Description

Anyone interested in owning a food company that should generate a free cash flow yield of 34% (and growing) this year?  After surviving the perfect storm of unprecedented commodity increases, a massive facility consolidation project, and the credit crisis over the past three years, John B. Sanfilippo  (JBSS) is finally emerging as a leaner, more efficient, and once-again profitable nut producer.    

JBSS produces Fisher brand and private label nuts to grocery stores, food service customers, contract customers, and industrial customers.  Rather than provide a detailed company background, I would rather refer you to the two VIC write-ups from 2006, one of which I wrote when I was clearly too early with this idea.  Instead, I’m going to write about what makes the company a far better investment today than it was back in 2006, despite the fact that the stock price is far lower today than it was in 2006.

The Perfect Storm:  Now that the operating challenges of the past three years are entirely behind the company, it’s worth reviewing what caused the company to lose over $30mm during 2004-2006:

·         Commodity environment:  A commodity cost spike occurred in 2005 as a result of demand created by the Atkins Diet combined with crop shortages.  By 2006 commodity costs were already coming down, but it was not yet what I would call a favorable commodity environment.  Since then, commodity costs have come down further, and the company closed its unprofitable almond handling business in FY 07.  Exiting the almond business was an extremely important move, because it was both unprofitable and inventory intensive.  Today, commodity costs are much lower (costs are pretty much locked in now for the remainder of FY 08), which should allow JBSS to generate gross margins around 16%, which is closer to their historical average.

·         Facility consolidation project:  To reduce costs and accommodate increased demand, management decided to build a new state-of-the art facility and close the handful of small manufacturing facilities it has built up over time around the Chicago area.  The company’s facility consolidation project was an expensive endeavor, requiring over $100 million in cap ex over the last several years.  Furthermore, during much of FY 08, the company’s P&L looked horrendous because, during the transition, the company had to operate two sets of manufacturing plants simultaneously.  After a long transition, the consolidation project is now complete, and the company’s current facility is probably the largest, most efficient nut processing facility in the world.  Management is taking advantage of its new low-cost position by taking private label market share from its competitors.

·         Debt restructuring:  During the 2005-2006 period when commodity costs were out of control, JBSS violated its debt covenants (based on Debt/EBITDA ratios) several times.  Fortunately these covenant violations occurred during a far more benign credit environment.  To avoid further covenant violations, however, management decided to restructure its debt with a new set of lenders in order to eliminate Debt/EBITDA covenants in exchange for long-term debt securitized by the company’s assets.  The restructuring was completed in early 2008.  Today, the company’s new $117.5 million revolver matures in 2013.  Also, the company has two mortgages for $45 million which mature in 2023.  As of Sept. 30^th 2008, the company’s balance sheet included $131.9 million of net debt.     

The company survived this perfect storm of operating challenges for two reasons.  First, the company owned unencumbered real estate which it was able to sell in order to generate cash.  Second, management cut an enormous amount of unnecessary costs out of the business.  In addition to exiting the almond handling business, management re-priced or discontinued an enormous number of unprofitable SKUs representing 20% of the business at the time.  Most of the discontinued business was replaced by private label contracts with new private grocery customers (Whole Foods, Trader Joe’s, and Target).      

FY 09 Outlook:  Despite numerous one-time cash charges during FY 08 (ending in June 2008) related to the company’s facility consolidation project and its debt restructuring, the company nevertheless generated positive cash flow.  In FY 09, I expect that the company will finally generate what I call a normal level of profitability and free cash flow again.  Here is my forecast for FY 09 (ending in June 2009):

While I offer a precise forecast of $1.70 in EPS, I would feel better about offering a range of EPS between $1.50 and $2.00.  Within that range, today JBSS is trading at a multiple between 3.5x and 4.5x my EPS forecast.  Given that EPS is very likely to go up further after this year, the current multiple makes no sense. 

If you were excited by my EPS forecast, just wait until you get to my free cash flow forecast!  Now that the new plant has been built, the company has moved into maintenance cap ex mode, which is about $7mm in cap ex per year.  Meanwhile, depreciation is running at approximately $15.8mm per year.  So it’s not far-fetched to assume that the company could generate $25 million or more in free cash flow during this fiscal year, all of which will be used to pay down debt.

 In addition, the company is selling surplus more real estate.  It is currently marketing its second facility in Elgin IL that it no longer needs.  Management expects to realize a figure between $5 and $10 million from the sale of this real estate, with proceeds used to retire debt.

One of the significant challenges for JBSS is capacity utilization.  The company’s new manufacturing facility, while super-efficient, is too large for the current sales base of the company.  Today the company operates at 60% of capacity, which is one of the reasons that I am forecasting a gross margin slightly less than 16% in FY 09.  However, the company recently announced two new pieces of private label grocery business which should add about $40 million in incremental annual revenue, although less than half of this revenue run rate will be realized during the FY 09 fiscal year.  In addition, JBSS is bidding on several other pieces of new business.  Now that JBSS is the industry’s lowest cost producer, it is well positioned to take business away from its private label competitors. 

One of the characteristics which make this idea so attractive is that earnings should grow for JBSS even in the midst of an economic recession.  Strapped consumers are going to be trading down to private label and shopping more at Wal-Mart; JBSS is a direct beneficiary of both trends.  Yet JBSS is trading as if it were an office products retailer.

Valuation:   The only applicable comps to JBSS are Diamond Foods (DMND) and Ralcorp (RAL), trading at EV/ttm EBITDA ratios of 13.2x and 11.8x ratios respectively.  While these are trailing ratios, if we were to apply just a 6x ratio to the EBITDA JBSS will generate during FY 09 (ending in June 2009), the company is worth $17-$18 per share.  Alternatively, if JBSS were to trade at a price reflecting a 10% current year free cash flow yield, the company would be trading around $23.50 per share.

Why is this company so undervalued?  Since this is my second JBSS post, it should be obvious by now that I really like this idea, so I’m probably the wrong person to answer this question, but let me offer a couple of suggestions nevertheless.  First, there is no longer any sell-side research on the company.  Second, anyone who takes a cursory look at this stock gets scared by the losses the company has posted during the last few years.  Third, during a credit crisis nobody wants to touch a company that violated its debt covenants as recently as two years ago.  Fourth, management is very non-promotional.  Despite all the one-time charges that occurred during FY 08, management didn’t even bother to publish financial statements with adjusted EPS calculations.  Anyone who wanted to examine this company had to work out the numbers themselves.  Fifth, there probably has been some forced selling in this stock, and the stock is not very liquid.

Primary Risks:

-          Commodity nut costs skyrocket again.

-          The company loses one or more major customers.

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