A Rising Canadian Star

11/17/2011 9:00 am EST

Focus: GLOBAL

One of the advantages of focusing on Canadian stocks is that you find some unique opportunities others overlook, notes Marc Johnson of The Investment Reporter.

Canada Bread (Toronto: CBY), one of our key stocks, put its large new bakery in Hamilton into service in the third quarter. We wanted to see what impact this had on the company’s results.

So far, better efficiency was largely offset by higher raw material costs and the higher loonie. But we expect growing sales at a lower cost to restore Canada Bread’s profit margins and earnings in the years ahead.

As a result, it remains a buy for long-term gains and dividends. These gains could come sooner if parent company Maple Leaf Foods decides to buy out the 10% of Canada Bread that it doesn’t already own.

President and CEO Richard Lan says, “We had excellent success with the commissioning of our new scale fresh bakery in Hamilton, Ontario in July, a major endeavor which was executed seamlessly—on time and on budget.”

The Hamilton bakery officially opened on September 28, at the end of the third quarter. It will take time for Canada Bread to profit fully from this investment.

In the third quarter, Canada Bread’s Fresh Bakery division incurred “$2.3 million of duplicative overhead costs” from the operation of three smaller and older bakeries in the Greater Toronto Area. It will close these bakeries between the end of this year through early 2013 as it transfers their production to the new bakery in Hamilton.

At that point, this $2.3 million a year cost should disappear. At present, the Hamilton bakery is producing rolls and breads. By the end of this year, it will start commercial production of two other product lines.

In 2012, the Hamilton bakery will start producing the four other lines, including flatbreads. After that, the bakery should generate additional cost savings.

Andrew Carnegie, who founded US Steel, said you should put all your eggs in one basket and “watch that basket very carefully.” Value investor Benjamin Graham, by contrast, advocated putting your eggs in different baskets.

By concentrating so much of its production in Hamilton, it seems that Canada Bread agrees more with Carnegie. But a strike or a natural disaster could seriously hurt the company. This is less likely when you have more than one bakery. All the same, the new bakery in Hamilton should pay off.

In the meantime, Canada Bread’s earnings may remain mediocre, as they were in the third quarter. In the three months to September 30, the company earned $21.8 million, or 86 cents a share—excluding restructuring costs and a one-time benefit from a tax adjustment. This was down marginally from $22.1million, or 87 cents a share, a year earlier. Sales rose slightly less than costs.

In the third quarter, Canada Bread’s sales rose by 1.4%, to $417 million. This mostly reflected higher prices on products to offset higher raw material costs. Higher wheat prices raise the cost of baked goods while higher gas prices raise the cost of their distribution.

The sale of the fresh sandwich division last year and the stronger loonie relative to the US dollar and the British pound reduced reported sales. Adjust for these and sales rose by 5%.

The trouble is, in the third quarter all regular operating costs as a group rose by 1.6%—more than sales. The problem was a 3.3% jump in the cost of goods sold. Lan says Canada Bread “largely offset” these higher costs due to cost cutting and better operating efficiency. Higher prices also helped.

Even so, the company’s pre-tax income of $31.8 million in the third quarter was down slightly from $32 million a year earlier. Then again, its cash flow was a little higher in this year’s third quarter.

Mr. Lan says, “As commodity costs stabilize, we will continue to seek opportunities to drive volume and [profit] margin growth through reduced costs, innovation and product sales mix.” This strategy seems reasonable.

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