Reddy Ice -- In Need of Global Warming

Reddy Ice Holdings Inc. (FRZ-$30.07), the largest U.S. maker of packaged ice—distributing approximately 1.9 million tons of ice per annum—recently reaffirmed its full-year 2007 outlook. The company said it expects to earn $19.2 million to $23.4 million for the year, or 87 cents to $1.06 per share, with revenue of $360 million to $370 million.

Analysts surveyed by Thomson Financial are looking for earnings of 97 cents per share on revenue of $365.4 million.

The 10Q Detective believes that earnings expectations are still too high. Wall Street is expecting 43 percent share-net growth on the back of margin improvements and 6 percent growth in sales for fiscal 2007. Top line guidance is predicated on seasonal gains in the second and third quarters (warm weather); a growth by acquisition strategy; and, continuing efficiency improvements by switching to ten-pound bags of ice (with exponentially higher unit pricing).

In our view, hitting even the low end of guidance will be a challenge:

• Selling ice is a commoditized business. Reddy Ice believes that they can offset related margin erosion by introducing new bag sizes at various price points. In 2006, sales of ten-pound bags of cubed ice accounted for approximately 42% of ice product revenues, up from approximately 24 percent and 5 percent of ice product revenues in 2005 and 2004, respectively. Management expects sales of ten-pound bags as a percentage of ice product revenues to continue to increase in 2007;
• As the key supplier in the Southeast to many regional customers—including Albertson’s, Food Lion, Publix, and Winn-Dixie—Reddy Ice believes that it is well positioned to share in its customers’ growth. Management is looking to capture incremental volume as these customers continue to reduce their supplier base in order to achieve efficiencies across the supply chain. However, the price elasticity of demand for ice is elastic [(Ed > 1), the percentage change in quantity is greater than that in price]. Hence, when the price is raised, the demand, and the total revenue of ice producers falls, and vice versa. Ergo, the only way Reddy Ice is going to capture customers and incremental volume is—in the long run—to lower the price of its ice cubes;
• Due to the seasonal nature of Reddy’s business, the Company records the majority of its revenues and profits during the months of May through September. Approximately 69 percent of annual revenues occur during the second and third calendar quarters. A wetter-than expected spring and forecasts for inclement weather patterns this summer could have an adverse impact on the level of demand for packaged ice and, as a result, Reddy Ice’s revenues and profitability;
• Freezing, packaging, and delivering bags of cubed ice are dependent on energy prices, a variable cost. Plastic bags, fuel expenses, and electricity expenses represented approximately 8 percent, 4 percent, and 7 percent of revenues, respectively, in fiscal 2006. Rising energy prices will continue to eat into future financial results;
• The packaged ice industry continues to be highly fragmented. Management intends to continue to pursue strategic acquisitions in existing or adjacent geographic markets that “enhance the density of its distribution routes and provide capacity rationalization opportunities.” We believe that this is nothing more than a roll-up strategy to boost organic growth: For example, in 2006, Reddy Ice acquired ten businesses, which contributed approximately $4.4 million, or 17 percent, to the $26.3 million increase in sales from 2005 to 2006.

The stock is currently trading near 52-week highs, buoyed by investors attracted to Reddy Ice’s 5.5% dividend yield. However, we believe investors ought not ignore that the dividend payout is governed by strict agreements governing Reddy Ice’s debt—and the Company is highly leveraged, too.

The indenture governing Reddy Ice’s senior discount notes restrict the amount of dividends and other distributions the Company may pay. Under the debt covenant, the Board is restricted from paying dividends on the common stock unless, at the time of such payment:

1. The consolidated coverage ratio (pro forma EBITDA for the most recent four fiscal quarters to consolidated interest expense for such four-quarter period) set forth in the indenture governing the senior discount notes must exceed 2.0 to 1.0;
2. Under Reddy Ice’s credit facilities, the Company’s total leverage ratio for the most recently ended fiscal quarter for which a covenant compliance certificate has been delivered must be less than or equal to 3.75 to 1.0.

As of March 31, 2007, Reddy Ice’s interest coverage ratio and total leverage ratio were 5.6 times and 2.7 times, respectively.

Irrespective of reconciling net income with non-cash expenses, Reddy Ice is using substantially all of its cash to pay dividend. A payout ratio of 268% will definitively limit the Company’s ability to pursue growth opportunities and operate its business generally.

There are significant amounts of goodwill and other intangible assets on Reddy Ice’s balance sheet, due to non-stop deal making—97 acquisitions (through March 9, 2007) in the last decade.

Goodwill and intangible assets total approximately $$301.9 million, representing approximately 51% of total assets.

And, as of April 24, 2007, Reddy Ice had approximately $10 million of cash on hand, but owed more than $429 million in long-term debt and other contractual obligations (operating leases and purchase contracts).

Total debt stood at more than 2.9 times stockholder equity and its interest coverage was a marginal 1.4 times available (trailing twelve-month) earnings.

In addition to liquidity problems, fuel costs, and the weather, we see other ice distributors as a threat to revenue growth. For example, Home City Ice Company, manufactures 4,400 tons of ice per day, retailing ice across all of Ohio, Indiana, Illinois, Kentucky, and West Virginia, as well as parts of Michigan, Pennsylvania, Tennessee, New York, and Maryland. An efficiently run operation of 28 state-of-the-art manufacturing plants, with 36 distribution centers, and a fleet of over 500 trucks, Home City Ice has frozen Reddy Ice from pursuing ‘growth through acquisition’ opportunities in the Midwest.

We believe that Reddy Ice has formidable competition from commercial ice equipment manufacturers, too. Technological innovations have made producing packaged ice on site less costly—in terms of energy consumption, untimely machine breakdowns and labor problems—for potential Reddy Ice customers. Working through a distribution chain, makers—like Manitowoc (MTW-$74.14), with a market share of 30 percent, Scotsman/Crystal Tips (25 percent), Hoshizaki (20 percent) and Mile High Equipment Co. (15 percent)—sell more than 300,000 ice machines each year to dealers or beverage and food distributors. Distributors and dealers then sell equipment directly to end-users.

Hospitals account for 39.4 percent of all commercial icemaker purchases, followed by hotels (22.3 percent), restaurants (13.8 percent), retail outlets (8.5 percent), schools (8.5 percent), offices (4.3 percent) and grocery stores (3.2 percent).

A typical commercial icemaker, which usually lasts about 7-10 years, consists of a case, insulation, refrigeration system and a water supply system. Each machine, on average, can harvest 500 lbs./day of crushed or ice cubes. Our readers can easily do the math. Each ice-machine a sales distributor successfully plants in certain end-users—think restaurants, retail outlets, and grocery stores—means 91.25 unit tons less in business for Reddy Ice!

[Ed. note. The Packaged Ice Association says that the ‘quality of packaged ice’—disease transmission from contaminated ice, presence of insect parts and foreign objects in frozen ice—reflects the quality of the source water and the sanitary conditions during manufacture. Ice retailers contend that many on-premise operations receive no oversight from local health inspection—ice is classified as a frozen food—and make ice of consistently poorer quality than ice made by major commercial producers.]

In our view, Reddy Ice is not a cheap stock, due to its valuation of 31 times forward earnings and its questionable ability to pay its dividend. Reddy Ice is showing all the signs of an aging company whose growth is too dependent on buying market size. Unstable cash flow and tougher comparisons in future quarters could soon dominate the story here more than the yield payment.

Editor David J Phillips holds no financial interest in any of the stocks mentioned in this article. The 10Q Detective has a FULL DISCLOSURE policy.