Thursday, July 13, 2006

Operating Uncertainty Hammers Pasta Player

American Italian Pasta (PLB) is a mess of a stock if we've ever seen one.

American Italian Pasta is the largest maker of dry pasta in North America. Its customers include most major US grocers, foodservice behemoth SYSCO (SYY), and food processors like Kraft (KFT), which all put PLB pasta in their products. PLB has grown through acquisitions; the recent purchase of the Mueller's pasta brand from Bestfoods, for instance, immediately increased PLB's shelf space. PLB does roughly $400M in revs per annum and currently employs just under 600 people.

The stock's down 60% for the year. We remain incredibly pessimistic about PLB's future:

1) The horror story all begins with the 14% job cut declared in 2004. In 2005, PLB was nailed with an auditing investigation into the company's accounting practices and financial statement adjustments. And in 2006, the firm's decision to divest nonstrategic brands from its core portfolio created even more uncertainty, scaring off buyers and leading analysts to slash estimates and change price targets.

2) PLB recently told food distributor Sysco, which accounts for $43 million of its total sales, to take a hike. This decision could be a blessing in disguise, if and only if it enables PLB to work with all the distributors PLB could not work with when it was tethered to the Texas-based food beast. All we can say for certain is that the omission of SYY from PLB's client list removes a guaranteed stream of revenue from the largest food distributor in the country. Is that smart thinking or is PLB's management snorting puro in the boardroom?

3) PLB could face Chapter 11 if it doesn't get its act together. Having thrown SYY to the curb, it's clear that PLB thinks it can create more value by penetrating the residual 75% of the fragmented pasta market. But if PLB fails, investors could go home weeping. PLB is too leveraged to be of interest to us, in other words: PLB currently has less than $4M on its balance sheet, but over $270M in debt. Moreover, the firm's .20 interest coverage ratio (EBIT/debt payments) is disturbingly low when compared to the industry mean of 5 x interest obligations. Lastly, a debt/equity ratio of 77% turns PLB's balance sheet into a ticking time bomb.

4) PLB continues to post below-industry average numbers. PLB's margins (gross, pre-tax, and net), ROA, and inventory turns fall well below those posted by comparable firms; in addition, American Italian's ROIC (return on invested capital, which we calculated using the firm's 2004 NOPAT) comes in at 1.5%, approximately 550 bps less than what its peer group returns, on average, to shareholders. Added to this risk is a tight 18M float that can exacerbate volatility in the worst of times; 45% of PLB's shares outstanding, we should add, are short.

5) We also ran PLB's numbers (we had to rely on 2004 numbers because the firm has still not released data for 2005) against the EVA "economic profit" model and found similarly alarming figures. The EVA model takes into consideration a firm's EBIAT (operating profit before interest but after taxes), cost of capital (WACC), and total invested capital (total assets - cash - accounts payable) in order to determine how much wealth a firm either creates or destroys for its investors. The formula is deceptively simple, actually: EVA = EBIAT - (total invested capital x WACC).

As you can imagine, PLB took its shareholders to the cleaners. We used 2004 numbers and arrived at an EBIAT [EBIT x (1 - tax rate)] of $14.2M. We then multiplied PLB's invested capital of $708M [$748M - $4M-$36M = $708M) x our cost of capital of 11% and arrived at a "capital charge" of $77.8 M ($708M x .11). This figure is then subtracted from $14.2M, which yields a negative number. As you can see, PLB destroyed shareholder value, erasing over $63M ($14.2M - $77.8M) in investor wealth in 2004 alone. Note that the EVA model is highly sensitive to whatever WACC (or cost of equity if the firm you're studying is debt-free) investors decide to plug in (garbage in, garbage out), but we still think it's a sound way to study intrinsic value and set portfolio expectations.

6) Generally speaking, the pasta industry isn't what it used to be: pasta makers have seen their top lines impaired by the low-carb diet craze. Many firms have had to restructure, lay off workers, and apologize to their investors for decimating value. No wonder, then, that of the 5 analysts that cover PLB, not one has a buy rating.

7) With a current ratio (current assets/current liabilities) in excess of 2.0 x, PLB is by no means in a liquidity crisis. In fact, PLB remains a low cost leader with significant brands, in our opinion. However, we deem the risk/reward unquestionably unattractive and would only recommend shares to a speculator banking on a successful turnaround, which wouldn't materialize until 2007, if that.

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