Description

Introduction

J&J Snack Foods (JJSF) is a snack foods and frozen beverages producer. Its best-known products are various soft pretzel brands (including SuperPretzel) and ICEE frozen drinks. J&J has been hit hard by the pandemic as about 2/3 of its sales are through schools, movie theaters, amusement parks, stadiums, and other venues that have been hit with restrictions. J&J’s operating income fell 85% in FY20. Yet, its stock price has recovered to pre-pandemic levels, and this seemingly unexciting business has an EV of $2.8 billion (nearly 3x sales) and trades at 32x its peak EPS of $5.00 in FY19 (J&J uses a September fiscal year). I think it’s a short with about 35% downside to $105 from the current price of about $160.

How Risky?

I came across J&J when looking for stocks that were up on the “reopening” trade and had completely recovered to pre-pandemic levels. There are lots of restaurant, travel, and entertainment stocks that fit the bill, but many of them appear to be too dangerous. JJSF looks interesting because it has exposure to movie theaters, entertainment venues, and out-of-home food service but appears to be much less likely to be a career-ender than shorting something like AMC. There is decent short interest in this stock, but it has fallen from 1.5 million shares in August to less than 1 million shares as of the last report. J&J has no known exposure to bitcoin, SPACs, autonomous vehicles, or Elon Musk.

The last short idea I posted on VIC was Movado in 2018. J&J, like Movado, is not a dirty company with a bad balance sheet or anything like that. Movado, though, worked as a short if people stayed with it long enough and covered it at the right time. J&J could be similar. This is not a terminal short. 

Previous Report

J&J was written up on VIC as a short by tdylan409 in May 2019. See that report for some discussion on how J&J appeared to be losing steam long before the pandemic. Coincidentally, JJSF was around $160 at that time of the prior VIC post. All the arguments made in 2019 about J&J’s overvaluation still apply and it’s probably a better short now. The only real difference between now and 2019 is that J&J was, and still is, affected by the pandemic. In 2019, tdylan409 thought J&J was overvalued at a forward P/E of 30x. Today, J&J is trading at 41x estimated FY22 earnings and it is coming off a terrible year. I think it could take another three years for J&J to return to FY19 profitability.

Catalyst?

My primary catalyst is that it takes longer than expected for J&J to get back to pre-pandemic sales and profits. I think the market is overestimating how quickly this will happen as J&J has high exposure to venues that have suffered during the pandemic. Consider that while sports and movies have resumed, theaters and stadiums are still mostly empty of consumers. Moreover, nobody really knows if the movie theater business will ever fully recover. The industry wasn’t in great shape even before the pandemic. Now, it seems likely that the number of movie theaters in the U.S. will decline. Unlike some rivals, J&J cannot make up for sales lost at out-of-home venues. J&J won’t go out of business…but would you pay 30x peak earnings for a company that sells frozen pretzels at Safeway?

A secondary consideration for a short is that J&J’s profit margins were in slow decline before the pandemic. This is about a 2%-3% organic growth business, and it is difficult to overcome inflation in expenses at this level. Investors seemed to have shrugged this off in the past. If, however, it becomes clear that J&J’s margins will not return to previous levels after the pandemic, the stock could get a lower valuation. 

History/Management

J&J’s CEO Gerald Shreiber must be one of the longest-tenured CEOs of any public company in the U.S. He bought a company called J&J Pretzel out of bankruptcy for $72K in 1971 and has been CEO even since. As he put it on a recent earnings call, “…You should be familiar with my name and whatnot as I've been in the same position now close to 50 years...” Shreiber is the living embodiment of the American Dream (according to him, anyway). Typical quote: “Our Company, born of ashes and dusted by destiny, represents all of what is right with this country.” All? Anyway, J&J has grown through numerous small acquisitions of bakery, snack, and beverage companies over the past five decades. The company has been public since it listed on NASDAQ in 1986.

From a corporate governance perspective, J&J is a typical family business. Shreiber, now 79 years old, is still involved but pulling back. Dan Fachner, CEO of J&J’s ICEE subsidiary, was promoted to president of the company in May 2020 and has taken a more active role. Fachner, like Shreiber, has been around forever - he has worked at ICEE since 1979 and has been president of the ICEE division since 1997. Fachner doesn’t really look like an inspiring choice to be Schreiber’s successor since he is 60 years old and ICEE has not been a great performer. Most of the value is on the J&J side of the business (pretzels), not the ICEE side, although the ICEE business may have some growth potential. Further, J&J’s management situation seems to have weakened over the past year as three top execs have left: its longtime CFO, its longtime COO, and a senior VP. Notably, the retirement of CFO Dennis Moore last spring was handled a bit strangely – J&J didn’t even put out a press release even though he had been in the position since 1992. His separation was just disclosed in an 8-K with no comment. In September 2020, J&J hired former Walmart finance exec Ken Plunk as its new CFO.

