Description

Illiquid microcap suitable for PAs.

Asset-light, minimal capex business available at 7x EBITDA (normalized) growing HSD organically over the long-term with aligned shareholders and management team (>40% insider ownership) .

Summary:

New to VIC, Innovative Food Holdings (OTCQB: IVFH) is an amalgamation of different food-related businesses but is at its core a white-label distribution business running gourmet and specialty food distribution for U.S Foods. IVFH has historically mistreated minority shareholders: in the past decade, it’s burned more cash than its present market capitalization; increased shares outstanding by 130% with little results to show for the dilution; and paid $7m (30% of market cap) in compensation to senior management, resulting in a (-70%) return to shareholders since 2013. However, the past is the past. Earlier this year, the CEO was finally ousted after a group of hedge funds (namely JCP, Bandera, and Carlson Ridge) built stakes in the business and took board seats. A new CEO was brought in who formerly led Kroger’s $10B Head of E-commerce division (IVFH does <$100m in revenue…), and he was recently joined by a former Kroger colleague in the COO spot.  Under new leadership, IVFH is boosting gross margins by improving pricing and procurement, cutting unnecessary SG&A costs, and re-examining what business segments should remain in the company’s hands. In Q2 2023, EBITDA margins turned positive for the first time since 2019 (Q1 and Q2 seasonally weakest), improving 650 bps y/y thanks to a 377 bps boost to GMs and 271 bps reduction in SG&A as a % of revenue (24.2% vs 26.9%). 

A lot of work is being done to right-size the company and I believe IVFH is now reaching an inflection point. I expect a surge in profitability over the next 12-18 months as management’s changes start to roll through the financials and IVFH’s seasonally strong quarters (Q3 & Q4) show what true profitability looks like under new leadership. I believe the new owners of IVFH will do their best to unlock value, by either selling off the underperforming assets or approaching USF to see if they would be interested in acquiring the food distribution business. When valued solely based on its food distribution business, IVFH trades at 7x normalized EBITDA. Food distribution co’s tend to go for double-digit multiples of EBITDA in a sale, providing nice upside potential before considering IVFH’s other assets or sales.

“you have managed to destroy inexcusable amounts of value and lose money greatly in excess of any money your direct-to-chef business has generated” - Carson Ridge Capital on the former CEO

“We are getting extremely deep into the weeds to understand every dollar the company is spending and why. I’m personally reviewing every check that goes out the door” – New CEO at 1st IVFH earnings call since 2016

Background (skip and jump straight to current situation if so desired) 

IVFH started as Alpha Solarco in 1979, without much of a business: the company had a dozen patents related to photovoltaic solar cell designs but had limited sales and no capital to speak off. It merged with Solectric in 1992, giving it a public listing since Solectric had IPO:ed in 1984. Over the years, the company engaged in a lot of sporadic activities, including establishing a Chinese JV, a technology transfer deal with Saudi Arabia and other fun stuff! It was downgraded to the pink sheets in 1996 after failing to meet NASDAQ’s capital requirement rules.

In 2004, Innovative Food Holdings was formed after Food Innovations, the food distribution business that sits at the core of IVFH today, utilized the Alpha Solarco shell (which had been rebranded to Fiber Application Systems Technology) to engage in a reverse merger.

The former CEO entered the scene in 2007 and remained in control up until Q1 2023. Under his supervision, IVFH diversified, or should I say ‘diworsefied’ into a lot of different venues, including e-commerce, food brand management and meal delivery. In total, 8 acquisitions have been made since inception. The acquisition of The Fresh Diet, a meal delivery platform, in 2014 was particularly atrocious (see Carlson Ridge Activist Letter for details) and so far the acquisitions of the e-commerce sites iGourmet and Mouth.com in 2018 have not proven to be spectacular either. The one exemption may be Artisan Specialty Foods, which served as a nice complement to Food Innovations and gave IVFH a stronghold in Chicago. The acquisitions were possible thanks to egregious corporate governance practices on par with Dear Chairman anecdotes (this is a foreshadowing of things to come…). I don’t feel like all of IVFH’s pivots over the years can be attributable to honest missteps as the CEO’s promotional behavior points to more sinister conclusions.  As just one example, the CEO attended plenty of niche investment conferences and went on podcasts to hype up interest in the stock so he could continue to make more acquisitions. It baffles me that the interviewer did not push back harder here, but I digress. These acquisitions often left IVFH saddled with debt, which the cash from the food distribution operations stubbornly resolved time and time again. Compounding the issues was flawed thinking on an operational level, with the cost structure expanding at a quicker pace than sales volume would support. Look no further than the purchase of a 200k sqft warehouse facility in 2019 for $4.5 million to support the e-commerce division. The facility was much larger than needed at the time and, despite offline-to-online tailwinds due to COVID, the e-commerce business failed to grow into the facility. Fortunately, parts of the warehouse have been re-fitted to run Gate Gourmet’s distribution (more on this later), alleviating these issues. Utilization improvements from the facility still exist, as the new CEO mentioned in the Q2 earnings call.

