One year ago, Aryzta’s new CEO, Kevin Toland, announced an emergency €800 million capital raise, severe cost cuts, and the sale of non-core assets. These were the three planks in his plan to save the company by bringing Aryzta’s giant debt under control. 

This morning, with the release of Aryzta’s 2019 results, we got our first look at whether Toland’s plan is likely to work. We learned revenue is down 1.5 per cent (flat if disposals are excluded); the US is still lagging; progress is being made on margins, and operating cash flows are above expectations.

Lots to take in. But with Aryzta, there’s only one number that really matters, the number that will have informed every decision they’ve taken for the last three years: the net debt/Ebitda ratio. Net debt/Ebitda is a type of solvency ratio. It shows total debt relative to profits.

In Aryzta’s case, it shows whether the company is about to be crushed by debt.

On that front, today’s news is good. Through disposals and cost-cutting, Aryzta is slowly getting a handle on things. 

The chart below shows the net debt/Ebitda ratio. For reference, a company with a net debt to Ebitda ratio above 5 would be considered heavily indebted — and this time two years ago, Aryzta’s clocked in at 7.65.

That was the low point. Then came the capital raise in 2018. Another year of divestments and cost-cutting has chiselled the number down to 4.68 in today’s results (albeit with the inclusion of last week’s Picard sale, which took place after the reporting period).

Here is the story of that debt-to-earnings graph: how debt got out of control, how it has been cut back, and where it’s going next.

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Before the plan to save the company, and the divestments, and the crushing debt, there was Aryzta’s former CEO Owen Killian. In his day, Killian was among the best paid and most respected CEOs in Ireland. 

In 2003, he took the reins of a company then called Irish Agricultural Wholesale Society (IAWS), a century-old farmers’ co-op that had morphed into a major farm inputs, food production and trading plc across Ireland and the UK. The group had just begun to expand into North America. 

Killian spun out the farm inputs and agronomy side of the business into Origin Enterprises, leading to its IPO in 2007. The last ties were severed in 2015 when he announced the sale of Aryzta’s stake in Origin – now a successful business in its own right across these islands, eastern Europe, and more recently Brazil.  

Instead, Killian focused on food.

He led IAWS into a reverse merger with the Swiss baker Hiestand to form Aryzta in 2008. The Hiestand stake was purchased from private equity firm Lion Capital, who would also sell the controversial Picard interest to Aryzta later on.

A roll-up gone wrong

Then, in the teeth of the recession — when assets could be picked up cheaply — he went on an acquisition spree. Aryzta bought 12 companies between 2008 and 2012 and nearly tripled its debt in the process. This is known as a roll-up strategy.

The market loved it. Aryzta grew margins by cutting shared overheads, and it expanded into new markets and new product segments. It did deals with giants like McDonalds, Subway, Burger King and Aldi. Sure, it had more debt. But what of it! The interest was affordable. And debt is what had made the whole thing possible.

It’s around this point Owen Killian started work on the renovation of his Shrewsbury Road home in south Dublin — featuring a two-story basement and a car elevator.

Then things got messy. The cold-blooded Brazilian private equity group 3G bought some of Aryzta’s biggest customers, and started squeezing it for better terms. Subway (a big client) had a lot of success in Europe, so Aryzta had to comply with EU rules by manufacturing more product in Europe, which led to under-capacity at its existing US factories.

This, in turn, led to the fateful decision to fill capacity by making its own retail products, which led to Aryzta to compete directly with – and mortally offend – a big client, General Mills. Which led to General Mills cancelling its manufacturing supply contract. 

The US bakeries caused even stranger difficulties, including the curious case of a heroin bag spewed out of a machine in Hazle Township, Pennsylvania in 2015.

A lot more went on. When US immigration officials checked the status of agency workers at Aryzta’s Cloverhill bakeries two years ago, they found that 800 of them were not allowed to work there and had to leave. The disruption caused havoc at the factories – and €58 million in losses before Cloverhill’s eventual fire sale last year. Some of those workers launched legal action against Aryzta and the agency that employed them earlier this year.