Shreiber may have taken a step back, but he still owns 19% of the outstanding shares and controls the board, which is mostly made up of company insiders. Unsurprisingly, Shreiber’s brother and his two daughters also work at J&J. None of the executives but Shreiber own significant amounts of stock. There has been no insider buying of any consequence at J&J for many years with one exception – Shreiber bought $18.4 million worth of stock in August 2020 at about $130/share. While this was a small purchase in relation to his current ownership stake (about $600 million), it was his only notable purchase in at least 15 years. He may have wanted to send a message during the pandemic.

As a side note, Shreiber introduced Fachner on the Q1 FY20 earnings call (in January 2020) by saying, “Dan, rest assured, I will kill you if we don’t have a great year.” He didn’t follow through.

I think there is little risk that J&J will be acquired by a larger food company. Shreiber would need to approve any sale and there is no indication that intends to ever sell. He is unfailingly optimistic. More importantly, J&J is more expensive than most potential acquirors and most of its brands are not that attractive or valuable. It has 80% share in soft pretzels, but that isn’t worth $3 billion.

J&J’s Brands/Segments

J&J produces products under about 40 different brand names. Many of them are practically unknown. Have you ever heard of Daddy Ray’s fig bars? Yeah, me either. Its best-known brands are SuperPretzel, the largest soft pretzel brand in the U.S., and ICEE, the frozen drink brand which has been around since 1967. I would hardly put either in the category of Coca-Cola or even Jif peanut butter. J&J also licenses some brands for weird novelty products like Oreo churros and does some collaborations. It even made limited-time funnel cake fries for Burger King. If you’re looking for a food company that is benefitting from the healthy eating, this is not it.

Bakery products accounted for 35% of J&J’s FY20 sales. Many of its recent acquisitions have been in the bakery area. I don’t think any of its brands in this category are strong. Its second largest (but most important) category is soft pretzels, which accounted for 20% of FY20 sales. J&J has a bunch of different pretzel brands that it sells in grocery stores, snack bars, convenience stores, warehouse stores, and just about everywhere else you find junk food. Its third-largest category is frozen beverages. This category dropped to 10% of FY20 sales from 15% in FY19 because of its high exposure to places that were closed or restricted during the pandemic. The rest of J&J’s sales are a variety of products like churros, frozen juice drinks, and funnel cakes.

J&J reports in three segments: food service, retail supermarket, and frozen beverages. As with many other food companies, J&J’s supermarket sales benefitted from the pandemic. In FY20, its retail supermarket sales increased 22.5%. However, this segment was still only 17% of total sales and the effect was probably temporary. As evidence, consider that J&J’s supermarket sales declined in FY19 as compared with FY18. Further, retail supermarket accounted for more than 100% of J&J’s operating income in FY20, but this was clearly due only to the pandemic. It’s a lower-margin business in normal times - it represented only 9% of J&J’s operating income in FY19. Meanwhile, J&J claims that 85%-90% of the grocery stores in the U.S. carry its products, so there is little chance that it can increase distribution materially.

Food service is J&J’s largest segment, but sales dropped 16% in FY20. Practically every part of this business was affected by COVID-19 as its sells through schools, stadiums, mall food courts, movie theaters, and other places that were restricted. Fortunately, it does have sales through warehouse and convenience stores that were less impacted. In normal times, food service is J&J’s biggest and most profitable segment – it accounted for 62% and 65% of its FY19 revenue and operating income, respectively. In FY20, food service recorded an operating margin of just 1.0%, down from 10.4% in FY19.

In the frozen beverage segment, J&J has significant revenue from sales of machines and repair and maintenance services. This part of the business has been growing. In FY19 (before the pandemic), beverage sales were only 56% of frozen beverage segment revenue with the rest being machines and maintenance. Frozen beverage segment revenue declined 26% in FY20, but the actual decline was worse than this because J&J acquired two ICEE distributors in the year. Excluding the additional revenue from these deals, its frozen beverage segment revenue declined 30% and its beverage sales (excluding machines and maintenance) dropped 45%. The segment reported a loss in FY20 but had an operating margin of 9.8% in FY19.

