Post Holdings Has Room To Run

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  • POST is up over 70% over the past year.
  • Acquisitions have rejuvenated the venerable food giant.
  • Amortization of intangibles unfairly weigh down POST.
  • Returns on capital will improve, but General Mills may be a healthier choice.

This article originally appeared on Seeking Alpha on May 27, 2016

Post Holdings (NYSE:POST) may be a 119 year-old company, but its recent transformation has been profound. In 2012, Post spun off the private label giant Ralcorp. Subsequently, ConAgra (CAG) nearly ruined itself through an acquisition of the hapless private label food manufacturer. Post looks incredibly wise in hindsight.

Impressive quarterly results seem to justify the 73% increase over the past year to $74 per share. Sporting a market cap of $4.73 billion and sales of $4.6 billion in 2015, the Post story has been based on a flurry of acquisitions.

POST acquired Mom Brands in May of 2015 for $1.2 billion. Other FY 2015 purchases included Power Bar ($150 million) and American Blanching Company ($128 million). The firm was even busier in 2014: POST acquired pasta maker Dakota Growers for $370 million, protein bars and supplement maker Dymatize ($380 million), and peanut processor Golden Boy (CAD $320 million). But the biggest chunk of business that Post swallowed was Michael Foods for $2.45 billion. Michael Foods has offerings from egg and potato products to dairy brands.

Post management is very enthusiastic about this rejuvenated company despite its declining dry cereals sales. But does POST have the energy to justify its $74 price? For once, this author is landing in bullish territory. I believe the stock is worth in excess of $90 per share.

Attention shoppers: discount in aisle four

There are indications that Post is a relative bargain compared to Kellogg (NYSE:K) and General Mills (NYSE:GIS).

**POST return on capital is based on 2016 estimates. GIS and K are presented as 2015 results.

One may argue that the comparison between these cereal brands – turned – food giants is slightly misleading. After all, Kellogg and General Mills are much larger enterprises, $26 billion and $37.2 billion in market capitalization, respectively. Still, they offer decent benchmarks for relative value.

General Mills appears to be the best of the bunch and the author will be digging deeper into the GIS filings for proof of its relative investment merit in a future article. GIS has low debt, a healthy dividend yield, a reasonable price to EBITDA ratio, and a hefty 17.5% return on capital (pre-tax and excluding a one-time non-cash charge). Kellogg seems a little overpriced by comparison.

POST only trades at 1.6 times book value and 7.4 times EBITDA. It had a paltry 2.5% return on capital in 2015, but should exceed 9% in 2016. This is nowhere near as strong as GIS, but it’s a very positive move in the right direction. If you apply a 10 multiple to 2016 forecast EBITDA, the value exceeds $140.

If you’re reaching for your “buy” button right now expecting to double your money, hold on. There are reasons why a value below $100 is much more realistic.

POST has a heavy debt load as a result of the acquisition spree. POST also lags in its brand investments. Capital expenditures must rise significantly in the future. Meanwhile, a consistent level of performance remains to be proven. While 2016 looks like it will be a strong year with over 9% return on capital, 2.5% was the number posted in 2015. The jury, therefore, may still be out.

I also raise the caution flag about POST’s ability to match the performance of its peers due to the daunting task of integrating so many brands and facilities under one umbrella. The decision to unload RalCorp must still draw smug smiles of schadenfreude around the Post water cooler. Yet, as so many poorly executed acquisitions have shown, caveat emptor always applies. For example, I note that Michael Foods was purchased for $2.45 billion from Thomas H. Lee Partners. Private equity firms are rarely known for selling assets unless full value can be harvested. There is a chance that POST has overpaid.

So you’ve read the reasons why I temper my enthusiasm for POST. Let’s now look at the reasonable case for more upside.

The tangibility of intangibles

Post has some accounting hurdles that mask the company’s strengths. They are required to amortize a large amount of intangible assets (customer lists, trademarks, etc.) due to their massive acquisitions. These charges are non-cash items but directly hit earnings on a GAAP basis. They will also persist for many years to come. In fact, Post goes out of its way to highlight these charges as a separate line item on the income statement. In 2015, these charges totaled over $141 million. This was enough to drag corporate level operating margins down from 7.62% to 4.58%.

The treatment of intangible asset amortization at Post does seem to be an unfair burden when compared to K and GIS. These food giants also have massive levels of intangible assets on their balance sheet, yet unlike Post, they are not required to amortize the vast majority of this accounting item. As the chart below indicates, K and GIS are not required to amortize nearly 90% of intangible assets. Meanwhile, the polar opposite is required at POST.

