Del Monte Pacific

[white collar]

Hello CY09,

I suppose the way I am approaching it is rather unconventional. As you mentioned, because net profit is currently negative, using P/E ratio would be futile. However, using forward P/E based on forecast earnings once the company turns profitable (which in DEL case is expected to be FY16) is OK and has been done so for distressed, loss-making or turning-around companies. Since I chose to use EBITDA instead of net profit, I have to make a corresponding discount to the target benchmarked P/E multiple. How much to discount is debatable.

Actually, the two big term loans of US$970m are primarily interest only repayments until maturity in 2021. Also, majority of this has already been swapped to fixed rates starting Feb 2016 to account for potential rates increases. LBO lenders would face huge difficulties getting credit approvals for an LBO loan anything more than 8 years. At time of LBO, the lenders would be aware that DEL’s capital structure and its inability to service heavy principal-payment during the proposed loan tenure. As you highlighted, it would have taken more than 30 years to do so. As such, refinancing and/or the issuance of additional equity are expected before 2021. Separately, in place of the postponement of the preferred share offering earlier this year, DEL has managed to secure a short two year term loan at relatively cheap rate.

Since the LBO, performance of the DEL has been as expected and I believe the lenders would be watchful on DEL’s next few quarters’ results to make sure it can sufficiently cover the interest component.

[CityFarmer]

One primarily prerequisite of a "turn-around" bet, is low debt ratio, which I learn from Peter Lynch. Peter Lynch had quite a number of successful "turn-around" stories.

I am optimistic on the company combined biz, on sales expansion and cost reduction. What I am not sure, is the time-frame to achieve them. The current debt level, has greatly restricted it, IMO

(sharing a view, which isn't common here, obviously)

[d.o.g.]

I am valuing it in similar form to the P/E approach where I am looking it from an entire firm value standpoint rather than from just the pure equity holders'.

The "entire firm value" is not a new concept, it is commonly called the Enterprise Value or simply EV. EV is defined as the value of the net debt, plus the market value of the equity. You arrived at a value of 45 cents per share in terms of enterprise value. But Del Monte has USD 80 cents per share of net debt. Therefore, by your own metrics, the equity value of Del Monte is negative.

You have to go back to first principles: you cannot simply ignore debt when valuing a business. Sure, you can assume that future cash flows will pay off the debt, but that means that until the debt is paid off, those future cash flows are not available to you. It is obvious that all else being equal, the equity of a company with no debt is worth more than the equity of a company with debt.

If Del Monte had no net debt, then yes, the equity has substantial value because future cash flows can be extracted for the benefit of the owners. But because of the debt, most of the future cash flows will go to the lenders. The value of the equity is reduced by the value of the debt. In this case, because the debt is so large, most of the cash flows, and therefore most of the value of the entire firm, belongs to the creditors.

In short, if you use EBITDA as a valuation metric, you have to take into account the capital structure of the firm i.e. you need to use EV = net debt + equity. Assuming equity value = EV would lead to severe overpayment in the case of Del Monte, with a high likelihood of a poor outcome.

Put yourself in the shoes of Warren Buffett or your favorite billionaire - say you have $10bn and decide to buy Del Monte at 45 cents per share. Is that all you pay? No - almost invariably the bank loans will have covenants that make them due immediately upon a change of control. So your true cost of acquisition is what you paid for the equity, PLUS the debt. Your real cost would be SGD 0.45 plus USD 0.80 = SGD 1.57 per share. Whether you can refinance the debt is a separate matter. The debt cannot be ignored. Yes, the future cash flows may be able to pay off the debt, but you are buying the company NOW. You do not have access to the cash flows yet. And if you do refinance the debt, guess what? Those future cash flows go to the banks, not you.

I will not belabor the point further.

[CityFarmer]

The 2nd share-buy-back from the company, 50,000 share @ S$0.295
http://infopub.sgx.com/Apps?A=COW_CorpAn...db4d45326f

There are two ways to pay-off the debt for DMPL, either (free) cash flow, and/or converting the debts into equities. I reckon the latter will play a major role, but it can't be done with right prices, without an improving operating result.

(not vested)

[CityFarmer]

Share-buy-back of another 20,000 shares, @S$0.295 per share
http://infopub.sgx.com/Apps?A=COW_CorpAn...035f8dc90c

I reckon the support, is on a price of S$0.295 per share.

