Summary

I recommend a long position in Premier foods, which trades at <4.5x 2010 free cash flow. Premier’s shares present an appreciation potential of 70%-250% within the next three years through re-rating and debt reduction. Currently the shares are very cheap for a couple of reasons: The company is highly indebted (1.49 bn net debt: 1.37 bn bank debt + 0.12 bn derivatives settlement) and had until recently a derivatives portfolio carrying a potential additional liability of 430m in 2013. The market fears that Premier will violate its debt covenants in 2011 and will be forced to dilute shareholders massively (just like in March 2009).  My thesis is that Premier will avoid covenant violations through asset sales (currently engaged in negotiations with Nestle and Princess) and focus on internal cash flow to reduce debt by $0.6-0.8bn. As a result of increased free cash flow (debt reduction), an improvement on its risk profile,  will lead to a re-rating of Premier’s shares.  There is not much of downside protection if the thesis does not hold and Premier is forced to do another equity offer. However, I believe that it is more likely that the thesis will play out, generating higher pay-offs than potential losses. Additionally, clear catalysts exist (asset sales within the next months, refinancing of debt within 18-24 months), which will provide an opportunity to check the validity of the investment thesis and adjust one’s investment exposure.

Background

Overview of the Company

Please read cyrus539 write-up from April 2009, which gives a good description of Premier Foods’ background as well as an understanding of the investment case at that time. Additionally, in Appendix 1, one can find (very) condensed financials of Premier (including my base case forecast until 2014). All monetary values are in British pounds.

Why is Premier so cheap? (Jan 2010-Jun2010)

Since January 2010, Premier suffered a share price decline of about 46% due to a number of operational and financial reasons:

1.     Mediocre to disappointing operational performance in 2010

Until 3Q 2010 sales were down 4.5% against the same period in 2009 due to a difficult environment, heavy promotional activity of competitors, structural problems in the industry (strong retailers) and raw materials price increases (ex. wheat price spike in the summer), which they were not able to pass entirely to customers (recently Tesco pulled various Hovis products due to price increases from Premier). Branded sales were roughly flat while own label sales declined more than 10%. This reduction of own label sales was partly in line with Premier’s stated strategy to focus on branded products and reduce its own label production. However, the market was expecting an increase in branded sales.

2.     Risks in the derivative portfolio suddenly surfaced

Premier was at risk of having to settle up to 430m of interest rate swaps in 2012 if interest rates stayed low. In addition to interest rate swaps with its debt maturities (swapping LIBOR for 5.2%), Premier had an additional, long dated interest rate swaps on its books that served no hedging purpose, essentially a bet on high interest rates. These swaps have a call option that the banks could exercise at mark-to-market value in 2012. At current mark-to-market, these swaps have created a 151m liability in June and a 167m liability end of September.

3.     Premier’s risk of violating its debt covenants in 2010 or latest in 2011

Premier has two types of covenants on its debt: Debt/EBITDA and EBITDA/interest. The major risk lies with the EBITDA/interest cover due to the additional interest on the long dated swaps. For the interest covenant, interest is calculated as unhedged interest on net debt + interest on hedge swaps + interest on long dated swaps. Under these circumstances, a covenant violation would only avoidable if interest rates were to rise sharply, EBITDA were to increase significantly or debt would be reduced significantly, none of which were likely at that time.

4.     Sudden increase in the pension deficit

The pension deficit skyrocketed from 11m in 2008 to 430m in June 2010, due to a downward revision of the discount rate (from 6.8% to 5.5%) as a result of the low interest rate environment. To reduce this shortfall Premier needs to contribute 40m/year until 2014.

Premier’s reaction

In the H1 2010 results, Premier laid out its financial strategy as  (1) de-risking the derivatives portfolio, (2) addressing the pension risk by closing the defined benefit scheme to newcomers and re-negotiating the benefits for existing beneficiaries, (3) being open to asset disposals to reduce debt and (4) tapping the capital markets to retire bank debt.

1.     Risk reduction through derivative Portfolio restructuring

On October 19^thPremier announced the restructuring of its derivative portfolio, which fixed the liability on the long dated swaps at 167m, of which 120m will be settled in 2012 and 2013. These 120 million will be excluded from debt and interest calculations for covenant purposes. In return 47m will be added to swap interest until 2013, raising the interest rate of the swaps from 5.2% to 6.2%. Additionally, the covenants have been tightened to:

                              2010    2011     2012
Debt/EBITDA           4.5x      3.9x      3.5x
EBITDA/Interest      2.4x      2.75x    3.3x

With this settlement Premier has put a fixed a number on its swap liability in 2012. Furthermore, interest on long dated swaps has been reduced to zero which increases the headroom for EBITDA/Interest cover.

