Economics of Dog Food

Leading pet food producer Ralston Purina has quietly mounted a run this year, growing some 40% in price year to date while most of the market looked elsewhere. It's a given that dog food is not the most glamorous industry, but a company that trades below its intrinsic value doesn't need to be. So while Ralston Purina may be under the radar screen for tech-happy investors, it is a case in point for a non-growth business that spins off huge amounts of free cash flow.

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By Bill Mann (TMF Otter)
November 15, 2000

It's not a stretch to say that Ralston Purina (NYSE: RAL) is not in the world's most exciting business. In fact, the company recently sold off its most "glamorous" component, spinning its Energizer Battery division off into its own public company, Energizer Holdings (NYSE: ENR). This, along with other divestitures of non-core businesses, has left Ralston Purina with its core brand and pet food products.

But who says that investing has to be "exciting" anyway? I get enough excitement in my morning commute. The goal of investing is to find companies that are undervalued relative to their potential future cash flows. And cash, regardless of whether it comes from pet food, laser beams, or toilets, is cash. Warren Buffett has not made thousands of Berkshire Hathaway (NYSE: BRK.A) shareholders rich by buying the "in" companies; rather, his modus operandi has been to seek out market inefficiencies. Thus Warren Buffett bought significant portions of Coca-Cola (NYSE: KO) and the Washington Post Company (NYSE: WPO). These are companies with moats around their businesses that were priced at a level where Buffett believed that their future cash flow potential produced "no-brainer" investing decisions.

So today I'm going to talk about the economics of dog food. Specifically, we're going to look at the leader in the domestic pet food market in the United States, the company with the checkerboard brand that controls some 55% of the total market. And in this time, in which so many of our angels of last year (or more sadly, last week) are being exposed as miserably unpredictable investments, I ask you: Is there a business at all that is less prone to the vagaries of the economy than pet food? Does it follow that pet owners are going to quit feeding their animals because of the confusion surrounding the next president?

By the way, did anyone else catch the fact that Lowe's (NYSE: LOW) has blamed the presidential uncertainty for its slow sales? How is it possible that people are holding off on that all-important miter box purchase until they're sure their man is going to be elected?

Ralston Purina is not in a market that shows much growth, or even volatility. It does, however, show a wonderful propensity to spin off free cash. For companies that have this propensity, growth becomes much less important.

For the nine months ending on September 30, 2000, Ralston Purina had sales of $2.087 billion from continuing operations, up from $2.006 billion the same period in 1999. That's an annual growth rate of 4%, which is unexciting. So how is the stock up so much this year?

The statement of cash flows gives us a solid clue. For the same nine-month period, Ralston Purina has free cash flow (which I define as net cash from operations less capital expenditures) of $316.8 million. In 1999, its free cash flow was $357.1 million. Free cash flow is the money that the company ends up with after all of its expenses from continuing operations are netted out. Ralston Purina's free cash flow numbers are, at a minimum, historically dependable.

Add to this the fact that Purina has embarked upon two share buybacks that have retired more than 9% of the total share float, and the story becomes more compelling. A company that has fairly consistent and predictable cash flow, that has embarked upon a dramatic share reduction, and is the market leader in a stable business is difficult to find.

What may be more difficult to find is such a company at a reasonable price. At $18 per share, where the company was priced in April of this year, its price-to-free-cash flow multiple was below 11, an amount that is significantly below the returns you could gain with cash in the bank. Now that the stock has risen so dramatically, the shares offer a much less compelling value purchase, as $27 per share puts Ralston Purina close to the intrinsic value of its future cash flows.

But that's a normative judgment, not a factual one. Neither I nor anyone else really knows what the cash flows will be in the future for any company that we subject to such analysis. (For the record, my model for Ralston Purina assumes the historical growth rate of its core pet food markets of 5%, less a discount factor of 8%.) But there are also some factors that could lead Ralston Purina to improve its cash flows, and thus raise its returns on equity and assets. Both historically quite high, with return on equity in particular coming in at 177% for the past year. Further, Ralston Purina, though fairly highly leveraged at a debt-to-equity ratio of 3.23 has in fact dramatically reduced its dependence on debt financing, in part through its spin off of certain assets.

The company really owns the bottom and medium levels of the pet food markets, but does have significant competition on high-end brands from Procter & Gamble's (NYSE: PG) Iams and Eukanuba brands, particularly as these enjoy a concerted effort by P & G to get shelf space at grocery stores, a domain that has essentially been ceded to Purina in the past. But Ralston Purina is confident enough in its ability to defend its ground that it is exercising some pricing power, announcing last month that it was raising its wholesale prices across its brands by 5%.

When companies are able to make such price increases it generally flows straight to the bottom line. Unless the price increase or the increased competition from P & G cause Purina to lose a big customer like Wal-Mart (NYSE: WMT), which constitutes more than 12% of its total sales, the company's cash flow margins should improve further.

It would be difficult to argue right now that Ralston Purina is a bargain. But the lesson from this company is simple: it is sometimes possible to find quality at a price well below intrinsic value. And a well-managed company that provides stable cash flows and slowly growing revenues can in fact provide significant long term returns if it is purchased at the right price.