Riding high again

by World Grain Staff
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Returning the company to its pasta roots in private label and food service, John P. (Jack) Kelly has helped American Italian Pasta Co. (AIPC) to achieve robust financial health. In a recent interview, though, the chief executive officer of Kansas City, Missouri, U.S.-based AIPC insisted this strategy of de-emphasizing branded pasta does not mean the company will be moving backward. To the contrary, Kelly has ambitions to build on the company’s strengths in ways that may give AIPC a dramatically different profile in the years ahead.

Roaring back from extremely difficult years earlier in the decade, the company’s net income in fiscal 2009 (year ended Oct. 2, 2009) was a record $88.3 million, more than quadruple net income in fiscal 2008 and a stunning turnaround from the company’s low point in fiscal 2005 when AIPC sustained a loss of more than $100 million.

Shares of AIPC were trading on Nasdaq at the end of February at $38.80. The price was up 328% from the $9.06 per share price in November 2007 when the hiring of Kelly was announced. The price was up 1,200% from the low of $3 per share in January 2006, when the company was mired in an accounting investigation that led to lawsuits, criminal charges and the departure of top AIPC executives.

"This company is really poised for growth," Kelly said. "If you take a look at our financial performance, it’s been nothing short of outstanding. If you look at our market performance the last couple of years, that was nothing short of outstanding. We’ve been among the best performing stocks since we were relisted. Our balance sheet is virtually debt free, well situated to increase shareholder value. We have many opportunities, whether its dividends, share buybacks or acquisitions, to continue to drive outstanding growth. Our goal is to be a top-tier performer in terms of growth.

"We think a lot of the same economic circumstances that have benefited pasta will continue to prevail in 2010 and 2011 as consumers rebuild their balance sheets. While we’re pleased with growth prospects for pasta through 2011, we are interested in additional opportunities. We have the category management skills that are continuing to drive performance for store brands. We are looking to expand into other underdeveloped store brand categories, leveraging what we’ve learned in supply chain, category management and grainbased procurement skills and conversion skills. We run over 3,000 s.k.u.s. (stock-keeping units) through our plants. If you take a look at our inventory levels, we are turning inventory very efficiently."

Even though his tenure at AIPC may still be young, Kelly has not hesitated to make major changes. A decision to de-emphasize the company’s branded pasta in favor of store brands required the difficult decision to shed business that was highly profitable. The company’s results in fiscal 2009 and the share price strength suggest the moves have paid off.

IN FOOD BUSINESS FROM HIGH SCHOOL

New to the pasta business, Kelly is not a food industry novice. Beginning while he was in his teens, the Philadelphia, Pennsylvania, U.S. native worked his way up the corporate ladder in the food business, beginning at the bottom and moving up a single rung at a time.

His father was in the dairy business, and Kelly worked in supermarkets to make money during high school. He has a degree in food marketing from St. Joseph’s University in Philadelphia, an education he believes paved the way for the career that he followed. When he graduated, he received 10 job offers in the food industry.

He began his career in 1974 at Oscar Mayer & Co., where he spent 17 years, first in the sales department and later in marketing. During his time at Oscar Mayer and afterward, Kelly was transferred numerous times — he counts 13 geographic moves over his career. An assignment that made a particularly powerful impression was a two-year stint in Italy, where Oscar Mayer owned a minority stake in Negroni, a meat processing company there.

"It was during this time I developed a passion for all things Italian — food, wine and art," Kelly said.

When General Foods acquired Oscar Mayer, Kelly was named national sales manager for the Jell-O snacks business, but when Philip Morris acquired Kraft, merging this business with General Foods, Kelly decided to leave the company for Häagen-Dazs, owned at the time by Grand Metropolitan P.L.C.

In 1992 he joined Fiorucci Foods, Italy’s largest meat processor, specializing in cured products such as prosciutto and cold cuts. Kelly was put in charge of the company’s U.S. operations, based in Richmond, Virginia. He spent eight years there, gaining responsibility not only for profit and loss but for the company’s balance sheet.

"They were very much a deli-oriented company, which gave me exposure to private label," he said. "Their customers included Sysco (a large customer of AIPC)."

Kelly’s last stop before taking the helm at AIPC was at San Antonio Farms, a Mexican foods manufacturer based in San Antonio. Kelly was CEO of the business, which is primarily a maker of private label salsas. The company was sold to Tree-House Foods in 2007. It was during the sales process that he interviewed for the position at AIPC.

