I took a good look at bread maker Goodman Fielder over the Christmas break. The generally accepted wisdom with this stock is that it owns some good brands but has too much debt and is poorly managed. These are problems worth worrying about but presumably there was some underlying value, and with the share price having fallen to less than 40 cents, it sounded like my sort of investment idea.
We didn’t buy it (today it trades at 68, thanks to the prospect of a takeover offer from Wilmar International), but not because it doesn’t make enough money. As I'll argue below, it makes too much. But before I do, lets look at some facts from my research:
1. This business isn’t as bad as most people think (okay that’s not fact; it’s an opinion). Goodman Fielder’s metrics look horrible at first glance: return on equity of 9.7%; return on assets of 6.9% (post tax); and net profit that has declined an average of 11% per annum over the past three years. Note that these are my numbers adjusted for goodwill writedowns and asset sales. Whichever way you cut it, it looks bad.
The low returns on assets and equity, though, have nothing to do with the quality of Goodman Fielder’s business. If you strip out the intangibles generated when Graeme Hart relisted the company in 2005, the return on tangible capital is a very healthy 24%. Pre-tax, that’s the equivalent of 35%. On these numbers, it’s one of the best businesses on the ASX, which suggests it has some serious competitive advantages, contrary to the perception that it's a marginal business.
2. Using the same logic, it’s a lot more leveraged than it looks. The reported debt/total capital ratio is 45%. Strip out the intangibles and it’s 134% - the debt significantly outweighs the tangible assets. That’s not unusual in a high quality business but with the interest cover dropping to 2.7 at the last full-year results, things were starting to look precarious.
3. The $259m capital raising in October 2011 should have patched things up but I’m not sure that it made enough of a difference. It looks like there might have been some funny business going on with the year-end accounts. Goodman Fielder’s net interest expense was $101m for the year and the hedged interest rate was 8.7%. That would imply an average debt balance of $1.16bn.
The net debt balance was less than $1bn at both the start and the end of the year. Some of the difference is explained by the fact Goodman Fielder only earned 1.42% on its cash (note to CFO, you might want to check out Ubank, Bankwest and ING Direct) but I still reckon there’s a $100m hole somewhere.
4. There has also been an increase in the use of off-balance sheet leverage since listing. The company has been selling assets and leasing them straight back under long-term leases. The committed lease payments have risen from $70m in 2006 to $222m at year end 2011. You don’t see that on the balance sheet, but it increases the operational leverage substantially.
The last three points are interesting but don't make or break the investment case. The first point on return on capital, however, has serious implications for future profitability.
In the early days of the Value Fund, we did very well out of an investment in Sigma Pharmaceuticals. Sigma and Goodman Fielder both receive the bulk of their revenue from customers in very strong bargaining positions. Almost 90% of Sigma’s revenue comes from the Pharmaceutical Benefits Scheme, where prices are dictated by the Federal Government. Two thirds of Goodman Fielder’s revenue comes from Coles and Woolworths, and we all know how they treat their suppliers.
In Sigma’s case, though, it was earning abysmal returns on its tangible capital. That capital, mostly inventory and receivables, was liquid and the shares were trading at a large discount to the tangible asset backing. Strange as it may seem, the low returns gave it leverage over the Government. Cut prices further, Sigma can argue, and we’ll withdraw our capital and leave. That capital is worth more in shareholders hands than earning a 5% return in the business.
Now try the same thing if you’re Goodman Fielder. Let’s say Woolworths wants Goodman Fielder to cut prices such that Goodman Fielder is 20% less profitable. That would cut Goodman Fielder’s return on assets from 25% to 20%; hardly a level of profitability at which it’s rational to walk away.
Worse still, half the tangible capital is property, plant and equipment which couldn’t be liquidated anyway, except at a sizeable discount to book value.
'Suppliers are asked to stand at the edge of a cliff and agree to certain discounts and if they don't they are told to look over the cliff and see if they like that better'. Usually, we like businesses generating high returns on capital. But when a customer has the ability to cliff you, it can be a hell of a long way down.
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