Dole Foods: A Fruity One

Dole Foods (NYSE: DOLE) recently announced it was undertaking a strategic review of its businesses with a view to a “spin-off or other capital markets transaction”. Speculation has focused on the possibilities of a spin-off of the packaged foods business, the jewel in Dole’s crown. Unfortunately, this is as much a sign of weakness as strength, Dole is struggling with a massive amount of debt and so this spin-off is a sign that the company is getting desperate. If we are to determine how this is going to play out for investors we should ask three questions:

1. How strong is the underlying business? Can it pull through without the spin-off?

2. What kind of value will the packaged business realistically achieve?

Underlying Business

Dole IPO’ed in 2009 to pay down debt, unfortunately the main facet of this business is that it is still struggling with this load. Dole appears to have achieved some significant operating gains over the past eight years or so. Asset turns appear tohave improved significantly although this has slowed down over the past four years. However, if we look more closely it seems that most of the gain is due to writing down PPE and selling off assets, any sales have often been at losses too. Unfortunately, it is difficult to isolate these writedowns but it is clear that the only ‘true’ operating gains were in the use of accounts receivable. The story with Dole is a company that appears to have made some bad investments in the past and has dramatically limited its options by taking on a lot of debt.

Dole’s debt position is quite complicated as well. In terms of  normal secured/unsecured debt and capital lease obligations there was roughly $1.65bn as of the last quarter. The expense on this debt was quite large, net interest expense was roughly 8% of the balance. The average return on net operating assets over the past five years was only 30bps above this. Clearly, the company is walking a tightrope with little left over for equity.

On top of this debt the company has large rental obligations, a pension fund deficit of some $250m, a fair value loss of some $194m on foreign exchange derivatives, and has guaranteed some $165m of subsidiaries obligations to suppliers. To top it all, the company has a range of legal liabilities that the company has not taken any reserves against. This is not to say that it will have to put the sheer volume of legal issues is worrying, the EU anti-trust and Nicaragua case in particular.

Is there anything left for equity? To simplify, we should ignore all the complicated liabilities and just focus on operations. What are the core sustainable returns being produced? If we expect the core return on capital to be around 8%, conservative historically, we would expect, with a 10% discount rate, the company to be worth around $2.44bn (explanation below). Great, this is above debt and capital lease obligations and subtracting these obligations from the total value of the company equity should be worth $9.16/share, not that far off the current price.

((Core return on net operating assets/0.10)*Net operating assets)

However, we should bear in mind three points. First, although the company has managed working capital well some $195m in cash was drained last year due to changes in working capital. Secondly, the company is, at some point, going to have to deal with its derivatives book and will probablly recognize more writedowns in long-term assets. Thirdly, and most importantly, this return is not above the cost of debt. The company may muddle through without making any big spin-off but with large amounts of debt coming due in 2013 and 2014 it will definitely struggle without a big improvement in operating margins.

Packaged Spin-off

Dole provides a great deal of disclosure about all of its divisions so we can get a clear picture of what a spin-off might mean. Below we have all the relevant statistics:

 

EBIT MARGINS 2011 2010 2009
Fresh Fruit 3.83% 3.02% 7.30%
Fresh Vegetables 4.25% 3.34% 2.28%
Packaged Foods 7.55% 8.40% 11.33%
TOTAL ASSET TURNS
Fresh Fruit 2.36 2.22 2.20
Fresh Vegetables 2.05 2.49 2.48
Packaged Foods 1.61 1.65 1.61
ROA
Fresh Fruit 9.0% 6.7% 16.0%
Fresh Vegetables 8.7% 8.3% 5.7%
Packaged Foods 12.2% 13.9% 18.3%

 

I would highlight two things: one, packaged foods is clearly a good business and two, it appears to be significantly less volatile than the other two divisions. If we apply the same logic to valuation as we used before, the average ROA is 14.8%, applying a 1.48x multiple to total assets (i.e a 10% discount rate) we get a value of $1.1bn. In other words, if someone paid $1.1bn cash for Dole packaged foods they would get, given historicals, a roughly 10% return, before tax, going forward (EV/EBITDA would be 9.21x). $1.1bn is roughly $12.65/share against a current enterprise value of  $33.81/share or 37% of enterprise value.

However, the assumptions going into this valuation are pretty conservative. A 10% discount rate is conservative and it is unlikely, if the division is bought as a whole, that it will be an all-cash deal. I would say that $1.6bn wouldn’t be out of the question, which at the bottom end is 54% of current enterprise value. It is also worth highlighting that my assumption of enterprise value is aggressive taking into account the total pension deficit and derivatives losses.

The spin-off would leave the company with fresh fruit and vegetables. Neither of these are as attractive as packaged foods but they are pretty decent. D&A in the fresh fruit division looks overstated (it is largely here where the company has been writing stuff off) so using capex instead these two divisions combined have produced on average $260m of cash/EBIT over the past three years. Again, if we make a massive simplification and forget about the horrible liabilities there is no reason these two divisions couldn’t be worth $1.5bn or $17.27/share. If the company manages its financial position properly it could be worth substantially more.

Putting this together, the current enterprise value of Dole is $34.44 and the sum-of-the parts may be worth as much as $35.69 ($1.6bn for packaged foods and $1.5bn for the rest). Subtracting debt of $1.65bn and the equity is worth $15.45, 56% upside from the current price of roughly $9.90. Of course, it isn’t quite that simple. The lawsuits, the derivatives, the leases, and the pension fund should make any investor nervous. What is more the company operates in a commodity business, Dole is a price taker. Margins are not at cyclical highs, there are nearer the lows, but we do not have enough historical data to see clearly. The company probably has more to write-off in fresh fruit and has a fairly incestous relationship with largest shareholder, David Murdock.

There is clear upside to a spin-off and it is really the last thing the company can do to save itself. On that basis, I think it is pretty likely that something to the effect of a spin-off will happen. The company will probablly manage to spin-off some debt as well and it should solve the main issues the company is facing. However, the fact is that there is still a lot of open-ended liabilities that won’t be spun-off. It is these could still overwhelm the remainder of the company and threaten the future.

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