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Tootsie Roll (Short) TR S
July 28, 2008 - 5:25pm EST by
gearl1818
2008 2009
Price: 27.61 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,510 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT
Borrow Cost: NA

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Description

Business:

Everyone knows Tootsie Roll they have been in business since the 19th century.  Their original and still leading product has been "Tootsie Roll".  Over the years, Tootsie Roll has had a history of acquiring other confectionary brands in order to generate growth.  Traditionally the deals were strategic, allowing the company to acquire new customers along with the brands.  Recently, the pace of acquisitions has slowed due to fewer acquisition opportunities, a less proactive management, fewer synergies and cross selling opportunities from deals, and more aggressive bids from other companies.  A list of Tootsie Roll’s brands include Tootsie Roll & Pop, Charms, Junior Mints, Andes, Charleston Chew, Dubble Bubble, Dots, Cella Cherries, and Child’s Play (a package of Tootsie Roll brands).  While we do not particularly like the company’s brands (our preference is Hershey bars), we do have some guilt pangs in proposing this as a short idea as the company has sent us a huge box of their products in appreciation for our “interest” in the company.

 

Our short thesis is as follows:

  • Company is highly overvalued @ over 34X earnings & 33X  free cash flow
  • Earnings are likely to fall short of the current consensus and, in fact, decline due to pressure from rising commodity prices, competition and the general consumer environment.
  • Earnings have also been temporarily inflated by hedges and advance purchases, which can be expected to expire over the next 12 months
  • The company has had almost no organic sales growth and declining margins every year since 1999
  • Suspect corporate governance structure with possible abuses of corporate assets
  • A buyout is unlikely to happen at prices anywhere close to the current price (and the controlling shareholders have no interest in selling)

 

 

Earnings & Valuation:

Tootsie Roll Industries trades at a very high valuation using multiple metrics, (34X ttm earnings, 33X ttm FCF & 14.7X EV/EBITDA.  These multiples are sinificantly higher than the company’s peer group (see exhibit 1 below), which already trade at a premium to the market.

Exhibit 1:TR trades at a premium to it peers
  PE EV/EBITDA
HSY 19.6 9.0
KFT 18.6 11.4
WWY 33.2 17.8
Nestle 16.2 9.8
Average 23.8 12.7
TR 34.7 17.5
 

The premium valuation is all the more amazing when considering that the company’s returns have been declining for years (see exhibit 2 below).

Exhibit 2: Declining Returns & Earnings
  2002 2003 2004 2005 2006 2007
Return on Assets % 9.4% 8.8% 7.6% 7.2% 6.8% 5.5%
Return on Capital % 11.3% 10.7% 9.3% 8.8% 8.4% 6.9%
 Return on Equity % 12.8% 12.2% 11.6% 13.0% 10.6% 8.1%
EBIT Margin % 24.2% 23.5% 21.4% 19.0% 17.5% 14.2%
Gross Margin % 43.5% 43.3% 41.8% 38.8% 37.6% 33.9%

We believe that Tootsie Roll’s decreasing returns stem from 2 problems- rising commodity costs and a weakening brand that has left the company without the pricing power to pass on those commodity costs.  We believe that while the Tootsie Roll brand still has some value, it is in a steep decline.  Given the increased number of choices for candy and better marketing by competitors, a consumer today is less likely then a child 10, 20, 30, or 40 years ago to purchase Tootsie Rolls.

 
The company sums it up best from their 1Q earnings release:

Mr. Gordon said, "The sales decline in the first quarter reflects the overall

recessionary economic conditions.  First quarter 2008 results were adversely

affected by lower sales volumes and higher input costs.  These higher input

costs principally relate to major ingredients and packaging materials, freight

and distribution as a result of higher energy and fuel costs, and products

manufactured in Canada due to less favorable foreign exchange rates.”

