Description

Maple Leaf Foods - A Potential CAD$1.5 Billion Hidden Liability?

Executive Summary

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:

1. The Canadian Competition Bureau as relates to the bread price fixing arrangement recently covered by the media;
2. 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;
3. Potential litigation from investors who relied upon prospectus based disclosure by MFI to purchase treasury shares from the company;
4. 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.

Situation Overview

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:

1. The alleged price fixing arrangement took place from late 2001 to March 2015, a period of over 14 years;
2. Other major grocery retailers are involved in the arrangement;
3. “another bread wholesaler” was involved in the arrangement;
4. 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:

Source: https://www.sotosllp.com/wp-content/uploads/2017/12/Statement-of-Claim.pdf

The Statement of Claim calls for CAD$1 billion of damages and compensation and punitive damages in the amount of CAD$100 million.

Source: https://www.sotosllp.com/wp-content/uploads/2017/12/Statement-of-Claim.pdf

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:

Source: https://www.sotosllp.com/wp-content/uploads/2017/12/Statement-of-Claim.pdf

Who Was Mind and Management of Canada Bread?

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):

1. Financial reporting and accounting standards;
2. Internal controls;
3. Corporate logistics;
4. Corporate manufacturing;
5. Strategy development;
6. Marketing services;
7. 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.

Source: Canada Bread Management Information Circular March 5, 2014

Canada Bread’s and Weston Foods’ Historical EBITDA Margins

GWL and Loblaw claim that the alleged price fixing arrangement began in late 2001. Interestingly, it appears that Canada Bread’s profitability (as measured by EBITDA margin) took a step function higher and stayed there beginning in 2001.

Source: Maple Leaf Foods Investor Day Presentation, June 20, 2013

As interestingly, as shown in the chart below, Weston Foods’ EBITDA margins appear to have declined after the price fixing allegation period ended.

Source: George Weston Limited Reports and Author’s Estimates

Impact on the Canadian Consumer

On January 11, 2018, Maclean’s wrote an excellent article on the impact of this bread price fixing to the average consumer. They point out that the price of a loaf of bread increased from $1.42 in July 2001 to $3.04 in March 2015.  Kevin Grier, a food market analyst then performed an analysis to forecast the price of bread if it had risen inline with overall food inflation, and found there was a $1.00 gap between the real price and Grier’s price, as shown below:

Source: Maclean’s “Loblaws’ price-fixing may have cost you at least $400”

Source: Maclean’s “Loblaws’ price-fixing may have cost you at least $400”

The article goes to further point out that the cost of bread also greatly exceeds the increase in the price of wheat flour, as shown below:

Source: Maclean’s “Loblaws’ price-fixing may have cost you at least $400”

January 31, 2018 – News Articles Reveal Further Evidence

The Globe and Mail reported that Canada Bread and Weston Bakeries agreed to increase wholesale bread prices through “direct communications between senior officials in each of their companies during a 14-year period”.

Source: Globe and Mail “Canada Bread, Weston Bakeries and major grocers behind alleged bread price-fixing: Competition Bureau”

In fact, the Competition Bureau’s investigation refers to the price fixing arrangement as the “7/10 Convention”. The price fixing appears to have covered all manners of bread products including bagged bread, buns, rolls, bagels, naan bread, English muffins, wraps, pitas and tortillas.

Source: Globe and Mail “Canada Bread, Weston Bakeries and major grocers behind alleged bread price-fixing: Competition Bureau”

The Competition Bureau documents go as far as to name Richard Lan, the CEO of Canada Bread, and COO of the Foods Group at Maple Leaf Foods, as being involved in some manner in the price fixing arrangement.

Source: Globe and Mail “Canada Bread, Weston Bakeries and major grocers behind alleged bread price-fixing: Competition Bureau”

The fascinating aspect of this situation is that unlike most Competition Bureau investigations into cartel-like behaviour and price fixing, which are often difficult to prove, it appears that the cooperation of GWL and Loblaw with the Competition Bureau has afforded them significant insight into how industry players behaved. In fact, it appears that because GWL and Loblaw were forced to keep their co-operation confidential, allowing “other participants in the alleged cartel continue to operate as if the cartel were still functioning.”

Source: Globe and Mail “Canada Bread, Weston Bakeries and major grocers behind alleged bread price-fixing: Competition Bureau”

GWL / Loblaw appear to be taking the high road, having been granted immunity from criminal charges, to fully lay out the extent of everyone’s participation. This cooperation should aid the Competition Bureau greatly in getting to a position to press charges.

Source: Globe and Mail “Canada Bread, Weston Bakeries and major grocers behind alleged bread price-fixing: Competition Bureau”

Impact on Canada Bread and Maple Leaf Foods

Canada Bread is subject to two sources of liability arising from these actions:

1. Potential fines from the Competition Bureau should it be charged and found guilty in the alleged price fixing arrangement.
2. Liability arising from class action lawsuits. A $1 billion lawsuit has already named them as a defendant.

Maple Leaf Foods may be subject to three primary sources of liability, which the market does not seem to have priced in any probability:

1. MFI was the majority owner and manager of CBY during the alleged price fixing period. To recap, MFI provided the Intercompany Management Services Agreement, provided executive officers to CBY (most of whom are also executives at MFI), and the two companies shared four common directors. Therefore, it can be argued that mind of management of Canada Bread are one and the same with Maple Leaf Foods. If I were Grupo Bimbo, the current owner of CBY, and I was hit with any criminal or civil liability as a result of prior management’s actions, I would pursue recovery of those damages from MFI as quickly as possible.
2. Presumably, MFI provided financial data and forecasts, and made certain representations and warranties to Grupo Bimbo on the affairs of Canada Bread during the sales process. On the basis that data provided was accurate, Grupo Bimbo decided to bid CAD$1.73 billion for Canada Bread. If it turns out that a certain percentage of revenues/EBITDA generated by Canada Bread was due to illicit activity, Grupo Bimbo may seek to recover damages from Maple Leaf Foods.
3. MFI also provided financial data and made certain representations to purchasers of its shares and investors in its debt. I see that MFI accessed the equity capital markets four times (in 2001, 2004, 2008, and 2010) via prospectus-based offerings. Any investors in those offerings would likely be interested in knowing that there are current alleged indictable offences carried out by certain members of management.

