Description

Ralston Purina is the largest pet food company in the world. With the 4/1/00 spinoff of its underperforming Energizer battery division, RAL represents a special situation play with strong growth, high profitability and low valuation.

As of 12/31/99, RAL’s pre-spinoff ROA (excluding $1.4 BB in marketable securities) and ROE were 21.0% and 32.3%; post-spinoff, the ratios are 25.0% and 55.1%, respectively. In FYE 9/30/98 and 9/30/99 RAL’s pet food sales grew 12% and 5%, EBIT grew 25% and 23%, and normalized net income (excluding non-recurring gains and using an assumed 38% effective tax rate) grew 33.3% and 53.1%. (The computations herein are based on the proforma financials in the company’s 8K filed 4/14/00.)

RAL is significantly undervalued relative to its competitors (including Heinz, Colgate, and P&G) and other food companies with strong brands. The peer group -- comprising P&G, Heinz, Kellogg, Hershey, Quaker Oats, Colgate and Wrigley -- has a median ROE of 31.2% and consensus current year EPS growth rate of 9.6%, versus RAL’s ROE of 55.1% (as of 12/31/99) and EPS growth of 53.1% (for FYE 9/30/99). In spite of RAL’s superior profitability and growth, the peer group’s median P/E is 26.8 versus 16.8 for RAL. RAL’s P/E is computed as: Market Cap ($5.4 BB) – Marketable Securities ($1.4 BB) / Normalized Net Income for TTM 12/31/99 ($238 MM).

Risks: (1) P&G acquired the Iams pet food brand in 9/99 and began distributing Iams in general and grocery stores – long the stronghold of RAL. For the quarter ended 3/31/00, RAL reported slower growth in its North American pet food sales and attributed the decline to Iam’s incursion into grocery stores. However, one analyst believes that since Iams made its big roll out in grocery stores during the quarter ended 3/31/00, competitive pressures should ease going forward. (2) RAL has about $1.40 billion in marketable securities (comprising Dupont, Conoco, and Interstate Bakeries stock) which represents about 25% of its market cap.

Catalyst

Catalysts: (1) Greater management focus on the pet food business after spinning off the declining battery business; (2) the significant premium (about 60%) at which comparable companies are trading appears too large to ignore for long, even if the market has some concerns about increasing competition for RAL; (3) according to a Reuters report (4/27/00) analyst coverage of RAL appears to have dropped off because of apparent confusion about how to account for the Energizer spinoff; (4) a portion of RAL’s $1.4 billion in equity investments is expected to be sold and the resulting cash used for stock buybacks; (5) the recent takeover offer for Best Foods could spark consolidation in the food sector and increase investor interest and valuations in the sector; and (5) even if there is no short term ‘pop’ in RAL’s stock price, Ralston Purina is a highly profitable franchise that represents an attractive long term investment opportunity at a relatively low valuation.