Description

Royal Wessanen

Investment Thesis

Wessanen (bloomberg ticker WES NA) is a turnaround story led by a great new manager, who has acted quickly and decisively to return to profitability the company’s largest business (distribution of natural and specialty foods in the U.S., which represents 60% of revenues). While the company and the stock have made incredible strides in the ten months since Ad Veenhof took over, the fix-it program is still in the early innings and today you can buy a business with solid management, a strong balance sheet and a 5% dividend yield for 7.9x ’05 ebitda, 9.3x ’05 ebit and 14x ’05 earnings. Admittedly, these are not the cheapest multiples I’ve ever seen, but you should be aware of two things. First, ’05 earnings are still well below where earnings will be when management is done fixing the business. Second, even on below normal earnings, Wessanen is trading at substantial discounts to its two largest publicly traded comps in the natural foods industry. Specifically, UNFI, Wessanen’s #1 competitor in the natural foods distribution business, trades for 13.8x cal ’05 ebitda and 25x cal ’05 EPS; and Hain Celestial, the largest natural foods manufacturer in the U.S. trades at 12x cal ’05 ebitda and 18x cal ’05 EPS (despite not having grown profits in four years).

So what’s Wessanen worth? It’s hard to say, because I believe that management is just getting started in identifying ways to improve the earnings power of the business---they certainly have a lot of raw material to work with after years of mis-management. But if I just take their existing plan and assume that they can execute against it, and apply a 15 P/E multiple or a 10x ebit multiple to their ’07 earnings targets, I think Wessanen will be a 20 euro stock in two years----providing investors capital appreciation of 62% and an additional 10% in dividends, for an annualized return of over 30%.

Importantly, the natural, organic and specialty foods categories are among the fastest growing areas of the food market (GNP+ growth) and therefore it is not out of the realm of reasonableness to think that if Wessanen is successful in fixing these businesses that it could one day receive multiples similar to those received by UNFI and Hain. Taking this dream one step further, if I were to apply UNFI’s cal ’05 P/E multiple to Wessanen’s ’07 earnings from distribution, Hain’s cal ’05 P/E multiple to Wessanen’s ’07 earnings from branded food manufacturing and a 10 P/E multiple to Wessanen’s ’07 earnings from private label manufacturing, I get a blended P/E of 20, or a price target of 27 euros. Naturally, as a value investor, I believe the UNFI and HAIN multiples to be excessive, but I think this analysis does give some sense of the possible.

Company Overview

Royal Wessanen is a 240 year old Dutch-based food company that operates in the U.S. and Western Europe in three businesses: distribution and marketing of natural and specialty foods products (this business is called “Tree of Life”); branded food manufacturing and private label food manufacturing. In the last two decades, the company has had a turbulent past that has seen it pursue and then abandon numerous strategies. The latest in a long series of missteps was severe execution problems within Tree of Life North America (“TOL NA”), which caused operating profit in the region to decline from 60 million euros in 2000 to a 30 million loss in 2003. The problems at TOL NA led the stock price to decline from approximately 14 euros/share in 2000/2001 to a low of close to 4 euros in early 2003.

In April 2003, Wessanen announced the hiring of Ad Veenhof as President and CEO, effective July 1, 2003. Prior to joining Wessanen, Mr. Veenhof had spent 30 years with Philips, where he was in charge of the Domestic Appliance and Personal Care division (DAP), Philips’ most profitable division. Ad ran the DAP division from 1996 through 2002, were he grew revenues and profits 7% and 19% annually, respectively, while improving DAP’s operating margin from 11.4% to 17%. Ad left Philips in May 2003 after the Board rejected two of his acquisition proposals. According to Ad, he accepted the position at Wessanen because he liked the challenge of trying to fix the business, something he thinks that he can do within 2-3 years.

Identifying the problems

Within a few months after joining Wessanen at the beginning of July, Ad quickly identified several major problems at TOL NA, including the following:

1) Their forecasting was lousy. The company had issued six profit warnings in a row and as a result, had lost credibility with the investment community.

2) Their IT systems were in disarray. The TOL NA business had been built over twenty years via a series of acquisitions, none of which were ever properly integrated. As a result, the company had numerous incompatible IT platforms---obviously not a good situation for a company in the logistics business. The company compounded these problems in 2002 when they tried to install an ERP system and completely bungled it.

