A Pasta Maker Worth Its Salt


By Anishka Clarke Investors with an appetite for value might like to give American Italian Pasta Co. (PLB

; recent price, $39) a twirl. Besides what we consider its attractive valuation, we at Standard & Poor's think it's a top pick in the Consumer Staples sector due to its strong leadership position in the dry pasta market and low cost structure. The stock carries S&P's highest investment recommendation of 5 STARS, or buy.

AIPC is the largest producer and one of the fastest-growing marketers of pasta in North America. Among the 3,500 items it turns out are "long goods" such as spaghetti, linguine, fettuccine, angel hair, and lasagna, and "short goods" including elbow macaroni, mostaccioli, rigatoni, rotini, ziti, and egg noodles.

When it began operations in 1988, AIPC's focus was the low-margin, private-label pasta market. However, in 2000, it began competing in the branded pasta market through the acquisition of established pasta names such as Muellers, certain Borden brands, and Golden Grain Mission. In addition to the retail segment, AIPC markets to institutional customers including Pillsbury, General Mills (GIS), and Kraft Foods (KFT). In the fiscal year ended September, 2002, the retail segment accounted for 74% of revenues, and institutional customers made up 26%.

OTHER NOODLERS. Dry pasta sales in the U.S. peaked in 2001, likely reflecting changes in diet - with carbohydrate-laden foods like pasta getting the cold shoulder in some popular weight-loss plans -- and market saturation. However, we believe that growth opportunities still exist for pasta makers. In the institutional segment, we foresee increased outsourcing of pasta production by the larger food processors as an opportunity. Additionally, we believe growth can be achieved in the retail segment with increased focus on marketing and positioning, and cost-reduction initiatives.

AIPC's retail operations compete in a highly fragmented market. It vies with domestic independent pasta makers, including New World Pasta, Dakota Growers Pasta, and Barilla (an Italian-owned company with production facilities in the U.S.). But New World has been experiencing financial difficulties since 2002 and is reorganizing its business. Its sales through mid-2002 were on par with AIPC. And Dakota remains a relatively small player with approximately one-tenth AIPC's sales.

AIPC should continue to take advantage of its financially weaker competitors over the medium term. Barilla, which operates primarily in the branded retail segment, is AIPC's most formidable competitor. On the institutional side, AIPC competes with pasta divisions of large food companies such as General Mills, ConAgra (CAG), and Campbell Soup (CPB). In our opinion, the larger food companies will move toward outsourcing more of their production needs as they seek to improve their cost structures. Given AIPC's increasing geographic reach -- and its low cost structure -- it should likely benefit from this trend.

CRANKING 'EM OUT. In our view, AIPC can sustain its leadership position in the dry pasta market based on its low cost producer status, geographic diversity, operational scale, and strong customer relationships. Its chief competitive strength, in our view, is its low cost structure. Within the domestic dry pasta segment, AIPC enjoys high operating margins, which as of the third quarter of fiscal year 2003 stood at approximately 20%. Compare that with New World's 10% (as of its last financial report in July, 2002) and Dakota, which has been operating at a loss.

Over the past several years, AIPC has invested in developing high-tech production facilities, in part to significantly reduce its reliance on labor. In fiscal 2002, sales per employee were $607,000, compared to $355,000 at Dakota and $307,000 at New World (as of 2001).

AIPC has four vertically integrated milling, production, and distribution facilities, three in the U.S. (Missouri, South Carolina, and Wisconsin) and one in Italy. A fifth plant, commissioned in Arizona in March, 2003, is intended to serve the Western U.S., an area currently underserved by the company.

All facilities are scalable and can accommodate various product-line extensions. Furthermore, they have the ability to expand production with little capital outlay. Accordingly, we believe operating margins have and will continue to benefit from a highly efficient capital-intensive operation. As AIPC extends its reach across the U.S., we expect it to take advantage of economies of scale at both the manufacturing and distribution level.

STRONG BASE. Given the nature of AIPC's sales contracts, fluctuations in raw material costs, in particular for durum wheat, which represents about 30% of total costs, are typically passed through to the customer. With a favorable durum-wheat outlook expected for 2004, we believe margins will benefit. Also, as AIPC expands its product base into the branded-pasta market - where products typically command higher prices -- we expect to see an improvement at the gross margin level.

AIPC has established a market presence in North America by developing strategic customer relationships with major food distributors and processors that have substantial pasta requirements. In addition, it supplies its private-label and branded pasta to 18 of the 20 largest U.S. grocery retailers.

Among its customer base is Sysco Corp. (SYY), the largest U.S. marketer and distributor of food-service products. Sysco accounted for 11% and 13% of AIPC's fiscal 2002 and fiscal 2001 revenues, respectively. Sysco recently extended its long-term exclusive supply contract with AIPC through 2006. AIPC does not have long-term supply contracts with its other customers, including Wal-Mart (WMT), but it continues to place an emphasis on securing these relationships.

PROFIT PICTURE. Accordingly, we believe AIPC will benefit from major expansion plans of Sysco and Wal-Mart over the medium term. Sysco's goal is to double sales over the next five years, while Wal-Mart's food segment has been growing at an increasing rate.

Under a program aimed at continued enhancement of its industry-leading cost structure, AIPC aims for 8% to 12% growth from existing operations, to be augmented by acquisitions, outsourcing, and continued geographic expansion. It has targeted annual cost savings of about $10 million by 2004, to be used mainly to expand brand marketing and increase profitability.

Our fiscal 2003 EPS estimate for AIPC, on an as-reported basis, is $2.53. We estimate Standard & Poor's Core Eanings for AIPC of $2.20 a share in fiscal 2003, reflecting 33 cents of stock option expenses. In fiscal 2004, we anticipate an 11% negative impact from option expenses and project S&P Core Earnings per share of $2.55. Our estimate is not affected by pensions, as AIPC does not provide a defined benefit plan for its employees.

VALUE ESTIMATE. In our opinion, AIPC will continue to gain market share in the near term, benefiting primarily from weakening competition. With expanding geographic reach and likely future acquisitions, we see continued growth over the long-term. With higher volumes and operations that can be easily scaled for higher production, we believe it can widen margins successfully over time.

Our assumptions for our

discounted cash-flow analysis include a five-year compound annual revenue growth rate of 12%, long-term net operating margins of about 12%, and an 8.5% cost of capital. We derived an intrinsic value estimate for AIPC's share of $48.

We view the stock as attractively valued at a recent multiple of 13 times our calendar 2004 EPS estimate of $3.02, a major discount to its peers and the S&P SmallCap 600 Index. Our 12-month target price of $47 is based on blending a 2004 p-e multiple of 15 for AIPC's peer group, our calendar 2004 EPS estimate, and our estimated intrinsic value of $48 a share.

In our view, AIPC faces several risks. These include a maturing pasta industry and limited future acquisition opportunities, which limits its ability to sustain its growth rates over time. In addition, a turnaround in operations at New World could limit AIPC's sales growth expansion. Future fluctuations in durum wheat costs also threaten margin expansion over the long-term. However, with existing pass-through agreements and as a large buyer of durum wheat, we believe this risk is manageable. Clarke is an analyst for Standard & Poor's Equity Services


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