Is Post being treated unfairly? Yes and no. Yes, operating income is actually much higher than accountants would lead you to believe. Unfortunately, there are no free lunches (or breakfasts) and the lack of investment shows up in the cash flow statement. In other words, Post may want you to give them the benefit of the doubt on their operating income, but their lack of brand investment tells a different story.

Intangibles may sound fuzzy, but they are very real drivers of value. In 2013, Professor Aswath Damodaran calculated Coca-Cola’s (NYSE:KO) brand equity was worth somewhere between $120 and $150 billion that was not on its balance sheet.

Unlike Coke, who largely built its brand through the compound efforts of decades of marketing and advertising, Post has essentially “bought” these brand assets. Yes, it’s unfortunate that Post has to charge off these intangibles. But they also need to be replacing them. Brands are nebulous concepts, but they are critical to consumer purchases. Unlike 2005, Power Bar no longer sits alone on the grocer’s shelf. It competes with Clif, Kind and every other protein-packed nutrition bar in the aisle. Post will have to spend millions to repackage and re-market this tired brand. As for their core breakfast cereals, when is the last time you were inspired to buy a box of Grape Nuts?

Compared with Kellogg and General Mills, investment and advertising are sorely behind schedule at Post. As the table above shows, advertising is much lower as a percentage of sales. Net capital expenditures are also much lower. A corporation cannot sustain growth if it doesn’t eventually replace depreciating assets at a comparable rate. Ultimately, the need for investments at Post will depress future cash flows.

Discounted cash flows indicate a $90 value

Let’s review. Returns on capital are going to start exceeding the cost of capital in a very strong manner during 2016. While they won’t exceed comparable food makers, they will create value. The strong performance is buried under the unfortunate accounting treatment of amortization charges on intangible assets. POST is relatively inexpensive but doesn’t deserve the same multiples as its peers until it shows consistent results and shows it can support its debt burden.

Presented below is my discounted cash flow analysis with a price of $90 per share. I indicate some consistent growth in the +5% arena, corporate-level operating margins slightly above 10% and a low weighted-average cost of capital of 4.54%. POST won’t pay much tax in the next few years due to some net operating loss carry-forwards.

This is a company with a 6.75% cost of debt that is about 49% leveraged. I applied Kellogg’s beta of .47 rather than the .21 shown on several finance sites. I gave Post the benefit of the doubt and showed depreciation and amortization add-backs in excess of capex for many years. As the years progress, I show depreciation and capex converging. Assets, both tangible and intangible, must still be replaced in order for growth to occur.

(click to enlarge)

A word about Pensions

The bullish argument for POST also includes the idea that the relatively small size of the business allows it to be more “nimble.” I’m not sure how nimble a 119-year-old company can be, but I take that compliment at face value.

POST is certainly not burdened by pension obligations. The big boys have big liabilities. Kellogg has $5.36 billion in pension obligations and a $732 million shortfall. GIS has $6.25 billion due with a shortfall of $493.6 million. POST has pension obligations less than $60 million.

Both K and GIS further obfuscate their hidden obligations through ridiculous pension investment return assumptions. Like most governments in the US, K and GIS are delusional in their projection that they can achieve 8.3% to 8.5% returns on plan assets in a world of sub-2% Treasuries. Taxpayers and corporate boards need to ask tougher questions and brace for future payments that are well beyond the scope of forecasts.

What does Post predict? 5.72%

Investing Sins: Confirmation Bias

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Without question, my short position in WMS was absolutely my worst decision (so far, I hope) in 2016. I covered yesterday morning. I had some put options as well. Huge loss.

Its a lesson for all investors: Do not take the opinions of pundits at face value. Do your own due diligence.

Second, the company had been viewed by many as a sinking ship because of a failure to file a revised 10k last year. However, I chose to ignore their preliminary estimates of earnings restatements. They were minimal charges and yet I still deluded myself that other shoes were ready to drop.

Beware confirmation bias. There is a huge tendency to form an opinion on a company and then seek to find ways to justify that belief. It is one of the biggest mistakes one can make in investing. I fell for it.

Finally, the other bias I am learning to filter is authority bias. Just because George Soros took a position in Barrick Gold in his last filing doesn’t necessarily mean I should rush out and buy gold. If Icahn says he’s going 140% short, that doesn’t mean he’s right.

Caveat emptor.

Why I disagree with Bill Gross about Carry Trades.

