The Finance Dabbler: The Pasta Pitfall Predicament

The past year has been gloomy for most investors. But the brave souls who bet on American Italian Pasta Company (AIPC) would disagree.

As you may have deduced, the company produces pasta — 300 different varieties of it. Its stock price jumped by over 350% in the last 9 months, while the S&P 500 plummeted 40%. Historically, such stunning results have been confined to companies that became overnight monopolies by virtue of research. In most cases, however, those companies did not produce pasta.

It makes one wonder whether AIPC has invented some sort of revolutionary hi-tech pasta. While an awesome concept, more likely is that investors have been gravitating towards consumer staples for fear of recession. Pasta is about the cheapest filler food Americans know – almost like the end of the line in terms of saving costs – and, should the economy continue to degenerate, more and more people would find it appetizing.

While I cannot claim to be an oracle for American dietary fad, I find the story of the superstar pasta company to be baffling. With a market capitalization of $471 million and earnings of $19 million in 2008 the price to earnings ratio for the company stands at a stellar 24. To put that into perspective, both Google (GOOG) and Kraft Foods (KFT) have P/Es of 19. Traditionally, higher P/Es have been the prerogative of companies expected to grow rapidly. Thus the ratio, in this case, would indicate investors are expecting AIPC’s growth to outpace both Google’s and Kraft’s.

And amazingly, odds are they’re correct… but only in the short term. If the recession positively affects America’s love of pasta, AIPC is well placed to be a beneficiary. The real question is whether the benefit is worth a 350% premium over last year’s price? After churning in loses of $100 million in 2005 and another $30 million in 2006, the company became profitable in 2007. Revenue growth between Sept. 2006 and Sept. 2008 was nearly 30%. What this suggests is that the company needs to maintain production above a certain level to cover its fixed costs. Once that has been achieved, its high gross profit margins allow it to pocket most revenues.

Readers will notice that AIPC’s growth has correlated with the tanking of the US housing market. However, no recession lasts indefinitely, and thus we can hardly expect AIPC to continue doubling its net income every year. In order to maintain its stellar revenue and earnings growth, the company needs to add production capacity. That does not happen overnight. Additionally, the possibility of increased US prosperity (and decreased pasta consumption) means that the management has to be careful about this option. Even if AIPC doubles its net income to $40 million in 2009, the company would find it difficult to maintain that level of profitability in the long-run. This is because the company does not operate as a monopoly — there are other pasta producers in US, including Kraft Foods, the Goliath of the food industry. Basic economics suggest that, due to competition, high margins do not last forever. Basic economics also suggests that Wal-Mart (WMT) will wrangle out every bit of margin from its suppliers. Unfortunately for AIPC, Wal-mart accounts for 23% of their sales.

To their credit, the company does have a decent operating cash flow. But a 13x price to operating cash flow is hardly impressive, especially for a company that pays no dividends and makes minimal stock buybacks. Investors could do better by holding on to corporate bonds.

AIPC tells a great story. But it is yet another stock that made its investors forget that a share is not a claim on just next year’s earnings, but on earnings forever. Unfortunately, in this story, the forever is not so thrilling.

Disclosures: None