Post Holdings Red Flags Galore

Post Holdings: Red Flags Galore|Must Read Mar. 29, 2016 8:30 AM ET9 comments

by: Lester Goh

Summary• Amongst debt-driven roll-ups, Post Holdings remains an outlier. Decent

recent results have apparently assuaged investor concerns, evident by share price performance - but I remain unconvinced.

• The bull thesis revolves around further acquisitions and reinvigorating acquired brands, a strategy which is heavily driven by continued access to the debt capital markets.

• Red flags include brand under-investment, commodity-driven margin expansion, and questionable acquisition discipline.

• Other concerns include frequent impairment charges, retailer pressure, and limited incremental debt capacity.

Post Holdings: Red Flags Galore - Post Holdings, Inc. (NYSE:POST) | Seeking Alpha of 20

http://seekingalpha.com/article/3961378-post-holdings-red-flags-galore 1/8/2016

• With largely declining earning power minimally offset by small, fast-growing segments, an 8x free cash flow to equity multiple appears appropriate, suggesting ~42% downside from current prices.

ThesisNot all roll-ups are created equal. Despite recent media news flow regarding such companies suggesting that such a strategy would eventually implode, there are numerous case studies of successful roll-ups (John Malone's TCI, Ecolab (NYSE:ECL), Danaher (NYSE:DHR), AB InBev (NYSE:BUD), et. al). Success with such a strategy generally requires stable, growing earning power to service debt, strict acquisition discipline, sustained capital investment, and distinctive improvements in the acquired companies. When these criteria are not met, things usually end badly. In my view, Post Holdings (NYSE:POST) ("Post", "POST", or the "Company") does not meet these hurdles.

Reasons for the opportunity: strong recent results, 'outsider' management, recent insider buying, roll-up euphoria.The bull thesis is predicated on Post continuing its unsustainable roll-up strategy and reinvigorating brand growth. It appears that the consensus view is overlooking (or dismissing) the reality of the Company's fundamentals and ignoring the time-tested truth that brands require sustained investments to prosper in this space.



Post is a congregation of large, but slowly declining segments (RTE cereal) and fast-growing, but small business units (active nutrition, private brands) purchased at 8x-10x EBITDA. Management has exploited cooperative credit markets that were willing to lend to highly-levered entities who are quickly losing their appetite, if the recent implosion in well-known roll-ups is any indication.With largely declining earning power offset slightly by fast-growing, but small segments, Post deserves no more than an 8x levered free cash flow multiple, in my view. Such a multiple suggests ~42% downside from current levels.Risks to the upside are limited given the presence of numerous red flags - brand under-investment, commodity-driven margin expansion, questionable acquisition discipline, frequent impairment charges, retailer pressure, and limited incremental debt capacity - which appear to be going unnoticed, as illustrated by Post's recent share price appreciation.This is a very non-consensus bet, evident from the current short interest being at an all-time low, per NASDAQ data. In my view, the consensus is missing very important signs of deterioration in Post's fundamentals - some of which has not shown up in the Company's financials - and instead choosing to focus on the acquisition-driven growth story, which is fast running out of steam.Why now? Multiple reasons - 1) potential margin contraction due to a combination of retailer pressure, higher input costs, and required brand investment resulting in a possible guidance revision lower, 2) potentially continued impairments to goodwill, 3) probable lack of acquisitions going forward allowing negative organic growth to come to light, notwithstanding difficult y/y comps and questionable acquisition discipline, and 4) credit markets shutting out highly-levered entities such as Post, coupled with limited incremental debt capacity, both of which severely deflates the inorganic growth trajectory.Quick BackgroundPost was a spin-off from Ralcorp - which was sold to ConAgra (NYSE:CAG). To those who have read Thorndike's book on 'outsider' CEOs, Ralcorp is a company that is synonymous with Bill Stiritz. Stiritz has had an amazing track record with multi-decade annual shareholder returns in excess of 20%.