The US bakeries caused even stranger difficulties, including the curious case of a heroin bag spewed out of a machine in Hazle Township, Pennsylvania in 2015. There was no suggestion that Aryzta had anything to do with the criminals hiding the drugs on its premises.

Meanwhile, the company’s German operations have faced a hard collective bargaining drive from local trade unions. In accounts filed for 2018, its subsidiary Aryzta Bakeries Germany GmbH reported a blanket 2.4 per cent wage increase agreement applicable in August of that year as part of annual negotiations. The subsidiary also acknowledged the need for further efforts in recruiting and retaining employees. Some of its staff went on strike earlier this month at its flagship Eisleben factory to put pressure on the latest round of pay talks.

In the end, Aryzta’s Ebitda margins had dropped from 17 per cent in 2014 to 8 per cent in 2018. Most of this was a result of losing big contracts, which in turn led to factories running at less than full capacity. 

In a short space of time, margins were cut in half. But the interest repayments, of course, went nowhere. All of a sudden, Aryzta had a serious debt problem. 

In 2017, Owen Killian was booted out. Kevin Toland from DAA was hired to clean up the mess. Under Toland, Aryzta has aggressively written down under-performing assets. 

Aryzta US Holdings I Corp, a wholly-owned subsidiary, wrote down €2.3bn in 2018 alone based on “significant reductions in the profitability of [its] indirect operating subsidiaries in the US during the year.” At group level, the company wrote down €859 million worth of assets in 2017, €362 million in 2018 and €4 million in 2019. 

The great baking write-offs

Since the publication of Aryzta’s previous group-level results for the year ended July 31, 2018, a number of its subsidiaries around the world have filed their own accounts for that year, including some large write-offs. These companies are part of a holding structure routed through Jersey, Ireland, the Netherlands and the UK. All filed 2018 accounts in recent months, audited by PwC.

While these impairments did not impact on Aryzta’s consolidated balance sheet as reported at the global level for fiscal year 2018, they illustrate where some of the most severe re-evaluations of the group’s business occurred as it underwent deep restructuring.

  • Ogaru, an unlimited company registered in Ireland, recorded an impairment loss of $2.5 billion on its 100 per cent holding in Aryzta UK Holdings I Ltd. This UK company in turn wrote an equivalent amount off the value of its wholly-owned American subsidiary Aryzta US Holdings I Corp. Both companies reported that the write-off resulted from “significant reductions in the profitability of [their] indirect operating subsidiaries in the US during the year. The US business was impacted by volume declines, and significantly higher labour and distribution costs. In particular, significant losses and operational issues arose at the Chicago and Cicero bakeries, locations which were disposed during the year.”
  • As a result of this impairment, Ogaru found itself in a negative equity position of $317 million on July 31, 2018. Its directors reported that it would be in the best interest of Aryzta to write off some of the debt owed to IAWS Management Services, an Irish-registered holding company for many of the group’s international interests. “Accordingly, subsequent to year end, in April 2019, €285.5 million of the company’s liability to IAWS Management Services Unlimited Company was written off, which resulted in a gain of $318 million in the profit and loss account at April 2019 exchange rate,” they wrote.
  • In Ireland, IAWS Finance Unlimited Company recorded an impairment loss of €303 million on its investment in Cuisine de France Holdings Unlimited Company. “This was as a result of the reduced future profit growth expectations in Cuisine de France Holdings Unlimited Company’s direct and indirect subsidiaries in lreland from previous estimates. This was additionally impacted by the disposal of a business during the year, which reduced future operating cash flow projections from previous expectations”. Cuisine de France Holdings owns 100 per cent of the Irish distribution business Aryzta Food Solutions Ireland Unlimited Company, which in turns owns the manufacturing subsidiary Aryzta Bakeries Ireland Unlimited Company.
  • Aryzta UK Holdings Ltd, a company with 100 per cent ownership of Aryzta’s British baking production business Aryzta Bakeries UK Ltd. and of its distribution arm in the country Cuisine de France Ltd, recorded an impairment loss of £94 million on its investments. “This was as a result of the significant reductions in the profitability in the UK during the year. The UK business was impacted by continued higher input costs arising from foreign exchange rate changes, and volume declines,” Aryzta UK Holdings reported.
  • Finally, Aryzta Holdings Canada Unlimited Company, which is registered in Ireland, recorded an impairment loss of CDN$90 million “as a result of the reductions in the profit of Aryzta Bakery Development Unlimited Company and its direct and indirect subsidiaries in Canada during the year”. This write-off is in excess of €60 million at the current exchange rate.