Now thankfully, ownership has changed hands, presenting us with the current opportunity.  Things have been brewing underneath the surface for over 3 years, since James Pappas at JCP joined the board, and recently the pace of change has quickened thanks to the installment of a new CEO. But before delving into the new leadership at IVFH and their incentives, let’s take a closer look at the businesses within IVFH.

The Good Asset - Food Distribution 

(FY22 figures unless otherwise specified)

IVFH’s revenues are broken down into 4 buckets: food distribution (80%), e-commerce (18%), brand management (1%) and logistics (1%). In practice, only food distribution and e-commerce are relevant. 

Specialty food distribution for U.S Foods is the main piece of food distribution, representing 61% of food distribution revenues (49% of total revenues) and generating $40m in sales. IVFH also manages food distribution for Gate Gourmet, a large airline catering company (13% of revenues), and runs food distribution to local restaurants in Chicago through its subsidiary Artisan Specialty Foods (18% of revenues?). A sample of products IVFH distributes: Alaskan wild king salmon, foie gras, Italian gorgonzola, porcini powder, and dry-aged buffalo tenderloin. The annual shareholder meetings do sound nice! If anyone is interested in doing some scuttlebutt, order their specialty alligator meat and do a taste test for me. I’d be interested in your thoughts and expect to hear from you in the comments.

The food distribution business serves an important niche. Specialty foods are not worth the attention of large food distributors due to their limited market and low turnover. It does not make sense to optimize for perishable, slow-turning SKUs (which will be different from, say, salad) and manage those relationships with small vendors if it does not generate sufficient revenue to make up for the additional investment. Instead, small providers like IVFH source small-batch SKUs from hundreds of local vendors across the U.S and connect them to a large distribution network (USF) that sells the items to restaurants through its large salesforce. The vendors get access to USF, which they wouldn’t be able to on their own, and USF gets over 3,000 new food offerings without having to manage the customer relationship. There is no need for USF to warehouse the products because they are shipped directly from the source to the end user with IVFH handling the distribution of the product. As such, IVFH does not need to carry inventory for most of its distribution sales either, resulting in high returns on capital (note that inventory levels were temporarily elevated in 2020-2022 as prior management botched the operations of its e-commerce business). The only additional capital needed in the business as it grows is more salespeople and customer service representatives. 

It’s a business with good economic characteristics: 10% normalized EBITDA margins, high organic growth (+15% org growth historically) and high ROIC. Since specialty foods are lower in turnover than regular items, they carry higher margins than what you would see the USF’s and SYY’s of the world generate but naturally require more capital-to-sales. We can see the historical performance of the distribution business from 2010-2017 when we had somewhat clean financials (separating out discontinued operations in 2014-2016 to strip out The Fresh Diet). During the period, IVFH generated a 6% EBITDA margin on average while producing ~20% organic growth per year. This is a great achievement when taking into account the corporate malpractices at the time, including the ever-increasing SG&A base. Importantly, Had SG&A remained at 21% of revenue (like it did in 2010 when revenue only totaled $9m) through 2017, the EBITDA margin in food distribution would have been over 10%. See the 2016 and 2017 financials for the margin potential within the business.

Overall food service revenue has grown at +15% per year and USF-specific revenues by ~13% per year since 2010. IVFH’s Gate Gourmet business has contributed a lot to growth in recent years, and is likely the main driver, while the performance of the company’s food distribution in Chicago is harder to distinguish from the filings. It’s difficult to pinpoint what % of IVFH’s business today is food distribution in Chicago, but we know it's between 0% and 18% of total revenue. Perhaps 10-18% of revenue is reasonable. It’s not an immaterial piece of IVFH but won’t make or break the investment either. Artisan Specialty Foods, the subsidiary serving the Chicago market, supplies over 1,500 food products to over 500 customers in the region. I’ll throw in here that Chicago’s population has been growing by ~0.3% per year in the past two decades and that this is expected to increase at an increasing rate in the coming 10 years, though you don’t need to underwrite that to make this investment work.

