Description

Pickles and Non-Dairy Creamer... not exactly a match made in culinary heaven.

Nevertheless, Treehouse Foods (NYSE: THS) has the makings of an interesting story. First, it's a classic spinoff opportunity. A bit of recent history is in order: Dean Foods (NYSE: DF), the $5.4 billion dairy products company, spun off its Specialty Foods division in June of 2005. Dean created THS for the purpose of effecting the spinoff in January of this year; transferred the assets and liabilities of its former Specialty Foods division to the new entity; and distributed one share of THS common for every 5 outstanding shares of Dean Foods common. The distribution was completed on June 27, 2005, and THS began operations as an independent public company-- Dean Foods retains no ongoing ownership in THS.

The two largest product lines of the new company comprise the aforementioned mouth-watering combination of pickles (roughly 50% of revenues) and non-dairy creamer (a little more than 30% of revenue), sold primarily through retail channels. The company believes that it is "... the largest manufacturer of pickles and non-dairy powdered creamer in the United States based upon total sales volumes. (THS is) also the leading retail supplier of private label pickles and private label non-dairy creamer in the United States." The company's proprietary pickle brands include Farmans, Nalley's, Peter Piper (a masterful bit of branding on that one), and Steinfeld. The non-dairy creamer segment sells under private labels and under THS's proprietary Cremora brand.

The company also sells a smattering (splattering?) of aseptic and refrigerated products that account for the remaining ~20% of sales. Aseptic (pressure-packed foods that do not require refrigeration) products include cheese sauces and puddings. Refrigerated products include Mocha Mix (non-dairy creamer) and Second Nature, a liquid egg substitute.

So the first point to be made is that classic spinoff behavior is at work; the institutional sell-off (THS's market cap is currently $600 million or so; Dean Foods is around $5.4 billion), coupled with weak quarterly results (more below), have resulted in a precipitous decline in price. At Friday's (12/9/05) close of 19.59, the stock is off 37.5% from its high of $31.35 in July of 2005.

The second interesting component of the story revolves around the new management team. Dean Foods struck a deal with an outsider-- Sam K. Reed-- to run THS as Chairman and CEO. Sam did not just fall off the apple cart. Previously he was CEO of Keebler Foods Company, from its inception as an independent company in 1996 through its sale to Kellogg in 2000 for $3.6 billion. Keebler's performance under Reed's team is instructive: the company was brought public in January of 1998 at $24.00. Reed and his team sold the company to Kellogg in 2000 for over $42 per share. Notably, Reed has deployed the same senior management team (David Vermylen and E. Nichol McCully) at THS that he worked with at Keebler.

So this is a management team that a) has run large, successful companies; and b) knows a thing or two about the food business.

Therefore, it's also of interest that Reed and his management group personally invested $10 million in the new concern. Furthermore, it's of particular interest to us that Mr. Reed & Friends' $10 million purchased approximately 1.7% of the company. The Reed deal implies a valuation for the entire (essentially debt-free) company of $588 million. Again, this is of particular interest as the company, 5 months after the spin-off, currently trades at a total market cap of $608 million. Now of course the management team has the benefit of a stock option plan, salaries, benefits, etc., as part of the package. But it's still very interesting that Reed & Friends invested $10 million of their personal funds on a valuation similar to the current one ($19 and change), after the company began life as a stand-alone about 5 months ago at close to $30/ share.

A third interesting feature of the THS story is potential upside related to acquisitions and general increase in leverage. At present, the company is essentially unleveraged following the spinoff-- $20 million of long-term/ current portion of long term debt as of the company's third quarter 10Q. We like the fact, however, that Mr. Reed and his team-- with an interesting track record of acquisitions-- has secured a $400MM unsecured debt facility for the new company, which can be expanded to $500MM under certain conditions. We expect Mr. Reed to put it to work.

So what's wrong with this picture--- why has the stock dropped from $31 to $19? Essentially, a combination of extraordinary factors have impacted the company's short term results, dampening both operating margins and the spirits of the short-term seers of the Street. First, in the glamorous world of pickle farming, cucumber disease is not a positive factor, and it has affected THS. Additionally, hurricane Katrina's impact drove up fuel costs and interrupted key supply inputs-- namely sugar production, as refineries battened down the hatches for the storm. Management has subsequently revised 2005 estimates downward to $685 million in sales for the full year, with operating earnings of $41 to $43 million. Please note that this figure incorporates (at a bare minimum) $10 million in extraordinary expenses associated with the spinoff.

We believe that normalized EBIT for the company in its current form is in excess of $80 million (note that for the 6 months ending June 30, 2004, the company generated operating income in excess of $41 million; we would submit to you that nothing radical has happened over the past year to alter the long-term economics of the pickle and non-dairy creamer world). So in a normal year, this starts to look like a company trading at EV/EBIT multiple of ($626MM/$80MM), or 7X to 8X. And those are numbers that we like much more than the "P/E = 23.72" that the Market sees. (For the record, the stock trades at 1.18X book, but the book includes some $308MM of goodwill...)

We're not big fans of prognostication, but we believe that short-term setbacks afford an attractive buying opportunity. The extraordinary supply interruptions and temporary fuel cost increases associated with Katrina, coupled with the spinoff factor, opportunity to add leverage, and management considerations, add up to an interesting story.

Catalyst

*spinoff considerations *rebound after Katrina *increase in leverage