Description

Ralcorp is the largest private label food manufacturer in the US and with estimated current year earnings of $2 on the face of it a moderately undervalued stock. Two additional points make the valuation a lot more interesting. First the company owns 7.55 million shares of Vail common stock worth about $100 million or a little over $3 per share, which contributed no income to Ralcorp last year. RAH is also restructuring its largest division which is operating at subpar profitability levels. The company is clearly aware of its undervaluation; it launched a Dutch auction self-tender at the end of 2002 for 4 million shares (13% of outstanding) which was undersubscribed.

Ralcorp has grown through acquisitions of small private label manufacturers. While the private label food business is clearly inferior to the branded food business in terms of profitability, it is still attractive and rapidly growing. There are three reporting segments, (i)cereals and crackers (ii) snack nuts and (iii) dressings (Carriage House). The first two divisions are doing quite nicely, with operating margins north of 10% and rising. The problem is Carriage House where operating income was only $11 million on sales of $450 million during the latest twelve months. To date RAH has been unable to significantly improve margins in this segment, but recently has taken a number of steps to improve profitability, including divesting several small non-profitable businesses, reassigning its divisional executive and closing one of the higher cost plants and redistributing its production. Hopefully the benefits of the restructuring will become apparent in the second half of the year.

At current prices, investors are paying nothing for the Vail interest or the potential turnaround at dressings. The Carriage House operations were acquired at roughly 50% of revenues and it appears from the annuals that the divested operations were sold at roughly the same multiples, which would provide a valuation of about $7 per share for dressings, which contributed 20 cents in earnings in the latest 12 months. Subtracting Vail and dressings, the resulting equity valuation is $15, as compared to expected profits of $1.80 for the remaining operations.

Even with the underperforming dressings division, RAH has been highly cash generative, with more than $2 in free cash flow last year and likely the same this year. The funds have been used for acquisitions and the self-tender. Since the self-tender was undersubscribed, it is highly likely that the company will be aggressive with share repurchase going forward.

Catalyst

Restructuring at Carriage House division and continued share repurchase.