At Ralcorp, Stiritz rolled up the competition, reduced costs, and invested a portion of those savings into new product development in order to reinvigorate brand growth. This worked wonderfully well. Given that he is presiding as chairman of Post, longs are likely betting on Stiritz working his magic at the Company.Stiritz continues to hold a significant stake in Post, but given his public investment in Herbalife (NYSE:HLF) and the complexity of said MLM, it appears likely that he could be very occupied with the Herbalife situation - he even hired uber bull Tim Ramey. Stiritz also barely participates in earnings calls, further suggesting that he is not focused on Post.Since the spin-off earlier this decade, Post embarked on an inorganic growth strategy. On day 1 of the spin-off, Post only possessed a secularly declining business - RTE cereal. Since then, the Company has utilized the stable, but declining cash flows of the cereal business to diversify its way into higher-growth segments such as cheese, pasta, refrigerated potatoes, and private label granola whose categories are expected to grow at low single digits, private label peanut butter and value-added eggs with expected category growth rates of mid single-digits, and portable proteins, with expected category growth rates of high single digits.As a point of reference, before corporate expenses and impairments, Post Consumer Brands ("PCB") accounted for ~48% of segment profit, Michael Foods ("MF") accounted for ~44%, Active Nutrition ("AN") accounted for ~-3% (i.e. unprofitable), and Private Brands ("PB") accounted for ~9%. Products are primarily sold to retailers (Wal-Mart (NYSE:WMT), Costco (NASDAQ:COST), Sam's Club), foodservice distributors (Sysco (NYSE:SYY), US Foods (NYSE:USFD)), and restaurant chains (Denny's (NASDAQ:DENN), iHop).Cracks amongst numerous popular roll-ups (Valeant (NYSE:VRX), et. al) has surfaced recently. Despite this, shares of Post have continued to perform well throughout 2015. The driver for this appears to be strong recent results which presumably validated the Company's model and assuaged investor concerns. However, I remain unconvinced, given the numerous red flags detailed in subsequent sections.Red flags galore



Brand underinvestment: Essentially, Post has transformed its portfolio from secular low single-digit decliners to mid single-digit growers, at least category-wise. This portfolio improvement is likely the reason why the market began assigning Post a premium multiple in through 2013. However, poor results led to a guidance take-down in 2014. Stronger headline results led to better financials (and de-levering of the balance sheet through low-quality EBITDA increases) in fiscal 2015 and a recent guidance lift which was likely the catalyst for share appreciation.However, headline results are not what they seem. In my view, Post was able to post (excuse the pun) robust results and delever largely due to low-quality earnings. For fiscal 2015, net sales for PCB declined ~3%, but segment profit jumped ~9% - both metrics excluding the impact of acquisitions. The Company has historically emphasized that it is willing to lose lower-margin RTE cereal sales in favor of higher-margin bagged cereal revenue, and these metrics (and the recent MOM Brands acquisition) certainly support that assertion.However, segment profit improvement was not driven by high-quality drivers such an improved product mix - which would signify progress towards higher-margin sales but was instead primarily driven by reduced marketing costs and promotional spending of ~$25m. Stated simply, reduced marketing costs accounted for ~80% of the increase in segment profit in fiscal 2015.Now, Post competes in a market where brand awareness is paramount. If consumers are not aware of your brand, sales will decrease and retailers will reduce the amount of shelf space allocated to your products, initiating a vicious cycle. While reducing marketing is great for an earnings boost in the short term, it is unsustainable in the long term.Marketing spend was also reduced in 2014 - suggesting that this practice is not isolated to 2015, though volumes were up ~1% (albeit on an easy comp), suggesting that decreases in marketing spend are leading indicators of volume declines - volumes fell ~3% in 2015. Management may try to spin lower marketing spend by emphasizing more efficient spending, but this story is unlikely to play out in their favor.For example, General Mills (NYSE:GIS) has been cutting marketing spending in recent years, and its cereal volumes have declined at a much quicker pace (mid single digits) than Post. Kellogg (NYSE:K) has cut advertising even deeper than



