Credit Suisse is lowering their rating on Ralcorp (NYSE:RAH):
We are downgrading Ralcorp from Outperform to Neutral and lowering our FY 10 EPS forecast from $5.10 to $4.75. We have reduced our target price from $75/share to $64/share based on a P/E multiple of 12.5x against our FY 11 EPS forecast. Our view that the company was well-positioned to benefit from private label share gains and from earnings accretion from the acquired Post cereal business has not played out particularly well.
We believe the company will need to make a significant investment in promotional spending on Post to regain the market share it lost this year to aggressive competitors. Over the past 12 weeks, Post's market share is now at 11.2%, down 260 bps compared to a year ago. To make matters more challenging, we find that the growth rate of private label food in general is slowing as the economic shock that drove consumer trial has now faded.
We expect downward earnings revisions heading into the 4Q earnings release on November 10 as analysts recognize the high sensitivity of RAH’s EPS to Post’s operating margin. Every 100 basis points of margin erosion in represents $0.13/share to RAH. If FY 10 is truly going to be a reinvestment year for Post, then our Post operating margin estimate of 21% (down 100 bps) in FY 10 may be too high.
With the stock trading at such a big valuation discount, it certainly feels like we are getting off this stock too early. Indeed, if we put a hefty valuation on the private label business akin to TreeHouse’s (8.8x EBITDA), then the market is valuing the Post business at only 4.4x EBITDA. However, we can’t justify supporting an Outperform rating until we get more comfort that management has accurately diagnosed the problems that Post is facing and has developed a compelling strategy for solving them. So far, we have not heard or seen enough proof.
Firm is also removing stock the U.S. Focus List.
Action: Somewhat mixed feelings on this one. There are some good arguments supporting a rather hefty sell-off today and in the coming days:
- Credit Suisse FY10 EPS est is going from Street high to Street low. How often do you see this kind of change in view? Once a year? At the moment I cannot recall anything else like that.
- Comments regarding promotional activity and margins do not sound good at all. It is a typical case of margin vs market share and co hasn't performed that well in that area recently.
- Removal from Focus List should add shares that need to be sold.
However, the stock is not too expensive, which might limit the downside. Also, the stock has been rather weak since mid-September and stocks have had a tendency to shed off anything negative recently.
I would expect to see around 2 points of downside today, maybe even more. The stock will probably gap down a point or so, leaving another point for early shorts.