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Total Produce (TOT:ID, TOT:LN) was one of my very first blog write-ups, back in Nov-2011 at EUR 0.39. [And I’ve written about it a number of times since]. Less than two years later, we’ve enjoyed a nice double on the stock – which is now trading within spitting distance of my original EUR 0.882 fair value target. This warrants a fresh perspective… But looking back, now I remember – even then, I offered up a very specific perspective:

So we’re talking a business that really runs itself, just what I like! Particularly as I don’t have great respect for management (except if you compare them say to Greencore Group (GNC:ID) management – whose shareholders may finally be put out of their misery with a potential bid, rumoured to be coming from Dubilier Clayton & Rice). Carl McCann is Chairman, while his brother David’s in the Chairman seat over at TOT’s ‘sister’ company Fyffes (FFY:ID), and neither is really a patch on their father Neil McCann (I was sad to hear he passed away recently) who joined Fyffes in 1948. I think of the crazy worldoffruit.com online effort in the v late 90s (which ‘…received a very positive reaction from within the produce industry and looks set to dramatically change the way in which fresh fruit and vegetables are traded across the globe…’), the lack of earnings growth in the past few years, the ludicrous de-merger of Fyffes, Total Produce & Blackrock (now Balmoral Int’l Land Holdings, whose shares subsequently collapsed & are now delisted), etc.

I also look at the excessive B/S Cash of EUR 89.6 mio, and I’m bemused (and slightly alarmed) to remember a colleague telling me many years ago his impression that having large amounts of Cash on hand appeared to give management the warm and fuzzies, and they appeared to enjoy playing the banks off against each other for deposits (and perhaps even some jolly currency switching). All very well, I confess I’ve been through all that myself professionally, but always felt frustrated at having giant hoards of Cash on hand to invest – in an ideal world, I knew the best thing for shareholders and Return on Equity was to have zero Cash and just come in each day and draw down/pay down on a Debt/CP facility. With TOT, of course, the obvious answer to this Cash is frequent execution of small/medium sized acquisitions across Europe (similar to what DCC (DCC:LN) has done for years in its Energy business) – considering the nature/scope of potential business acquisitions, I think there’s a marvelous opportunity here to hoover up cos and double their operating margins v quickly through cost elimination and economies of scale.

Then of course there’s the silent but deadly fart in the room…finally figuring out it’s time to swallow their pride and reverse the Total Produce/Fyffes break-up – a nil-premium merger is the obvious way to achieve this and I imagine could easily yield 2-3 years of decent EPS growth even if the underlying business remained unchanged. But kudos to management for the 22 mio share buyback last year…! I was impressed, can you please repeat?

Wow – considering how new the blog was (and how dirt-cheap TOT was at the time), I’m astonished I was so critical of management! But I’m sure I was also conscious of how limited my audience was back then… 😉 On the other hand, these comments nicely illustrate that I’ve had an activist perspective since day one. Now, with the share price so much higher, it’s that much more important to focus on management – their strategy & their failings.

But first, we need a refresher on the company’s key financials. Total Produce de-merged from Fyffes at the end of Dec-2006, so let’s begin there:

TOT Summary

[Note: I’m also including 2006 segment results for reference. Plus TOT’s results for the Last Twelve Months (LTM), which incorporate their most recent interims – I’ll return to these a little later].

Since the de-merger, Total Produce has raised revenue by 51% in the past 6 years (albeit a significant portion of the increase came back in 2007). Adjusted EBITA’s their preferred measure of operating profitability – a cumulative 39% increase has lagged revenue, as their (fairly static) adj EBITA margin has averaged 1.83% since (versus 2.09% in 2006). Adjusted diluted EPS has clocked up the same increase, for a slow but steady 5.7% CAGR. It’s worth noting this comment from the interims: ‘Trading conditions are satisfactory and the Group is revising upwards its full year earnings target into the upper half of the range between 8.00 to 8.80 cent per share.’ With the current EPS run-rate already at EUR 8.38 cts, I think we can confidently expect at least 8.8 cts for FY 2013. That would mark two yrs of 10%+ earnings growth – which we haven’t seen since 2007.