both Post and General Mills and has seen low-teens declines in cereal volumes. These two examples perfectly illustrate the unsustainability of the strategy. In my view, the General Mills/Kellogg situation portends the future of Post if the Company continues cutting marketing.It appears to me that Post is opting to under-invest on crucial items such as marketing in favor of milking its brands for cash. While this may allow margins to be maintained (or even grow) in the short run, the Company would eventually have to face the music and cope with a weakened competitive position which materializes in the form declining organic growth, like it has.It is probable that this reduction in marketing spend is not intentional but instead illustrates that the Company is being forced to cut brand investment in order to service its massive interest burden and/or pay off debt as well as meet its senior secured and interest coverage covenants (see infra).The recent acquisition of MOM Brands was also touted by the sell-side as an attempt to stem the decline in the cereal business. The asset increased Post's market penetration in bagged cereal (a low single-digit growth category) from ~8% to ~52%. Given the decline in marketing spend, it is unclear whether Post can capitalize on its leading market position in this sub-segment.The effects of brand under-investment is not limited to PCB, which accounts for ~48% of overall segment profits excl. corp costs and impairments, as discussed. Egg volumes at MF were down ~7% in fiscal 2015. Although egg product sales were up ~1%, this was boosted by a one-time tailwind of the avian influenza outbreak which drastically reduced egg supply, resulting in substantially higher ASPs.Potato products and cheese also saw decreases in volume of ~6% and ~4%, respectively. Pasta was the only bright spot, with volumes increasing an undisclosed amount, but the category is too small to move the needle.Segment profit jumped substantially for MF, but this was largely due to the inclusion of 8 months of results due to the timing of the MF acquisition as well as the drastically higher ASPs, as discussed. Year-over-year comps were laughably easy as well, given the ~$21m in inventory fair value adjustments incurred in 2014.



Although the AN and PB segments experienced strong double-digit growth in volumes, their contributions to overall segment profits are too small to move the needle, as discussed. It would take many years of continued double-digit growth in these segments to overcome the negatives in the larger PCB and MF business units.There are some negatives in these supposedly high-growth segments as well. Within AN, the PowerBar brand is one of the largest, contributing ~$300m in sales. Growth in this brand has remained lacklustre (~$270m in 2009, now ~$300m-$350m) as compared to the Clif brand owned by competitor Clif Bar which has grown from ~$150m in sales in 2009 to ~$500m in sales to date. Clif is a direct competitor and given its strong sales growth, Clif is likely stealing meaningful shelf space from Post, which initiates a vicious cycle.In my view, Post would either have to a) hit guidance by continuing to under-invest in its brands, or b) miss guidance by increasing market spend to grow market share. Both outcomes are not pretty.Commodity-driven margin expansion: Though Post has seen expanding margins recently, the expansion was partly driven by lower input costs (e.g. here, here, and here), in my view. This tailwind has since morphed into a headwind given the recent jumps in commodity prices. The tailwind is not isolated to Post as the above-linked news releases show, which leads me to conclude that margins may have - to a significant extent - been driven by reduction in input costs.Input costs for Post primarily comprise of wheat, oats, vegetable oils, dairy, cocoa, sugar and many more, per the Company's disclosure in the 10-K. In recent months, the prices of these commodities have spiked up substantially (as seen here, here, here, here, and here), which should pressure margins in coming quarters as higher prices travel through the value chain.It is quite possible that recent commodity price trends are signaling a cyclical upturn in the cycle. This assertion is supported by the fact that crop protection chemical producers (such as Dow Chemical (NYSE:DOW), Syngenta (NYSE:SYT), Monsanto (NYSE:MON), FMC (NYSE:FMC), and Platform (NYSE:PAH)) have identified high channel inventories as early as 2014.