All impairments came with a directors’ note that “profitability is expected to improve in the future in both geographies, including the benefits from the group’s Project Renew improvement programme”. Aryzta did not reply to a query from The Currency on the consolidation of these subsidiary impairments.

The cuts

The quickest way for Aryzta to improve its net debt/Ebitda ratio is to grow margins by cutting costs. 

In the Killian years, Aryzta was able to grow margins by acquiring overstaffed businesses and then laying off staff. That’s how it ended up with a rich 17 per cent Ebitda margin in 2014.

Now Aryzta is making a 9 per cent margin. This is a long way down from 17 per cent, but actually not so bad for a middleman producer of unbranded, high volume products like burger baps and raspberry danishes. Its competitors are making an average of 7.5 per cent.

Renew is costing money up front: €65 million this year, €45 million in 2020, €40 million in 2021.   

In any case, Toland has a plan to grow margins the hard way. It’s called Project Renew. It involves investing in automation, reducing headcount and outsourcing some functions.

Renew is costing money up front: €65 million this year, €45 million in 2020, €40 million in 2021. That’s paid for by part of the €800m capital raise last year.

The risk over Renew is that it’s made up of lots and lots of small, bitty improvements: layoffs to save €7.4 million per year; automated bread-scoring to save €650,000; muffin auto-palletising to save €300,000. There are more than 100 projects in total. Lots of small projects are harder to execute than fewer, bigger ones.

In today’s results we saw that Renew is bang on track. It’s delivering its targeted €40 million annualised cost savings. The goal for Renew is €90 million cost savings per year by 2021; and €90 million per year, if it happened, would go a long way. It would boost Ebitda margins by around 1.2 per cent. 

A lot is riding on Renew. It’s one of the three levers Aryzta can pull to get its net debt/Ebitda ratio back under control in the short term. Its ability to improve margins by cutting costs will be by far the biggest factor in determining whether it can avoid being crushed by debt. 

The debt pile

Cutting costs is one lever. Raising capital from the markets, as happened last year, is the second. Selling off assets is the third.

Debt amplifies profits and losses. Aryzta used it to great effect during the Killian years. Now debt is working against it. You don’t often see a share price chart as dramatic as Aryzta’s unless debt is involved:

Aryzta aims to get rid of €380 million of non-core assets in order to cut debt. The disposal of Picard last week (see below) follows that of La Rousse Foods in Ireland, and Cloverhill Bakeries and Cicero in the US. Aryzta is now 85 per cent of the way towards its €380 million goal, so there are around €50 million worth of assets still to sell. 

Looking at accounts filed by Aryzta subsidiaries around the world, options for disposals are narrowing. The most profitable businesses in its portfolio, such as Pré Pain in the Netherlands or Coup de Pâtes in France, are aligned with its core market, efficiently serving customers with highly flexible baked goods solutions. Getting rid of them would undermine the group’s overall strategy. Others are located in regions of growth for these types of products, such as Asia and the Pacific, and offer promising prospects.

The assets that currently return little profit to Aryzta while still holding a significant intrinsic value for potential buyers may in fact be those that made the company in the first place: the industrial bakery production facilities in its historic markets. Aryzta Bakeries Ireland Ltd.’s sales fell from €89 million to €79 million last year, and operating profit from €13.7 million to €4 million. Meanwhile, Aryzta Bakeries UK  Ltd. filed a £2.6 million operating loss out of £42 million in revenue.