So, this is a largely fixed-cost business that is very dependent on people buying pretzels and frozen drinks outside of their homes.

Capital Allocation/Acquisitions

J&J is sitting on a lot of cash. At the end of December, it had $247 million ($13/share) in cash and securities and zero debt. Most of its cash is invested in short duration high-grade corporate bonds. Its 2020 10-K mentions that it has about $40 million in cash sitting in two bank accounts. Clearly, there is no risk of Shreiber getting involved with Roaring Kitty. J&J reported all of $4.4 million in investment income in fiscal year 2020.  

J&J hasn’t been returning much capital to shareholders. Its share buybacks over the past three fiscal years totaled just $11.7 million, much less than the $31 million in cash generated from option exercises. Meanwhile, it paid $42 million in dividends in fiscal 2020. J&J had been raising its dividend on a yearly basis but did not do so at the end of FY20. Its quarterly dividend has been set at $0.575 for the past 6 quarters, so its current dividend yield is only about 1.4%. This is rather unimpressive for a low-growth business with seemingly limited internal investment prospects.

J&J has said that it is holding its cash for acquisitions. The company was built through purchases of many small food and beverage companies. Shreiber has said that J&J will only make deals in the food sector. Lately, though, it has struggled to find attractive deals at reasonable valuations. These days, it would need to outbid about 100 SPACs. J&J’s last sizable acquisition of an unaffiliated food company came way back in FY17 when it bought Illinois-based baker Hill & Valley. J&J paid $31 million for Hill & Valley, or about 0.7x its more than $45 million in annual sales. For comparison, J&J itself trades at nearly 3x sales. Hill & Valley is best-known for pre-baked cakes, cookies, and pies that are sold in grocery stores, some of which are private label. Hill & Valley is one of the better-known producers of sugar-free baked goods, so it made J&J more competitive against healthier fare. However, J&J disclosed that Hill & Valley’s contribution to its FY17 operating income was practically nothing – an operating margin of less than 2%.

Soon after the Hill & Valley deal, J&J bought Labriola Baking Company, which bakes bread and pretzels. J&J paid for $6 million for Labriola, or about 0.4x its annual sales of about $17 million. Again, nobody else seems to be lucky enough to get J&J’s valuation.

Other than that, the only recent acquisitions have been of ICEE distributors. J&J is trying to build ICEE by marketing it directly throughout the nation. It wants ICEE to be more of a razor/razor blade model, with the blades being ICEE machines. This is, apparently, one of the bullish arguments for the stock, and machine revenue has risen. Since 2017, J&J has bought 3 ICEE distributors covering 6 southern states for a total of $68 million. J&J paid about 3.5x sales in these deals. J&J now owns nearly all U.S. distribution and intends to own the rest in time. It also owns international distribution (Canada, Mexico). The plan/hope is that J&J can build ICEE into something more than a novelty at movie theaters and mini marts. On its most recent conference call, Fachner said that J&J is “knocking on doors” to expand distribution into QSR opportunities. He said that there are ongoing tests. However, it’s hard to have a lot of confidence that something exciting is about to happen at ICEE since Fachner has been running the business for 24 years. That’s a lot of time for door knocking, even if J&J did not directly own the operations everywhere. ICEE seems limited - it is a seasonal (summer) product consumed outside the home rather than an everyday beverage.

Two Quick Points…

J&J’s capex appears to be large in comparison with similar companies. Capex was 5.7% of sales in FY20 and it was slightly up in dollars despite the weak sales. According to its 10-K, J&J has 18 warehouses and distribution centers for its snack foods operations and a whopping 177 facilities for its frozen beverage/machine operations. There was a question about this big footprint on J&J’s most recent conference call and management stated that it had no expectation of reducing the number of its facilities. J&J did close one factory in Chicago during the pandemic, but that’s it.

Higher commodity prices (sugar, for example) are negative for J&J. Given the competition in food sector, the firm has limited ability to raise prices. When it has raised prices in the past, it has lost some distribution. J&J’s snacks are sold through about 50 distributors.

Segment Financials

Organic sales growth for this business is typically in the low single digits. There’s nothing that really stands out. Long-term growth in food service is probably only about 2% per year. J&J had just over $1 billion in revenue in FY20 and FY21 will probably be similar.