Potential Financial Benefit for CBY

I will be the first to admit that calculating any sort of financial benefit and/or damages to CBY is very difficult as a public investor. Any analysis of this sort would depend on the accuracy of a large number of assumptions. However, one can make an educated estimate as to what such a liability might be.

I utilize the following methodology (bulleted letters correspond to table below):

1. Start with Canada Bread’s reported revenue.
2. Subtract the international revenue.
3. Arrive at Canada Bread’s Canadian revenue.
4. Estimate the % of products affected by the alleged price fixing arrangement (I have assumed 30% for conservatism, could be substantially higher given that it sounds like large amount of products were affected).
5. Calculate the dollar amount of Canadian revenue which was affected by the alleged price fixing arrangement.
6. Estimate the % overcharge due to this price fixing arrangement using Kevin Grier’s analysis. This is a key assumption, and I have assumed that it tops out around 22-23% in the latter years.
7. This gives you the Revenue/EBITDA impact from overcharging retailers (note should be 100% margin given it is pure profit).
8. This column shows CBY’s reported Adjusted EBITDA.
9. This column shows CBY’s Adjusted EBITDA after deducting my estimate of overcharges;
10. This column shows the percent decline in EBITDA after deducting my estimate of overcharges.

In total, CBY may have benefited over $550 million over this 14 year period that the alleged price fixing took place. Note that this does not account for the time value of money, which would at least partially offset any sort of argument that class action lawsuits take a long period of time to resolve.

I acknowledge that these estimates and the admittedly imprecise methodology is unlikely to be accurate, but I believe that there is conservatism built into the figures. As a reality check, Bloomberg published an article yesterday quoting the Competition Bureau as saying that “At least $1.50 has been artificially baked into the price of a loaf of bread during a 16-year-long bread price-fixing conspiracy”. Assuming a loaf of bread costs $3.04 (from Statistics Canada), 50% of that loaf cost was due to price fixing, as compared to my estimate of 22-23% in the latter years.

I also did a sanity check by comparing CBY’s reported Adjusted EBITDA from 1998 to 2000 (prior to the alleged price fixing), to my Estimated non-price-fixing Adjusted EBITDA margin. Both averages come out to 7.1% which gives me some degree of comfort.

Did Grupo Bimbo Significantly Overpay for Canada Bread?

Grupo Bimbo paid CAD$1.73 billion for Canada Bread in May 2014. Maple Leaf Foods received $1.65 billion in gross proceeds as the 90% owner of CBY. The estimated acquisition multiple was 9.8x 2013 Adj. EBITDA.

When Grupo Bimbo acquired Canada Bread, I assume that they came to the ultimate price based on:

1. A data room which was setup with historical financial results for Canada Bread;
2. Meetings with the management of Canada Bread (and Maple Leaf Foods) where they discussed prior performance of the business, current results, and the ability of the business to sustain its historical performance;
3. Potential financial projections provided by former management of Canada Bread (and Maple Leaf Foods);
4. The assumption that Canada Bread has a positive market reputation as a national provider of wholesale bread in the country.

The recent revelations question the accuracy of all the above assumptions which Grupo Bimbo may have relied upon. We will see what the Competition Bureau and the courts ultimately decide, but if CBY management and potentially MFI management are found to be guilty of fraudulent or criminal misconduct, Grupo Bimbo may have grounds to seek damages from MFI. My understanding is that the presence of any fraudulent or criminal misconduct means that any limitations of liability afforded by the transfer of ownership are irrelevant.

Assuming that CBY’s actual EBITDA was closer to $104 million, and that Grupo Bimbo would have paid a lower multiple for the business, I estimate that the “fair price” in this scenario for the asset would have been closer to $779 million, rather than the $1.73 billion actually paid.  This calculates to $950 million of potential overpayment.

Summary of Total Potential Liability for MFI

To summarize, MFI is facing potential liability of over $1.5 billion from the following sources:

MFI is a $4.4 billion dollar company today. The realization of these liabilities would reduce the stock price by $12.00/share, corresponding to 34% downside.

Potential Outcomes?

Canada Bread issued a press release today (Jan. 31, 2018) and made a few interesting statements:

Source: https://www.canadabread.com/media-statement-–-update-canada-bread-response-release-ito-related-industry-wide-competition-bureau

I find the highlighted sentences very interesting. Particularly, that the “allegations do not reflect the Canada Bread we know. Our current leadership takes these allegations very seriously and are actively investigating to take necessary measures.”

In my view, the outcomes for CBY’s former management and MFI’s current management are limited. Any attempts to plea innocence are complicated by the fact that GWL and Loblaw are fully co-operating as a whistle-blower.

Attempts to use a “scapegoat” technique and lay the blame on a lower level employee would be difficult, as Richard Lan (CEO of CBY and COO of Foods Group at MFI) has already been personally implicated to some degree.

Risks

1. Strong quarterly results at MFI – reports Q4 2017 results on Feb. 22.
2. Any potential litigation could take quarters/years to fully resolve.

Catalyst

Potential CAD$1.5 billion liability that is currently not being priced in by the market from:

1. Current ongoing investigation by the Canadian Competition Bureau
2. Current and future class action litigation from consumers
3. Potential litigation from Grupo Bimbo