Picard

A misadventure in French frozen foods

At the height of Owen Killian’s dealmaking in 2015, Aryzta spent €447 million acquiring 49 per cent of the French grocer Picard. 

Picard’s sleek, almost clinical frozen food stores are a favourite of French shoppers, ranking consistently among the country’s favourite brands. The business is highly profitable, returning €182 million in profit before tax and exceptionals out of €1.4 billion in sales last year. Its margins are two to three times wider than those of other French grocers. 

But there was a problem with the deal: Picard is 51 per cent owned by a hedge fund, Lion Capital, which borrowed to build its ownership stake. After Aryzta bought its Picard stake, Lion passed its €1 billion debt onto Picard, which dramatically cut the value of Aryzta’s stake. 

It was also Lion Capital who had sold a third of Swiss baker Hiestand to IAWS in 2008, leading to the formation of Aryzta.

Last week Aryzta finally got rid of 44.5 per cent of Picard for €156 million. Adding in the dividends its received from Picard, it has taken €247 million from the company in total, plus its remaining 4.5 per cent stake, which is worth €16.3 million. 

By any standards, this is a disastrous return on the €447 million. But as the market response to the news last week shows, €156 million for 44.5 per cent is a good outcome. Now Aryzta can use this cash to cut its debt, and draw a line under the Picard affair.

All these assets could be sold off in order to cut net debt. In all, three things go into the net debt calculation. The first is cash, which is subtracted from net net. Aryzta has €378 million cash at hand, plus another €156 million from the Picard sale which haven’t made it into the 2019 figures.

Then there’s term debt. Aryzta has €1.1 billion of it. In 2019 it paid €85 million interest on its term debt. 

Then there’s €866 million of what’s called hybrid debt. This is like term debt, with a few differences. The first is that Aryzta has the option to pay the principal off at any time, or roll it over perpetually. Coupon payments can also be rolled up — i.e. left unpaid for a further year — but if Aryzta ever pays a dividend or a coupon payment, it is obliged to pay all the rolled-up coupons.

Aryzta now owes €81 million of hybrid coupons, and that number grew by €38.9 million in 2019. Because hybrid debt is more flexible than ordinary debt, it’s a more expensive source of finance. The benefit of hybrid debt from Aryzta’s perspective is that the coupons can be deferred, so it’s unlikely to cause a crisis in the short term. 

The upshot is Aryzta won’t touch the hybrid debt because it doesn’t want to have to pay the whole lot at once. It’ll keep rolling coupons over and cut the overall debt burden by paying down term debt. And when the term debt has been sufficiently reduced, it will go to the market to replace the hybrid with cheaper term debt. 

As for term debt, Aryzta is limited by what’s called a covenant to keep it below 3.5 times Ebitda. Keeping below the covenant was the big stress this time last year, but now term debt is at 2.43 times Ebitda and falling.

The following chart shows the change in Aryzta’s net debt in the last three years. The big drop in you see in 2018 is the capital raise, €455m of which was used to reduce debt. The drop from January 2019 to July 2019 is helped by the Picard sale.

Problems – important and urgent 

Aryzta in 2019 has two types of problem. Both are important but only one is urgent. 

As we’ve seen, the debt overhang is urgent. The less urgent, but still important, problem is the fact that Aryzta is selling burger baps and cakes to increasingly health conscious consumers. A mature food business should be able to grow revenues by 2-3 per cent per year; Aryzta’s revenue growth, excluding disposals, is flat.  

It’s true, cakes and burgers aren’t fashionable. But as McDonald’s and Restaurant Brands (which owns Burger King, Popeyes and Tim Hortons) show, it’s possible to grow sales of unfashionably unhealthy food. McDonald’s shares are up 29 per cent in the last year and Restaurant Brands’ is up 24 per cent. Aryzta is a big supplier to those companies. 

The consensus among consumer market analysts is that the global frozen bakery demand served by Aryzta is set to continue growing at a mid-single digit rate for the coming years. Existing trends, including the quest for ever more convenience and westernisation of diets in emerging countries, are not being questioned.

