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Jason Young

SLE AT A GLANCE

P/E ► 25.2 AVG EV/EBITDA ► 10.0 AVG ROA ► 5.6% AVG ROE ► 15.9% AVG Debt to Equity ► 2.96 AVG Current Ratio ► 1.53 AVG Interest Coverage Ratio ► 4.50 AVG

 

 

 

 

 

 

Sara Lee (NYSE: SLE) is a leading retailer of packaged meats and baked goods both domestically and internationally. The company whose brands include Ball Park, Sara Lee and Hillshire Farm, has suffered poor operating performance over the last decade. In an effort to improve margins, the management implemented a transformational plan that resulted in the divestiture of several businesses, including, its apparel business, representing 40% of its sales. The operating plan should result in substantial cost savings and while allowing Sara Lee to make critical investments in research and development for its core businesses. There are some doubts as to the probability of success given that the company has already failed to deliver upon key revenue and profitability goals post restructuring.

While operating margins are expected to improve for the packaged foods industry as a whole, due to lower commodity prices, Sara Lee remains more vulnerable to any potential upswings in prices than its competitors. Moreover as a significant but non-dominant player in many of its markets, Sara Lee lacks the pricing power of some its competitors. Its competitive advantage remains unclear.

Products and Customers

2006 Revenue breakdown by business segment excl. branded apparel

Sara Lee's businesses can be broken down into 4 major categories:

• North American Retail Food and Beverage - Meats (sausage, lunch meet, pork, etc.) and fresh and frozen baked goods
• Food Service - Meat goods, beverages and bakery products
• International Beverage - Coffees and teas
• International Bakery - Fresh and frozen baked goods
• Household and Body Care - Insecticides, Air fresheners, shoe care products and body care products (based primarily in Europe)

Customers

Sara Lee's Food services are marketed to hospitals, restaurants and entities that serve food. Sara Lee's other businesses market their products to supermarkets and other retailers. Wal-Mart Stores (WMT) which is responsible for 15% of the company's sales is Sara Lee's largest customer. No other customer is responsible for more than 10% of the company's sales.

Reorganization

In the packaged goods industry a company's ability to increase it sales are driven by population growth and product innovation. Given that Sara Lee's businesses are based primarily in North America and Europe regions, of the world with relatively modest population growth, the company is placing a strong emphasis on product innovation.

In an effort to refocus on its core businesses and better position itself for long term growth through product innovation, Sara Lee underwent a major reorganization of its businesses in 2006. Under this reorganization SLE spun off its branded apparel Americas/Asia businesses into a public company called "HanesBrands, Inc." Sara Lee also sold several other businesses including its European Meat, US Retail Coffee and European Nuts and Snacks businesses. Collectively, these businesses represented approximately 40% of SLE's sales. The company will also streamline its operations through consolidation of key processes. The company plans to utilize the cash generated from the divestitures and consolidation to fund extra research and development. The company has also committed to increase spending on marketing, a function on which Sara Lee has traditionally spent significantly less than its competitors.

Trends and Forces

Commodity Prices

Sara Lee's businesses depend on a wide range of raw inputs ranging from corn to hogs. The prices for these inputs are subject to volatility and can be affected by a number of factors including demand, governmental agricultural programs and weather. A drought could for instance reduce the quantity of green coffee beans available, increasing green bean prices. Oil Prices are another major input which can affect both packaging and deliver costs; SLE delivers baked goods directly through customers.

Although Sara Lee hedges commodity prices, this hedging is relatively minor and does not fully shield the company from volatility. Commodity prices have mostly fallen over the last 25 years but from 2002-2005 the packaged food industry saw dramatic increases in commodity prices resulting in a nearly 80 basis point drop in profit margins. Government programs can also affect commodity prices as certain commodities benefit from government subsidies which are subject to change. Any increase in cost resulting from lower subsidies may be passed on to companies like Sara Lee.

Rising Wheat Prices

In September 2007, wheat futures more than doubled compared to the previous year, from $3.95 per barrel to nearly $9. The company had financial instruments to hedge against rising prices for wheat, an important input for its baked goods, but market prices rose above the $8.50 ceiling for those hedges.

Limited Pricing Flexibility

Because Sara Lee operates in highly competitive markets, the company has very limited pricing flexibility. While it may be able to pass on higher commodity costs to its customers, in many cases its ability to do so is limited, as any increase in price may result in lower sales volume and or defection of customers to competitors.

Health Scares

Sara Lee and its competitors are subject to health concerns related to their products. This is particularly true of its meat businesses. Over the last several years there has been increasing media attention on mad cow disease. Any future outbreaks have the potential to negatively impact the sales volume and profitability of its beef sales. Health concerns also have the potential to spark increased government regulations. Any substantial change in regulations can increase the cost of compliance and reduce operating profitability.

Health and Wellness Trends

Consumption of Healthy Food by Age Group

This trend is being driven in part by baby boomers. As seen in the following graph 30% of Americans in the 50+ age range consume healthier foods as opposed to 19% for those 19-34. As the former population ages and it experiences more health problems, eating healthier becomes a top priority.

Competitors

Sara Lee is a significant but non-dominant player in many of its markets. As such it is at a distinct disadvantage when compared to some of its competitors, many of whom are concentrated in a single market. McCormick for instance holds over 50% of the US market for spices giving it significantly greater purchasing power than Sara Lee. In this case McCormick would be able to negotiate better prices with its suppliers given that it orders greater quantities. Sara Lee also operates in markets that are relatively fragmented - no dominant player exists. Within these markets Sara Lee is often neck and neck with its competitors with no appreciable advantages in terms of scale.

As seen from the chart below, Sara Lee is trailing its competitors in terms of pre-tax margin. While the company has divested several non-core and non-performing business it will still be some time before it is clear whether this will be enough to close the gap. Sara Lee's marketing efforts have also been lack luster. As a percentage of revenue Sara Lee spends the least on marketing. These factors combined with very low sales growth over the last two years put Sara Lee in a decidedly unfavorable competitive position.

Both within the US market and internationally Sara Lee's operating margins have also lagged behind its major competitors.

References