 

The Company has taken actions and implemented programs, including selected

price increases as well as cost reduction programs, with the objective to

recover some of these higher input cost.  However, these actions have not

allowed the Company to recover all of the significant increases in input costs

in first quarter 2008.

 

The 2 main commodities that Tootsie Roll uses in its products are corn (high fructose corn syrup and dextrose) and sugar.  The other major commodity that Tootsie Roll uses is oil, for packaging and transportation.  These commodities have all been very strong for the past few years but have really spiked this year (see exhibit 3 below).

Exhibit 3: Rising Commodity prices
Yr End 2000 2001 2002 2003 2004 2005 2006 2007 7/24/2008
Corn ($/bu) 2.03 2.06 2.37 2.34 2.06 2.00 3.20 4.59 5.98
Y-Y%   1% 15% -1% -12% -3% 60% 43% 30%
World Refined Sugar 10.95 11.52 10.25 9.23 11.23 15.00 15.86 13.78 16.35
Y-Y%   5% -11% -10% 22% 34% 6% -13% 19%
Crude Oil WTI 26.72 19.96 31.21 32.51 43.36 63.05 67.43 95.24 124.23
Y-Y%   -25% 56% 4% 33% 45% 7% 41% 30%

Tootsie Roll attempts to pass on increased commodity costs in 2 ways.  Primarily, they have changed the size of their product based on the belief that customers will not notice that their tootsie roll is now 1 7/8 inches instead of 2.  We would point to Tootsie Roll’s stagnant sales as evidence that customers are noticing this game.  Tootsie Roll also attempts to recover costs through selective price increases, although they acknowledge that they have a tough time doing this and are often unable to pass on all the cost increases, as retailers have threatened not to stock their product at times.  We note that Wal-Mart is 22.4% of sales (down from 24% in 2005) and are notoriously tough on attempts to increase pricing. 

 
Accordingly, we believe that 2008 will be a very tough year for Tootsie Roll, as the rise in commodity prices has accelerated.  We believe that the estimates in our model beloe are reasonable.  The only assumption we have made is a 2.8% decrease in gross margin for 2008, which is in line with the historical trend of the last few years, especially given the inflationary pressure of the last few years.  We estimate 2008 EPS of $0.72 (see exhibit 4 below), which is well below the current consensus (is only one analyst) of $0.82.  Given the spike in commodity prices over the past year, earnings could be a lot worse.

 

Exhibit 4: TR Income & Cash Flows Models
               
2005 2006 YoY% 2007 YoY% 2008e YoY%
  Total Revenue                 491.1               501.1 2.04%              497.7 -0.68%          492.7 -1.00%
Cost Of Goods Sold                 300.4               312.6 4.06%              329.0 5.25%          339.5 3.19%
  Gross Profit                 190.7               188.6 -1.10%              168.7 -10.55%          153.2 -9.17%
Gross margin 38.83% 37.64%   33.90%   31.10%  
Selling General & Admin Exp.                   97.6               101.0 3.48%                97.8 -3.17%            98.8 1.00%
  Operating Income                   93.1                 87.5 -6.02%                70.9 -18.97%            54.5 -23.19%
  Net Interest Inc.                     1.1                   4.4                    5.0                3.5  
Other Income                     1.9                   1.9                    1.0                1.1  
  EBT                    96.1                 93.7 -2.50%                76.8 -18.04%            59.1 -23.10%
Income Tax Expense                   36.4                 28.8                  25.5              19.5  
  Net Income                   77.2                 65.9 -14.64%                51.6 -21.70%            39.5 -23.43%
Diluted EPS  $1.32  $1.15    $0.91    $0.72  
Weighted Avg. Diluted Shares Out.                   58.4                 57.5                  56.6              54.6  
               
Supplemental Items              
EBITDA                 109.7               105.2 -4.10%                87.7 -16.63%            71.4 -18.63%
Effective Tax Rate % 32.0% 30.4%   33.1%                0.3  
               