39 per cent of UK bread users say that “it is hard to know which bread or baked goods are a healthy choice”.

Mintel

It is, however, a changing landscape, with increasingly fragmented consumer segments looking for products to suit their individual lifestyle – from ethnic background to dietary preferences. One unifying trend is the search for cleaner labels, with Mintel bread innovation analyst Amrin Walji counting almost one in five new products developed around the world last year claiming to be without additives or preservatives.

Broader health concerns are a shared feature, with 55 per cent of US consumers claiming to live a healthier lifestyle year-on-year – but 39 per cent of UK bread users saying that “it is hard to know which bread or baked goods are a healthy choice,” according to Mintel research.

Bord Bia’s 2018 bakery trends report estimated that in Aryzta’s historic markets, the category was on a 4.8 per cent annual growth trend in Ireland – but was stagnant in the UK, with growth in cakes and pastries offset by a fall in bread consumption. Two thirds of consumers in both countries said it was important that “nothing artificial” was added to their food. Bord Bia identified fortified baked goods, such as protein-enriched bread, among emerging trends in these islands.

These characteristics present Aryzta with both the opportunity of solid demand on its markets, but also with a series of challenges. The strongest growth is taking place in regions, such as Asia and the Middle East, where the group has had a smaller presence – while its traditional European and North American markets are the most competitive and exposed to more stringent consumer expectations.

And meeting the demand for increasingly individualised products – not to mention fast-rotating dietary fads – requires agility that only a highly efficient large-scale industrial player can achieve. 

Input costs give welcome respite

After being hit by high input costs in recent years, Aryzta looks set to enjoy a pause on agricultural commodity markets. The European wheat harvest recovered fully this year, after last year’s drought, and global stocks are expected to remain high for the coming year despite dry weather in the southern hemisphere. Wheat prices have declined in the past few months and there is no sign of tension down the line.

Butter prices have fallen from the dizzying highs of 2017 and 2018 as all major dairy regions increased production this year. Butter is currently worth north or $4,000/t, down from over $6,000/t two years ago. A gap has also opened between US butter prices, currently above $4,700/t, and those in Europe and Oceania, $500/t or more lower. This offers a global group such as Aryzta a chance to source cheaper ingredients outside its troubled US market – though President Donald Trump’s threat of a new trade war with the EU on dairy ingredients may cause problems here.

Reduced global sugar production this year may lead to price rises, but at between $300/t and $350/t in London all this year, the commodity has remained dirt cheap, trading at nearly half the value of the $600/t peak hit in 2017. Sugar prices recently fell below the previous decade-low of late 2015.

Bucking the trend, the global production of vegetable oils is forecast to fall in the current crop year, causing a reduction in stocks at the end of this year for the first time in nearly a decade. Yet any resulting price increase would only catch up on recent drops, and the European Commission concluded in its latest market outlook at the end of September that there are “still ample supplies for global oilseeds for the 2019/20 marketing year”

Digging a trench

Aryzta’s mistake was to build a tower on the foundation of 17 per cent margins. Those weren’t sustainable. When margins reverted to a level more typical of the industry, the edifice almost collapsed. 

Today Aryzta showed it’s slowly, slowly lowering its debt burden. The absolute level of net debt is down from €2.3 billion in July 2018 to €2 billion in January 2019 and €1.4 billion as of this July (including cash from the Picard sale). And the debt/Ebitda ratio is inching down, from 7.65 to 4.68. 

Flat sales are a significant worry. But the cost cutting is starting to feed through. Today we saw better than expected €144 million operating cash flows. In two years’ time Aryzta should be making 10-11 per cent Ebitda margins.

In order words, Aryzta is stabilising its debt. Since 2015 it has burned investors, laid off hundreds of workers, fired a CEO, lost important contracts and wrote down almost a billion of assets. But this year it successfully dug a trench around its core B2B frozen baked goods business.

Next, Kevin Toland and Aryzta face an arguably tougher problem: growing the business.