Marcial: Pros Are Nibbling at Tootsie Roll

The confectioner could be a takeover temptation for larger rivals as the business continues to consolidate

Life is not so sweet these days for candymaker Tootsie Roll Industries (TR). First-quarter sales tumbled, costs spiraled higher, and earnings are on a downward slope. Even so, the smart-money crowd is starting to gather in the stock. That has lifted Tootsie's share price since late April, when the stock traded at $23. It sprinted up to $27 by early June, where it has remained. What's the scoop?

"We have increasingly been nibbling, buying more shares of late, although we have been in the stock for the past five years," says Mario Gabelli, chairman and CEO of investment firm Gabelli. (GBL). Why?

Hungry for a sale

Tootsie Roll possesses many of the ingredients that make it a palatable buyout target, as several pros are well aware. The company certainly needs new energy to spark a lift in sales, earnings, and stock price. And Tootsie Roll's management hasn't displayed the skills to improve the company in the current environment of rising commodity prices and stiffening competition.

Add it all up, and there could be several companies or private equity groups interested in buying the company.

"I believe it isn't a question of if, but when, the company is sold," observes Gabelli. He acknowledges that he has had that feeling for the past five years. But he is more hopeful now since Tootsie Roll chairman and CEO Melvin Gordon is now 88, and his wife Ellen Gordon, the company's president and chief operating officer, is 76. They control some 76% of the class B voting stock and 54% of the common shares of the Chicago-based company, so the question of a hostile or unsolicited takeover at the Chicago-based company seems out of the question.

"Nonetheless, it looks like a sale will happen, although the big question is when," says Gabelli, who is sounding less impatient on the subject. The Gabelli organization has boosted its stake in Tootsie Roll, to 6.3% from 5.5% earlier this year. Other big shareholders include Wells Capital Management, with a stake of 9.5%, T. Rowe Price (TROW), which holds a nearly 5% position, and Barclays Global Investors (BCS), with 4.3%.

Sluggish growth

The company's flagship product, the well-known Tootsie Roll, has been produced using the same formula since its inception in 1896. Its other candies include Tootsie Roll Pops, Charms, and Caramel Apple Pops. New products introduced in recent years, such as Charms Maxxed Energy Lollipop, with ginseng, taurine, and caffeine, have failed to reignite sales growth, notes Elliott Schlang, an analyst at Soleil Securities Group.

However, Schlang recommends holding the stock for its long-term fundamentals, including its "well-recognized brand name, strong balance sheet with probably understated assets, cash flow, and dividend." The stock remains attractive, says Schlang, despite the mediocre results and the rich price-earnings ratio of 31 times estimated 2008 earnings.

He notes that historically Tootsie Roll has been able to grow by implementing product extensions and marketing programs. However, its records of 24 consecutive years of growth in sales and 19 in earnings were broken in 2001, when sales dropped 1.

3% and earnings per share declined 13% because of disappointing Halloween candy sales in the aftermath of September 11 and the consequent U.S. economic slump.

Tasty synergies?

Sales growth has been sluggish since then, and earnings have not exceeded peak earnings of $1.24 a share in 2000. Schlang says margins and the returns on assets, equity, and invested capital have been down to multiyear lows. He figures sales in 2008 will be flat at 91¢ a share and lower in 2009 and 2010. He blames the poor numbers on anemic new-product introductions and the higher cost of ingredients such as sugar, corn syrup, vegetable oil, cocoa, milk, dextrose, and gum base.

All these woes might attract its bigger rivals, which could see the prospect of rewarding synergies and potential growth in combining with Tootsie Roll. Such larger competitors include Hershey (HER), Mars and Wrigley (WWY), which announced their combination on Apr. 29, Switzerland's Nestle, Cadbury-Adams, and Russell Stover. Any one of these rivals could end up buying Tootsie Roll.

Like Gabelli and Schlang, the big institutional stakeholders in Tootsie Roll expect to eventually move on and sell the company. Gabelli, for one, has been buying shares at an average price of $28 to $32. With the stock currently at $27, it is obvious that Gabelli has high expectations that in any deal, Tootsie Roll would be worth much more. With a current market capitalization of $1.4 billion, Tootsie Roll would seem an inexpensive acquisition for its larger peers, even allowing for a rich takeover premium. And that would be a sweet treat indeed.

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