Description

J&J Snack Foods (JJSF) - Short

May 2019

Summary

J&J Snack Foods is a manufacturer of snack foods and frozen beverages. The company competes in a few niche areas such as soft pretzels and frozen beverages, but otherwise operates in competitive, relatively low-return portions of the food industry. The portion of the business that is exposed to retail supermarkets is likely to continue to decline over time; the food service portions of the business are better positioned, but those are unlikely to show strong growth. It is also quite likely that the company is being managed less aggressively and capably than it was in the past, as Gerry Shreiber, who has been CEO since 1971, is now 76 years old and has delegated much responsibility. JJSF currently trades at 32x FY2019E EPS and 23x EBIT and will likely grow earnings at low to mid single digits going forward. Shorting JJSF is compelling given its high valuation and limited risk of high revenue or EPS growth, with the potential for very attractive returns on the short should the business falter more than expected.

The Business

J&J Snack Foods manufactures and distributes snack foods and frozen beverages to retail grocery and foodservice customers, including fast food chains, schools, stadiums, movie theatres, theme parks, malls, convenience stores and mass merchandisers. The company’s main products include soft pretzels (JJSF is the largest soft pretzel manufacturer in the US), churros, baked snacks and pastries, frozen beverages, frozen juice bars and ices, and handhelds. In FY2018 (year ended September 2018), JJSF generated ~$1.1bn in net sales with its three segments – Food Service, Retail Supermarket and Frozen Beverages – accounting for ~66%, ~11% and ~24% of sales, respectively. The company is based in Pennsauken, NJ and has a number of manufacturing facilities across the U.S.

JJSF is positioned well in the Soft Pretzels business. Soft pretzels are one of JJSF’s largest product lines (~21% of consolidated sales). Industry sources estimate that the company has a ~75% market share in pretzels at food service locations and a ~90% share in retail supermarkets. Additionally, the company is the owner of proprietary pretzel-manufacturing technology. The key brand in the portfolio is SUPERPRETZEL, along with smaller brands like Brauhaus. Though sales growth has been volatile for the segment in recent years, we do not anticipate that JJSF will lose share in this business.

The company’s Frozen Beverages franchise is also well-positioned. The segment represents 24% of sales (including the 9% of total sales derived from maintenance services), and key brands include ICEE and Slush Puppie. JJSF competes with large soft drink manufacturers for counter and floor space for its dispensing machines at retail locations – however, once the machines are installed, business is generally quite sticky with recurring sales of both beverages and maintenance services. JJSF has been acquiring a number of ICEE distributors in recent years, extending control over the full value chain and increasing maintenance revenue.

Outside of pretzels and frozen beverages, competition is quite fierce in JJSF’s product lines, and there are many competitors vying for consumer dollars and shelf space. Additionally, JJSF’s brands are not very well-known outside its core franchises. We believe that these dynamics are particularly negative for the company’s bakery, handheld, and frozen juice treat product lines.

JJSF’s top 10 customers account for 43% of sales. Four of these 10 customers are food distributors – it is likely that a number of the others are grocery vendors (including Wal-Mart). JJSF’s products are sold across a wide variety of venues, including schools, warehouse clubs, convenience stores, movie theatres, stadiums and malls. Distributors play an important part in getting products for the food service segment to the end customer, and the company works with over 100 distributors.

A number of factors pressured JJSF’s results in FY2018 causing EBITDA to decline by 2% for the year. These included increases in distribution costs, product recalls, production inefficiencies, and higher costs for labor and ingredients. While it is difficult to predict the significance of these negative trends to the company on a go-forward basis, they do highlight that the business is certainly not bulletproof (despite the fact that the stock is priced for perfection). Pricing power is difficult to come by for many brands in JJSF’s portfolio, which makes it difficult to offset these types of cost pressures.

Management

JJSF has a long-tenured management team. Gerry Shreiber, CEO and Chairman (age 76), has led the company since its founding in 1971 and Dennis Moore, CFO, has been with the company since 1984 (assumed CFO position in 1992). Gerry Shreiber purchased the J&J Pretzel Co. for about $73,000 at a bankruptcy auction in 1971. Over the years, shareholder returns have outpaced the market and the company has produced strong returns on invested capital (averaging 15% over the last 10 years).