3) Service levels were poor and well below industry standards (e.g. high out of stocks at retail, frequent date code issues from old inventory). This was partly the result of the above mentioned IT issues, but also due to the absence of processes and the attention to detail that is a necessity in a distribution business.

4) Their cost structure was out of line relative to their revenue base. In mid ‘02, TOL NA lost two large, high margin customers (Albertsons and HEB), representing 10% of the company’s sales. Former management compounded this problem by stealing the Wild Oats contract from its principal competitor, United Natural Foods (UNFI), at very low margins. With essentially 20% of their business moving at once, and inadequate processes, the company not surprisingly ran into difficulties.

5) Accounting systems and controls were inadequate. In the summer, a review of Wessanen’s balance sheet had revealed that certain items should have been reflected in TOL NA’s results in prior periods—ie, prior period results had been overstated by approximately 14 million euros.

Putting in place a fix-it plan

Having identified the problems, Ad quickly took several steps to fix them, including the following:

1. The first thing he did was address their forecasting issues. Having had six profit warnings in a row, he would not tolerate a seventh. He gave all of his managers four weeks to come back to him with reasonable forecasts for their business units. As Ad put it, anyone whose forecast turned out to be unreasonable “would have a personal problem”.

2. In August 2003, Wessanen announced a major cost savings initiative, called Project Phoenix, which will lower the cost base by 100-115 million euros by year end 2004 by reducing management layers, improving efficiencies and optimizing procurement. Specifically, the company expects 10 mil euros of savings from removing two layers of management and streamlining corporate headquarters (headcount reduction of 20-25); 45-55 million euros from rationalizing production facilities, terminating the Wild Oats contract and reducing headcount by 1,100-1,200; 25-30 million of savings from optimizing procurement; and 20 million of savings from better usage of shared services, infrastructure, back offices, etc.

115 million euros is a big number, representing 4.8% of Wessanen’s revenues. Part of this savings will be reinvested behind Wessanen’s branded food business, in an effort to make this a bigger part of the mix over time.

3. In October 2003, he cancelled Tree of Life’s money losing contract with Wild Oats. Importantly, in addition to the 8 million euros Wessanen lost on this contract in 2003, the working capital savings from eliminating the inventory specific to serving the Wild Oats contract will cover the entire cash costs of Project Phoenix (approx. 30 million euros).

4. Ad retained his former IT expert at Philips to review Wessanen’s
IT systems and to recommend a fix. This advisor recommended that Wessanen ditch the failed ERP system and to convert all of their distribution centers to a single IT system, something which had never been done when these companies had originally been acquired. This was all done at a cost of less than 10 million euros.

5. With respect to the accounting issues, Wessanen retained an independent accounting firm to conduct an investigation. This investigation identified several problems with the company’s accounting procedures and practices and recommended certain remedial actions to correct these problems and enhance internal controls. As part of this review, the company’s CFO agreed to step down once a successor has been found. In addition, Wessanen recouped a portion of the bonuses paid to those TOL NA’s executives who had been in charge when the accounting improprieties took place.

6. While doing these things, Ad completely revamped the senior management team, hiring several former colleagues from Philips, a new CEO of TOL NA, as well as brand management experts from leading multi-national branded products companies (e.g. P&G, Nestle and Unilever) to help grow their branded business. As alluded to above, the company is in the final stages of hiring a new CFO.

7. Lastly, Wessanen conducted a complete strategy review and set out long term financial targets. Specifically, Wessanen established operating profit margin targets for each of their businesses (4% for distribution; 10-12% for branded; 6-7% for private label). In addition, Wessanen committed to building the company’s branded business, with the goal of ultimately reaching a branded/distribution mix of 50/50 by 2007 (note: this will most likely see them divest of some of their private label business, which represents 12% of sales, and require some acquisitions, as branded business is 27% of sales today).

Delivering against the plan—so far, so good

So how is Wessanen doing in executing against the plan. So far, so good. The company has met or exceeded sell-side expectations three quarters in a row, while increasing guidance for ’04 to 70 million euros, a 315% and 50 million euro improvement from ’03 results. They are well on their way toward getting the Project Phoenix savings by the end of ’04 (40% achieved by end of q1 ’04). They have gotten out of their money losing contract with Wild Oats (as well as two other losing contracts) and have substantially reduced working capital to pay the cash costs of project Phoenix. With respect to IT, they have successfully converted 15 of their distribution systems to the single platform, with just two more to go, and have established a data warehouse that ultimately will allow them to extract value from all of the information that they are collecting. In the accounting area, they have written off the excess inventory and have instituted processes and controls to ensure that misstatements don’t happen again. As mentioned above, they have completely rebuilt the top management team. Service levels have improved dramatically. And net debt has been reduced by 60 million euros in the first quarter of ’04, with working capital coming down by 34 million.

