Saturday, April 21, 2007

Menu Foods' future clouded by recall

Reported in today's Toronto Star... (my comment in italics, and emphasis is mine)

The value of Menu Foods Income Trust Fund units recovered slightly this week as short sellers reduced their positions in the belief the worst of the pet food recall might be coming to a close.

(I don't believe this is the case, time will of course tell)

But problems at the underlying operating company, Menu Foods Inc., are far from over.

A month after issuing one of North America's largest pet food recalls, the Mississauga-based company faces a slew of lawsuits from angry consumers and an uncertain future.

The recall affects 60 million units of "cuts and gravy style" dog and cat food, sold in cans and foil pouches. They're sold under a variety of brand names through virtually every major supermarket chain, pet specialty retailer and mass merchant in North America, from Wal-Mart to Loblaws to Petsmart.

Production for one of its biggest customers, Procter & Gamble's Iams/Eukanuba brand, remains halted.

Well that's good news.

All of which will have "a significant impact" on the company's financial results this year, chief executive officer Paul Henderson acknowledged in a press conference last month. The hit could reach $40 million, the company estimated.

Investors will get a better glimpse of the initial cost once the company publishes its quarterly results for the period ending March 31. The period includes the first two weeks of the recall.

The company has yet to announce when it might release those results. By law, it has until May 15 to do so.

But the impact on Menu Foods and the wider pet food industry could last much longer as it struggles to regain consumers' trust amid reports the death toll reaches into the thousands.

"We expect to see a severe financial impact on Menu's business," Mary McKee, an analyst with CIBC World Markets, wrote in a research report shortly after the company issued the recall March 16.

She cited both the immediate cost of the recall, future cost of defending itself against legal action, and the longer-term damage to its reputation.

Officially, only 16 pets died as a result of consuming wet pet food containing "adulterated" wheat gluten imported from China. But veterinary groups in Canada and the U.S. report the number is far higher.

The ingredient, used to thicken wet pet food sold in cans and pouches, was found to contain melamine, a substance used to make plastic, fertilizer and fire retardant. U.S. investigators are probing the possibility it was deliberately added to boost the protein content of the wheat gluten to accepted levels.

On March 16, the day Menu Foods announced the recall, its unit value plunged 25 per cent.

It was a tough blow for a company that had just completed a major turnaround. Already hammered by federal tax changes that hurt all income trusts last fall, Menu Foods had recently recovered from a difficult period that saw sales and profits hurt by a rising Canadian dollar and higher aluminum costs.

Few pet food owners had ever heard of Menu Foods before the recall. That's not surprising, given that all of its business involves making pet food for sale under other retailers' and companies' brands.

Founded in Streetsville 35 years ago by Donald Green, who bought the plant from Quaker Oats Co., Menu Foods was largely a regional player until former Loblaw executive Robert Bras got involved in 1977.

Bras, who had worked alongside Dave Nichol at Loblaw, saw Menu Foods' future in the burgeoning market for private label. Once scorned by consumers as cheap second-rate products, store brands were just emerging as an attractive alternative to big national names. Cheaper than the big brands, but more profitable for the stores, it was a win for both retailers and consumers. Nichol was a big part of that story as the marketing whiz behind Loblaw's President's Choice label.

By the time Menu Foods went public in 2002, it boasted $234 million in sales, based on an annual compound growth rate of 21.2 per cent a year. Its customers included most of the top supermarket chains, mass merchants and pet specialty retailers, from Wal-Mart to Petsmart.

But some original owners, now in their 70s, were seeking to cash out. The company went public amid the income trust craze, raising $129 million. Soon after, Bras unexpectedly died.

Serge Darkazanli, a director of Menu Foods General Partners and former CEO of Westfair Foods Ltd., came out of retirement to head the company.

Over the next two years, Menu Foods invested heavily in new plants and equipment, according to its annual information form filed with regulators last month. The company expanded further into foil pouches, a new style of packaging favoured by higher-end brands. It bought a wet canned food manufacturing facility from P&G/Iams in South Dakota and entered an exclusive five-year contract to meet the pet food giant's needs.

It raised another $85 million (U.S.) in senior secured notes and $36.5 million in trust units to pay down debt and fund further expansions, including the purchase of two warehouses in Kansas and New Jersey.

But by mid-2005, the company was in trouble, breaching covenants with lenders as it missed targets amid a rising Canadian dollar and higher aluminum costs. Darkazanli retired and was replaced by Henderson.

During 2006, the company initiated several price increases and sales and profits improved. In February 2007, it had renegotiated the terms of its loans and secured senior debt.

The future looked rosy.

The North American market for pet food, at $15.5 billion a year, seemed to have nowhere to go but up as more households adopted pets and more pet owners shifted to premium brands.

While the recall has set the company back, analysts said, Menu Foods' sheer size may be its saving grace.

The company dominates the $3.2 billion a year wet food segment. Its rivals are mainly local or regional players who can't compete effectively for space on national retail shelves.

As well, it's no longer alone in this mess. Two rival pet food makers, Del Monte Foods and Nestlé-Purina, have disclosed problems in their own facilities with the same ingredient in the weeks since Menu Foods first came forward.

Menu Foods "continues to enjoy the confidence and support of its creditors and lenders," said spokesperson Sam Bornstein.

Well, it was going good until that last comment.