Ralcorp will spin-off 80% of Post Cereal (NYSE: POST) to existing shareholders in a tax free transaction to close by the end of January 2012.  Within 5yrs RAH will distribute to shareholders the remaining 20% of post it plans to retain. The company intends to pay no dividend for the foreseeable future, and will borrow $950mm and pay to Ralcorp $900mm commensurate with the spin-off. The decision to spin the business relates to Ralcorp’s rejection of ConAgra’s repeated offers to buy Ralcorp for cash during the May-September period this year. Post has the #3 market share position in the $9bn North American ready-to-eat-cereal category; with iconic brands such as Honey Bunches of Oats, Raisin Bran, Fruity Pebbles, Shredded Wheat and Grape Nuts. Ralcorp reports on a September 30th fiscal year end.

POST will spin-off with FY2011 EBITDA of $256mm, cash of $27mm and total debt of $950mm.  So, net debt will be $923mm.  As of FY2011 RAH had 56.4mm fully diluted shares, debt of $2,373 and cash of $58mm, for combined company net debt of $2,314mm.  After adjusting RAH debt for the $900mm cash payment by POST, the new net debt at the StubCo will be $1,414.  The RAH close price of $85.86 on 56.4mm shares implies a market cap of $4,843 for the combined companies. FY2011 Adjusted EBITDA at RAH was $800mm on a combined basis, and $800 RAH Total - $256 POST = $544mm EBITDA for StubCo.  The combined company currently trades on (4,843 + 2,314 = 7,157 TEV / $800mm EBITDA) = 8.95x LTM EBITDA. Although POST is troubled, the branded nature of the business and the quality of the franchise make it similar to GIS and K, which trade on 10-11x LTM. RAH has historically traded at 8-9x LTM, and generally at a discount to the prevailing average multiples of its branded competitors.

So, if we put POST on 10x LTM EBITDA that implies a TEV of $256mm x 10 = $2,500mm. $2,500mm of TEV less $923 of net debt gives us an equity value of $1,637mm, or $1,637/56.4mm fully diluted shares = $29.02 per share. So, RAH trading at 85.86 - $29.02 for POST = $56.84 for the stub. A price of $56.84 for RAH StubCo, times 56.4mm shares implies an equity value of $3,206, plus net debt of $1,414mm = TEV of $4,620. And $4,620mm/$544mm LTM EBITDA = 8.5x for Ralcorp StubCo.

RAH is set to generate an incremental $50mm from the purchase of a business from SLE, so without any organic growth, the forward multiple would be more like $4,260/ ($544+$50) = 7.1x, which is just a touch below the five year historical average forward multiple of 7.5x.

An implied StubCo share price of $56.84 is reminiscent of the middling $55-$65 trading range that characterized most of 2007-2011 for the stock. The 8.5x LTM multiple too is also consistent with the historical 8-9x LTM (the average of eleven individual annual averages from ’01-present is 8.7x).

While the StubCo valuation makes sense, and may even verge on attractive, its contingent upon putting 10x LTM on a business that has seen EBITDA decline 7% in each of the past two years because of mismanagement. How can one justify this valuation? Let’s instead look at the free cash flows 10x LTM EBITDA would imply a $1,637mm market cap ($29.02), and according to the From 10 Filed today, CFO-CAPX was $129mm in FY2011. $1,637/$129mm = 12.7x. 9.0x implies $24.48 or 10.7x FCF, 8.0x implies $19.94/share or 8.7x FCF and 7.0x implies $15.41/share or 6.7x FCF. If I deduct say $6mm of incremental tax adjusted interest expense to account for the increase in leverage from the dividend to RAH StubCo, that pushes up each FCF multiple by about 0.4x. Note that RAH will go into the transaction 2.9x Net Debt/FY2011 EBITDA, and come out with 2.6x.  POST will spin with 3.6x Net Debt/EBITDA, a slight increase based on its $784.5mm inter-company debt balance of $784.5mm at year end ($784.5mm/$256mm=3.06x).

The valuation looks full here, the only upside would be the 0.4x of fwd EBTIDA at StubCo, which would be worth about $4.00/share. 0.4x * ($544+$50mm)=$594mm = $237.6mm / 56.4mm shares = $4.21.  The better opportunity will be if the market mis-prices POST with a low EBITDA multiple, and therefore a super-low Free Cash multiple.

