Description

Suiza Foods Corporation (NYSE: SZA) is the largest manufacturer and distributor of fresh milk and related dairy products in the United States. The company was started in 1988 as a packaged ice business, and entered the dairy business in December, 1993 by acquiring a Puerto Rican dairy company. The company has grown very rapidly in recent years through a aggressive acquisition strategy, having completed over 40 acquisitions since its IPO in April, 1996.

Suiza operates in two reportable business segments: Suiza Dairy Group (SDG) and Morningstar Foods (MF). SDG sells fresh dairy products -- mostly fluid milk – but also sells ice-cream, half & half, whip cream, condensed milk, cottage cheese, etc. This division generated 2000 sales of $4.66 billion, of which 66% was proprietary and licensed brands (examples: Adohr Farms, Velda Farms, Borden) and 33% was private label. MF generated roughly $700 million in 2000 sales by selling extended shelf life fluid, aerosol and other dairy and non-dairy products including creamers, aerosol whipped topping and egg substitutes. Approximately 42% of MF’s sales were proprietary and licensed brands (examples: Intl. Delight, Sun Soy, Naturally Yours) and 58% were private label.

In April, 2001, Suiza announced the company-transforming acquisition of Dean Foods (NYSE: DF). The deal will increase Suiza’s sales from $6 billion to $10 billion and will provide the company with a national market share of approximately 30%, roughly six times its nearest competitor. Suiza agreed to pay $40.92 per DF share [$21 cash + .429 shares of SZA], or 7.1X EBITDA (pre-synergies). The market was slow to re-value Suiza shares based on the pro-forma earnings for the combined companies because it was unclear the deal would get done without significant additional concessions. On December 6th, the company announced it would divest five additional plants (on top of the six it initially agreed to) to satisfy regulators at the Department of Justice, who were conducting their second review of the transaction. Moreover, management stated that these concessions would not affect previous guidance and that it expected the merger to close by the end of the year.

The combined company will have approximately 43 million shares @ $60 or a equity market cap of $2.58 bn. Pro-forma debt will be approximately $3.85 billion for a total enterprise value of $6.43 billion. The company has guided to cost savings of $60 million in year one and $120 million by year three comprised of a few big buckets: (i) economics in purchasing energy, resin, paper & plastic; (ii) duplicative corporate overhead, (iii) advertising & promotional spending, (iv) integrating its NRP distribution business, (v) taking duplicative manufacturing facilities out of service. There should be significant opportunity to exceed these estimates as synergies in most typical food deals are 7-8% of the deal size (versus 4.8% here); moreover, Dean’s operating margins have been 150-200 basis points below SZA’s over the past several years which should be an opportunity. On a valuation basis, the company in its first year should generate $880 million of EBITDA (7.3x EV/EBITDA) and cash EPS of $5.70 (10.5x) [includes $.80 per share eps boost from adoption of FASB 142]. The company trades at a 60% discount to the S&P (23x eps) and a 50% discount a composite of 17 food companies (which trade at 18.6x eps) which seems too cheap for a company of this quality.

Management, led by Gregg Engles, is highly regarded and have generated a 29% IRR for investors since the IPO. Cash flow [capex should run about $150 million a year] is very stable, despite margin volatility related to swings in commodity prices, which have fallen sharply [raw milk price have fallen 29% in the past two months and butter prices have declined 43% from their peak in August]. Importantly, the company will control a 6000 route, direct store distribution network and will be the only producer with a national footprint that can match large retailers. The negatives include: (i) SZA operates in a mature industry with relatively low absolute growth [consumption is flat but SZA has been increasing volumes 1-2%, although it doesn’t show up in the IRI data because 60-70% is private label which is not captured] and low profit margins, (ii) integration issues are not a slam-dunk, (iii) the company will be levered at 3.8x Debt/Ebitda, which will limit its flexibility in continuing its stock buyback, (iv) SZA has probably under-invested in R&D, although DF has innovated and (v) the business is asset intensive [although fuel costs are largely passed through]. Finally, SZA missed their third quarter, although the entire shortfall was related to problems from its 43% owned packaging business, Consolidated Container. Much of this miss was characterized as a one-time charge by new management and Suiza intends to sell its interest in this business. Importantly, the core dairy business performed as expected in the quarter and will benefit from lower commodity costs in the fourth quarter.

Catalyst

Catalyst will be approval/closing of the Dean Foods transaction and the recognition that 10.5x eps is too large a discount to both the S&P (60% discount) and the food group (50%).