Since our August 2011 write-up on Greencore (GNC ID/GNC LN), two material events have unfolded that are material to our thesis.  (we have attached our initial thesis below in the 'catalyst section').

1)      First, effective last week, the company de-listed from the Irish Stock Exchange and relisted in the UK.  We believe this move should have a materially positive impact on the stock’s liquidity and its visibility to the market, factors which in our opinion have been a large drag on its valuation.  As part of this move, the company changed its functional currency to Sterling from Euros, which will largely eliminate currency translation volatility from its results going forward.

2)      Second, in the fall, the company was approached by a brand-name private equity firm about their interest in purchasing Greencore.  Based on our due diligence, we believe the purchase price being discussed was roughly 50% higher than the current share price of £0.57/share.  While the discussions ultimately ended due to financing issues (European credit markets), we believe that this deal could come back if/when the European financing markets thaw a bit, as we believe that there were no fundamental issues that arose in due diligence that led discussions to end.

Thus, today, Greencore is a well managed food company trading at less than 5x next year’s EBITDA (giving no value to an NOL that is worth ~20% of the company’s current market cap) with a legitimate near term catalyst in the relisting.  Longer term (2 yr investment horizon), we see fair value at £1.25/share, supported by private market value that is well in excess of the company’s current share price.  Below, we describe each of these developments in more detail.

Relisting

As mentioned above, Greencore recently de-listed from the Irish stock exchange and now trades exclusively in the UK under the ticker “GNC LN”.  Beyond the benefits of moving to an exchange that offers a much broader liquidity pool than Ireland, the relisting is significant because Greencore expects to be added in early March to the FTSE all-share index, which will require UK index funds to purchase Greencore shares.  This is significant because we believe that over the past two months Greencore has faced a material headwind in that Irish index funds have been forced sellers ahead of the company’s January 20^th delisting from the Irish exchange.  Thus, we expect this technical headwind to switch to a tailwind of forced UK index buyers. 

An added benefit of the relisting is the change in the company’s functional currency from euro to sterling.  This is relevant as over 90% of the company’s revenues and earnings come from the UK – thus, this switch removes the substantial currency translation risk which has affected the business in the past. 

Private Equity interest

On October 25, 2011, the company disclosed that it had been approached by an unnamed private equity suitor (speculated  to be Clayton Dublier & Rice in the Irish Times and Financial Times) and that discussions were ongoing.  The company indicated that it had not solicited the offer and that it agreed to open a formal due diligence process for the buyer only after the board had determined that the price range being discussed was such that that if an offer were made, that the board was inclined to recommend the offer to shareholders. 

The stock initially reacted positively to the announcement, increasing by ~15-20% to a high of £0.61/share.  However, on December 5^th Greencore announced that discussions had ended, citing “the board’s unanimous view on the strong underlying value of Greencore and the current dislocation in global equity and debt capital markets”. 

Based on our due diligence, below we describe what we think led this deal not to happen:

1)      We believe the proposed price of the transaction which led the board to agree to open a forma due diligence process was in excess of a 50% premium to pre-announcement price; 

2)      The debt-capital markets deteriorated sharply during the fall as the European credit crisis widened.  This stressed European banks and contributed to a 75% reduction in EU private equity activity in 2h ’11 versus 2h 2010.  

3)      As a result of the deteriorating capital markets, the potential purchaser faced higher than expected financing costs that reduced the price at which it was willing to consummate an acquisition.  Meanwhile, the Greencore Board, which is optimistic about the company’s long term prospects and its substantial undervaluation, was not willing to budge on price.  Hence, the discussions ended and the stock retreated to its pre-announcement price of just over £0.50/share.

While the discussions have ended, we do not believe it is out of the realm of possibility that they return as financing markets thaw and Greencore continues to execute well on its integration of Uniq (a highly value enhancing acquisition completed in September 2011 – and described in our August 2011 writeup).  Once the Uniq integration completes in September 2013, Greencore will generate sizeable FCF (yield of ~25%) and de-lever quickly causing a debt to equity value transfer.    In the meantime, we believe the attractive valuation and the catalyst from the listing will make Greencore a good stock.  

