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Saputo: Morningstar Deal May Curb International Growth

 December 04, 2012 01:13 PM

(By Mani) Saputo, Inc. (TSE: SAP) $1.45 billion deal to buy the Morningstar Unit of Dean Foods Co. (NYSE: DF) diversifies Saputo's U.S.-based manufacturing, but falls short of improving its ability to achieve international growth.

Morningstar manufacturers and distributes a variety of traditional and specialty dairy products including coffee creamers, ice cream mixes, traditional and value - added milks and cultured products such as sour cream and cottage cheese. Revenues are split 64 percent foodservice and 36 percent retail, so there is likely significant overlap with Saputo's existing customers in those channels.

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"Though volume growth has been solid, we see limited prospects for vast improvements in operating efficiency and margins," CIBC analyst Mark Petrie said in a client note.

The acquisition of Morningstar is somewhat of a departure from Saputo's typical pattern of taking on underperforming cheese manufacturing assets and bringing profitability up to more typical Saputo-levels.

Indeed, this purchase is more about product diversification and gradual volume growth than margin expansion or byproduct processing.

"Under a scenario where Canada's supply management system is unwound, this transaction actually begins to look somewhat defensive," the analyst said.

Perhaps, most importantly, this deal gives Saputo a strong platform to defend its Canadian earnings and exports from the U.S. in the event Canada loosens supply management. Morningstar currently operates 11 manufacturing facilities domestically and has one of the most extensive manufacturing networks for dairy products in the United States.

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Morningstar has trailing annual revenues of C$1.6 billion and trailing annual EBITDA of about C$153 million, which would imply a purchase multiple of about 9.4 times Morningstar's trailing annual EBITDA.

However, Saputo has indicated it will receive substantial tax benefits related to the accounting treatment of the purchase as an asset transaction, a treatment that allows the company to deduct substantial additional tax depreciation and goodwill.

Saputo has indicated that the net purchase price represents 7.9x Morningstar's trailing EBITDA after deducting the present value of this tax benefit from the purchase price, .

"We would characterize the price as fair, but given the limited prospects for vast improvements in operating efficiency and margins, we do not see this as being in the mold of the Alto or Land O'Lakes deals in terms of value creation," said Petrie who expects synergies of $5 million to $10 million over the next 12-18 months.

Morningstar has shown strong results over the last year as pricing and margins have spiked with lower input costs, and volumes have posted strong gains largely driven by successful product innovation. The company has also undergone a large cost-cutting and efficiency exercise, which has supported gross margins and held operating expenses flat.

In its most recent quarter, Morningstar posted 54 percent growth in operating income despite 3 percent decline in net sales. Morningstar's margins are likely to swing with milk, cream, and butterfat pricing. 

"While we do not believe current levels represent the peak in terms of Morningstar margins, it is possible that much of the upside has been captured," Petrie noted.

While Morningstar has been able to seize attractive growth opportunities in some new high-margin categories, the industry is one of modest organic demand growth. However, this acquisition brings significant diversity to Saputo's U.S.-based manufacturing, increasing exposure to foodservice, and with a product platform that more closely mirrors its Canadian business (save fluid milk).

Saputo remains a best-in-class operator, with healthy cash flows, a strong track-record of intelligent capital allocation and a balance sheet that affords flexibility. Unfortunately, the industry itself has little organic growth and volumes are generally trending on either side of flat. The exception to this is the international market, specifically Asia and Latin America, where demand for dairy products continues to grow.

"This transaction clearly falls short of Saputo's goal to build a platform that can take advantage of the growth in international demand for dairy products," the analyst wrote.

However, if Canada's regulatory environment changed and borders opened up, this would give Saputo a strong platform to bring product from the U.S. into Canada.

"Though the Morningstar deal is immediately accretive and gives SAP a more efficient capital structure, it also consumes some of its powder for a deal that does improve Saputo's positioning against these global growth opportunities," Petrie added.



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