Description

Galaxy Nutritional Foods (Amex: GXY) is a rapidly growing manufacturer and marketer of soy and rice-based, lactose-free, low cholesterol, and no saturated fat dairy alternative products such as cheese (90% market share), yogurt, smoothies, butter, milk, sour cream and other products. They currently sell to over 14,000 supermarkets (Safeway, Albertsons, Kroger...) and health food stores (Whole Foods, Wild Oats...) with an average of 4.5 sku's per store. Their goal is to get into 20,000 stores with 20 sku's per store. This is an opportune time to look at Galaxy as they should be EBITDA neutral in the 3rd quarter starting October 2001 (March fiscal) and are about to launch new products such as a Tropicana Smoothie (Tropicana selected GXY's soy/rice milk and manufacturing capability for the smoothie), healthy desert products and new shred and chunk cheeses. In addition, Galaxy has been in trials with Pizza Hut which is using Galaxy's cheese for a healthy pizza. The feedback has been very positive thus far. Sbarro just approved GXY's Veggie Mozarella for almost 800 stores. Also, Subway, the 2nd largest fast-food chain behind McDonalds, is using Galaxy cheese for their healthy sub business. Currently over 100 Subways are using Galaxy product and this may ramp to 10% of the 15,000 total Subways soon (the Chairman of Subway Fred DeLuca owns 3%+ of Galaxy stock). Last, Burger King is doing a meatless burger and is considering GXY's cheese. The company has also become quite lean and has able to most of its past manufacuring and operational problems behind it. They have layed off many plant workers and have invested significantly in more efficient production capability. Additionally, they have replaced the former CFO and have hired formed a very credible operational team (the CEO, while an industry visionary, is not an operator). GXY expects EBITDA margins to approach 21% within 8-12 months. After doing $47 million in sales last year, Galaxy should approach a $70 million run rate by March 2002. The fourth quarter beginning January 1, 2001 should be the first impressive quarter for the company (good sequential revenue growth, lower wages and raw material costs and cap-ex and working capital payback). Galaxy hosted their annual shareholders meeting in Orlando this past Friday. GXY's new COO Chris New provided guidance for the upcoming fiscal year beginning April 1, 2002. They expect $85 million in revenues with a 21% Ebitda margin and $14 million in pre-tax income.


Health Benefits

The U.S. FDA announced that eating 25 grams of soy protein per day might help reduce the risk of cancer, heart disease, diabetes, and osteoporosis. Galaxy has the healthiest product on the market because they add more isoflavones (plant chemical unique to soybeans that has antioxidant properties), fiber, calcium, and vitamins than any other manufacturer. Galaxy’s products are lactose free, low cholesterol and most have no saturated fat. The growth hormones, antibiotics, and food fed to animals in the world are very unhealthy for human consumption. Vegetable proteins are substantially healthier

Manufacturing

Galaxy has 2 facilities; 1 modern cooler/cross-docking facility that is worth $5 million and which was “given” to GXY for $150,000 by Pepsi. They have leased (with option to buy) 1 manufacturing facility that is state-of-the-art and was ranked the 5th best dairy plant out of over 900 in the U.S. GXY employs a hot manufacturing process, which eliminates dangerous pathogens such as Ecoli, Salmonella, Listeria and other bacteria. (they start and finish with a hot process). Galaxy just spent $15 million and significant time and effort to build capacity to $600 million to meet demand. They are about to start shipping Wal-Mart and others shortly so the capacity comes at a good time. Problems re shortages and inefficiencies that the company experienced last year should be addressed completely by February 2002 at which time the Company will have integrated the new manufacturing machines, with accounting systems, which will generate more useful inventory and working capital reporting.

Growth

Company sales to the retail channel will ramp dramatically starting in February 2002. Significant orders are already in place. GXY should achieve close to $50 million in sales for the current fiscal year (2002), which should increase by almost 100% in FY 2003. In addition, landing major national food service contracts (Sbarro, Pizza Hut, Tropicana) could potentially dwarf retail sales. Given that the company has laid off more employees, will have lower slotting fees, more efficient equipment (with all significant cap ex behind the company and much better working capital management), and sales about to ramp, the Company should start generating an accelerating amount of cash this year. In fact, the last few weeks of Q3 were EBITDA positive and q3 as a whole should be EBITDA neutral.