Original Write-Up (August 2011):

Greencore Group plc is an Irish small cap food company that trades at 4.7x earnings pro forma for a recently announced acquisition that is expected to close in September.  The stock has declined 40% ytd due largely to the unfortunate fact that the company conducted a rights offering in late August in order to finance a portion of the acquisition price - given recent developments in European equity markets, the timing of this capital raise could not have been worse.  Beyond trading at 4.7x earnings, the company offers a dividend yield of over 10% at the low end of its stated payout range and this dividend is 2x covered.  Lastly, within one year of the closing of the transaction, the company is expected to re-list on the London Stock Exchange from Dublin, which should greatly help the stock's profile and liquidity.  Below, we describe the business, the recent acquisition and our financial forecasts.

Overview of the company and the opportunity

Greencore Group plc is an Irish-listed food company with 90% of its business it the UK.  Its principal business is providing ready meals, sandwiches and other prepared foods to grocery stores and other food-to-go establishments on a daily basis.  The so-called "convenience foods" market is a growing market as it capitalizes on time-starved consumers' need for convenience.  Greencore is the most profitable company in the industry, with a track record of above-industry-average revenue growth and profit margins.  The long term outlook for the business is favorable, as not only does the market grow, but many of Greencore's competitors are in financial distress and have retrenched from the marketplace. 

Recently, Greencore announced the acquisition of one of its distressed competitors to consolidate its #1 position in the sandwich market (Uniq plc is the acquiree).  Beyond the natural cost synergies of combining two participants in the same industry, the acquisition is highly strategic, as it provides a port of entry for Greencore into Marks & Spencer, which is a significant player in the UK fresh food market and which previously had not been a customer.  This acquisition was achieved at a very attractive valuation of 5x EBIT, pro forma for synergies and the closure of the target's unprofitable operations.  In addition, the target brings with it €400 million of net operating loss carry-forwards that will substantially limit Greencore's cash taxes for years to come.    Lastly, but importantly, within one year of the closing of this transaction, Greencore will convert its functional currency from the Euro to Sterling and will delist from the Irish exchange and move its primary listing to London.  We believe the company will enjoy added visibility by trading in the larger London market; moreover, the change in its functional currency will reduce the exchange rate translation risk that has often added complexity to its financial results.

Despite having a strong competitive position in a growing market and despite being about to close a highly value-creating transaction, Greencore's shares have fallen by 40% year to date.  The stock's decline is largely attributable to the fact that Greencore recently conducted a rights offering to fund a portion of the Uniq acquisition - in what is as bad an environment as one could imagine for a small-capitalization Irish company to come to market looking for capital. 

Herein lies the opportunity.  At the recent closing price of ~€0.55, Greencore is trading at ~4.7x year one earnings post the transaction; this multiple declines to 3.7x in year two as synergies are achieved.  Importantly, this valuation does not include the value of the NOL, which we estimate is worth €0.15/share or 25% of the market value of the company. 

One additional source of value is worth mentioning.  In recent years, Greencore has been investing to build a convenience foods business in the United States.  To date, progress has been slow and the business has been losing money.  However, the business is expected to be break-even this year and management expects the business to generate UK-like margins over time, perhaps as early as 2012.  We estimate that the company has invested $50 million or nearly €0.10/share in this operation.  While it is impossible to value this new business venture, the invested capital to date is meaningful relative to the market value of the company and thus is a potentially valuable option.

A little Additional Background

Greencore began as the monopoly sugar producer in Ireland.  Like many Irish companies participating in a small home market, Greencore diversified in order to grow, using sugar cash flows to diversify into businesses such as malt, bottled water and convenience foods.  In the late 2000's, driven by the EU's WTO-driven decision to restructure sugar quotas and production economics, Greencore embarked upon an asset rationalization plan to sell non-core businesses.  Since then, the company has exited virtually all of its agribusiness operations, leaving the company with the convenience foods business.  Thus, from a stock market perspective, it is only relatively recently that Greencore has evolved from being a cyclical agribusiness/food conglomerate into becoming a pure-play convenience foods company.