"I was aware of AIPC from the time the company was formed," Kelly said. "It was a great story. Part of it was my interest in Italian products."

Kelly spent two months at AIPC as chief operating officer, transitioning to the post of CEO as Alvarez and Marsal, a turnaround firm, wound down its engagement. He succeeded James Fogarty, an Alvarez managing director, who had been AIPC president and CEO since September 2005.

The succession brought to an end a nightmarish chapter in AIPC’s history. In September 2008, the company reached a settlement with the Department of Justice and Securities and Exchange Commission (SEC) related to the company’s accounting and financial reporting practices. The SEC had alleged AIPC had overstated earnings by $59 million during fiscal years 2002-04. Several executives were charged by the SEC, and two were sentenced to prison.

The Alvarez years largely were focused on dealing with issues related to the investigation, Kelly said.

"Accounting matters took a lot of attention," he said. "It was a question of getting that done, getting current with our reports. We were dealing with shareholder lawsuits. The focus was on maintaining cash flow. Auditors, forensic accountants occupied a great deal of people time figuring out how to come out of the situation the company faced. Restatement expense was considerable.

"When I came, all the heavy lifting had been done. I understood what had happened and, more importantly, I understood the remedy. Now we have a new general counsel, an internal audit group that reports to the board, a disclosure committee that makes sure our statements are right. All this is done to be sure the numbers reported can be challenged internally if necessary if there are questions."

Kelly had particular praise for Paul Geist, the company’s chief financial officer (CFO), who in June 2009 was named Kansas City "CFO of the Year" by the Kansas City Business Journal.

"It’s a remarkable exclamation point to the fact that the bad news of the past was basically just accounting problems, not fundamental business, quality issues or service issues," he said.

Notwithstanding all the negative attention that accompanied AIPC’s problems, Kelly said the company was anything but a wounded animal when he arrived.

The company remained a leading supplier of private label and branded pasta, operating plants in Excelsior Springs, Missouri, U.S.; Columbia, South Carolina, U.S.; Tolleson, Arizona, U.S.; and Verolanuova, Italy. AIPC also operates durum mills at Excelsior Springs and Columbia. The company has 675 employees.

FUNDAMENTAL BUSINESS ALWAYS STRONG

"What I found when I got here, was AIPC has always had a wonderful reputation," Kelly said. "It had hit a bump in the road, but that had nothing to do with the fundamental business operations. Fundamental business operations around service, quality, always were very strong. The company has never lost any luster in terms of its ability to serve customers, its reputation with our accounts. So I found a really great, very strong company when I got here. I was impressed by its people and the board, including members of the senior management team.

"Management was filled with smart people, really focused, who understood the operation really well. These are people with really strong backgrounds."

Another plus, Kelly said, was the AIPC plants.

"I had a chance to see the Excelsior Springs plant before I joined and I was very impressed by the assets," he said. "They are excellently maintained. Walt George, who leads our supply chain organization, including operations, is very dedicated to preventive maintenance. We take each line down every nine weeks for an extensive rebuild so they are operating at optimum efficiency and optimum quality. Safety also is of paramount concern."

In spite of the company’s many strengths, Kelly identified two key and thorny questions that needed addressing when he took the helm: What is the strategy for growth? What should be done with the company’s brands?

"Our challenge with the brands was steadily declining volume, declining profitability and increasing trade spending," Kelly said. "That was problematic from a macro level. Store brands were growing and pretty solid.

"We went into a situation analysis and took the business apart, getting beneath the superficial stuff to see what was really going on. We asked, ‘What do we do better than anybody else in the world that we think we could build on and has economic viability?’ We discovered it was very clear that what this company was founded on was still a great basis for growth. The company is a very efficient, very high quality producer of pasta."

Kelly was not the first CEO at AIPC to struggle with the role of brands at the company. The company was established in 1988 by Richard Thompson, who secured a supply agreement with Sysco as the springboard for building AIPC into one of the nation’s largest pasta makers. Three years later, the company was struggling trying to establish Pasta LaBella as a consumer brand when Thompson left the company. While AIPC grew dramatically during the tenure of Timothy S. Webster, Thompson’s successor as CEO, AIPC struggled during this period to generate growth from its lineup of brands, acquired at various points during the 1990s.

