Thursday, February 11, 2010
Over the past two days, DF stock price plunged almost 20% because its Q4 earnings came in below estimates, lower-than-expected earnings forecast and faces headwind on higher cost of dairy milk.
DF has an annual sales of about $11.1B. Of which $8B goes to cost of sales, $2.5B goes to operating expenses, and $0.25B goes to interest expense. Leaving about $0.35b to both stockowners and Uncle Sam - of which tax rate is 35%.
In 2009, DF earned $1.38 a share or $240m. With an outstanding share count of 183 million, the company is valued at $2.65b. Free cash flow for 09 was $391m.
Now DF looks cheap compared to many of her competitors, who easily are valued from 13 to 16 times its earnings or even higher based on FCF. This could be because DF is a low, if not the lowest, margin food business. DF is also highly leveraged at 5.77 times of shareholder's equity. To operate the whole business, $7.8 billion in total is needed. Of which, $4.2b is interest-bearing debt, $1.37b from shareowners, and the rest from trade debtors and others.
The question is the sustainability at such highly-levered rate. The cash flow certainly can service the interest payment and pay down debts. We know that all business are structured differently - some with more equity, and some with more debts - but in the end, all are financed through different sources which are different in seniority. Now, lets assume DF is debt-free, i.e, DF must convert the $4.2B into equity. Then the market value increase from $2.65b to$6.85b ($2.65B + $4.2B). Then, DF need not have to pay a dime of interest expense which will save them $250m a year, or $163m after-tax. In total, DF would earns $403m ($240m + $163m), which prices DF at a PE valuation of 17 ($6.85b / $403m).
I know the above seems confusing. In summary, stock holders put up $1.37b in equity to get a return of $240m after tax, while, debt-holders put up $4.2b to get a return of $250m before tax.
So a debt-less structure would be less advantageous to the current stockowners. Therefore, it would be better that DF structure the business where it is financed more by debts than by equity holders, where equity holders will get more of the share of the pie, and debt-holders less.
In conclusion, DF is relatively cheap, but not without reasons and risks. The main risk is DF must meet certain financial covenants on her financial debts. If DF fails to meet such covenants in the event of really adverse economic conditions, share price would plunge because the company may be forced to restructured the financing structure of the business by converting debt to equity at a price that is totally disadvantageous to current common shareowners. But at $14.5 - moreover at a 52-week low - it is worth to take a look. I wouldn't say this is a good long-term holding but certainly a holding that would get a reasonable return within a reasonable time frame.
I am also looking at the defence contractors sector - players like Raytheon, Northrop Grumman, Lockheed Martin, General Dynamics, L-3 Communications. Will share more on this when I am through.