Fyffes a 'hold' as uncertainty reigns

Investor: The Irish equity market has begun the year in fine form, rising by approximately 2.5 per cent in the first few weeks of the new year. This is in line with the positive opening to the year by global equity markets. A key positive influence globally has been a change in the rhetoric of the US Federal Reserve, suggesting that the end to its interest rate tightening cycle may occur within the next three to six months.

One of the more volatile stocks in recent months has been Fyffes, which is facing an enormous trading challenge as it endeavours to cope with fundamental changes in the EU banana regime. The shares have also suffered from the adverse ruling it received in its insider dealing court case against DCC.

However, developments in the outlook for the future profitability of its fresh produce business have far greater import for the share price. Fyffes is best known for its bananas and rightly so as bananas account for as much as 60 per cent of group earnings before interest and tax.

Fyffes imports nearly 40 million boxes of bananas per annum into Europe and is the number two supplier to the EU market after Chiquita.

Strong banana prices in 2004 and 2005 enabled Fyffes to grow its profits strongly over the past two years, and earnings per share (EPS) are now estimated at 23 cent for 2006. This compares with the 15 cent earned in 2003 and the share price consequently enjoyed a strong run up to the third quarter of last year. As it became increasingly clear that the EU would move to a tariff-only regime from January 1st, 2006, the shares came under selling pressure. The EU has since formally approved the new regime and has set the tariff level at €176 per tonne.

Market analysts now expect that the previously high banana profit margins will quickly revert to the much lower margins pertaining on other fresh produce lines. There is thus a high degree of uncertainty regarding Fyffes' future profitability and this is evidenced by stockbrokers' forecasts of 2006 earnings per share ranging between 13 and 17 cent.

If the Fyffes share price was solely dependent on current and prospective trading conditions it would in all probability decline sharply from current levels. Any subsequent recovery in the share price would then be dependent on firm evidence that the company could generate reasonable returns in the new environment on a sustained basis.

However, banana profits are only part of the story when it comes to analysing Fyffes. A key positive aspect is that it boasts one of the strongest balance sheets in the sector. This could be of major significance given that deregulation is likely to trigger consolidation amongst the top players in the business.

Del Monte has already kicked off the process by putting itself up for sale. Fyffes has € 200 million cash on its balance sheet, which puts it in a strong position if it chooses to become involved in merger and acquisition activity.

Furthermore, Fyffes has announced plans to demerge its Irish and UK property interests from its fresh products business and to list them in a separate quoted company. Analysts estimate that these properties could be worth as much as €180 million.

Adding this to the company's cash balance of €200 million equates to almost 50 per cent of Fyffes current market capitalisation of € 800 million. On a per share basis these assets account for 110 cent with the balance representing the market's assessment of the value of the fresh produce business.

In Investor's view this underlying strength in the company's balance sheet limits the share price downside risk considerably. Indeed the plan to demerge the property interests offers some upside potential to the share price.

The takeover battle for the Jurys Doyle hotel group provides a recent example of the upside to property values in the current market when a bidding battle emerges.

The positive aspects of the company's asset strength and the negative impact of the new banana regime are now finely balanced. However, existing shareholders should continue to hold the shares until the property interests are demerged, by which time there should be greater clarity regarding trading conditions in the new banana regime.