One of the differences between J&J and some other snack companies is its frozen beverages business. Yet, frozen beverages only accounted for 25.6% of J&J’s operating income in 2019. This doesn’t seem to be one of those exciting drink stocks that comes around from time to time. ICEE has been around for more than 50 years.

Income Statement

J&J’s EPS dropped to $0.96 in FY20 from $5.00 in FY19 due to the pandemic. Its EPS of $5.51 in FY18 is not comparable due to a large tax benefit. J&J’s operating margins were just under 10% in FY18 and FY19. While these operating margins are not bad for a food company, they were over consistently over 11% just a few years ago. 

Balance Sheet

J&J is a very conservatively managed company. It has $13/share in cash on its balance sheet and keeps most of it in liquid instruments. There was talk that it could buy out some distressed food companies during the pandemic, but it hasn’t happened.

Cash Flow Statement

J&J generated $90.4 million in FCF in fiscal year 2019, so it is trading at about 31x peak FCF. I can’t see a company like Kraft Heinz or Mondelez paying a multiple like that to buy it. J&J’s FCF fell to $34.3 million last year, and it doesn’t look like it will be much more than that this year. J&J may not get back to 2019 FCF until FY24. 

Key Metrics

J&J’s margins haven’t been improving. Its margins peaked in 2014, when it had gross, EBITDA, and EBIT margins of 31.3%, 16.1%, and 12.1%. In FY19, these margins were 29.5%, 14.6%, and 10.5%. They were much lower in FY20 due to the virus. J&J’s cash conversion cycle has worsened. It was less than 40 days in the early part of the last decade but over 50 days in recent years. I don’t seen much reason to expect margin expansion after the pandemic is gone.

Earnings Multiples

Here is a summary of J&J’s median market multiples over the past 40 quarters:

J&J typically trades at around 2.0x sales, a P/E in the mid-20s, and 13x EBITDA. For fiscal year 2022, I’m expecting sales of $1.1 billion, $144 million in EBITDA, and EPS of $3.91. So, based on historical multiples, J&J is about 50% overvalued.

Due Diligence – “The Simpsons”

An in-depth examination of the pretzel industry can be found in “The Simpsons” episode entitled, “The Twisted World of Marge Simpson” (Season 8, Episode 11). In the episode, Marge buys a Pretzel Wagon franchise from Frank Ormand (Jack Lemmon). Eventually, the mafia gets involved. Here’s a relevant clip that explains the pretzel market in detail:

https://comb.io/iwlykR

Frank Ormand: Wherever a young mother is ignorant of what to feed her baby, you'll be there. Wherever nacho penetration is less than total, you'll be there. Wherever a Bavarian is not quite full, you will be there.

Marge: Don't forget fat people. They can't stop eating.

Homer (walks by): Hey, pretzels.

Valuation

JJSF has often appeared to be overvalued in comparison to similar firms. However, I think it is especially so at present. The current EV is about $2.8 billion, so it is currently trading at about 20x estimated FY22 EBITDA of $144 million. This is a high multiple, even in comparison with historical metrics. Using 12x forward EBITDA, I get an EV of about $1.7 billion, which comes out to about $105/share. This is a P/E of 27x FY22 estimated EPS of $3.91. These are aggressive multiples for snack companies, and one could argue that they should be even lower. Regardless, a price target of $105 represents 35% downside.

The market may anticipate earnings to rebound quicker. Since food service usually generates most of the EBIT, it would need to get back to normal quickly for J&J to return to peak profitability. Even so, there is no guarantee that its margins will come all the way back since they have been declining. 

One could potentially hedge a short in JJSF by going long Hostess (TWNK), which looks cheaper. Hostess had a 17.2% adjusted operating margin last year, which is far above even peak operating margins for J&J. Another possible hedge is Limoneira (LMNR), which I wrote up last year. LMNR should benefit from the reopening of restaurants as most lemons (its primary product) are consumed outside of the home.

The all-time high for JJSF was just under $197, or about 22% above the current price. That level was reached in September 2019, when J&J was expected to earn over $5.50/share in FY20. That was a different time, obviously.

Conclusion

Why short LKNCY, BLNK, TSLA, AMC, NFLX, or GME and end your career? Here’s a New Jersey snack food company with a Silicon Valley valuation. My price target on JJSF is $105, representing 35% downside. 

Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author has a position in this stock and may trade this stock.

Catalyst

ongoing weakness due to COVID-19, margin degradation