Competition

Very limited. GXY has over 90% market share of the “Alternative Cheese” category. In 2000, IRI data showed a 46% growth rate. A major advantage for GXY, the retailer and consumer is that the shelf life of the cheese is 6 months (probably longer but they don’t say that on packaging). This is obviously a major advantage when trying to manage inventories. GXY had less than 1/10th of 1% shrink last quarter versus 54% for Yves and 30% for Lite-Life. Yves is a Canadian company that is sourcing (thus, not controlling their own destiny, higher cost structure) an alternative cheese product and they are not having much success. GXY is beating Yves in their home Canadian markets. Dean Foods/Suiza owns Whitewave and may be interested in either buying or building for the alternative category. Tree of Life owns Soyakaas (not in produce in mass channel) and Rella. Neither is doing very well in the cheese category. Lisonatti is not doing very well with UNFI or the Northeast cooperatives. Lisonatti only has modest sales in chunk cheese and GXY just got their new chunk line up. Tofurella doesn’t do their own manufacturing – their sales are non-existent.

Management: Angelo Morini started this company over 30 years ago and was one of the pioneers of the neutraceutical industry and owns 35% of GXY. The company also just hired Chris New from Tropicana to be Director of Marketing and COO. Chris helped grow the Pure Premium brand from $700 million to over $2 billion for Tropicana. John Jackson is the National Sales Manager. He was previously at Heinz. Additionally, the company recently hired a new concern from a dairy concern and, at the least, she must be an improvement over the last CFO, who was not very good.

Financial: $775,000 sales per week is break even. GXY should be EBITDA neutral in 3Q 2002. (March FY). GXY is currently speaking with senior lenders about a new senior collateral-based line of credit. The company has approximately $27 million in debt. Normalized gross margins are around 36%-39%. Normalized ebitda margins are around 20% on an operating basis but could rise toward 25% as efficiencies and leverage are realized. GXY is now expensing all slotting fees and in q4 2000, they took some 1x charges, thus clearing the decks for positive comparisons going forward. Given that the former CFO did a poor job on collecting receivables and did not negotiate a new working capital line in a timely manner, Q2 2002 results suffered. Nevertheless, inventories and receivables will be down nicely in Q3 2002. GXY has the opportunity to refinance some debt at lower rates, thus saving 6% on $15 million or $900,000. In January 2002, Galaxy raised $2 million for working capital and thus should be set for some time.

Other: GXY did have to pay up for Casein (largest raw material) in q4 and q1 which they buy from Europe (the government held up exports). This problem is now corrected as 4 or 5 new suppliers have recently come online and they have figured out a way to produce at super-high temperatures which kill all bacteria. Casein prices are now dropping substantially. They buy the highest quality soy from Dupont. John Hancock owns 15% of GXY. Fred DeLuca owns over 3%+ and Kern Capital owns almost 4%. The company has built the infrastructure and capacity to build a larger company. Execution is now the key. The demand is strong and orders are in hand. GXY has a unique product offering and a dominant position in a growing category.

Catalyst

Valuation/Catalysts: The average industry takeout multiples are 2.2x sales and 16x Ebitda. Pepsi paid 3.6x sales for Sobey (which was the fastest growing alternative beverage company). Conagra paid 2.1x sales for Lite-Life. Slim-Fast got 3.5x sales (Goldman Sachs banker). Hain paid 3x sales for Celestial. Worthington Foods got 1.7x sales. Gatorade got 24x Ebitda. Kraft paid 2.7x sales for Balance Bar. Power Bar got 2.5x sales. This is a consolidating industry and many large players are looking to capitalize on the trend toward healthy eating in this country. The "alternative cheese" category, which GXY dominates, has one of if not the highest IRI growth rates in the food industry. GXY owns a high-growth category, is building a strong brand name, has high operating margins (and rising this year), has contracts with major corporations and has almost $2/share in PPE.

I expect that Galaxy will begin communicating with the Street much more aggressively, now that they are able to ramp production. This may include a more formalized investor relations effort. Additionally, regional specialty firms such as Adams, Harkness & Hill have recently visited the company. While GXY’s ramp over the next year, as well as its increased visibility on its own should serve as a catalyst, I expect that the company will be shopped at some point within the next 12-18 months to a much larger company. Assuming reasonable execution, and with a strong brand and significant excess capacity, I project a base target of 2x revenues of approximately $85mm (FY ‘03) or $170mm-$25mm+/- in debt or approximately $11-12 per share. This would equate to less than 10x EBITDA, which is well below recent industry transaction multiples. More likely, by next Winter/Spring, GXY will be on a run-rate north of $100mm in revenues and will be producing EBITDA margins north of 20%, which would result in a more reasonable takeout valuation of $15-18 (2x sales or 13-14x EBITDA).