2.     Start of the asset sales process

In October 2010, Premier announced that several interested parties have approached it on the sale of its meat-free business (Quorn brand and others). In November 2010, Premier announced negotiations with Princess (Mitsubishi Corp) over the sale of two canning factories.

3.     Pension liabilities

Negotiations on the reduction of benefits in the defined benefits plan have begun. The company has announced that it expects results by April 2011.

Investment Thesis

The investment thesis is based on belief that the following points will hold. I will try to explain why I think these assumptions are plausible:

1.     Premier can maintain its operational performance

There are three basic assumptions for Premier’s future operational performance:

a.      Third party manufacturing: Premier will continue to reduce its third party manufacturing (in 2010 estimated -11%). Most of the third party manufacturing is low margin and came with the acquisitions but is not part of the Premier’s core business. I have modeled an annual reduction of -10% to -6 %.

b.      Branded sales: Premier appears to be a pretty good operator of its brands. For example, they did a good job at reviving the Hovis brand, which was in decline when it was acquired in 2007. However, Premier currently has severe limitations in promotional spending, which impact sales growth. Therefore,  I have assumed an annual branded sales growth between -1% to 3%.

c.      Margins: I have assumed that margins will remain roughly the same, as potential input price inflation and pricing pressure from retailers will be offset by price increases and reduction of the lower margin third party production.

These assumptions translate in three different scenarios of organic  sales growth with constant margins (no asset disposals): Bad Case:-4,2%, Base Case: -1,4% and Good Case: 0%.

2.     Premier can reduce its debt by an additional 300m-500m

Premier must reduce its current bank debt burden by 500-800m within the next 18 months for two reasons:

a.      To refinance the debt in the capital markets at reasonable rates (not “junk” status)

b.      To avoid violating its debt covenants.

Debt covenants, and specifically EBITDA/Interest, have been tightened to 2.4x in 2010, 2.75x in 2011 and 3.3x in 2012. The requirements for interest cover have increased by 37% in 2012 (2.4x to 3.3x). The following table shows EBITDA/interest covenant headroom under various operational and debt reduction scenarios.

In addition to using cumulative free cash flow of about 300m (2010-2012) for debt reduction, Premier must sell more than 350m assets. This will allow Premier to avoid possible covenant violations which will give Premier about two years to find new financing for its (now much lower) debt.

Recent developments make it increasingly likely that they will be able to sell assets of up to 500m in 2011 at the necessary valuations. These actions make it more likely that they will meet these debt reduction targets. Premier has put the meat-free business (which they acquired for 200m) and their canning operations up for sale.

On Dec 1^st, Reuters broke the news that Nestle was bidding 230m for the meat-free business. The next day, Premier issued a news release stating that they were in advanced negotiations with two parties. Price levels seem reasonable. Anything above 180m for meat-free alone seems good given that the whole chilled&meat-free division will generate about 22m EBITDA this year. Another sign that this sale might be imminent is the fact that the newly created position of COO will oversee all of Premier’s operations except for the meat-free division, which will still report directly to the CEO.

Premier has also put its canning operations up for sale. I do not have any particular insight yet on the progress of the sale of the canning operations except that they are talking to Princess foods (part of Mitsubishi Corp) and that this operation could be worth up to 250m.

3.     Premier can refinance its debt in reasonable conditions

Once debt is reduced by 500  - 800m through asset sales and free cash flow, debt to EBITDA ratio should be in the 2.3x to 2.7x range. Most likely, Premier will be perceived as far less risky and have a good chance to refinance its debt in the capital markets at reasonable conditions before the debt is due in 2013 (ex. Northern Foods and Greencore have private placement bonds at less than 6% fixed interest).

What could Premier be worth in 2013?

For valuation purposes, I assumed the three operational scenarios mentioned above:

                                                                        Bad         Base         Good
2010-2014 annual sales growth                    -4,2%       -1,4%        0%

I have assumed a debt reduction of 500m through asset disposals and free cash flow and a stabilized pension deficit of 310m in 2013 and 270m 2014 (essentially being reduced by the 40m/year contribution) and debt refinanced at 8% in 2013. This leads to the following valuation at the end of 2013. Gain is calculated over current market value of

The difference between the 2013 and 2014 free cash flows is mainly due to the fact that debt will be refinanced in 2013 and certain interest charges (derivatives) will need to be paid in addition to the new interest charges.

Appendix 1 – Financial Data (base case with 500m of asset sales)

Asset sales – begin 2011 / mid-end 2011: Sales of sufficient size could be the trigger to invest

Refinancing of debt – 2012

Reinstatement of dividends end 2012/2013

Earnings – Check whether in expected range