Sales for these companies have been pressured from much of the past 2 years as the channel continued de-stocking - which is a pretty good proxy for crop plantings - suggesting a paring back of crop supply. Hence, it would not be a stretch to postulate that farmers will continue holding back on crop plantings until prices recover significantly - after all, they are not making a profit on average around current prices.As a point of reference, commodity prices in general have been declining for years (as seen here for a broad basket of commodities, most declining 50%+ in the past half-decade), so if the recent price trends are an indication of a recovery in the cycle, holding margins stable would be a mean feat for Post. Given the appreciation in shares of Post in recent months, it appears the market has yet to price this factor in.Margin compression via higher input costs is not solely limited to commodities. Egg producers have increasingly moved to cage-free egg production. Post's management even made a statement mentioning that the change is likely to be secular in nature due to changing consumer preferences. When even McDonald's (NYSE:MCD) announces that it is going with this trend, it is difficult to argue otherwise.According to press reports, less than 5% of eggs produced in the U.S. were from cage-free facilities, indicating that the conversion still has a lot of steam left in the engine. Post is highly exposed to this conversion given its ownership of ~13.5m hens through its MF subsidiary, according to trade publications.The above-linked press reports cite that it costs an egg producer anything between $30-$60 to switch from traditional facilities to cage-free, suggesting that it could cost Post in the range of $300m-$700m in coming years to make the switch, assuming that the <5% statistic applies to the Company. To make matters worse, the press report also mentions that it is more expensive to maintain cage-free facilities - operating and capital costs are ~36% higher than conventional systems. Notably, this trend - which could lead to multi-year (McDonald's announced that the transition will take it about a decade) pressure on margins - is not really mentioned by the sell-side, and does not appear to be priced in.



Questionable acquisition discipline: While Post has acquired assets that are generally attractive - they positively repositioned the Company's growth trajectory in a major way - there have been quite a number of issues that stand out and have raised my concerns on management's acquisition discipline.For example, Post acquired Dakota Growers for ~$370m in September 2013 (acquisition closed on January 1, 2014) Per the press release, Dakota Growers had ~$300m in sales in ~$42-$46m in EBITDA. Before Dakota Growers was sold to Post, it was in the hands of Viterra, who bought it from MVC Capital for ~$240m in March 2010. Per that press release, Dakota Growers had ~$275m in sales and ~$42m in EBITDA.I am hard-pressed to reconcile why it makes sense for Post to pay an extra ~$130m for an asset that has barely seen any growth in the three years prior to the Post acquisition. Viterra cited that its acquisition of Dakota Growers "creates potential for market expansion and greater recognition in the industry". It appears that was all for naught. Moreover, considering Dakota's sales grew by ~$30m and EBITDA remained flat, this does suggest unprofitable growth, or a shift to more commoditized, lower-margin products for the sake of top-line growth.Another head-scratcher - if Viterra could not grow the business by much at all, it raises the question: what can Post do that Viterra could not? There weren't any synergies to speak of - Dakota is classified in the MF segment, which could suggest synergies between the two. But this scenario is impossible because MF was acquired in June 2014, Dakota in January 2014. One could probably justify paying a higher price if MF was acquired first and Dakota was a bolt-on to realize synergies, but that is not the case. It seems the most likely explanation is that Post substantially overpaid for the Dakota acquisition (Viterra acquired at ~5x EBITDA, Post at ~8x).Questionable acquisitions are not solely limited to the Dakota asset. Post's largest acquisition to date, Michael Foods, is suspect as well. Post acquired MF for ~$2.45b in April 2014 (acquisition closed in June). Per the press release, MF has ~$2b in revenue and ~$255m-$270m in EBITDA. Rewind the clock back four years to May 2010 and you'll see Goldman buying MF for ~$1.7b from Thomas H. Lee.



