Patties gets hungry

PORTFOLIO POINT: A reinvigorated Patties Pies has the potential to restore depleted investor confidence.

The stockmarket crash has had the interesting sidelight of relegating many mid-sized companies to the ranks of micro caps, as their market capitalisation falls below $200 million.

It is unusual for microcap investment universe to include companies with established household brand names; it may be inhabited by companies whose brands become well known later. Great companies such as Microsoft, our own MYOB or Cochlear were all once microcaps that went on to become large-cap companies. Generally, though, most microcaps – in terms of brand recognition – are a work in progress.

Patties Foods (PFL) might not be a name on every investor’s tongue, but anyone who has been to the cricket or football will have some connection with the classic 61 year old Four’n’Twenty brand, synonymous with Australia’s beloved meat pie. Patties Foods manufactures and distributes several well-known branded savoury and dessert pies, including Four’n’Twenty, Patties Pies, Herbert Adams, Nanna’s and Snowy River. Patties Foods was once valued at more than $300 million; it is now well within our sweet spot with a market cap of $120 million.

So why the fall from grace? A look at Patties’ numbers for the December half provides part of the picture. Net profit after tax was down 35% on a year earlier even though revenue grew 6.5%. The profit decline stemmed from poor operational management and factory inefficiencies, which provided its main competitor, Sargents Pies, with increased shelf space at Woolworths and Coles. Operational cash flow declined to a mere $1.7 million.

The chief executive was replaced by Greg Bourke from Weston Foods, who is now focused on extracting cost savings from Patties’ logistical infrastructure, and streamlining production processes. Patties also bolstered its management depth by appointing Grant Leyden as general manager of manufacturing. Leyden previously held posts at Goodman Fielder, Fonterra and Cadbury.

Bourke’s vision is to deliver on operational efficiencies through better management of the company’s manufacturing facilities, where a number of inefficiencies have been identified. Also under the microscope is the company’s marketing budget. Patties’ needs to get a better return on investment for its advertising expenditure.

But the key to a stock price revaluation will be Patties’ ability to drive revenue growth. The retail food savoury market in Australia is dominated by two companies: Patties Foods, with about 47% market share; and the Sydney-based privately controlled Sargents Pies, with about 24%. The remaining 29% is made up of smaller operators and white label brands (in which Patties also competes).

Patties’ internal problems gave Sargents a heads up over the last 18 months, but Patties is the dominant player, with a wider product range and more marketing muscle to defend its space and market share against a smaller less resourced competitor. The savoury food market is arguably in a mature stage and although Patties intends to actively promote new product launches, this will only add a limited amount of momentum at best.

The recession does provide opportunities for Patties, however. Its retail prices range from 70¢ for the budget brands to $1.20 per 100 grams for the premium brand pie. Patties’ pies offer Australian families with high energy source food at very accessible prices.

But Patties is not just a retail play; it also has a wholesale unit called Food Service, which caters to franchise stores and includes convenience and education distribution channels. There is still plenty of growth for Patties in this sector of the market, where it only holds a comparatively low 22% market share, up from 19% a year ago. There is potential to scale up its presence in this area, whilst on the retail front Patties is in defence mode as Sargents is aggressively competing for market share by way of price and capitalising on Patties’ mistakes.

The overall size of the retail market should still offer some growth. After all, meat pies are a cheap alternative to dining out in an expensive restaurant, and as Australian families look to cut their food bills, the good old meat pie might offer an inexpensive savoury treat.

The second-half numbers will benefit from a lower cost financing facility as well as a new supply contracts to a non-supermarket retailer worth $8 million a year. If Bourke and his new management team can slice production costs and deliver the sauce on top (sales growth), Patties has the potential to regain some of the depleted investor confidence. The brand value and the depressed stock price do raise the appetite.

nPatties Foods, by the numbers
	Value
Current Share price	79¢
Sales FY08	$164 million
EBITDA FY08	$26.9 million
EBIT FY08	$22.5 million
NPAT FY08	$13.8 million
ROCE FY08	12.50%
Dividends per Share	7.3¢
Dividend Yield	9.20%
P/E Historical FY08	7.9 times
* Source: Company data, historical data only

Carlos Gil is the chief investment officer of the Microequities Deep Value Microcap Fund.

Disclosure: Carlos Gil and/or associated entities own shares in the company, Patties Foods Limited (PFL). The article contains general information only and should not be construed or relied upon as legal, financial or professional advice.