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Bill Gross

 

 

 

 

 

 

Bill Gross has issued a new message to investors in a letter entitled Bon Appetit! He is worried about yield spread compression and refers to the past forty years as a “Gray Swan” event. I disagree. The demise of the carry trade is greatly exaggerated.

I am going to go out on a limb here and offer a mild critique of Mr. Gross’ letter. Admittedly, I am on the thin limb – actually, its more like a leaf… I have never completed a “carry trade” myself, nor am I articulate in the fine points of duration. The one thing I do know is what a yield curve looks like, and I don’t think the shape of that curve will change for many years to come: Up and to the right… The demise of the carry trade is greatly exaggerated.

Bill Gross is a very wise man and a fixed income investor par excellence, but he has also been wrong from time to time.

A couple of general observations about the latest Bill Gross missive:

First, Mr. Gross doesn’t provide any Earth-shattering revelations here (pun intended). With the exception of life insurance and pension fund managers, I don’t think there is anyone left who doesn’t believe that a large measure of returns in the investment world have been the result of steadily declining interest rates post-Volcker.

Second, I don’t believe anyone disagrees that the low hanging fruit of a wide yield spread has been squeezed out due to the proliferation of liquidity. Therefore the probability of risk mis-pricing has risen significantly. Mr. Gross’ point about the danger of illiquid assets is very relevant. I am in the commercial real estate industry and the compression of yields has been breathtaking.

Third, I am very surprised to hear Bill Gross talk of the past 40 years as a one-off “Gray Swan” event. He usually has a fantastic sense of historical context which he seems to disregard in his letter. World capitalism has faced severe disruptions, panics, and most of all – deflation. The last decades of the 1800’s were marked by massive over-investment in railroads and steel (enabled by foreign capital) which caused multiple panics and a severe depression. The Great Depression itself was a period of deflation where the entire banking system ceased to operate because there was no ability to borrow short and lend long. The depositors simply refused to “lend” to the banks at all. The current period, in many ways, is not unprecedented.

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I’m really not that unusual! People confuse me and Alan Greenspan all the time.

Mr. Gross contradicts himself. He says that volatility is very likely in a market with compressed yield spreads, and yet he glosses over the disruptions of the past. He says you will rarely find a 12 month period where bonds had a negative performance. To make this statement assumes that the ebbs and flows of credit markets have been homogeneous. In fact, there have been pockets of massive volatility in credit markets: The 1974 IMF intervention in the UK bond market, the capitulation of New York City’s municipal bonds, the massive defaults of the central american debt crisis of the early 1980’s, Long-Term Capital Management, the Asian and Mexican currency crises, etc were all relatively recent events. Each one of them required highly coordinated international central bank intervention. Each one of them alone could have rendered the 40-year “Gray Swan” analogy useless. Indeed, if the past 40 years is a “Gray Swan”, it is one of artificial nature – entirely managed by central banking intervention. 2016 may be an extreme moment in time, but again, it is not unprecedented.

Here are some specific disagreements I have with Mr. Gross’ position:

1. The playing field of the post-Lehman era is littered with bond managers (including Bill Gross on occasion) who have bet against a reversal in yields, only to find themselves on the wrong side of the trade. Rates have continued to decline.

2. Gross has contradicted himself by recently recommending securities like Annaly Capital (NLY) and the Nuveen Preferred Income Opportunities Fund (JPC), both of which rely on short term leverage to juice long term yields. Are these not carry trades?

3. Three reasons for declining rates show little signs of reversal. Inflation has continued to decline. Indeed, we may well be on the cusp of a Japan-style 20-year+ deflation cycle. Next, the entire banking system relies on the ability to borrow short and lend long at higher rates. The Federal Reserve will do everything in its power to maintain this friendly arrangement for as long as it takes. Finally, the carry-trade referred to by Mr. Gross limits its perspective to the domestic environment. It ignores the other main trend of the past few decades – the demand for US Treasuries as a safe haven and/or the repatriation of export-based dollars. The argument also ignores the desire to borrow money in a currency that is depreciating to obtain stronger dollar yields.

4. To the extent that inflation has the very strong possibility of turning into deflation, holding Treasuries sounds like a decent investment to me. Real yields improve in a deflationary environment. Meanwhile, pricing power at US corporations evaporates. What would you rather own? A piece of paper that can produce a 3% real yield (2% nominal yield) or stock in a commodity-based company that has falsely improved earnings per share through debt-binges for stock repurchases?

You may have to go to Mars to repeat the last 40 years, but the carry trade is going to continue for several more years right here on Earth.