

Fresh Del Monte sells fresh fruit and vegetables to food retailers. It grows its own produce on company owned farms all around the world, and also buys in additional fresh produce from independent growers. After harvest and packing, the fresh produce is shipped in company-owned refrigerated vessels to distribution centers and ripening warehouses, again, all around the world. Finally it delivers the fresh, “Del Monte” branded produce to food retailers who are the company’s customers, who in turn re-sell this fresh produce to consumers.

Economics of the industry

The industry is dominated by well established brand names who each have been in the business of growing and distributing fresh produce for more than 100 years: Dole (since 1851), Fresh Del Monte (1892) and Chiquita (1870) sell, for example, two thirds of bananas by value, the biggest selling fruit globally.

The main industry barrier to entry centers on the high switching costs faced by food retailers (i.e. Fresh Del Monte’s customers) when assessing a new industry entrant. Food retailers know that consumers often make a judgment on the whole store’s quality based upon their perception of the quality of the fresh fruit and vegetables – a major reason why many supermarkets position their fresh produce displays near the store entrance. Retailers understand, from bitter experience, how difficult it is to ensure the consistent delivery of quality fresh produce irrespective of any number of logistical challenges faced daily by global suppliers: for example weather, season, labor issues of agricultural workers in developing countries, shipping and land transportation for perishable fresh produce. Retailer buyers are scared to switch to a new or smaller supplier who does not have a consistent track record of delivering on time, fresh produce, which does not spoil overnight. Retailers recognize that their reputation and brand name is on the line when they sell fresh produce to consumers, and would rather stick with a company that is consistent, than switch to a cheaper, but unreliable supplier. These high switching costs therefore provide a form of barrier to entry, and are manifest in the value of the brand name for each of the major players.

However, although this barrier to entry has successfully limited new entrants, it has not translated into an acceptable level of return on capital for the industry as a whole. The industry has not been a lucrative one in recent years, generating a measly 4.2% average ROE for the three largest players over the past decade. (Compared to its competitors, Fresh Del Monte is run more efficiently, and has better niches - e.g. #1 in gold pineapples, a high margin fruit - as evidenced by their consistently higher operating margins and a decade average ROE for the company of 12.4%). For the truly long term and patient investor, I suppose this lack of industry attractiveness might at some point create mean reversion for industry profitability. Industry profitability could therefore rise, as industry exit and/or lack of new entry combines with capacity constraints – resulting from years of under-investment due to the lack of incentives and inadequate profitability - driving future returns higher. There is some evidence of industry exit at the second tier level (e.g. some smaller scale Latin American banana growers have recently failed, reducing supply and improving pricing) and both Dole and Chiquita are much more heavily leveraged than Fresh Del Monte, meaning that the withdrawal of a major competitor is not an impossibility. There is also evidence of industry-wide under-investment: total investment by the three main incumbents (measured by net capex. less D&A for Dole, Fresh Del Monte and Chiquita) has been a net negative for the past ten years (suggesting significant under-investment even as sales have grown), with each of the past five years recording annual negative investment. Ultimately though, mean reversion in industry profitability is a powerful, but hard to time, economic force. This is not a necessary factor for the investment thesis because Fresh Del Monte already earns adequate, above industry average returns on capital, but the possibility alone is worth considering.

Growth prospects reflect end consumer demand that is quite stable through economic cycles, although some substitution between fruits does occur (for example recent months have seen a switching by North American consumers from higher priced fresh cut fruit to whole fruits as a manifestation of increasing thrift). A gently upwardly sloping unit volume curve is to be expected as Western consumers increasingly recognize the health benefits of fresh fruit consumption and Emerging market consumers trade up from fruit of unreliable quality.

Valuation – asset approach

Price/Book ratio is 0.91x.

For valuing this company, the single simplest valuation metric - for all its imperfections - is stated Book Value ($23.3 per share at 30th June 08). Book Value can serve as a quick but conservative valuation of the company because it consistently underestimates the replacement value of the company’s assets. These are both hard (real) assets and intangibles.