Operationally, this paints a picture of a dull but very dependable company. Which makes perfect sense: You really can’t find a more basic business model than a large pan-European (& increasingly global) fruit & vegetable distributor, who passes along volatile price changes to customers almost on a real-time basis. But dig a little deeper – and a potentially disturbing, but not unusual, picture emerges… Let’s take a closer look at management’s capital allocation record – here’s an investment schedule for the past 6 yrs:

Total Produce Investment

[Net PPE = Acquisition of PPE/Software + Development Expenditure Capitalised – Disposal Proceeds from PPE. Acquisition Spend = Acquisition of Subs/JVs + Loans/Investments into JVs + Acquisition of Non-Controlling Interests + Deferred Consideration]

Wow, management spent over a quarter of a billion Euros on acquisitions & net capex!

So, what did shareholders get in return? Well, revenue increased by nearly a cool billion! Sounds good, ’til you realize (all other things being equal) it cost EUR 251 million (mio/m) to buy/enable/deliver EUR 950 mio of sales. Effectively, that’s a Price/Sales (P/S) ratio of 0.26 – by comparison, TOT currently trades on a 0.09 P/S (and a miniscule 0.05 P/S two years ago!). Aah, but aren’t we forgetting all the cost-savings & synergies those revenues provided? Er yes, if we could bloody well find them…an adj EBITA margin of 1.92% in 2012 is barely higher than the 1.83% long-term average. But still, adj EBITA’s up 39% since 2006, so that’s an incremental EUR 15.1 m of annual EBITA we can hope to earn from this cumulative investment. Except that’s a 6.0% annual return on investment. And slap on an interest & tax charge, the net return on investment can barely hope to reach 4.0% pa!

Now some might quibble with the impact of timing & benefits, and what to include/exclude from this exercise. OK, if we focused on a single year or two, that could throw up big differences – but 6 years leaves nowhere to hide. Anyway, how much difference would it make – the figures might even get worse!? Some might also demand a more sophisticated financial analysis – but how much extra insight would you really gain, versus relying on a calculator & the back of an envelope? The only valid adjustment that occurs to me is the exclusion of maintenance capex. We don’t have those figures – let’s use the 2007 depreciation charge (of EUR 13.7 mio) as a proxy. This reduces cumulative investment spend to EUR 169 m, but only drags net return on investment up to 5.7% pa. That doesn’t set my heart aflutter, no matter how much I play around with the numbers – how about you..?!

Meanwhile, over the same period, management only bought back a single block of shares – worth a grand total of EUR 8.6 mio – a mere 3% of their spend on capex & acquisitions!

This is bloody empire-building gone mad…

As was the ridiculous de-merger into three companies. I mean, what’s better than one empire – well, duh, it’s three empires! As was the notion an online fruit & veg portal would utterly transform the valuation of Fyffes, and even the fruit & veg market itself. [OK, maybe I’ll give ’em a free pass on this – investors were just as wild-eyed at the prospect!] As is the presence of EUR 89 mio of cash on the balance sheet, plus EUR 11 m of investment property & unlisted securities – all of which appear surplus to requirements.

Basically, everything in my original quote (above) rings true, except for my touching faith that acquisitions were the key to enhancing shareholder value. But that was before I sat down & discovered how poor management’s investment record has actually been… So it’s galling to hear TOT’s recent entry to the N American market (via a 35-65% purchase of The Oppenheimer Group (Oppy), cited as a key driver of this year’s improvement in investor sentiment. [It’s worth highlighting the implied 0.12 P/S ratio on that deal. Plus a 0.10 P/S ratio for 50% of the Frankort & Koning Group in 2011]. I’m unfortunately reminded of my bete noire, Greencore Group (GNC:LN) – the N American market’s so huge, feckless management could spend years there (& God knows how much money) just tilting at windmills…

Now, if you’re easily spooked, this may all appear quite alarming. This promiscuous use of shareholders’ cash (plus debt) to fund expansion at all costs, and regardless of return, smacks of a management team severely lacking in judgement. It’s also reminiscent of those buggy-whip companies who spend ever-increasing amounts of money trying to escape their fate by boosting sales & lowering unit costs – which usually doesn’t work out so well for shareholders.