Cash Flow
  2005 2006 YoY% 2007 YoY% 2008e YoY%
Net Income                   77.2                 65.9                  51.6              39.5  
Depreciation                   14.7                 15.8 7.48%                15.8 0.00%            15.8 0.00%
Capex               (14.7)              (39.2)  166.67%             (14.8)  -62.24%         (14.9)  0.68%
Free cash Flow                   77.2                 42.5 -44.95%                52.6 23.76%            40.4 -23.17%
FCF per share  $1.32  $0.74 -44.09%  $0.93 25.73%  $0.74 -20.36%
 
To make matters worse, the company has been inflating its results through hedging.  Tootsie Roll has had hedging and advanced purchases equal to approximately 20% of their COGS for 2008. If you assume that Tootsie Roll reaped just a 10% savings (low given their commodities were up as much as 43% in 2007) on these hedges, then earnings would have been inflated by 10% ($0.09, see exhibit 5 below) in 2007.  Tootsie Roll gives absolutely no transparency on the profitability of these hedges; it just flows straight through the income statement.  We expect continued hedging gains in 2008.  Eventually, the company’s hedges will expire and, unless commodities drop significantly, the company’s earnings will suffer a meaningful decline.
 
Exhibit 5: Income Adjusted for Hedges
Hedging Adjustments
2006  
Commodity hedges 8,353
Purchase obligations 64,870
Total 73,223
Assumed % price increases avoided in 2007 10%
Dollar amount 7,322
   
Adjusted Income Statement 2007
  Total Revenue          497.7
Cost Of Goods Sold          329.0
Estimated reversal of hedges              7.3
  Gross Profit          161.4
Gross margin 32.42%
Selling General & Admin Exp.            97.8
  Operating Income            63.6
  Net Interest Inc.              5.0
Other Income              1.0
  EBT             69.6
Income Tax Expense            23.0
  Net Income            46.5
Diluted EPS (as adjusted to reverse hedges)  $0.82
Weighted Avg. Diluted Shares Out.            56.6
   
Supplemental Items  
EBITDA       8,417.6
Effective Tax Rate % 33.1%
 
Based on its operating reults and prospects Tootsie Roll should trade at $15 per share-- this represents roughly 21X our 2008 EPS estimate or 20X our FCF estimate for 2008.  However, we would note that we probably would have tough time valuing Tootsie Roll at more than $10 a share which would imply a valuation of a 14 PE and13.5X FCF.  Even if Tootsie Roll can maintain their premium multiple the stock will just decline as earnings stagnate or fall.

 

Corporate Governance:

Tootsie Roll is a family-run business. Melvin Gordon is 88 years old and is still Chairman & CEO, and his wife Ellen Gordon (76 years old) is President & COO.  People who have knowledge of the company believe that Ellen is now running the show.  It is pretty clear that for most people 88 is quite an advanced to be a CEO of a company.  Additionally, nobody on the board is younger than 66.  Not only do the Gordons own over 40% of the shares, but their shares also have super voting rights, giving them absolute control over the company.  The Gordons have free access to a private plane, a company apartment and over $8 million in combined compensation.  These are all clearly red flags.  See exhibit 6 below—It is hard to argue that their compensation is tied to generating strong operating results.

Exhibit 6: Gordons get Paid Regardless of Results
  2007 2006 2005 2004 2003
Total Compensation of the Gordons 8.509 10.4 8.627 8.308 8.392
Gordons comp as a % of EBIT 12.0% 11.9% 9.3% 9.2% 9.1%
Gordon's private jet expense 1.01 1.01 0.62 0.62 0.51

The company maintains a lack of transparency to investors.  They do not hold any conference calls and do not meet with investors.  The total length of their annual report is only 28 pages, and their 10-k is actually shorter.  Only 1 firm covers Tootsie Roll, and that is an independent research company.  The company has no debt, yet still holds close to $100 million in cash and short-term investments.  Companies with these type of corporate governance issues tend to trade at fairly deep discounts to their peers they rarely trade at premiums as is the case here.