Hard asset valuation: Tangible Book Value is currently $16.2

This is a business that relies on extensive hard assets (e.g. agricultural land in emerging markets, a fleet of refrigerated ocean-going ships, warehouses and distribution centers in North America and Europe), and GAAP book value consistently underestimates the actual replacement cost or objective asset valuation of these hard assets. For example, agricultural land owned and currently under production (totaling 63,200 acres, mainly in Costa Rica and Brazil) is reflected at historic cost; refrigerated vessels are reflected at depreciated value, which is well below replacement value.

Intangibles: goodwill is less than the value of the brand name.

In addition to needing these hard assets to conduct business, the company also needs a brand name. Although this might not be intuitively obvious to the consumer of fresh fruit (aren’t all bananas the same?), industry structure and history shows that participants ascribe significant value to strong brands in fresh produce. As examples, David Murdock took Dole private in March 2003 paying $695 million for the company’s brand name and trademark (Deloitte’s independent valuation of the Dole brand name). Both the Chiquita and Del Monte brand names survived bankruptcy with significant value: Chiquita’s trademark was recorded to have a carrying value of $388 million in December 2002 after its bankruptcy that year, determined through independent appraisal using a “relief from royalty” method. The Del Monte brand name for global Fresh Produce is owned, royalty-free and in perpetuity by Fresh Del Monte; (the Del Monte brand name for prepared foods is split geographically between Fresh Del Monte for Europe Middle East and Africa, Del Monte Foods for North America, and Del Monte Pacific for Asia – a legacy dating back to KKR’s 1988 acquisition of RJR Nabisco and subsequent splitting of the Del Monte brand name into its two food lines). Current management recognized the value of the Del Monte brand when they bought the company in 1996 out of bankruptcy, having successfully operated a 2nd tier fresh produce company for two decades, but without the benefit of a globally recognized brand. The value of Del Monte’s century old brand name, one of three to dominate its industry, would be hard to reproduce, but based on the above valuations is very likely to be worth in excess of the $450 million current goodwill carried on the balance sheet (which relates to acquisitions unrelated to the Del Monte brand name, made since 1996). So it can be seen that the intangible element of stated Book Value is also a conservative estimate of the reproduction of total intangible assets, suggesting that the stock currently sells for at least a 10% discount to a conservative valuation of the reproduction of its assets. Some street analysts’ asset appraisals point to the stock trading at a 50% discount to current asset valuations.

Another reason that Book Value is a good starting point for valuation is that the company earns an acceptable level of profitability from its assets. Below is the track record (ROE) since 1997 when current management took over:

Historical Returns on Equity (%)

08        07        06        05        04      03      02      01      00    99        98        97
12.3    13.2    -14.1    9.2    13.0        24.0    25.7    17.4    7.2    13.4    15.5    15.5

Average ROE: 12.8% (97-07)

If these annual returns were generated by a hedge fund manager net of fees, and you were given the opportunity of buying into the fund at a 10% discount to NAV, I daresay that many would find this a sufficiently attractive proposition.

Finally, the weighing machine of the market seems to agree with the conclusion that Book Value is a useful proxy for a conservative valuation. If someone wished to explain daily market valuations going back to 1997, a simple formula of minimum: Book Value and maximum: Book Value plus $1 billion would describe 82% of market data over the past 11 years. The stock has only traded below Book Value on 3 occasions prior to the current episode. Two of these, in 1999 and 2003 were marked by temporary concerns about management integrity (proven to be unfounded). In 2006 the stock traded to a maximum discount of 25% below Book Value, during a period of significant losses that caused Book Value to decline. It should be noted that the company is currently profitable (consensus eps 2008: $2.86; H1 08 actual: $1.73) and pays no dividend, so reported profits accrue to retained earnings, raising Book Value.

