Caveat Emptor

First a few notes about my MFI portfolio. Then a long and boring discussion about the importance of doing due diligence. Caveat Emptor.

Pretty much a flat day for my portfolio. Can't complain, can't get excited. The amazing stock the past two days has been PNCL. It went up 10% yesterday as I noted. Today up another 5.5% to finish at $6.64. I am almost back to break-even ($6.68).

The funny story was True Relgion Jeans (TRLG). They announced today that they hired a "Visionary" (Denim and Lifestyle Apparel Design Visionary to Join Creative Team at True Religion)... gotta love it! I just picture their home office with incense and beaded doorways with people meditating.

Warning, Warning! Discussion about doing research below. Jim Cramer fans should abort!

I know it is my MFI diary, but lessons from my Non MFI side keeping creeping in. Heck it is hard to write everyday about just MFI! I wanted to bring full circle to my comments about PFACP yesterday. I had bought this stock entirely because Thomas Ko in the MSN Strategy Lab had laid out a nice case for it. It was exactly what I wanted in a difficult market:

1. Food stock
2. Dividend
3. Undervalued

At least that was what I read from him. I do not blame Mr. Ko, everyone has to take ownership of their investment decisions. I should have done more research before buying. I did that research yesterday after deciding that his CHCI recommendation was a poor one and that he does not necessarily have a golden touch. I show the results of my research, not to embarrass myself or Mr Ko, but rather to remind people (myself included) to do their own homework.

The two big points he gave for buying the stock were (1) while they announced the termination of their 43 cent quarterly dividend, they were likely to commence it again in 2007 and (2) they own 40% of Birds Eye Foods which of itself has an enterprise value of $1b.

Both very promising for a company worth just $20m and trading at $6.00 a share (and seemingly too good to be true). Now I read the 10Q yesterday for both PFACP and for Birds Eye (a privately held corp). Here is what I found and my understanding (disclaimer: I could be wrong).

PFACP is basically a holding company. They generate very little revenue (so far as I could tell) on their own. Their primary holding is 40% of the common shares of Birds Eye Foods. Here is their history.

They basically got too leveraged when they bought Dean Foods Vegetable Company in 1998. So they had to find new equity. They made a deal in 2002 with Vestar Capital. As part of that deal, Pro-Fac got $10m a year for 5 years (the source of revenue for the dividends that is ending) and the 40% stake in common equity of Birds Eye. Vestar got 55% common equity of Birds Eye plus (and this is the important part) 100% of the preferred stock (paying 15% compounded dividends) in Birds Eye. For that, Vestar paid 175m plus the 5 $10m payments.

Now let us see where Mr Ko was wrong (IMHO).
He stated that the enterprise value of Birds Eye was about $1b. I looked at Birds Eye Financials at the net worth was about $275m. Maybe in the market, these firms trade at 4x book, but I don't see where the $1b comes from.

He stated that PFACP has 40% of Birds Eye. That isn't really true. They have 40% of the common equity. In the 10Q, the value of the preferred is $244m. Maybe I am really, really wrong, but I don't see where PFACP has any part of that $244m. In Finance 101, I remember that preferred stockholders come before common stockholders (thus the name). So the $275m of total equity is reduced by $244m (which BTW is growing at 15% compounded quarterly) leaving roughly $30m for the common guys. PFACP has 40% of the $30m = a whopping $12m and shrinking fast unless Birds Eye can grow faster than the 15% preferred dividend rate (not happening).

Point #2 - resumption of the dividend. Here is what the 10Q says: "Holdings LCC will use commercially reasonable efforts to cause Birds Eye foods to make annual distributions to Holdings LLC, which can in turn be used by Holdings LLC to fund distributions to its common unit holders, including Pro-Fac. Many factors could affect whether such distributions are made in the future and the current financing arrangements of Birds Eye Foods with its senior lenders includes a covenant which precludes such distributions without the permission of the senior lenders."

To put that into English, I read that Birds Eye Foods can only pay distributions to their common shareholders (PFACP) with the permission of the bankers. Well, I can tell you that the bankers will absolutely not allow those payments to be made if in any way it impairs Birds Eye from paying the money owed to the bankers. So the question is whether Birds Eye is awash in cash?

I gotta tell you, if they are awash in cash they are sure hiding it well on their financial statements. In the 9 months ending March 2006 Birds Eye made $11.5m. That is an annualized rate of $14.7m (granted it was higher, about $25.5m in 2005). Now going forward that would be almost $25m as they don't have the $10m distribution any more. Out of the $25m, they have to pay the preferred dividends to Vestar, which by my math will be $39m. Basically, as I see it, PFACP has no income stream. I think they made a five year deal in 2002 out of necessity (bankruptcy may have been the other option) and now they will have to pay the piper. I have to admit that I am not sure where all the money goes... I can't believe that Birds Eye could have +$900m in sales annually and only have $25m left at the end in profits. I hope I wrong, though I will be a disinterested bystander. (disclosure: I now own 0 shares, though I missed an upswing today).

Do Due Diligence!