Leverage: A Slippery Banana Peel

When Chiquita Brands (NYSE: CQB  ) announced it was paying Performance Foods Group (Nasdaq: PFGC  ) $855 million for Fresh Express -- the No. 1 packaged salads company in the U.S., with a 40% market share -- it said the acquisition was a "strategic and transformational move."

Well, it's time to investigate how strategic that move actually was. Historically a weak period for the company, net income came in at $0.3 million a share, up from a $20 million loss in the same period last year, although numbers came up short of analyst expectations -- sending the stock down about 11%.

After the market closed yesterday, Chiquita Brands announced third-quarter results. Bananas, 43.1% of this quarter's total sales, are still the heart and soul of this company. Strong European banana prices allowed revenue to increase 8.2% over the comparable year-ago quarter and operating income to soar 24.1%. Remember, though, that banana price moves according to crop status and other commodity factors, injecting a degree of cyclicality into its revenue stream and according pricing strength.

Fresh Select, the whole fresh fruit and vegetable business (excluding bananas and salads), is still the company's second-largest business unit, with 28.1% of total sales. This operation, with many new product start-up costs, saw its revenue increase a surprisingly small 1.6% and its operating loss increase 75% to $2.8 million. While this division is getting attention selling to large customers like McDonald's (NYSE: MCD  ) , Yum! Brands (NYSE: YUM  ) , and Ahold (NYSE: AHO  ) , it has yet to turn those sales into operating profits.

Fresh Cut, the division of Fresh Express' salad business that brings the lion's share of revenue, accounts for 27.1% of total sales. Sales increased 4.9% and operating income radically increased to $7 million. Even with its monstrous packaged salad market share, this business' operating margin is a modest 2.6%. But if Chiquita can garner the $20 million in synergies the company expected when it announced this acquisition, this division's operating margins will exceed those of the banana business.

But let's set aside the potential benefits of the Fresh Express business and take a sober look at today's numbers. Debt stands at $1.1 billion, half of which is borrowed using variable interest rates. A 1% increase in interest rates would cost the company roughly $6 million in annual interest.

And consider this. While operating income almost doubled to $20 million, interest expense increased 121.4% to $21.7 million. More than anything, I'd like to see the company get its debt down (a stated goal).

While the Fresh Express acquisition did broaden the company's sales (a good strategic move), bananas are still king at Chiquita. And while banana prices have been strong, analysts see 2006 earnings of only $2.30 a share. That's down from an expected $3.67 this year. Still, the stock is trading at 10.9 times 2006 earnings, which can hardly be called expensive.

So far, the company's cash flow has allowed it to pay down $50 million in term loans. It needs to continue on this track so the leverage doesn't become the slippery banana peel that causes earnings to take a dip.

For those looking for alternatives, consider Motley Fool Hidden Gems recommendation Fresh Del Monte Produce (NYSE: FDP  ) . While Del Monte is also using debt to bolster its results, it has done so at a much more modest level -- selling at 10.2 times 2006 estimated earnings.

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Fool contributor W.D. Crotty owns shares in Chiquita, McDonald's, and Yum! Brands. The Fool has a strictdisclosure policy.


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