OK, before we all start hyper-ventilating: Total Produce can trace back its roots back 125 years (via Fyffes) – so I think we can safely assume it survives another few decades. And it’s a leading distributor of fruit & veg – nobody’s invented a new way of doing that recently, nor has anybody come up with a good substitute for fresh fruit & veg (Morgan Spurlock was bloody lucky not to get scurvy!). Personally, I think there’s a silver lining here for investors – in fact, a silver bloody cloud. Not for the first (or last) time, perhaps Warren phrases it best:

‘I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.’

While management piss away money on poor capital allocation choices, the business itself just keeps humming along. And regardless of their faults – if something ever goes unexpectedly & horribly wrong, I expect management would turn off the money spigot, roll up their sleeves, restore margins & earn their way out of trouble. So that should protect your downside nicely. And there’s big upside here too, Total Produce is an activist’s dream – in fact, it might just be the perfect candidate for a private equity bid. I think regular investors often under-estimate the potential of dull & dependable companies, but private equity investors don’t: They can (relatively) safely leverage up the business, focus on expanding margins, squeeze higher cash flows out of the business, regularly extract equity capital, and sell the business when public market appetite’s at its best. They really only focus on driving organic sales growth if it offers a high probability of superior returns & economies of scale. And similarly, they only pursue consolidation opportunities if it offers tangible & immediate cost-savings & revenue synergies.

Of course, public company management can utilize a rigorous capital allocation process to implement a similar (private equity) approach. Even with very modest sales growth, a dedicated focus on margins, cash flow, and frequent & substantial returns of capital (via buybacks & tenders), will almost invariably produce superior long-term shareholder returns. Of course, this presumes management has a keen sense of intrinsic value – thereby ensuring capital’s returned in a value-enhancing (rather than a value-destroying) manner.

Now, I’m not suggesting this upside (or downside) will suddenly materialize tomorrow. Total Produce obviously has some well-respected investors on its share register, but none strike me as particularly activist – in private, let alone in public. Private equity funds, on the other hand, have tens of billions in dry powder available. But I haven’t heard a whisper of PE interest in TOT, and they may end up very distracted by a trillion dollars of distressed debt across Europe. But if we arrive at a fair valuation based on current financials, and invest accordingly, there’s potentially a significant & asymmetric risk/reward attached to such an investment. And I love owning cheap businesses/assets which have free & potentially valuable option(s) attached.

OK, so what’s that fair valuation right now?! Well, I’ll still apply a P/E & P/S valuation approach here, with some important tweaks. For Price/Sales, I’m none too comfortable accepting something like adj EBITA, unless I’m convinced it’s a decent proxy for underlying operating profit. You can evaluate this in a number of ways – I think the safest is to simply compare adj EBITA with operating free cash flow over time:

Total Produce EBITA & Op FCF

TOT basically reports net operating cash in the US manner, i.e. after tax & net interest paid. Let’s add them back to calculate adjusted (i.e. normal) net operating cash flow (Op CF), and deduct net PPE to arrive at operating free cash flow (Op FCF). I’m delighted to see operating FCF/adj EBITA remains pretty stable on a yearly basis & averages 96% over the entire period. [Again, this is exactly the kind of cash flow profile PE investors love to see..!] So a P/S valuation based on the adj EBITA margin looks entirely reasonable. However, TOT has significant non-controlling interests (NCI) in its subsidiaries – we must adjust accordingly.

There’s no ideal way to go about this – I generally haircut operating margin by the same NCI percentage as I see applied to net income. This can be volatile year-on-year, even with no change in underlying sub interest – so I also tend to apply a weighted average percentage, using the past 2-3 yrs (& weighting towards the most recent year). Here’s the result:

Total Produce EBITA exc NCI

While this reduces the effective margin for shareholders, it’s encouraging to see the underlying adj EBITA (exc. NCI) margin has been slowly & steadily increasing to 1.49%. Using my normal rule of thumb (a 10-12.5% operating margin generally corresponds with a 1.0 P/S), I’ll continue to apply a fair value 0.125 Price/Sales ratio.