One also should be aware that the UK market is extremely negative on the overall convenience foods industry, notwithstanding the growth characteristics of the market.  There are two primary reasons for this.  First, many investors look at the extremely consolidated nature of the UK grocery industry, in which the top four players control 90% of the market, and conclude that being a private label supplier to this industry cannot be a good business.  Second, the industry was oversupplied for a period in the mid-to-late 2000's, which led to poor industry returns and significant financial difficulties for many industry participants, including companies such as Northern Foods, Uniq plc and Bakkavor. 

However, we believe the market is unduly negative on the industry and unfairly paints Greencore with the same brush that it applies to competitors which are not as well run as Greencore.  Specifically, we believe that the market underappreciates the skill needed to provide consistent, high quality, freshly prepared food-to-go, to nearly every store in the country, on a daily basis.  Convenience foods are an important source of distinction/differentiation for the big UK grocers and we believe they greatly value the service and are willing to pay a fair price for it - provided there is a balance between supply and demand of this service.

In recent years, in response to low returns caused by the excess capacity, several plants have been closed.  This has brought the industry back into balance and removed the pricing pressure that existed for a period in the late 2000's. 

The Numbers

Greencore closed recently at €0.60/share.  Pro forma for the rights offering, there will be  384 million shares outstanding, giving the company a market capitalization of €230 million.  Pro forma net debt will be €284 million.  The company also has a net pension deficit of €79 million after-tax, which we include in our calculation of enterprise value.  Thus, the company has a pro forma an enterprise value of ~€590  million.  Below, we show our financial forecasts.  These forecasts assume only 70% achievement of synergies in year one following the deal closing.  

We describe our forecast further below.  In fiscal 2010 (ending September), Greencore earned EBITDA in its convenience foods business of €54 million.  Included in this number were losses in the U.S. of ~€3 million.  As mentioned above, the company expects to breakeven in the U.S. this year.  We also expect some organic growth in the UK this year due to year to date results and announced contract wins.  However, given the poor UK economy, we have not modeled in this improvement.  Thus, we estimate convenience foods profit of €57 million in the fiscal year ending September 2011 and expect this number to grow in future years.

Uniq, the business Greencore is about to acquire, earned €10 million in its last fiscal year.  Included in this number is €8 million in losses in its Everyday Desserts business, which is in the process of being closed.  In addition, Greencore estimates synergies of €12 million from corporate overhead and purchasing.   Thus, we believe Uniq has pro forma earnings power of €29 million and that the pro forma combined company has earnings power, excluding any positive contribution from the U.S., before growth of €86 million.  With some growth, we expect the combined company to earn €91 million in EBIT in F'13.  Subtracting interest expense of €20 million and applying the company's 18% tax rate leaves net income of €58 million. On a per share basis (384 million shares), this equates to €0.15/share in EPS.  As mentioned above, the stock closed recently at €0.60/share or 4.7x the pro forma earnings power of the company.  This does not include any value for the NOLs or for the U.S. business.  It is also worth mentioning that the company maintains a dividend payout ratio in the 40-50% range, so the dividend yield is ~11.4% at a 45% payout ratio.

In terms of the balance sheet, prior to the Uniq deal, the business had a net debt to EBITDA ratio of 3x.  This ratio will be maintained post completion of the acquisition, as more than half of the acquisition price is being funded by the rights offering.  Operating profit will cover interest expense 3.4x in year one and by 4.6x in year two as synergies are achieved.  Further, net debt will decline quickly given the high cash flows we project, even with the company paying out 40-50% of earnings as dividends.  We project net debt to EBIT to reach 2.1x in three years. 

Valuation and Price Target

We believe a business of this caliber should trade at 10x earnings.  It is a relatively stable business selling a staple product, participates in a growing market, has leadership positions and is well managed.  As shown below, based on our forecasts, in two years time, we expect the business to earn €0.15/share.  By that time, its balance sheet should be in good shape, with debt to EBITDA of 2.3x and 2.8x including the pension, which seems readily manageable for a food business - EBITDA will comfortable cover interest by 4x.   At 10x, that equates to fair value of €1.50/share, which is 250% above where it trades today.