Someone's in the Kitchen With Ralcorp

 | Sep 28, 2012 | 11:30 AM EDT
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Keith Meister was a former right-hand man of Carl Icahn, a billionaire who recently dedicated his hedge fund to managing only his money. Meister went on to found his own hedge fund, Corvex Capital, in 2011 (view Corvex's portfolio here). According to a recent 13F regulatory filing, Meister's firm has amassed a 5.15% stake in Ralcorp Holdings (RAH), a company specializing in a number of snack and food products. Corvex owns 2.84 million shares of Ralcorp, up from about 607,000 as of June 30.

In August, Meister called on Ralcorp to either sell itself or change its strategy. Ralcorp received an unsolicited takeover bid of $94 per share from ConAgra Foods (CAG) in September 2011. This was before Ralcorp announced the spinoff of Post Holdings (POST) in January, distributing an 80% stake to shareholders, while retaining 20% of the Post common stock (which it has announced it will sell). This 2:1 distribution (one share of Post for every two shares of Ralcorp) has yet to exceed the value of $94 per share that ConAgra offered.

Post Holdings is the producer of the popular cereals Raisin Bran, Fruity Pebbles and Honey Bunches of Oats, among others. Post Holdings shares have increased 13% since the separation.

The average consumer has probably never heard of Ralcorp because it is a major manufacturer of private-label, or store-brand foods. As Ralcorp notes on its website, national store-brand sales exceed $48 billion annually and grow at an annual rate of about 5.5%. Ralcorp's businesses include American Italian Pasta Company (dry pasta); Ralston Foods (cereals); Bremner (cookies and crackers); Nutcracker/Flavor House (snack nuts); and Ralcorp Frozen Bakery Products (frozen griddle products). These labels produce "high quality products that compare to the national brands," according to the company. In addition to the booming presence of well-branded, high-quality, low-priced store brands, Ralcorp stands to benefit from rough economic conditions because stores tend to allot more room to private-label foods during such times.

Short-term, however, Ralcorp has had trouble meeting earnings estimates and controlling costs. The recent drought in the U.S. has spiked a variety of food commodity prices, particularly corn. Corn futures are unrelentingly pricey, and 2012 stands as one of only two years since 1960 in which corn demand outstretched corn supply in the U.S. For a company making a variety of different foods containing ingredients such as high fructose corn syrup, Ralcorp might have trouble improving its bottom line until well into 2013.

This story is supported by the valuation statistics. Looking at share price as a multiple of sales, Ralcorp's multiple of 0.9 is below that of Kraft (KFT), Kellogg (K), and Unilever (UL). So Ralcorp has done a good job selling its products, but since it cannot charge a large-brand premium, it operates on tighter margins. Indeed, Ralcorp has an operating margin of 8.3%, while Kraft, Kellogg and Unilever have operating margins above 13%. Finally, since Ralcorp cannot fall back on its brand name during commodity price spikes, its earnings fall and its shares begin to look more expensive. Ralcorp's shares presently trade at 18.8x forward earnings, which is two to four points higher than where the other companies trade.

We would be cautious about initiating a position in Ralcorp right now. Meister is an activist investor, so he likely has a long-term plan for the investment and inside insight to the stock going forward. An entry point below $70 seems to be what many analysts are hinting at (including those at Standard & Poor's). If Meister can effect change in the company and coax it into selling itself, this could be an interesting merger play.

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