 

Buyout is unlikely to come anytime soon:

It seems likely that most holders of Tootsie Roll stock are hoping for a buyout.  While the Gordons are old, it is doubtful that they are going to agree to sell the company (they have blocking rights and seemingly want to keep the company under their control), and in the meantime, the value of Tootsie Roll will likely decline.  While there are currently no other Gordon family members working for the company in critical executive positions, we were told by Ellen Gordon that some have expressed interest in taking over the company if the opportunity were to arise. 

 
We believe that Tootsie Roll is unlikely to garner much of a premium in a takeover.  Tootsie Roll already operates at close to industry leading margins (see exhibit 7 below).  Other than the Gordon's compensation, Tootsie Roll runs a fairly lean operation (see exhibit 8 below); maybe the only costs to take out is the Gordons themselves which could save over $8 million pretax. 
 
Exhibit 7: TR's operating margins are inline with the industry
  Operating Margins
HSY 16.4%
KFT 12.8%
Nestle 14.0%
WWY 18.4%
Average 15.4%
TR 13.8%
   
   
Exhibit 8: Not much fat to trim
  SG&A as a Percentage of 2007 sales
HSY 18.1%
Nestle 42.4%
WWY 34.8%
Average 31.8%
TR 19.7%
 

Bulls would point out that a strategic acquirer could still eliminate a lot of costs and would point to the earnings potential after doing so (See Exhibit 9 below).   According to our analysis, an acquirer could possibly purchase Tootsie Roll at today’s stock price if they cut at least two thirds of SG&A.  This is extremely unlikely given the frugalness of the company.

Exhibit 9: 2008 Estimated Earnings Adjusted for Potential SG&A Savings
SG&A Savings 0% 25% 50% 75% 100%
  Total Revenue         492.7          492.7          492.7          492.7          492.7
Cost Of Goods Sold 339.5 339.5 339.5 339.5 339.5
  Gross Profit         153.2          153.2          153.2          153.2          153.2
Gross margin 31.10% 31.10% 31.10% 31.10% 31.10%
Selling General & Admin Exp.           98.8            74.1            49.4            24.7                -  
  Operating Income           54.5            79.2          103.8          128.5          153.2
  Net Interest Inc.             3.5              3.5              3.5              3.5              3.5
Other Income             1.1              1.1              1.1              1.1              1.1
  EBT            59.1            83.8          108.4          133.1          157.8
Income Tax Expense           19.5            27.7            35.9            44.1            52.2
  Net Income           39.5            56.0            72.6            89.1          105.6
Diluted EPS (Adjusted for SG&A Savings)  $0.72  $1.03  $1.33  $1.63  $1.93
Weighted Avg. Diluted Shares Out.           54.6            54.6            54.6            54.6            54.6

We would also point out that from our conversations with analysts and the company that the larger companies that could possibly acquire Tootsie Roll (Cadbury, Hershey, Mars-Wrigley & Nestle) are only interested in large brands.  Since Tootsie Roll is primarily comprised of smaller brands, if a deal were to take place, it is likely that the acquirer would divest smaller brands that make up a large part of Tootsie Roll’s revenues and profits, which would defeat the purpose of buying the company.  Due to the company's high valuation, private equity is also unlikely to make a large bid.  We believe that in the event of a takeover, Tootsie Roll is unlikely to get much, if any, premium to today’s valuation.

Risks:

Commodity prices could shoot back down, helping Tootsie Roll’s earnings.  While we see it as unlikely, a buyout or takeover remains a possibility.  Short interest is close to 20% of float so any positive change could cause an exaggerated move in the stock.

Catalyst

We believe that earnings will be a downward catalyst for the stock. 3Q earnings should be out by late October or early November. We think that earnings will continue to decline.
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