Shares in food manufacturer Premier Foods (LSE: PFD) rose by as much as 23% this morning, after the groups interim results beat expectations.
Adjusted pre-tax profit rose by 21% to 28.1m, while operating profit from continuing operations swung from a 12.8m loss last year, to a 23.3m profit.
The gains are the result of the first quarterly increase in sales of branded goods for two years. Premier said that branded sales rose by 1.6% during the second quarter, driving an increase in profits.
This is a bigger achievement than it might sound. Premier Foods has been one of the casualties of falling sales in the big supermarkets. The firms branded goods, such as Mr Kipling, Bisto and Sharwoods, are mainly sold in big supermarkets, not in discounters such as Aldi and Lidl.
To help combat the decline, Premier has introduced new products and adjusted the sizing of certain other projects. Marketing spend is also expected to rise by 10-15% over the year as a whole, with an emphasis on the run-up to Christmas.
At the start of this year, Premier Foods two biggest problems were its mountain of debt and its large pension deficit.
During the first half, the pension deficit fell from 211.8m to just 32.8m, thanks to a set of accounting tweaks which reduced the firms pension liabilities from 4,460m to 4,151m.
Net debt was unchanged at 585m during the first half, but Premier says that this figure should reduce significantly in H2. This could be very profitable for shareholders.
A big opportunity
Premier Foods shares have been trading on a forecast P/E of about 4.5 for some time now. The reason for this is that the firms 585m net debt has overshadowed its market cap, which was around 300m before today.
This level of debt made a conventional P/E valuation (which ignores debt) irrelevant, so the market valued Premier on its enterprise value (market cap plus net debt). On this basis, Premier shares are valued at around 13 times forecast earnings, which is probably about right.
However, if Premiers net debt falls sharply, the firms enterprise value will fall. Id expect Premier shares to rise to offset this fall, especially if Premier can sustain its improved sales through the key second half of the year.
In my view, Premier shares could reach 60-70p over the next few years. The pace of the gains will depend on how fast the firm can reduce its net debt. However, as debt falls, interest costs should also fall, freeing up more cash to reduce debt.
Whats the risk?
The risk, of course, is that Premier wont be able to generate a sustained improvement in sales, or that its operating margins will be too slim to generate enough free cash flow to repay debt, rather than just servicing it.
This could happen. Todays results show that the firms 6.8% operating margin generated an operating profit of 23.3m during the first half. Unfortunately, this was eaten up by 24.1m of finance costs, mainly interest payments.
Im willing to give Premier the benefit of the doubt after todays results: these shares could be a profitable buy.
However, owning shares in companies with too much debt is very risky. Shareholders can lose everything.
That’s why I’d recommend a close look at “7 Simple Steps For Seeking Serious Wealth“ before making any decision about Premier Foods.
This exclusive FREE report from the Motley Fool’s top experts carries no obligation and includes a simple set of investing rules that could help you avoid loss-making investments.
Best of all, the investing strategy described in “7 Simple Steps …” could take you as little as 20 minutes per month.
To download your copy of this report now, just click here.
Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.