You have probably heard ad nauseam about how the low interest rates of the past nine years have caused many investments roughly classified as dividend growth stocks to become overvalued because they have served as substitute investments in place of bonds. My corollary is that the balance sheets of most large businesses are under-scrutinized right now. Cash-rich balance sheets aren’t leading to premium valuations, and excessive debt doesn’t seem to impose a penalty right now.
I had this in mind when I studied the balance sheet of Post Holdings (POST), an acquisition-hungry St. Louis company that owns some familiar brands, including: Power Bar, Shredded Wheat, Fruity Pebbles, Raisin Bran, Grape Nuts, and Honey Bunches of Oats. These brands aren’t strong enough to demonstrate industry-leading pricing power, but they are strong enough to raise prices by a bit more than inflation costs each year. If Post Holdings had a strong balance sheet and traded around 15x earnings, I’d cover it regularly on the site as a “Top 50” investment.
But it does neither.
Post Holdings is always on the hunt for acquisitions, and uses debt rather than equity issuance to fund recent mergers such as MOM Brands and Willamette Egg Farms.
As a result, Post Holdings has $4.5 billion in debt against post-integration profits of around $220 million. That is insane. That is a leverage ratio of $22 in debt for every $1 in profit that the company earns. Even the guys at 3G would say, “Damn, that’s a lot of debt.”
The upside is that Post Holdings sees earnings per share climb when it makes acquisitions, and it does have $1 billion in cash right now. And the financing is extremely long-term, with no meaningful amount of the debt coming due until 2022. The strategy is to ramp up profits to make the debt burden tenable between now and then.
I see two problems with this likelihood.
First, the cereal brands only grow earnings at around 4-6% annually, exclusive of acquisitions. It would surprise me if the current offerings at Post generated more than $330 million in annual profits by 2022. That is still a 10:1 net leverage to net profits ratio as the end game. It will have to spend some of its $1 billion cash hoard on other acquisitions to get the profits up, but by the same taken, that would further weaken the balance sheet strength.
But what really gets me is that the valuation is showing no effects of this high debt load. It is trading at a price of $76 per share compared to about $2.50 per share in current profits. That is over 30x earnings for a leveraged-to-the-gills, mid single-digit growth business. I don’t get it.
The only justification that I can think of is that the investor community is expecting an entity like Kraft-Heinz, General Mills, Kellogg, or Nestle to step in and acquire Post Holdings. Maybe that will happen, but I don’t understand making an investment where the sole appeal is that someone else will come along and save you from your folly. Who wants to define success as reliance on a greater fool? If one doesn’t come along, you will find yourself holding a stock at $76 that ought to be trading in the $70s somewhere in the 2020s.
There is a reason why Post Holdings doesn’t pay a dividend. It can’t afford to part with half of its profits like its peers do. If the cheap credit ceases, it may have to start redirecting profits to pay down debt in the event that refinancings become necessary.
Post Holdings is always leveraged maximally, and when that debt burden starts costing 5-6% instead of 2-3%, the shareholders are going to suffer. Especially at this starting valuation. That’s the point of leverage. It magnifies both the upside and the downside. Perhaps the shareholders may be saved by future merger activity, but the current high valuation would be undeserved if the balance sheet were strong, and it is especially hazardous when you compare the billions in debt to the low hundreds of millions in profit.