IVFH’s contract with USF extends automatically every 12 months unless either party notifies the other not to renew. We do not know the details of the Gate Gourmet arrangement yet. 

Other Assets… (can also be skipped)

IVFH has been losing money in recent years due to diworsification initiatives into new lines of business coupled with excessively high executive compensation. These other businesses may have potential but I’d be hard-pressed to assign any value to them in their current state. For simplicity’s sake, I’m assigning $0 value to them. I’m giving management the benefit of the doubt on stemming current losses from these operations within the next 12 months, an assumption I’m only confident in due to the change in leadership and the economic alignment with the board.

E-commerce:

• Asset 1: iGourmet, sells artisan foods and food subscription boxes through iGourmet.com, but also offers its food items through third-party channels like Amazon and Walmart. 
• Asset 2, Mouth.com, similarly offers specialty foods and monthly subscription boxes but targets corporate customers (gift boxes) to a larger degree it seems. 
• Asset 3, Plantbelly.com, builds on IVFH’s experience in ecommerce and subscription boxes, with the added twist that all ingredients are plant-based. Simple enough!

These websites serve an interesting purpose: aggregating niche food products from small passionate producers around the U.S and giving them a platform to reach consumers. However, the scale required to operate the e-commerce business is unclear and so is whether the end market is sufficiently large or non-competitive enough to support it or not. The sites earn most of their profits in the holiday season so the cash flows are back-loaded in any given year.

The remaining divisions are not really worth spilling ink over as their contribution is immaterial. Here’s from the 10-k if you’re interested: OFB and Oasis function as outsourced national sales and brand management teams for emerging organic and specialty food CPG companies of a variety of sizes and business stages and provides emerging and unique CPG specialty food brands with distribution and shelf placement access in all of the major metro markets in the food retail industry.

A detail that could be worthy of attention are the logistics revenues, which simply reflect the warehousing IVFH does for third-party clients. This small segment helps to optimize the utilization of the company’s existing facilities by renting out unused space.

Dethroned  

In Q1 2023, we said goodbye to the old CEO in favor of a new ruler. The past leader inflicted great harm on IVFH, not only through past actions (which pushed IVFH to the brink of survival)  but in order to go separate ways, IVFH had to pay him $1.8m, or more than 10% of the market capitalization at the time. A $1.3m accrued liability is on the books, yet to be paid. We also waved goodbye to the “Head of Strategic Acquisitions” for a cost of $126k. Purging is expensive!

The CEO was bound to be pushed out sooner rather than later. It’s a development that’s been in the making for over 4 years, ever since James C. Pappas bought 10% of the shares in 2019 (through his partnership, JCP) and pushed for 3 board seats. Incidentally, the average price paid at the time is almost equal to the last traded price of ~$0.55 per share. When Mr. Pappas failed to get his proposed changes implemented, he brought on a few friends. Jeff Gramm of Bandera Partners joined the board in 2021 and participated in a private share issue (as did JCP), acquiring over 7% of the company. Mr. Pappas and Mr. Gramm have a history of doing business together. In 2013, they teamed up to take control of Morgan’s Foods, resulting in the sale of the business one year later. Pappas and Gramm are also both on the board of Tandy Leather Factory, where Gramm sits as executive chair. That story is still playing out, as avid VIC readers are aware. Notably, Mr. Gramm is the author of the excellent book Dear Chairman, which tells the story of the rise of shareholder activism. Mr. Pappas’ actions seemed to have also given Denver Smith of Carlson Ridge Capital a change of heart, as he began accumulating more shares in IVFH after having previously sold shares he had owned as early as 2013. Interestingly, Mr. Smith just became a director in Q1 2023.

Today, JCP owns 16% of IVFH, Carlson Ridge owns 7.5%, and Bandera Partners owns 7%. Other large owners not mentioned previously include Hank Cohn (director) with 9% ownership and Inlight Wealth Management with 7% ownership. 

The board of directors now overwhelmingly skews shareholder-friendly, with the majority of the seats occupied by the new fund shareholders plus the CEO and COO. James Pappas is chairman of the board. There is still work to be done: Joel Gold, for example, has been on the board since the start in 2005 and is remarkably still a director at IVFH as of 2023 despite the horrid performance in those 18 years. Investors should not cheer his presence on the board. The man is also 81 years old…

All Hail the New King

Bill Bennett was brought in as the new CEO in Q1 of this year, having previously served as VP and Head of E-commerce at Kroger for 3 years, and before that 7 years at Walmart. I would have been excited with any CEO when contemplating the alternative, but Mr. Bennett’s first 4-5 months at IVFH have really made me excited.

