Description

Premier Foods (PFD LN) is a value opportunity trading at 5.7x P/E, 16% FCFE yield on 2010 estimates (note: 2009 above does not capture merger synergies) and with 140% upside to a conservative DCF valuation (more on why we focus on levered metrics and further thoughts on the DCF valuation below).  PFD fits into two themes: (1) its operating profit growth is a function of delivery on credible merger synergies rather than (albeit defensive) top-line growth, and (2) this opportunity exists primarily because it is a good company that HAD a poor capital structure -- this was fully redressed on March 5th through an equity offering and yet the company's share price continues to trade at stressed (though not distressed) valuation levels.  Our investment thesis is that PFD's price-value gap will close as consensus recognizes (1) its underlying cash-generative value case -- see valuation discussion below, and (2) gets comfort on the significant headroom to newly reset covenants in a stable (successful former LBO by Hicks, Muse) business.

PFD is a straightforward business to understand with an open management team.  It is the U.K.'s leading supplier of ambient grocery products with turnover of £2.6bn operating through three divisions: Grocery (77% EBITA), Hovis Bread (7% EBITA) and Chilled & Ireland (16% EBIT).  Its portfolio of "Great British Brands" includes staples such as Hovis bread, Mr. Kipling cakes, Bisto gravy, Bachelors soup, Branston pickles, Harley's jelly and Oxo stock as well as private-label produce (a hedge for some down-trading in the current environment). To give you a better sense of the brand equity, more than 99% of U.K. households have bought a PFD product within the last 12 months; in the U.K. these are truly household names and some are on par with any of Heinz's products in the U.S.  PFD's market is fragmented (it has 2x the market share of No. 2 Nestle U.K.) and the company itself was built through a string of acquisitions: it was founded in 1975 as Hilsdown Holdings and used its cash flows to do a series of great brand acquisitions; in 1999, it was LBO'd by Hicks, Muse and under their ownership purchased Nestle's ambient food business before listing on the LSE in 2004.

PFD's current predicament stems from two sizable recent acquisitions: in 2006, PFD acquired the U.K. and Irish businesses of Campbell's for £460m which added a number of strong brands to the portfolio (including Campbell's Soup, which had to be rebranded as Batchelor's condensed soup, but still carries the label "Formerly Campbell's.  Same great taste"); and in 2007 it acquired rival RHM in a highly leveraged transaction for £1.2bn.  Its capital structure was strained as a result of (1) the debt raised to close these transactions, (2) an inability to divest non-core assets to pay down some of this debt as the M&A market dried up in 2008, and (3) the working capital impact of commodity price hikes in 2008 that combined to push net debt / EBITDA levels up towards 5x.  This was the classic case of a fundamentally sound business (perhaps even one which is more insulated than most in today's macro environment), with a deeply flawed capital structure, and deservedly trading at stressed levels.

The company fully addressed its capital structure issue on March 5th: through an equity offering partially underwritten by private equity firm Warburg Pincus (which ended up taking a 16% stake) PFD raised £379mn net of expenses (~1x EBITDA), renegotiated covenants and terms with its lenders, and gained clarity on its pension funding and contribution profile.  On our numbers, which are in-line with consensus and discussed further below, PFD no longer has a capital structure issue and comfortably clears covenant levels:

We always feel more comfortable basing our analysis on attractive unlevered valuation metrics; yet, we acknowledge that we are equity investors and ultimately we will be purchasing PFD's equity -- which does come across cheaper because the company will have 3.4x EBITDA of debt on its books; but, we also recognize that this is the adequate level of debt for PFD's cash generation profile and that de-leveraging will be swift (recalling once again that this was a very successful LBO in the past and if anything is in a stronger strategic position today). Indeed, our thesis is that the equity has been beaten down to current levels primarily because of the market's lack of comfort with the company's capital structure which is no longer an issue and hence the reason not to own has gone away.

Keeping this in mind, on 2010 earnings (note: 2009 is misleading as it does not capture incremental synergies from the RHM transaction amounting to 10% of EBIT) PFD is on 5x EBITDA, 6x EBIT (cheap unlevered), 5.7x P/E (very cheap levered) and 16% FCFE yield (ditto).  Our preferred valuation metric, particulalry given PFD's stable cash generation, is a DCF where we are thoughtful about both the company's growth profile and incremental ROIC; growing the business with GDP and fading ROIC to the company's 7.3% WACC in the terminal year (i.e., no value added from terminal year growth) we get a price target of 83p (140% upside) which implies 12x EPS for 2011 and yields a 55% IRR on a two-year perspective.  Alternatively, ambient grocery is a low growth GDP-type (notwithstanding PFD's dominance in a fragmented market and either a bid candidate itself -- as was rumored last week in reference to Kraft -- or a consolidator of competitor brands), defensive, low beta business earning an ROE of 10%; on these metrics, it does not deserve a very high multiple and a steady-state Gordon Growth model yields a 13x P/E target.  We acknowledge that these are implied valuation metrics for the company's intrinsic value and that the price-value gap will not closed overnight -- if we were to take a peer multiple of 8x 2010 EPS (note: we view the peers as undervalued themselves) then we would get a price target of 48p or 39% upside.  Thus, taken together, we see near term upside of 39% but 140% upside to intrinsic value which can take longer and on a two-year view yields a 55% IRR. 

The following table highlights PFD's trading multiples.  In terms of projections, we believe the consensus sell-side range is tight and effectively correct (we think they miss the valuation case by focusing on relative multiples and ignoring the cash flows, and in one instance of having an incorrect figure for the new amount of pension underfunding which is now £11m)-- on a very simplified basis, we would highlight the key delta between 2010 and 2009 EBITA as being (1) synergies of £33m, and (2) increased marketing spend of £10m; and between 2010 and 2011 being incremental synergies of £10m.

 As an aside: Following the capital raising exercise, March 31st reports revealed that Paulson & Co had bought an 8.9% stake in the company and Och-Ziff had bought 2.3%; so perhaps this is no longer off the beaten track and it is beginning to hit investors' radar screens.  We would highlight both the near term upside as well as the fundamental upside to intrinsic value on a longer term view.

Catalyst

Fundamentally good company with a poor capital structure; March 5th resolution of all capital structure issues; re-rating to intrinsic value to follow suit.