[I have to admit I’m perplexed by this margin. In my experience, if I recall, basic/no-frills distributors will usually earn 1.5-3.0%, and possibly even 5%, operating margins. A mere 0.5% of incremental margin here would expand margin (& potentially the company’s value) by a third! PE funds would slaver over an opportunity like that…

The problem may actually lie in another disastrous aspect of management’s acquisition policy – the general avoidance of outright purchases (as per my examples above). Leaving substantial equity (20-30%+) in the hands of sellers might feel warm & fuzzy, but it’s no way to execute an acquisition. Even Buffett, who’s usually the warmest & fuzziest of investors & bosses, invariably purchases companies in their entirety. Because anything less than total control can quickly become a cultural, legal & tax road-block to realizing intended acquisition benefits. Anyway, there’s plenty of other ways to incentivize owners/management to stay on in a business (for an appropriate bedding-down period)].

However, I’m now firmly convinced that P/S valuation (& the company) can support the current gross debt load. Reference my summary financials table again (above):  I estimate the current run-rate for adjusted interest expense (exc. unwinding of discounts expense) is EUR 7.4 million, while adj EBITA stands at EUR 56.7 mio. This puts adj interest expense/adj EBITA at 13.1% (or 7.6 times interest coverage) – I’m comfortable with this ratio up to 12.5%-15%, particularly if it’s a stable business. [And it’s worth remembering gross debt’s only EUR 163 m – with 2012 operating CF & operating FCF at EUR 68 m & EUR 56 m respectively, any necessary debt pay-down should prove a doddle. Incidentally, TOT’s net pension deficit’s a very manageable EUR 27 m].

Obviously, this implies current cash, investment property & unlisted securities of EUR 99.7 m should be available to shareholders, free & clear – we’ll include it in our valuation. At the current share price, this would ideally fund the best acquisition management could possibly make – Total Produce itself! That is, a return of capital via share tender and/or a buyback programme – both value-enhancing & tax efficient.

That just leaves a suitable P/E ratio to determine: With 10% earnings growth in 2012, plus likely 11%+ growth for FY 2013 (barring an exceptional turn of events), I’m comfortable raising my fair value P/E ratio a notch to 11 times. At this point, and again noting management guidance, I also consider it reasonable to base my valuation on EUR 8.8 cts EPS per share. Which produces:

((EUR 3,074 million LTM Revenue * 0.125 P/S + 99.7 m Cash/Inv Property/Securities) / 329.9 m Shares + EUR 0.088 EPS * 11 P/E) / 2 = EUR 1.22 Fair Value per share (for an Upside Potential of 53%)

[Now, this may seem a colossal jump from my original EUR 0.882 price target, but that was two years ago – TOT’s financials have improved since, the earnings growth rate’s increased, and its cash pile is now surplus to requirements. And don’t forget I’ve revised my target along the way – most recently in April, to EUR 0.99. btw I was very interested to see Daniel Gladis, of Vltava Fund, present Total Produce as a single stock idea recently – he wrapped up by indicating EUR 1.10 as a (pretty similar) price target].

The price chart looks promising too:

Total Produce Chart

The EUR 0.83-0.88 price range is key life-time resistance, and the share price has been treading water just below that range for the past month & a half. A decisive break of this resistance zone opens up clear blue sky – with no remaining price anchors for investors to reference, that could imply an accelerated & more volatile share price trajectory. I now have a 5.9% portfolio holding in Total Produce.

  • Total Produce (TOT:ID):  EUR 0.795
  • Market Cap:  EUR 262.3 million
  • P/E:   9.5       (based on LTM adj dil EPS)
  • Price/Sales:  0.09       (based on LTM revenue)
  • Target Mkt Cap:   EUR 401.6 mio      
  • Tgt Fair Value:   EUR 1.22
  • Tgt P/E:   14.5       (based on LTM adj dil EPS)
  • Tgt P/S:   0.13       (based on LTM revenue)
  • Upside Potential:   53%