Maple Leaf Foods - A Potential CAD$1.5 Billion Hidden Liability?
I believe Maple Leaf Foods (“MFI”) is a compelling short based on potential litigation claims from its ownership and management of Canada Bread (“CBY”), which may be brought by:
The Canadian Competition Bureau as relates to the bread price fixing arrangement recently covered by the media;
Class action litigation from nearly every Canadian consumer who purchased bread over a period of time that spans 14 years. Canada Bread is already a defendant on a $1 billion class action suit;
Potential litigation from investors who relied upon prospectus based disclosure by MFI to purchase treasury shares from the company;
Potential for fraudulent or criminal misrepresentation, on the financial affairs and forecasts of Canada Bread when MFI sold it to Grupo Bimbo in 2014 (coincidentally when the period of alleged price fixing ended) which may have resulted in Grupo Bimbo significantly overpaying for the asset.
I believe that a conservative estimate of the above sources of liability total CAD$1.5 billion, which represents over $12.00/share in value and would indicate 34% downside for MFI’s stock at current levels.
Based on a press release from Grupo Bimbo today, it is possible that they are also coming to the view that any criminal or civil liability against CBY should be for the account of MFI instead. The market does not seem to recognize these potential liabilities, perhaps having forgotten that MFI used to own 90% of CBY or thinking that the sale transaction insulates MFI from any potential damages.
Maple Leaf Foods is a Canadian protein company. It was written up in 2012 by nantembo629 and in 2014 by RWB. Their prior posts provide good background on MFI’s Value Creation Plan which was started in 2010 to increase shareholder value by modernizing and consolidating their prepared meats supply chain.
Today, the Value Creation Plan is complete and the company was successful in lifting its EBITDA margins from 7.3% in 2010 to 11.8% today (LTM Q3 2017). As part of this long process, the company was subject to an activist investor, who threatened a proxy contest, entered into a settlement agreement, initiated a Board rejuvenation process, and streamlined the asset portfolio.
MFI sold one of its marquee assets, Canada Bread, in 2014 to focus its remaining operations on meat products. CBY is the second largest national bakery in Canada. It produces fresh bread and specialty bakery products in Canada, frozen par-baked bread in the US, and bagels & croissants in the UK. CBY was sold to Grupo Bimbo, a Mexican multinational bakery with operations globally, for an Enterprise Value of CAD$1.73 billion.
This transaction was important to MFI, as it significantly de-levered its balance sheet, de-risked the Value Creation Plan (which required over $1 billion in capex investments) and set the company up for significant share price appreciation for the next few years.
Source: Yahoo Finance
The Canadian Bakery Industry
Investors looking at this situation first need to understand the Canadian bakery industry. The elephants of the industry are Canada Bread and Weston Foods (“WF”), which is the bakery division of George Weston Limited (“GWL”). GWL’s other primary asset is an ownership interest in separately traded Loblaw, which operates Loblaws and Superstore, the largest retailer in Canada, as well as Shoppers Drug Mart, a significant private label business in groceries and household items, and an ownership interest in Choice Properties REIT.
Notably, CBY and WF are the largest and only national-scale fresh bakeries in Canada. Given its short shelf life and fragile nature, fresh bakery is a direct store delivery business (fast-turning, high velocity, consistent consumer demand) and therefore requires significant scale in logistics.
Canada Bread has been very proud of its leading market share, touting in Maple Leaf Foods’ 2013 Investor Day Presentation that they hold 30% market share in commercial bread, 35% in white bread, and 40% in grain bread. I note that Weston Foods’ bakery is larger than CBY by revenues.
Source: Maple Leaf Foods Investor Day Presentation, June 20, 2013
Based on an Agriculture and Agri-Food Canada report on bakery products in 2013, I estimate that CBY and WF had a combined ~46% market share of relevant Canadian bakery categories as shown below:
Source: Agriculture and Agri-Food Canada and Author’s Estimates
The market share of CBY and WF would be considerably higher in base categories such as commercial bread, where they own the most dominant brands such as Wonderbread, D’italiano, Weston, MultiGo, Country Harvest, Dempster’s, Villaggio, and Stonemil. In these categories, their combined market share could be more than 60%.
This high level of concentration is suggestive of an industry with favorable pricing dynamics. This was not a secret in the industry, nor with investors. Irene Nattel, a sell-side analyst and Managing Director at RBC Capital Markets made the following observation and asked this question to GWL management in 2014 when CBY was sold to Grupo Bimbo:
Source: 2014 Q4 George Weston Conference Call Transcript from Bloomberg
Other sell-side analysts have been even more straightforward, here is a statement from Robert Gibson, a research analyst with Octagon Capital, when CBY was sold:
Source: Wall Street Journal
George Weston / Loblaw Act as Whistle-blower
On Oct. 31, 2017, GWL and Loblaw confirmed that they are aware of an industry-wide investigation by the Canadian Competition Bureau concerning a “price fixing scheme involving certain packaged bread products”.
On Dec. 19, 2017, GWL and Loblaw released further details on the “price fixing arrangement” :
Source: GWL and Loblaw Press Release
The key take-aways from GWL/Loblaw’s disclosure is that:
The alleged price fixing arrangement took place from late 2001 to March 2015, a period of over 14 years;
Other major grocery retailers are involved in the arrangement;
“another bread wholesaler” was involved in the arrangement;
GWL/Loblaw have been acting as a whistle-blower, admitting their participation in the arrangement and cooperating the Competition Bureau’s investigation, and have been granted immunity from criminal charges or penalties.
Naturally, given the market structure and market share concentration in the country, the other “bread wholesaler” Loblaw refers to was Canada Bread.
Class Action Lawsuits Initiated
On Dec. 21, 2017, a class action lawsuit was initiated against Loblaw, George Weston, Weston Foods, Canada Bread, and a number of retailers:
Specifically, Canada Bread and its predecessors, affiliates and subsidiaries is named as a co-defendant in this action. It is also revealed in this Statement of Claim that a search warrant was executed for Canada Bread’s headquarters, located at 10 Four Seasons Place:
At this point, it is important to understand who was the mind and management of Canada Bread. Canada Bread had an Intercompany Management Services Agreement (“IMSA”) with Maple Leaf Foods since 1995. The key take-aways are that MFI provided the following services to CBY (amongst others):
Financial reporting and accounting standards;
Senior management time and operating involvement.
These (along with the other services provided) are extensive functions and cover all aspects of Canada Bread’s business. Evidence of the scope of these services is shown in the amount of fees paid by CBY to MFI, which totaled $51 million in 2013. For context, CBY generated $176 million of EBITDA in 2013. Furthermore, the IMSA covered the entire alleged price fixing arrangement period, from 1995 to at least May 23, 2014.
Source: Canada Bread 2013 Annual Information Form
Significant Management and Director Overlap
Based on a review of CBY’s Management Information Circular, it appears that the C-suite of CBY and MFI was almost entirely comprised of the same people, as shown below:
Source: Canada Bread Management Information Circular March 5, 2014
The overlap extends to the Board level, with 4 out of the 7 CBY directors also holding executive positions at Maple Leaf Foods.