Under Mr. Bennett’s leadership, IVFH has:

1. Refreshed its board of directors, including electing a new chairman
2. Restructured IVFH’s short-term maturities (!)
3. Turned IVFH profitable (in less than two quarters, mind you) by raising prices and slashing marketing costs (!)
4. Greatly improved working capital and inventory management
5. Hired a new COO (Mr. Smallwood from Kroger)
6. Launched a loyalty program for iGourmet
7. Finalized a budget and incentive program for 2023
8. Onboarded new auditors (Assurance Dimensions)

Mr. Bennett’s first earnings call on Aug 10th (and IVFH’s first earnings call since 2016) greatly validated my belief in management’s capabilities and IVFH’s path going forward. I highly recommend you listen to it.

“We are getting extremely deep into the weeds to understand every dollar the company is spending and why. I’m personally reviewing every check that goes out the door” – Bill Bennett, Aug 10th

For starters, Mr. Bennett expressed his unwavering commitment to a return to profitability and growing shareholder value. 2023 is going to be a year of stabilizing the current operations and setting IVFH up for future growth in 2024 and beyond. We saw this expressed in the financials, as sales declined by 6% but margins returned to positive territory, improving by 500 bps q/q and 650 bps y/y. The change is even more impressive considering that Q2 is one of the seasonally weakest quarters for IVFH with most of the profits being generated in Q4. Gross margins were a big part of the story, improving by 370 bps in Q2. Mr. Bennett believes there is plenty of opportunity here still. Shockingly, when new management came in and inspected the business’ operations, they found HUNDREDS of food line items that had not seen price adjustments since 2020, despite 5-6 supplier price hikes. With this in mind, it’s not surprising that IVFH could not break a profit. The new management has gone through the entire catalog and made the necessary price changes. Some of these adjustments are yet to flow through the financials. Gross margins should be between 300-500 bps higher in a normal year, or ~30%.

Additionally, a lot of internal financial reporting had historically been lacking at IVFH, making it hard to gain a day-to-day inside view into the profitability of the operations. This is being addressed. A lot of the improvements will be simple process improvements that are minor in and of themselves but when combined compound into a significant cash flow lift. For example, inventory procurement is getting improved, the company is being more aggressive on drawing down accounts receivable, and is renegotiating legacy pricing terms. Every single purchasing contract is getting looked at. These changes are all contributing to a much improved capital conversion cycle. 

Food service will receive more attention than under previous leadership and is now considered to be the main growth driver, in contrast to the previous e-commerce pivots. After the price changes that have occurred, food service is now a “significantly more profitable business“ according to Mr. Bennett. E-commerce sales are decreasing more rapidly than food service, primarily due to lower marketing spending. This is a strategic choice as IVFH’s LTV/CAC ratio has historically been out of whack. New management is halting all unprofitable marketing expenditure until the ratios can be improved and the cash flows exist to support a more aggressive marketing strategy. 

In summary, everything I was expecting/hoping to happen (and more) is getting done.

At this point it may be worth asking what’s in it for the new CEO? Why leave Kroger? Mr. Bennett is paid a $375,000 salary and an annual incentive bonus of at least 50% of base, surely less than he would make at Kroger, but more importantly he’s rewarded with a lot of stock should he turn IVFH around. His share grants equal 7.5% of the current shares outstanding (maximum consideration) and are vested in stages based on price, ranging from $0.6-$2.00 per share. At $2.0 per share, Mr. Bennett would own just over $7m of a $100m enterprise. Not bad. Similarly, the new COO has ~700k stock options (with higher targets than Mr. Bennett’s) and is eligible for 1.5m stock appreciation units, ½ vesting at $1.50 per share and the other ½ vesting at $2.0 per share (both tranches to be settled in cash). I consider them well incentivized. Add in the +45% owned by the board and Insight Wealth Management and the picture is bright. I account for potential dilution in my calculations of fair value. 

Looking ahead, after GMs have returned to normal, Mr. Bennett has a big opportunity to right-size SG&A at IVFH outside of marketing costs. A large portion of it should be addressable as IVFH managed just fine with SG&A equal to 21% of revenue in 2010 when total revenues were just $9m. The opportunity is there to increase IVFH’s profitability by 40% versus its 2018 EBITDA (peak profitability year in history) by boosting food distribution EBITDA margins to 10% and stemming losses in the company’s other divisions. Should this occur, IVFH trades at 5x normalized EBITDA today.

