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Takeaway: We see CAG as a relatively inexpensive name that has additional upside to earnings.

CAG recently announced the acquisition of RAH for $90 per share in cash.  The transaction transforms CAG into the largest private label food manufacturer in North America.  Private label grows faster (about 2x the growth of branded in the United States over the past decade), but is much more volatile in terms of top line trends and margins.  RAH competes in a number of center of the store categories – cereal, pasta, snacks, sauces, etc.  We get two major points of pushback with respect to our positive view on CAG and the transaction:

  1. Does private label and branded under the same roof work? It didn’t when RAH tried to manage the branded cereal business at Post.
  2. The branded portfolio at CAG remains unimpressive

In response to the first point, it certainly didn’t work with RAH and POST, but CAG has already been doing it reasonably well within its existing portfolio.  The key is very little overlap in terms of categories, which is/was the case for the base business at CAG and is the case with the combined business as well.

The last point regarding the branded portfolio isn’t wholly unreasonable and has been our concern surrounding CAG for a number of years.  However, the portfolio has been streamlined and improved via acquisitions and divestitures and, more importantly, management has been increasingly focused on providing consistent support to the brands.  Bottom line, the portfolio isn’t great, but certainly improved.

Finally, over a long enough period of time, the jockeys (management) in the race matter as opposed to just the horses (brands).  Management can tear down or build brand equity, and we are a believer in the jockey (CEO Gary Rodkin) at the reins of the combined CAG-RAH.

Accretive to the top line

As mentioned above, private label has grown at about 2x the rate of branded products over the course of the last ten years.  Over that time, we have seen substantial improvement in the quality of private label offerings, to the point where private label brands, in some cases, compete at a near-premium price point.  Retailers want private label as a foil to the branded manufacturers.  While we believe that consumers prefer brands, we also think they want value as well, which is where private label comes in.

We also think that the organic growth profile at RAH is underappreciated for a couple of reasons.  First, as a serial (not cereal) acquirer it was at times difficult to parse out the organic growth profile.  Additionally, as a cereal acquirer (referring to POST this time), the poor performance and all around bad idea of that deal clouded numbers for a good bit.  On an organic basis, since 2005, RAH has grown its top line at an average of 4.9% - with a low of -0.2% in 2010 and a high of +12.1% in 2008.  So, as mentioned previously, there is some volatility on the top line.  When factoring in acquisitions (excluding POST), RAH’s top line grew at an average of 14.7% over the same period.

Keep in mind that private label remains a highly fragment industry, and the same type of consolidation opportunities that were available to RAH will be available to the combined entity as well, to the benefit of the top line.

Targeting $225 million in synergies by Year 4

Cost synergies are approximately 5% of the revenue of the company being acquired, within the range (5-7%) we have seen for other staples transactions, but at the lower end of the range.  We believe that there is upside to this number – moving closer to synergies representing 6% of RAH revenues garners another $45 million in cost savings, a number that we don’t find unreasonable given the likely conservatism on the part of management at this early stage and what we have seen from past transactions.

Bear in mind that the projected synergies are incremental to the cost savings programs that were in place at both RAH and CAG, so we see significant income statement flexibility in the coming years.

The impact of commodities is magnified in both directions for private label

Higher input costs are a significant issue for private label manufacturers as private label has less income statement flexibility than branded product as there is no advertising or marketing expense that can be cut to preserve EBIT margins in the face of gross margin pressures.  Further, to the extent that private label manufacturers raise prices to offset commodity increases, gross margins can be negatively impacted by manufacturing inefficiencies and fixed cost absorption as a result of lower volumes.

RAH has had an issue with raw material and freight cost increases in spades over the years – in fiscal 2012 alone, commodities and freight added $313.2 million to the company’s cost structure.  All but $72.6 million of that was covered by pricing actions, but the magnitude of the impact is staggering in relation to the total EBIT for RAH in 2012 - $358.7 million excluding the Post results in Q1.

Our firm view is that commodity prices will moderate as that asset bubble bursts or slowly deflates.  If that is the case, private label manufacturers will have substantial flexibility with respect to margins or pricing, which could lead to share gain opportunities and increased volume.  Increased volume should lead to improved fixed cost absorption and gross margin gains.

Bottom line is that as much as commodities hurt on the way up, there is as much gain to be had on the way down.  This is true for both RAH and the base business at CAG – CAG’s consumer foods business experienced double digit inflation in fiscal 2012, some relief from that is part of the reason that our EPS forecast for CAG is $0.08 ahead of consensus for the 2013.


The combined entity will have $18.2 billion in revenue, and should be able to grow top line in the 3-5% range, including 1 pt. from private label acquisitions.  We estimate that the transaction could be between $0.15 - $0.20 accretive, conservatively, in the first year, excluding incremental amortization of intangibles that is above our pay grade to calculate.  We assume an interest rate of just below 4% for the acquisition debt, as CAG refinances and exchanges the existing RAH debt that it assumes.  RAH’s weighted average interest rate is currently over 6%.  For the sake of simplicity, we assume a steady run rate on synergies, using our higher number of $270 million by the fourth full fiscal year after the transaction closes ($67.5 million per year or about $0.10 per share, per year).  So, synergies alone could provide 4% EPS growth.  We estimate that deleveraging could provide another 1.5 pts to EPS growth or likely closer to 1.0 pts as we net out share creep from exercises as the company has suspended its share repurchase program.  Bottom line, the combined business could deliver 8-10% EPS growth without the benefit of any margin expansion associated with a more benign commodity cost environment – looking out to fiscal 2015 for CAG, we can see an EPS number in the $2.75 range.  Recall that RAH’s issues with commodities represented over a $300 million headwind last year.  Assuming even a $20 million recovery, that is another $0.03 to $0.04 of earnings.  Looking at the average group multiple of 13-14X ’15 EPS, we can see a stock price in the upper $30s over time.

Solid Management + Synergies + Lower Commodities + Better Top line

We see CAG as a relatively inexpensive name (13.8x calendar 2013 EPS versus the packaged food group trading at 17.6x) that has additional upside to earnings on a standalone basis as well as a transformative acquisition that is scheduled to close during calendar Q1 2013 that should provide investors a path to a higher EPS profile through accretion and synergies.

Robert  Campagnino

Managing Director