According to the Post press release, MF has been growing EBITDA at an average of ~5.3% compounded annually since 2008. Assuming EBITDA compounded at the same rate from 2010 to 2014, the metric would have grown ~23% during the time that Goldman controlled the asset. Yet, Post paid ~44% more than Goldman for the firm.Synergies could not have been the main factor driving the large delta in the prices paid by Goldman and Post given that the Company estimated $10m in synergies to be realized - which in and of itself suggests minimal overlap in operations - or $70m of tax-effected present value (assuming a 10% discount rate, 30% tax rate). Providing incremental capital for growth cannot be the reason as well, given that Goldman is flushed with capital. Access to distribution is a non-starter as well, given that MF already had access to many sales channels, as implied by its ~$2b in sales. Post's assets leveraging on MF's distribution is unlikely as well, given a drastically different customer base (MF sells to foodservice distributors).It appears to me that the only viable explanation for this dubious discipline is that Post is stretching and being forced to overpay for assets in order to continue to show Wall Street growth. On the margin, it appears difficult to classify Post's acquisition discipline as anything but highly questionable, in my view.Frequent impairment charges: Notwithstanding my above commentary regarding Post's acquisition discipline, data disclosed by the Company also raises similar questions.Post recorded ~$61m in impairments in 2015, ~$296m in 2014, and ~$567m in 2011. These impairments have been spread across numerous Post brands, which does raise the question as to whether the Company is acquiring durable assets. Furthermore, the ~$567m impairment charge in 2011 which was pre spin-off (i.e. 2011 Post was solely the RTE cereal business) does suggest significant deterioration in earning power.In addition, several brands have faced significant headwinds which resulted in their useful life being reduced to just 20 years. Examples include the Grape-Nuts brand and the Post Shredded Wheat brand.



~$181m of the 2014 impairment charge was allocated to PCB, implying that the Company has yet to stem the decline. Given that the RTE cereal category has been in a secular decline due to changing consumer preferences and that Post is reducing marketing spend - which raises doubts over whether it could capitalize on the MOM Brands acquisition, future impairments to this business unit is likely.There is still a lot of room (~$1.4b in goodwill net of accumulated impairments) to write-down the goodwill allocated to PCB. Moreover, such frequent (and large) impairment charges calls into question the logic of adding back amortization charges (currently ~20% of total-addbacks) to arrive at adj. EBITDA.Although the most recent 10-K discloses that the fair values of remaining unimpaired reporting units exceeded their carrying values in excess of 15%, the Company's history of significant impairments does suggest that the assumptions used to arrive at such a conclusion might be overly aggressive.With largely declining organic growth and segment profits, Post may be forced to revise its assumptions in the future, which could either lead to fair values exceeding carrying values by a marginal amount, or further impairments. The frequency of impairments also suggests that management might be trying to delay the inevitable by gaming earnings metrics through continued acquisitions.Retailer pressure: As discussed, Post's primary distribution channel is through retailers. Retailers have been facing earnings pressure recently, due to a combination of FX headwinds, mediocre economic growth and lower foot traffic. They have responded by right-sizing working capital by reducing inventories, stretching accounts payables to match inventory turnover, and pushing suppliers for better pricing. Wal-Mart, who is Post's largest customer (~10% of sales), has been particularly aggressive on this front.At Wal-Mart's 22nd Annual Meeting, the retailer outlined its strategy to reinvigorate earnings growth. One leg of this reinvigoration is detailed in the prior paragraph and supported by management commentary (emphasis mine):