Valuation:

I value IVFH purely based on its food distribution business since I view the other assets with great skepticism and think you should as well. As I mentioned earlier, I’m confident enough in the management team’s operations and the board’s ability to assess what opportunities are worth pursuing to ascribe a neutral value to the remaining operations outside of food distribution. Should E-commerce improve under the guidance of Mr. Bennett and Mr. Smallwood, great; should it not improve in the first 12-24 months, they will likely minimize cash burn and divest the assets. Happy to hear pushback on this if you have strong views either way.

IVFH’s normal EBITDA margins should hover around 8-10% considering that it reached a 6% margin for most of its life as a public company when it was only generating $10-20m in sales and while being looted by former management (see expanding SG&A base every year – nothing else is more consistent at IVFH!). It tracks well with my view on normal GMs of ~30% and that SG&A should be able to creep down to 21% of revenue, like IVFH achieved back in 2010-2011 as well as in 2016-2017. Using an 8% EBITDA margin, IVFH trades for 7x normal EBITDA in 2024. I grow 2022 revenues by 10% to get to my 2024 sales, resulting in just over $70m in sales and $5.6m in EBITDA. This is slower-than-usual topline growth as 2023 will be a stabilization year that’s likely more muted in terms of growth, with the pace picking up in 2024.

Food distribution businesses tend to transact at 12x EBITDA on average, though the two largest players (Sysco and U.S Foods) naturally trade in public markets at a slight premium to the average. Since food distribution is highly fragmented with the top 3 players controlling c. 40% of the market and the remaining 60% coming from a long tail of small local and regional providers, consolidation is always top of mind. I would not be surprised if USF eventually acquires IVFH when/if it becomes large enough to justify bringing the additional volume in-house. SYY is the company in the industry with a history of doing smaller and frequent acquisitions but USF has done a few $100-200m deals in the past too (see TOBA and, more recently, Renzi). IVFH’s reliance on USF limits an acquisition to, well, USF, so relying on a sale for unlocking value here could be futile. Consider the value inherent at IVFH regardless: with HSD organic growth and little required capex, one can easily pay 10x EBITDA and earn a +10% return. So while a discount to the avg is likely warranted due to the customer concentration risk, the high organic growth compensates for a lot of it.

I further think that the EBITDA contribution to an acquirer (uh uhm USF) post-integration would be a lot higher than IVFH’s steady-state margin, above 10% if 2016-2017 are to go by (one of the rare moments in IVFH history when there were no acquisitions and SG&A did not increase more rapidly than revenue). I feel pretty good about applying a 10x EBITDA multiple on IVFH’s operations. This translates to a 15x P/E and results in a 50% upside to the current share price of $0.65. The return to normal margins should occur within the next 12-18 months, resulting in a 30% IRR through 2024.

Longer-term, I see potential for IVFH to be worth $1,65 per share in 5 years from now if they manage to grow at 7% per year and reach a 10% EBITDA margin. This is a much lower growth rate than IVFH has achieved in the past but assumes a lot of improvements on the SG&A front. The 5-year target presents a 154% upside and a 23% IRR.  

Unfortunately, shares have rallied close to 90% from $0.35 to $0.65 since I began this writeup in July so the upside has compressed some but still has decent potential. This tells you how crazy cheap it was previously. I’m sorry for my slow typing! I will serve the VIC community better next time around. Considering the illiquidity of IVFH (the float is <50%, or sub-$15m), we may get more opportunities to acquire shares at not-just-cheap-but-crazy prices.

I see further upside potential than what I’m currently modeling. As the company’s cash flows improve, it opens up the ability for the debt to be restructured at better terms, decreasing interest payments and providing further upside to the equity value. Additionally, I’m not familiar enough with the intricacies of tax law to know whether the substantial NOLs ($15.8m) are utilizable despite a +50% change in ownership of the company, so I’m not going to consider them for now but could add 10% to my EV if they are applicable. If you can share your perspective on this, let me know in the comment section! 

Risks:

• 2 largest customers represent 63% of revenue
• I could be gravely underestimating the health and/or complexity of the business and it may prove more difficult than anticipated to turn the business around
• Revenues could be inflated due to the low prices set by former mgmt and new price increases may result in a significant drop off in revenues

Catalyst

• Full year of profitability
• Investor day in 2023 (date TBD)
• Sale of various business lines