Description

I believe the equity of Interstate Bakeries represents a compelling investment opportunity with attractive risk / reward characteristics. At $3.86, I believe that a reasonable range of value for the stock is $7.50 and $3.00 representing an up of around $3.50 and a down of around $1.00. While better and worse scenarios can play out, I think the better scenarios are more likely than the worse one’s.

While the company has and is experiencing serious financial and operational issues, a long term view of the situation is warranted. Interstate has recently filed for Ch. 11 bankruptcy protection in the Western District of Missouri. The filing, though disappointing from an emotional perspective, is a catalyst for the company to turn things around and enhance enterprise value from current levels. Bankruptcy does not mean the equity class is always cancelled. If value exists through the equity level, old shareholders will receive a recovery. There are several recent examples where equity has or most likely will receive value (Seitel, Footstar, Hawaiian Holdings, etc.). The debt securities of the company trade at levels implying value through the debt. The bank debt is well bid in the high 90s and the converts have traded in the 80s – 90s context. The advisory contract for Alvarez & Marsal states that A&M will receive 5% of the value created (definition TBD). The job of the equity holders will be to make sure that value is defined as value through the equity level. If appropriately defined, our interests will be aligned with A&M. An equity committee is in the process of being formed to press this point among other things.

Leading Player - Strong Brands

Interstate is the nation’s largest wholesale baker and distributor of fresh baked bread and sweet goods. IBC operates 54 bakeries, 1000 distribution centers and approximately 1,250 thrift stores.

IBC has the largest market share (~15%) of branded fresh bread sales. It has around 23% of all doughnut sales which was tied only with Krispy Kreme. (Source: ML Food Industry report 5/12/03). The IBC product line is marketed under a number of well-known national and regional brands which include Wonder, Hostess, Dolly Madison, Drakes, Baker’s Inn and Merita. These brands are very prominent in the bread and snack section of your local super market. I encourage you to take a look. Wonder bread is the number #1 selling white bread in the US. The Hostess line of products includes well known names as Twinkies, Ho-Hos and Suzy Qs. Other sweet good brands include Devil Dogs, Ring Dings and Yodels.

Capitalization & Valuation

Bank Debt: $475
6.0% Sr. Sub. Convertible Notes $100
Total Debt $575

Shares Outstanding 45.4
Stock Price $3.86
Market Cap. $175
TEV $750

To this total I add $150M of other debt to arrive at an adjusted TEV of $900. I throw this in to account for other debt or expenses that may arise out of the bankruptcy process. The first day filings talk about a number of other liabilities including healthcare, workers compensation and pension liabilities. The amount of these other claims may turn out to be more or less but I think $150 is a fair starting spot. Also, the company probably has some amount of cash on the balance sheet. The filings haven’t disclosed the cash balance on filing date. Any amount of cash would offset any high liability claim people want to factor in or lower the TEV.

Using a $150M EBITDA run rate number gives you a valuation multiple of 6x. Comparable companies include Flowers, Lance and Grupo Bimbo which trade at multiples of 8.3x, 6.8x and 6.4x respectively. Acquisitions in the industry have been between 6 and 8x and sometimes higher.

Due to the financial leverage here the stock price is sensitive to the multiple. If the company is valued in line with the comps upon emergence the stock should trade around $6.00 / share.

The net PP&E and Land is listed at $836M in the latest filings. While the machinery may be overvalued for book purposes the land is most likely undervalued. While many of the bakeries are older and less modern limiting their value, there is most likely interest at the individual bakery level for companies that want to increase their presence in certain areas of the country. Industry analysts have told me that Flowers has shown interest for certain IBC bakeries as they have a desire to increase their presence in sweet goods. Also, there may be understated land value in non core properties that IBC can sell to raise cash during the bankruptcy.

At these valuation levels I believe there is good upside potential with manageable downside risk. Given the reasonable valuation, the opportunity to cut costs in bankruptcy, the potential for a industry turnaround (Atkins, input costs, etc.) and the potential to sell all or a portion of the company there is significant option value to the upside. I believe this option value and reasonable valuation make it unlikely that the equity gets wiped out in bankruptcy and would trade down to $1 or $2 in a worst case scenario. If needed, certain decisions could be made by equity holders to preserve equity value such as a rights offering as was done in the Seitel case.

Cost Savings

While sales trends have been weak, I believe that the company can cut significant costs and streamline the business. The company is in the middle of a cost reduction effort named project SOAR as well as the implementation of a SAP account program. Both of these efforts have created extra expenses and headaches. I have had conversations with employees who have said that the company was paying bills late and getting switched to COD simply because of the headaches associated with the SAP implementation. A recent employee told me that around $25 million in annual savings are very achievable and are in the process of being implemented. He thinks these is a lot of “fat” in the company and that these cost saving were only related to his area of supply chain management. I have heard stories that up until this past year the district managers have not had computers. The company has acquired a number of bakeries through acquisition the largest being Continental Baking Co. (Wonder & Hostess lines) from Ralston Purina in 1995. Historically, each bakery was operated as a separate company. Only recently has the company started to integrate the functions that been done at each bakery.

The company has already closed 2 bakeries and is in the process of closing 4 more. I think more bakery closings are likely during bankruptcy that can generate even more cost savings.

Using a multiple of around 6x would create an extra $3 / share of equity value when these cost saving are fully realized.

Takeout Candidate

I believe that IBC’s strong brands and leading market presence make it an attractive acquisition target for an industry competitor or a brand orientated private equity buyer. I believe both types of buyers recognize the mismanagement at the company and the opportunity to cut costs and operate more efficiently by taking out some of the excess capacity within the industry. Depending on how operations develop during the case, I can see the development of an auction for the company which would most likely drive up the valuation.

Industry Trends

Interstate is a victim of what many in the baking industry term “the perfect storm” of higher input costs (wheat, flower, eggs, oil etc.) and weak sales trends. Industry sales have been affected by the Atkins low carb diet craze that preaches limiting the consumption of carbohydrates. IBC has been particularly slow to respond to this trend as well as the trend towards whole/multi grain breads. Only until recently has IBC offered anything but white breads and snack foods.

These trends are clearly negative. However, there are some signs that the Atkins trend may be peaking. If consumer preferences shift, at least a little, away from the low carb mindset the company would get a sales boost which would impact the bottom line significantly. While I am not depending on this shift, it is a possibility that this along with the operational changes could create a reversal of the snowball effect that we have seen over the past few years. If you want to short Atkins, going long IBC may be your best bet.

Strong Historical Cash Generation

The fixed cost nature of the business has made recent sales decline very painful. Despite thee trends, the company has demonstrated the ability to generate significant operating cash flow. Cash flow from operations less capex over the past 3 years:

2003: $56M
2002: $124
2001: $94M

With a market cap of only $175M these numbers look very attractive.

Catalyst

Reorganization through bankruptcy process
Implementation and realization of cost savings
Possible sale of individual bakeries or the entire company
Potential for industry turn around (Atkins decline, lower input costs)
Valuation