As AIPC scrutinized its brands, Kelly saw a varied portfolio contributing a significant amount of earnings but broadly declining.

"We were first, second or a close third in 15 of the top 44 markets in the country even though we had not spent a lot of money on our brands to support them," Kelly said. "We really had not invested back in our brands in terms of new products or innovation."

Kelly described branded marketing efforts in the past as a "peanut butter" approach.

"You take a pot of money and spread it the same way across all your brands," he said.

As AIPC looked at its brands, retailers were doing the same thing across just about everything they were selling, Kelly said. Many were rationalizing the third, fourth and fifth best-selling brands. AIPC made the decision to withdraw brands that were fifth, fourth or sometimes third in a market.

STRONG FOCUS ON REMAINING BRANDS

As the company has withdrawn, it invested more money in remaining brands and has attempted, often with success, to fill in behind its withdrawn s.k.u.s with more space devoted to store brands.

"Store brands account for 30% of sales in some stores and 50%-plus in others," Kelly said. "We realized that if we understood best practices, we could apply those lessons to other customers, bringing know-how to retailers whose store brand penetration is not as great as the top retailers. Most retailers want to grow store brand penetration, seeing it as an important part of their efforts to create a unique identity for consumers.

"What’s crucial is that our store brand product quality is every bit as good as what we make for branded pasta."

Asked why Barilla was able to successfully create a national pasta brand while AIPC struggled with its brands, Kelly identified several key differences between the companies.

"Barilla is privately held and doesn’t have to worry about quarterly earnings the way a publicly traded company does," he said. "They are very large; I’ve seen estimates of sales at about $3 billion per year. Their concerns aren’t short term. They’ve done a terrific job, and they have the advantage of promoting Barilla as Italy’s No. 1 brand, which it is."

The retrenchment into private label helped open management’s eyes into avenues for expansion beyond its basic pasta business. Ironically, the lessons the company gleaned from its efforts in branded pasta have proven crucial in making AIPC stand out as a leader in store brands, Kelly said.

"It’s something we do better than anyone in the United States, no matter what the category," he explained. "And in part that’s because of our branded experience. It was selling branded pasta that gave us tools around category management and shopper insights that we now can bring to bear against our customers’ brands that allow us not to just produce but market our customers’ brands. I’m not just talking about the pasta industry. I’m talking about the entire private label industry, most of which grew up as a manufacturing, not a marketing, business. "

How retailers perceive private label has changed significantly over the last five years, in part because of retailer consolidation and the perceived benefit for retailers to creating these banner brands that allow them to attract customers. On the other hand, because the retail segment has become more fragmented between formats such as the value channel, club, traditional and mass merchandisers, creating an identity has become a greater challenge for retailers, Kelly said.

"It has become recognized on Wall Street that the healthiest, most successful retailers also have the highest store brand penetration," he said.

While trends for the company’s branded business were negative, Kelly said the decision to withdraw from several markets was not easily made. After all, even in decline, the branded business generally was the most profitable for AIPC.

"That was the challenge," he said. "That was the risk in our strategy. We knew what the retailers were saying about rationalizing brands, but would they actually do it? But we wanted to focus on growth, and we were expending resources (dollars and human) on brands that did not have a realistic hope of recovery. Still, the withdrawal strategy took a certain amount of courage of conviction. But to be stuck was no place to be either. Trench warfare with no advance is no way to win a war."

NEW HEALTH AND WELLNESS APPROACH

Together with changing its approach toward brands, Kelly saidAIPC takes a more realistic view toward achieving growth in the health and wellness category.

For many years, AIPC had used its Heartland brand as the principal vehicle for serving as a carrier of health and wellness benefits. As a result, new products with these benefits were not incorporated into its other brands.

"With the strategic review of our brands, we realized that creating a national health and wellness brand was not a likely scenario for AIPC," Kelly said. "Instead, we began putting health s.k.u.s in our other brands and private label. We had been depriving our brands of products with the greatest potential to give growth to the company."

Despite the declines of several of the company’s brands, significant pockets of strengths have been identified and will be nurtured.

"Market by market, we are looking for brands to strengthen," Kelly said. "For instance, for all of Barilla’s success elsewhere, Mueller’s is still the top brand in the Southeast. It’s still large in Michigan. But we are withdrawing from the Northeast. So we will continue to support it."