Second, we will add capabilities to our supply chain. It has been one of our most important strengths and we are working to morph our supply chain of today to enable us to win in the future. Today most of our distribution centers were obviously built for the purpose of serving stores. We are changing that to have a stronger [each] capability for moving individual items.We will connect our various types of DCs and stores and improve our inventory accuracy and efficiency. Optimizing the inventory in our system is a huge lever to serve customers better and to take a lot of cost out, not only through transportation and handling but also through markdown elimination.A dynamic connected supply-chain with improved forecasting leveraging predictive analytics can serve customers and reduce cost by merging truckload, pallet, case and each movement. Accurate inventory placement is a really good way to make money."Source: Wal-Mart's 22nd Annual Meeting Transcript

In the retailer's subsequent 4Q fiscal 2016 call, it reported strong progress on these



fronts (emphasis mine):

...we're getting better at the fundamentals of retail and managing the business better. We are reducing comp store inventory and improving our in-stock performance. We also had a sound plan for the 6 holiday season that ensured customers could rely on us for low prices throughout the season, not just at big moments......Department managers have been hired in key areas of the stores, and our new training programs are underway. New technology is in our associates' hands, and better processes are creating efficiencies in the stores, driving higher in-stocks and a continuing decline in comp store inventory. As we've discussed, there will be more investments necessary to further deliver on our plan, but we've remained on-task, and we're seeing progress..."Source: Wal-Mart's 4Q 2016 Earnings Call Transcript

The Washington Post also reported that Wal-Mart planned to double-down on private label and fresh foods, two categories that Post has a small exposure to.



While the exact impact of these initiatives by many retailers (not only Wal-Mart) is difficult to quantify, the directional effect will clearly be negative. Stretching payables would mean more cash for retailers and less for Post (as retailers' A/P is Post's A/R) while reduced inventories would pressure the Company's sales. Increased focus on private label and fresh foods could possibly result in the reduction of shelf space for Post's core brands, although this effect would be marginally mitigated by increased shelf space for Post's PB segment.The customer concentration also suggests that negotiating leverage is heavily tilted towards retailers and to make matters worse, Post's core brands have been showing organic declines for many quarters now, further lessening the Company's bargaining power. Notably, the sell-side does not appear to factor in these pressures.Limited incremental debt capacity: Post has largely financed its many acquisitions with debt, taking advantage of the low interest rate environment. On management's 2016 EBITDA guidance (of which I am highly skeptical of, per my above commentary), Post is levered at ~4.5x net debt/EBITDA. Longs appear to be assuming that the Company would continue making acquisitions to diversify away from its secularly declining cereal segment - PCB.While bulls may highlight that Post has been levered at far greater levels (net debt/EBITDA has been stretched to ~7x before), thus suggesting substantial incremental debt capacity, this neglects to consider the recent amendments to the credit agreement. Previously, Post could lever at to ~7x with no financial covenant, but it appears that financial institutions have woke up.Current covenants that apply to Post (per the most recent 10-Q) are as follows - maximum of 3x senior secured leverage ratio, quarterly interest coverage of 1.75x, and interest coverage of 2x for incremental unsecured debt.The Company appears to be near the limit for its senior secured capacity, given that this ratio is ~4x if we use the high-end of 2016 EBITDA guidance as the denominator ([$4,200m in senior secureds - $800m in cash] / $840m in adj. EBITDA).