History:

Post began in 1895, when Charles William (C.W.) Post made his first batch of "Postum," a cereal beverage, in Battle Creek, Michigan. Two years later in 1897, Post introduced Grape-Nuts, one of the first ready-to-eat cold cereals. From 1925 to 1929, the Postum Cereal Company acquired over a dozen companies and expanded to 60+ products. The company changed its name to General Foods Corporation and over several decades introduced household names such as Post Raisin Bran (1942), Honeycomb (1965), Pebbles (1971) and Honey Bunches of Oats (1990). General Foods was then acquired by Philip Morris Companies in 1985, and subsequently merged with Kraft in 1989. In August of 2008, the Post cereals business was split-off from Kraft and combined with Ralcorp.

Ralcorp paid $2.66bn, or 8.9x forward FY09 EBITDA of $297mm for Post (with $1.8bn of the purchase price allocated to goodwill).  Since that time a business with roughly a $1bn of sales, $300mm of EBITDA and 12.2% market share has shed $100mm of sales, $40mm of EBITDA and 1% of market share.

What Went Wrong:

After the acquisition from Kraft, Ralcorp failed to put an organization in place to effectively sell and promote the Post brands. This caused a 4 day shut-down when Kraft transferred to RAH the responsibility for sales in mid-2009. In place of the Kraft sales force RAH turned to brokers. RAH also lacked a proprietary tool for the management of trade spending.  Trade programs were erratic and produced low returns on investment. Finally, RAH boosted price at twice the rate of the category (16% Post v 7% in the category) but cut advertising spend 6%.  Spending too little on advertising may explain why EBTIDA margins at Post were in the 26%-27% range from ’09-’11 but were in the 18%-21% range at Kellogg and General Mills.

The new management team has increased the internal sales staff to 31 persons from 15 and has "augmented its analytical capabilities."  Outside the US (i.e. Canada) the company intends to continue to rely on “brokers, distributors, and similar arrangements.” Sales to Canada account for roughly 12% of top line. The team also took $471.4mm of goodwill impairment in F4Q11.

Chronology of Con Agra:

CAG wrote to RAH on 3/22/11 bidding $82, a 26% premium to the prior day close ($65.31).  Then on 5/4/11 CAG increased the offer to $86; RAH rejected it. Two months later on 7/14/11, Ralcorp announced plans to spin-off the Post Cereal business.  Further, on 8/9/11 RAH announced the acquisition of the Sara Lee private brand refrigerated dough business for $545mm. Undeterred, in a letter on 8/11/11, CAG offered $94, and set a 9/20/11 deadline for acceptance. RAH rejected the offer on 8/12/11 and then again reiterated its rejection on 9/19/11 in a press release. CAG withdrew its offer on 9/20/11, and on 9/26/11 RAH filed a Form 10 associated with the spin-off.  The second and most recent version of the Form 10 was filed on 12/23/11 (available here: http://investors.ralcorp.com/default_view.aspx?GURL=http%3a%2f%2firxml.corporate-ir.net%2ffilings%2ftoc.data%3fid%3d0000950123-11-103930%26sXbrl%3d1%26compId%3d102251)

Operations:

Post has 1,300 employees and owns and operates four integrated cereal plants (three in the US and one in Canada).  The company owns and self operates one of its five distribution centers, and the trucks that deliver Ralcorp products also deliver Post products. After the spin, Post expects this delivery arrangement to continue for the foreseeable future. The top ten customers account for 56% of sales, and Wal-Mart alone accounts for 21 of the 56 percentage points (i.e. $200mm). Ready-to-eat cereal is a highly promoted, center of store category that shoppers frequently purchase.  76% of the time consumers eat breakfast at home, and 25% of the time that breakfast includes a ready-to-eat cereal.

Post will not opt out of the Missouri Business Combination statute, the same statute that permitted RAH to rebuff CAG’s overtures with ease.

Management:

The CEO of RAH, William Stiritz, will join POST as CEO. Stiritz was formerly CEO and Chairman of the old Ralston Purina – he was instrumental in the sale of its pet food business to Nestle, and the spin-off of both Ralcorp and Energizer.  The CEO, COO, CFO and EVP of marketing all worked for the Ralston Purina pet food business at one time.  The COO, in particular, will leave his role has head of Purina Nestle Pet Food North America in Jan 2012, to assume his new role at Post. As a footnote, the COO, CFO and EVP each did their MBA at the University of Washington in St. Louis. If they propose to turn the business around with the launch of a new breakfast cereal for dogs, I would sell the stock immediately.  Barring that, however, the new team seems well suited to taking back a point of market share and launching some new products.

Conclusion: I would be on the lookout for a mis-pricing of POST based on a low EBITDA multiple that reflects the troubles of the past five years, rather than the durability of the franchise constructed over the past 100 years.  Even poorly run this business still only managed to give back a percentage point of market share. There is minimal upside from here - and it is to be found primarily in a small improvement in the multiple of the StubCo.  Wait for the spin, and try to buy POST cheap.