Kelly said in addition to Mueller’s, Golden Grain will be retained in certain markets and that Anthony’s may have potential for expansion. He said the brand sells very well in Southern California. Martha Gooch likely will be offered in a few markets in the middle of the country but that Ravarino and Freschi (R&F) will be withdrawn from retail and offered only at food service.

"This allows us to take our marketing dollars and concentrate them where brands were strong, spending on advertisements and consumer promotion, not just trade spending," he said.

For AIPC, 2009 was a year of execution against its new strategy. As the year progressed, it became clear that the wisdom of the decision was reinforced by changes transpiring outside the company.

The step coincided with an accelerated pace at which retailers were rationalizing brands toward the largest, Kelly said. The importance of store brands has been heightened by attention the world’s largest retailer, Wal-Mart Stores, Inc., has been giving its Great Value brand.

"They’ve identified Great Value as the largest brand in America and have really focused on that," Kelly said. "They’ve hired several leading C.P.G. company marketing executives to help lead and run that brand as a real brand and to put all kinds of investment and marketing strategies against that. We’ve been able to participate with Wal-Mart in some of that as a brand, not just a less expensive alternative."

Also beneficial was a sudden change in underlying pasta industry trends.

"Additionally, when we developed the strategy, we did not expect the traditional pasta category to grow 4.5% in 2009 and achieve record volume of 1.42 billion pounds," Kelly said. "It really helped fuel our strategy. We got a tail wind from the economy we never expected. With problems with unemployment, pasta became a great food for people to turn to. It has great value and is very simple to prepare.

"Also beneficial to us, there was a migration to store brands. While the category grew at 4%, store brands sales grew at a rate three to four times greater."

While 4% category growth overall and higher growth still for store brands were highlights for pasta in 2009, Kelly found other positive data for the industry. He noted that household penetration rose to 76% in the first half of 2009 from 74% in 2008.

"That’s an additional 1.9 million households purchasing pasta," Kelly said. "Penetration of healthier pasta products grew to 21% of households from 16%. Shoppers bought pasta an average of eight times in 2009, up from 7.2 times in 2008." He said the potential for further increases is considerable.

While the pasta business remains intensely competitive, Kelly said the focus of several companies has moved from generating volume to tapping into unmet consumer needs.

"I believe the industry has changed its risk-reward profile," Kelly said. "Back before Atkins it was all about market share and volume. Today, the industry is more mature and has become more sophisticated about diversity. It recognizes consumers have different needs and that pasta can be a vehicle for benefits such as fiber or omega 3.

"New World Pasta has done a terrific job in developing healthier products. Barilla, too. New World just introduced a product with one serving of vegetables."

With its tilt away from branded products and toward store brands, Kelly acknowledged that AIPC will be walking something of a fine line when it comes to product innovation. Beyond the high risk associated with new products, with 9 of 10 failing, retailers typically do not look to private label suppliers as a principal source of new products.

"Certainly on private label we will be a fast follower," he said. "Some retailers are willing to be on the leading edge with new products, but most want to follow a brand to set the price point.

"That said, we have a research and development line that produces 500-pound batches. That’s valuable when you consider the tremendous volume turned out by our other lines. It’s small and flexible, a great laboratory."

Kelly believes significant opportunities in product innovation have not been met. While whole wheat pasta has enjoyed some success, the product tastes different than regular pasta, he said. He noted the success the bread industry has had in finding whole grain products that match more closely in taste and texture with bread baked with enriched flour.

At AIPC’s Italian plant, the company is working to introduce a gluten-free pasta made from corn and rice.

"It’s a very interesting product," Kelly said. "We’re also working with ancient grains, quinoa in particular. Consumers don’t appreciate that pasta contains 12% protein, but what if we could deliver protein at 20% to 25%, and at a lower cost per serving than traditional protein sources?

"We need to help people understand how pasta fits into their lifestyle. We need to make healthier products more appealing."

Returning to opportunities for expansion outside the mainstream category, what does the company have in mind?

"The first thing we will concentrate on is the mega-pasta category," he said. "Not just dried pasta, but it could be frozen or refrigerated, macaroni and cheese, side dishes. Mega-pasta is probably an $8 billion category. Dry pasta is a $1.4 billion category.

"We can apply what we know to that other $6.6 billion or so and find categories that are underdeveloped for private label and leverage what we know to help to develop greater shares there."

Josh Sosland is editor of Milling & Baking News, World Grain’s sister publication. He can be reached at jsosland@sosland.com.

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