The denominator per the credit agreement is not adj. EBITDA, however, but consolidated cash flow, whose definition differs from adj. EBITDA in that there are more add-backs to arrive at that metric - we would probably require internal company information to arrive at that number. Regardless, it appears that the Company has limited incremental senior secured capacity.Incremental unsecured debt capacity is strained as well. The 2x interest coverage for incremental unsecured debt uses consolidated EBITDA (which appears to have the same definition as adj. EBITDA, per the credit agreement) in the denominator, so on the high-end of 2016 adj. EBITDA guidance, interest coverage is ~2.7x ($840m in adj. EBITDA / [$4,500 in gross debt * 7% average interest]).While this might suggest to longs that there is some headroom, it neglects to consider several important points. The Company has been mainly issuing senior notes at rates such as 6% (the 2022 note) when it was not as highly-levered. However, as its debt increased, Post was forced to pay higher interest, as illustrated by the 2024 note (7.75%) and the 2025 note (8%). Incremental debt will likely be priced at rates higher than these.Furthermore, it is important to note a key nuance. The above rates were priced for the senior notes, which is guaranteed by the nearly the entirety of Post's operating subsidiaries. As noted, incremental senior secured capacity is likely capped, implying that incremental debt would have to be issued on an unsecured basis. Unsecureds will definitely command a much higher yield than the secureds given the lack of recourse to operating subs, which pressures interest coverage and thus limits incremental capacity.Finally, the Company has recently announced a $300m share buyback program, which further diverts cash flow away from acquisitions.ValuationWith organic earning power largely declining due to difficulties in PCB and MF, Post deserves no more than a 8x free cash flow to equity multiple, in my view. On management's 2016 high-end of EBITDA guidance of $840m (again, of which I am skeptical of - reasons: see supra), I estimate levered free cash flow of $325m before working capital adjustments (although historically not a significant use of cash, this could change given retailer pressure as discussed).



[Math: $840m - $315m in interest - $150m in capex - $50m in taxes]Although management allocates a portion of capex guidance to growth, I am doubtful that these would fall off in coming quarters given the historical under-investment in the business, and hence I am allocating the entirety to maintenance capex.On these numbers, shares of Post are currently trading at ~14x levered free cash flow, assuming ~69m shares. Such multiples are usually assigned to businesses with mid single-digit growth potential over the long term, which Post is anything but. Assuming its multiple contracts to 8x (which is more suitable for companies who are low to mid single-digit decliners), shares of Post see ~42% downside from current levels.While longs could make the case of levered free cash flow growth through debt paydown, paying off debt would imply the lack of attractive acquisition candidates and result in multiple contraction offsetting free cash flow to equity growth, given the current valuation appears to assume further acquisitions.Catalysts

• Gross margin contraction - Likely due to retailer pressure to lower price (resulting in lower ASPs for Post) and right-size inventories (resulting in lower volumes for the Company). If volumes fall low enough, retailers could significantly decrease the amount of shelf space allocated to Post, starting a vicious cycle. Additionally, margins could also contract due to recently rising input costs as Post comes off a multi-year tailwind in lower commodity costs. Moreover, the continued push to private label brands by retailers would also pressure margins due to private label possessing structurally lower margins (due to lower ASPs, which is why retailers want them - they sell very well) vis-a-vis their branded counterparts.

• Guidance take-down - This has happened in the past and resulted in significant selloffs as management made aggressive assumptions about its future results. As discussed, guidance will likely be achieved through reduction in key opex items such as marketing or will be revised lower as Post restarts brand investment spending. However, it is also interesting to note that the Company's



debt load might be forcing it to cut key opex investments in favor of paying off debt, as its interest coverage is nearing its limits; Post is likely focused on paying off debt quickly to restart the acquisition growth story.

• Lack of acquisitions going forward - This would result in cleaner financials (the one-off tailwinds would also come off) and bring to light the negative organic growth the Company has been experiencing in its core segments, materially deflating the growth story. Post has historically financed its acquisitions through tapping the credit markets, but given recent troubles at highly-levered entities (e.g. Valeant), as well as Post's already-stretched balance sheet, credit markets might not be so cooperative.

• Further impairments - Likely given the Company's history of seemingly-aggressive assumptions regarding fair value of its reporting units.

• Difficult comps - Recall that PCB increased segment profits largely due to decreases in marketing spend. If the Company chooses to return to investing in its brands, it would have to go up against a difficult comp. Moreover, the MF segment had a one-time boost stemming from substantially higher pricing due to the avian influenza outbreak in fiscal 2015. With two of its largest segments facing tough comps, it is not a pretty sight.

• Equity raise to delever - Management has not shied away from issuing equity to make acquisitions, and given its leverage and stretched valuation, an equity raise is certainly possible to reduce its debt load.

