Tuesday, November 29, 2011

Take a Spoonful of Ralcorp Stock

Do people eat more cereal during a recession? And if so, is there an investment opportunity in the stock of leading ready-to-eat (RTE) cereal makers Ralcorp (NYSE: RAH) and Kellogg (NYSE: K)? The hedge fund that famously popped Enron's bubble, Highfields Capital Management, is loading up on Ralcorp shares. Should you follow?

Highfields Capital Management asked a question about Enron's financial statements during an April 2001 conference call. In response to the question, then-CEO, Jeff Skilling, called Highfields' analyst Richard Grubman an unprintable expletive that begins with 'a' and ends with 'e'. 

Highfields made a fortune shorting Enron and recently Highfields turned its money-making sights on Ralcorp -- boosting its stake in Ralcorp by 200% to 1.5 million shares in the three months between June 2011 and September 2011.

Why might Highfields be interested in an industry as mature as RTE cereal? According to IBISWorld, it's growing steadily despite economic turbulence. Over the last five years, it's grown at an average rate of 3.2% and it is expected to end 2011 with $13.3 billion in revenue -- 1.9% above its 2010 level. Moreover, IBISWorld predicts the industry will grow at a 2% annual rate through 2016.

But Ralcorp is hardly the industry leader. That spot goes to Kellogg with 34.2% of the market to Ralcorp's 13.9%, according to IBISWorld. And Kellogg gained that lead by winning when it comes to the industry key success factors such as advertising, filling up retail shelves with different varieties, and economies of scale in purchasing and manufacturing.

Could Highfields be attracted to Ralcorp's financial performance? It looks like the interest is in a possible buyout. That's because Ralcorp postponed its fiscal fourth quarter earnings report from November 8th to November 29th so it could calculate the accounting impact of its spinoff of its cereal division -- Post Foods, according to Dow Jones Newswires. This could affect ConAgra Foods Inc.'s (NYSE: CAG) bid to acquire Ralcorp.

Meanwhile, Ralcorp narrowed the range of its expected fiscal year earnings to a range between $5.21 and $5.27 a share -- it had previously forecast 2011 earnings ranging from $5.20 to $5.35. And earlier in November, analysts were expecting Ralcorp to report an 11.1% EPS increase to $1.40 on an 8% rise in sales to $1.2 billion, according to Narrative Science.

Kellogg's third quarter results were  a big disappointment to its investors. It reported a 14% decline in earnings to 80 cents a share -- nine cents short of analysts' expectations. Kellogg attributed this to supply chain investments. Meanwhile, Kellogg revenue rose 4.9% to $3.31 billion but fell $10 million short of expectations, according to ActiveInvestor.

So here's what the investment choice between Ralcorp and Kellogg boils down to:
  • Ralcorp: growing modestly, narrow margins; expensive stock. Ralcorp sales have risen 4% in the past 12 months to $4.7 billion while its net income fell 28% to $225 million -- yielding a low net margin of 4.8%. Its PEG (where a PEG of 1.0 is considered fairly priced) of 1.33 is pricey on a P/E of 20 and expected earnings growth of 15.1% to $6.03 in fiscal year 2012.
  • Kellogg: shrinking, decent margins; over-priced stock. Kellogg sales have fallen 1.4% in the past 12 months to $13 billion, while net income has soared 2.9% to $1.2 billion – yielding a decent 9.1% net profit margin. Its PEG of 3.06 is very expensive on a P/E of 15 and expected earnings growth of 4.9% to $3.54 in fiscal 2012.
Ralcorp is the better tasting of these two stocks. It is still over-priced so it would only make sense to buy its shares now if you think -- as Highfields probably does -- that ConAgra will make a bid for the company at a higher price. Kellogg seems to be blundering despite its market dominance -- as a result, its stock is tremendously over-valued.

If forced to pick one -- I'd buy Ralcorp.

2 Comments:

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