As a result of steps taken to date, Wessanen is expected to generate 70 million in ebita in ’04 and 105 million in ’05. The stock trades at approximately 12 euros per share, has 73 million shares outstanding, and thus has a market cap of 875 million euros. With net debt of 100 million euros, total enterprise value is 975 million. On ’05 estimates, Wessanen therefore trades at an ’05 EV/EBITA multiple of approximately 9.3x. By 2007, however, I expect Wessanen to generate ebita of 155 million. Based on this forecast, the current stock price and the associated debt paydown of approximately 150 million euros expected between now and the end of ’07, you are paying 4.9x ’07 ebitda. Granted, this is two years off, but given the forward multiples that UNFI and HAIN get (12-14x ebitda), I think this look forward gives some perspective of the potential upside here if Wessanen delivers.

More importantly, as discussed below, I believe there is still plenty of opportunity for earnings enhancement beyond what has already been announced.

The future—more to come

While the stock has certainly rebounded nicely behind the major improvements made in the last year, we believe there is plenty of room to go. For starters, the company still has not realized anywhere near all of the savings from Project Phoenix. As these drop to the bottom line in 2h ’04 and in ’05, strong earnings growth will continue. More importantly, I believe that there is plenty of low hanging fruit left for management to further improve the business, particularly in the inventory management/working capital area.

Having just come back from a visit to one of their distribution facilities in Florida, I came away shocked by how many sku’s they have that are contributing very little to the top or bottom line. One of the employees at the DC indicated that a single SKU need only generate $50/week in revenue ($2,500/yr) to stay in the inventory base. This is crazy…and management knows it. Just a simple comparison of Wessanen’s sku base versus UNFI’s highlights the magnitude of the opportunity here. Wessanen currently has 65,000 sku’s in its distribution system, generating sales of $1.8 billion, for a sales/sku rate of $28,139. In comparison, UNFI has only 32,000 skus yet generates revenues of $1.5 billion, for $47,031 of revenue per sku. Granted, there is some difference in the mix of these two companies (ie, UNFI is only in the natural products business, whereas Wessanen also distributes specialty products---which are generally gourmet products), but the gap should not be anywhere near this wide.

Our distribution center tour also revealed that Tree of Life currently has trucks that take product from their facility in St. Augustine, FL to customers in Baltimore---despite the fact that they have a DC in New Jersey. Based on what little part of the business that I saw, I believe that inefficiencies such as these are rampant within the business, and that the combination of strong management and functional IT systems will enable Wessanen to squeeze profits from these inefficiencies.

While I describe above the ample opportunities for the business to get more efficient, it is also worth noting that the natural inefficiencies of participating in smaller markets like natural foods and specialty foods (ie delivering “ones-ies and two-sies” to customers as opposed to full pallet distribution normally associated with food distribution) serves as a barrier to entry to potential new competitors.

Lastly, Ad Veenhof has talked about his longer goal of moving the company’s branded business toward 50% of the mix, up from 27% today. Ad is a branded products guy and clearly believes that being a branded manufacturer is a better business than being a distributor. While this strategy is not without risks----e.g. competing with your vendors, the difficulties of competing against major multinationals like Nestle and Unilever---Tree of Life’s role as a distributor of natural and specialty products should give them a great window into consumer trends and an edge in identifying small, growing, private businesses that could be grown further with greater brand support and additional distribution.

Risks

The biggest risk that I see is that the company will be unable to retain the cost savings from Project Phoenix. Already, management is reinvesting some of these savings into their brands and it is not clear to me that they have the brands or the people to build a successful branded business.

Moreover, fast growing food brands don’t sell cheap, and I worry whether Wessanen will overpay for this growth, particularly given the “fad-ish” nature of the natural and specialty foods business.

Finally, I also worry about how Wessanen’s focus on building its branded business will impact its relationships with its vendors.

Catalyst

Delivering against promises

Quantification of additional areas of improvement (e.g. working capital). New CEO of TOL NA has promised Ad that he will come to him in August with the next steps in the plan to improve profitability at TOL NA. I expect an announcement on this subject in the fall.