• A large ill-advised acquisition financed with incremental debt - As discussed, management's track record suggests questionable acquisition discipline. If Post makes a very large acquisition and experiences major problems with integration or otherwise resulting in its financial capacity being strained to the limits, the entire enterprise could collapse as the senior secured notes have recourse to nearly all (90%+) of the operating subsidiaries.

• Significant declines in share prices catalyzing a reflexivity effect due to significant hedge fund/mutual fund ownership - Post is owned by well-known hedge funds such as Paulson & Co. and Ratan Capital. Many hedge funds were forced to bail on Valeant - presumably due to redemptions - when its shares declined substantially, and we could see something similar here in the event



shares drop materially. Moreover, Fidelity is the largest shareholder in Post (and interestingly does not appear to be an incremental buyer - they sold ~200k shares last quarter), and the mutual fund appears to be bailing on its Valeant stake, selling ~3.6m shares (or ~30% of its ownership) last quarter. It is probable to envision a scenario where Fidelity is indiscriminately getting out of its stakes in roll-ups, which would imply that the firm would be an incremental seller of Post's shares.

Risks

• Announcements in acquisition resulting in a price 'pop' - This is a risk that shorts might want to consider avoiding if they do not have sufficient capital to ride it out, as acquisitions have historically resulted in an increase in Post's share price subsequent to the announcement. Mitigant: It appears that this may be a less of a risk going forward, given that the recent acquisition of American Blanching was met with a double-digit share price decline. Regardless, shorts with 'weak hands' should remain cautious.

• Sustained turnaround in organic growth for core segments. Mitigant: PCB, which is ~48% of segment profit, primarily sells RTE cereal which is a category in secular decline. While the segment might post some organic growth in some quarters, this normally coincides with the holiday season (as seen in 1Q FY16 results). Additionally, with reduced marketing spend and presumably lower brand awareness, it is difficult to envision incremental shelf space being allocated to this segment by retailers. Moreover, retailers have been turning away from this segment, as discussed.

• Financing acquisitions through stock. Mitigant: Post is already quite levered and is nearing the limits of its senior secured debt capacity, which should deter sellers from accepting Post's stock as currency. In addition, a significant equity issuance would also result in shorts getting paid.

ConclusionPost exhibits numerous characteristics that renders it a compelling short - 1) overvaluation relative to its mediocre growth profile - characterized by negative organic growth and amplified by persistent brand under-investment, 2) a highly-



levered balance sheet, coupled with limited incremental debt capacity for acquisitions to carry on the inorganic growth story given covenant restrictions, 3) significant potential for margin contraction due to a combination of rising input costs, declining sales, and retailer pressure, 4) dubious amortization add-backs given a history of recurring and significant impairments, 5) questionable acquisition discipline deflating the effectiveness of the acquisition-growth narrative, and 6) an uncrowded short, as evident from short interest returning to all-time lows.Considering that the market has been increasingly unforgiving of roll-ups that do not perform (e.g. Valeant, et. al), Post is a compelling short candidate offering ~42% downside from current levels.Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.Additional disclosure: The author's reports contain factual statements and opinions. He derives factual statements from sources which he believes are accurate, but neither they nor the author represent that the facts presented are accurate or complete. Opinions are those of the the author and are subject to change without notice. His reports are for informational purposes only and do not offer securities or solicit the offer of securities of any company. Mr. Goh ("Lester") accepts no liability whatsoever for any direct or consequential loss or damage arising from any use of his reports or their content. Lester advises readers to conduct their own due diligence before investing in any companies covered by him. He does not know of each individual's investment objectives, risk appetite, and time horizon. His reports do not constitute as investment advice and are meant for general public consumption. Past performance is not indicative of future performance.



Post Holdings Red Flags Galore

Documents

Transcript of Post Holdings Red Flags Galore