Insider ownership of JJSF currently stands at ~21% with Gerry Shreiber holding a 19% stake in the company.

Acquisitions have been a key piece of JJSF’s growth over time. The company generally tries to buy small, bolt-on brands that are either struggling or have been neglected by their parent companies. These acquisitions have been small in scope over the past 15 years and have ranged across all segments. JJSF’s largest acquisition in recent years was the $31mm purchase of Hill & Valley, a premium bakery that produces sugar-free cakes, cookies, pies, and muffins.

Going forward, CFO Dennis Moore has stated that it is difficult to find close fits in the pool of available acquisition targets. Management has also stated that they consider valuations in the food industry to be high, which somewhat limits their options. The company has run with a cash balance for a number of years.

Gerry Shreiber’s annual cash incentive is equal to 2.5% of the company’s net earnings. Daniel Fachner, the President of the the ICEE Company, receives an annual bonus of 2% of the EBIT for the ICEE Company. Other executive officers receive annual bonuses that are either a % of salary or not tied to any specific formula. The company’s use of long-term incentive compensation is limited, as several executives have already accumulated substantial stock ownership.

Financials/Valuation

In 2016-2017, organic growth slowed to 2-3%, and management has stated that it is difficult to hold margins steady at these low levels of organic growth due to the pressures of wage/commodity price inflation. Organic growth in the 3-4% range, as we forecast, would likely imply stable margins going forward.

Over the past 15 years, JJSF’s NTM P/E has averaged 22x and NTM TEV/EBITDA has averaged 10x. Trading multiples for the company are currently at all-time highs.

At a share price of $161, JJSF trades at 32x FY 2019 earnings. This represents a significant premium to packaged food peers, the S&P 500, and the company’s own trading history. Given the slow pace of growth and competitive nature of many of JJSF’s markets, we believe that a lower trading multiple is warranted, making JJSF an attractive short opportunity. Results of the short could be even better if competitive pressures intensify, if the company faces operational difficulties related to a management transition, or if industry profitability declines due to labor costs, price competition, or any other reason.

Risks to the Business

• Given the discretionary nature of its products, JJSF’s sales would likely be more impacted by a weak economy relative to other packaged food companies. A large portion of JJSF’s sales are generated at malls, movie theaters, theme parks, etc., and would likely be harmed by tighter consumer budgets.

• Commodity price increases for wheat, sugar/sweeteners, cocoa and chocolate could potentially harm JJSF’s results. This is especially true given the company’s limited pricing power.

• Wage inflation could negatively impact JJSF’s profitability. 28% of JJSF’s labor force is unionized.

• Competition in the food industry could negatively impact JJSF’s profitability. Though JJSF has strong positions in certain niches, there is tremendous pressure on legacy brands across the food industry.

• Shifting consumer preferences to more healthy food products could adversely impact JJSF’s sales growth. Long-term, shifting consumer preferences towards more ‘better-for-you’ products could result in lower sales as JJSF’s products skew generally towards unhealthy treats like funnel cakes. This risk should not be overplayed, however – JJSF’s products tend to be one-time treats purchased at entertainment venues, as opposed to more staple food items, and so are somewhat insulated from these sorts of concerns.

Risks of Being Short

• The company will continue to be active in M&A and could make smart capital allocation decisions. Management has a decent track record in small/bolt-on M&A and has a good amount of capital free to deploy. A sizable deal at an attractive valuation could be very positive for the business. This risk is somewhat mitigated by management’s view that multiples in the packaged foods space are elevated.

• New licensing agreements or product innovations could have a positive impact on the company’s growth. It is possible that JJSF management could strike gold with a new product or category that generates a lot of buzz and sales. Additionally, licensing agreements with well-recognized brands could serve to drive sales – recent examples include the company’s agreements with Sour Patch Kids and Pillsbury.

• JJSF could be acquired by another packaged food company. This risk is somewhat limited by JJSF’s current premium valuation.

Catalyst

Catalysts

• Declines in grocery business

• Economic recession

• Operational missteps

• Changes in input costs