Valuation – earnings approach

P/E 07        7.6x
P/E 08        8.6x
P/E 09        6.5x

EV/EBIT 07    10.1x        (N.B. effective tax rate typically ranges 0-9%)
EV/EBIT 08    12.7x
EV/EBIT 09    9.6x

Valuation – Comps

                Debt/EV    Op. Margins 07    ROE 07    P/B    P/E 08
FDP        23%           5.3%                     13.2%        0.91x    8.6x
Dole        88% *        1.9%                     negative    private    private
CQB        52%           0.7%                    negative     0.75x    9.0x
FFY LN   0%            3.0%                   4.1%         0.85x    11.0x

* equity valued at BV

Valuation – private market

David Murdock paid $2.385 billion for Dole in March 2003, which represented the following valuation ratios:

Price/Book (’02)            2.6x
Price/Book (’95-’02)     3.2x

EV/EBIT (’02)            8.7x
EV/EBIT (’95-’02)    14.3x

Fresh Del Monte (in its predecessor form) was purchased at the following prices:

1989    $875 million (sold by RJR Nabisco to Polly Peck)
1992    $600 million (sold by Polly Peck in receivership to Carlos Cabal Peniche)
1996    $534 million (sold by G.E.A.M. in receivership to Mohammad Abu-Ghazaleh et al)

Management

Given the treacherous history of the industry, I need to have evidence that management is both competent and aligned in their interests with minority shareholders. The track record here contains plenty of evidence on both issues.

Mohammad Abu-Ghazaleh (born 1942 – current age 66) is Chairman, CEO, and together with his extended family, owns slightly more than one third of stock outstanding. Growing up in Jordan, with a father who imported fruit into the Middle East in the 1950s he himself has worked for 42 years in the fresh produce industry, managing privately held businesses all over the world. General Manager for Metico, a Middle East fresh produce company for 20 years, in 1986 he moved to Chile to run his family’s company United Trading Company for 10 years. He built UTC into a fresh produce company with operations in Chile, the USA, the Netherlands and Uruguay: a small-scale version of Fresh Del Monte. In 1996 it had annual revenues of $257 million with net income of $8.7 million.

In 1996 Freshglo Limited (Fresh Del Monte’s predecessor) was a diseased company, recently changing ownership five times (1989-1996), consistently being under financial distress (losing $132.9 million in 1996), and finally being seized by the Mexican Government in 1995 after its chairman became a fugitive on charges of embezzlement and fraud. However, it had one redeeming feature: the perpetual, exclusive license to use the Del Monte® brand name for fresh fruits and vegetables on a royalty-free basis. With 3 decades of industry experience, in 1996 Mohammad Abu-Ghazaleh recognized the opportunity: here was a global fresh produce business, with most of the necessary infrastructure in place, and the benefit of a terrific brand name, available at a cheap price. He swung at what appeared to be a perfect pitch, and has gone from being financially secure to becoming truly wealthy. His family’s current stake is valued at approx. $500 million, having taken profits over the past decade of about the same value by occasionally selling stock, gradually reducing his family’s stake from the initial 80% to the current 34%.

Mohammad Abu-Ghazaleh therefore keeps a large portion of his and his extended family’s private wealth invested in the company that he manages. His current stake goes well beyond mere “skin in the game” – he remains invested to a very substantial degree. Agency costs are therefore significantly reduced due to this owner-entrepreneur structure. The benefits this affords the minority shareholder are significant: management makes quick, rational decisions where conditions require. For example, into the last down cycle in 2005-06, management quickly rationalized certain product lines (e.g. sweet onions) on which they found it difficult to make an acceptable profit – they simply stopped selling them. Like a market trader at a traditional “fruit and veg.” stall, management has their own money at stake to ensure that they only buy and sell fresh produce at an acceptable profit. This owner mentality applies to capital structure as well: soon after the start of the current credit crisis, management issued stock to pay down debt (November 2007). Plenty of companies would have felt inhibited by the negative “signalling” effect of such an action, and the stock did indeed tank on the news of the secondary issue (management also sold some of its own stock at the same time, with the same conditions), but in retrospect this was a smart thing to do.