(not vested)

[cif5000]

You have to go back to first principles: you cannot simply ignore debt when valuing a business. Sure, you can assume that future cash flows will pay off the debt, but that means that until the debt is paid off, those future cash flows are not available to you. It is obvious that all else being equal, the equity of a company with no debt is worth more than the equity of a company with debt.

The cashflow will be available to equity holders as long as loan covenant is not breached. True, in a liquidation process, the banks claim ahead of shareholders. But as a going concern, they have to hold each other's hands. In fact, the banks have more skin ($1.9bn) in the game now against a market cap of ~$0.44bn.

Stock market values equity differently from private buyers. No matter how huge the leverage a Company has, all one can lose is 100% of investment as an outside equity holder. Not that a 100% loss is small but I'm trying to show that the risk can be disproportionate compared to losing 5x or 8x the capital.

One observation I made with the stock performances of steel stockists (i.e. value of equity) is that those with debt were better than those without when the sector was booming. Of course when the tide went out, the safer ones retreated less.

Unless the controlling shareholders are selling the business (whole or part), EV would matter less than matrices like P/E. If the group returned to an EBITDA of $225m, the P/E will be in single digit.

[d.o.g.]

The cashflow will be available to equity holders as long as loan covenant is not breached. True, in a liquidation process, the banks claim ahead of shareholders. But as a going concern, they have to hold each other's hands. In fact, the banks have more skin ($1.9bn) in the game now against a market cap of ~$0.44bn.

Yes. currently the banks have more to lose than the shareholders. But this is precisely why dividends will be omitted until the debt is significantly paid down, or a lot more equity is raised. At EBITDA of US$225m, net debt/EBITDA is still 8x, which would normally be considered very high.

Even if capex is zero (almost impossible),  interest is zero (definitely not true) and EBITDA is US$225m (not true yet) it would take Del Monte 4 years to cut the debt in half and (maybe) be allowed to pay dividends again. Because interest will consume large chunks of EBITDA, a more realistic timeline would be 6-7 years. A lot can happen in that time.

Yes, Del Monte could improve operations and increase EBITDA beyond US$225m. But it could also screw up and EBITDA could drop further to the point that the banks decide to look for a new owner. The new owner might well buy some of the debt and convert it to equity, massively diluting or even completely wiping out the previous shareholders.

Just my $0.02.

[cif5000]

I couldn't find the requirement to half the debt before dividend can be paid.

Out of the ~$1.9bn in total debt, about $1.23bn is carried on DMF balance sheet and "only" $647m by the rest of the Group. DMPL has already authorised 600m preference shares and when issued, the proceeds can be used to reduce the borrowings at this level.

Pre-KKR, DMF Consumer Products was averaging $195m of operating income annually (including the GFC period). So DMPL could be right that KKR had messed it up. Whether or not the damage was permanent will determine if the debt at DMF level is excessive. If all goes well, DMF could be streaming up $50m or more annually after interest expenses and without having to pay off the debt.

Just another view.

[thefarside]

I couldn't find the requirement to half the debt before dividend can be paid.

Banking loan covenants would require certain debt service coverage ratio from operating cash flow. It may or may not be a hard target but I suppose there would be requirements not to pay dividends, or cash sweep etc., if the company can't meet DSCR ratio over a certain period of time. To improve DSCR ratio, either EBITDA improvement or debt reduction has to take place.

Given that DMFI sits in a different vehicle of the DMPL group, if there is a bankruptcy how much would the remainder equity of DMPL still be worth given that they would have blown most of the equity of DMPL into their DMFI equity share? This is a path risk and not an insignificant one, I think.

[CityFarmer]

Pre-KKR, DMF Consumer Products was averaging $195m of operating income annually (including the GFC period). So DMPL could be right that KKR had messed it up. Whether or not the damage was permanent will determine if the debt at DMF level is excessive. If all goes well, DMF could be streaming up $50m or more annually after interest expenses and without having to pay off the debt.

Just another view.

I concur the view that, KKR has done a damage on the DMFI consumer biz. I reckon it might due to lack of focus, since KKR has more interest in pet biz. DMPL should be able to reverse it back to normal, if not better, IMO.

But the debt is certain that it has to be paid back eventually, and the future interest rate is almost certain in an up trend. The rest are uncertainties.

(not vested)