Hani El Nafy COO, (born 1950 – aged 58) was with Mohammad Abu-Ghazaleh at UTC since 1986, and moved with him to Fresh Del Monte in 1996. Most of the rest of senior management was maintained from the predecessor company. Management compensation is very reasonable (aggregate compensation expense for all 14 executive managers and 7 outside directors during 2007 was $6.9 million). Stock options are by no means excessive. Evidence of management’s thrift and efficiency is seen throughout the company: SG&A costs are the lowest in the industry, typically 5% of sales or about half of the level of competitors’.

The bear case – why is it cheap?

1.    Largest acquisition in current management’s history (Caribana, June 2008) coincides with a general decline in risk appetite by both investors and banks
2.    Stagflation – input inflation will continue, without the ability to pass on price increases to food retailing customers and end consumers.
3.    A reality for many professional investors that investment risk = price risk, rather than risk of permanent loss of capital. For investors who paid double the current valuation three months ago, three very significant daily price drops in subsequent weeks have sorely tested any investment thesis they may have had, and as a result most have sold. The three price crashes over recent weeks (with their reasons):
•    April (at all time highs for the stock, the previous CFO sold stock on his retirement, some managers exercised options and sold stock - plus one noted analyst downgraded from “buy” to “hold” on valuation grounds (subsequently upgraded back to “buy” three days later after the stock price had dropped 25%)
•    June (competitor Chiquita warned of a "substantial" Q3 08 loss, still awaited)
•    July (Q2 08 earnings miss)
•    It should be noted that management never appears unduly concerned by significant stock price volatility.

Risks to Thesis

1.    Debt –
•    increases substantially from current, due to further major acquisitions. Unlikely against history, they have aversion to too much debt (as soon as get into debt, apply operating cash flows to reduce it).
•    Debt spiral caused by back to back annual losses and asset impairments. In a normal environment, the variety of owned hard assets should give lenders the confidence to relax covenants temporarily. In a negative scenario, although not ideal, the company could opt for a similar asset sale and leaseback to what Chiquita did with its shipping fleet last year – if similar ship valuations were achieved this would cover 100% of current debt.
2.    Loss of alignment: If the owner manager family sells out completely. There is also some key man risk here, due to the lack of obvious succession plan, despite a competent executive team.
3.    Brand impairment: major impairment of Del Monte brand through actions of either Fresh Del Monte or Del Monte Foods.
4.    Tax: Normalization of effective taxation rate to US levels – reduces return on assets commensurately.
5.    Trade politics : European quota system changes contributed to CQB’s 2001 bankruptcy (aided by high leverage and single product focus)
6.    Crop disease: Normally this should be limited to current inventories of crops in the ground. In extreme situations, entire plant varieties can be wiped out. e.g. Panama disease led to the Cavendish variety replacing the previously dominant variety the Gros Michel in the 1960s.

Generic risks

1.    Fraud, corruption
2.    Litigation
3.    Environmental hazard liability, e.g. contamination from pesticides
4.    Stupid acquisitions (non-core, or just expensive)
5.    Stupid sale of the company
6.    Terrorist attack on company vessel, causing uninsured loss and legal liability

Catalysts

1.    Momentum investors finish selling as they complete their exit. A total of 88% of the float turned over during the six weeks between the two daily price crashes on June 16th and July 29th 2008, suggesting that this process is near completion. Investor base is currently being re-populated by value investors.
2.    Buybacks are a low probability due to management’s preference for using excess cash to repay debt.

This is not a solicitation to buy or sell any security. The author has based this paper on sources believed to be reliable, but he bears no responsibility for their accuracy or otherwise.

Catalyst

1. Momentum investors finish selling as they complete their exit. A total of 88% of the float turned over during the six weeks between the two daily price crashes on June 16th and July 29th 2008, suggesting that this process is near completion. Investor base is currently being re-populated by value investors.
2. Buybacks are a low probability due to management’s preference for using excess cash to repay debt.

show sort by

			2008	2009
Price:	21.31	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	1,349	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT