Description

Counter to the July 2008 bearish VIC write-up on Lance (LNCE), we find LNCE to be a compelling investment idea at current levels.  We feel that after the stock's recent sell-off from the October 2009 high of above $27, it is an opportune time to accumulate shares.  In our opinion, LNCE is a high quality, well managed company that is underappreciated for its potential earnings power, growth prospects and private market value.  Lance boasts a pristine balance sheet and substantial operating leverage in its P&L.  We believe that Lance is nearing an inflection point in a several year transformation period that began when CEO David Singer arrived in 2005.  We feel that investor awareness will grow as we enter the 2^nd half of 2010 when Lance will be experiencing higher revenues coupled with lower commodity costs resulting in increased margins and rising returns on invested capital.  We feel there is substantial upside to today's share price.

Background:  

Lance, based in Charlotte, NC, is one of the largest manufacturers and distributors of snack foods.  The company's products include sandwich crackers and sandwich cookies, potato chips, cookies, crackers, other salty snacks and candy.  Lance maintains strong national brands (Cape Cod, Lance) and lesser known, yet strong regional brands (Tom's, Archway and Stella D'Oro).  The branded business represents 60% of revenues.  Additionally, LNCE maintains a private label business that is capturing significant share in the mass retail channel.  The private label business currently represents roughly 30% of revenues.  The remaining 10% of revenues are generated from its contract manufacturing business.

The company's current prospects, and the reason we are bullish on LNCE, are a reflection of the efforts of David Singer and the management team he assembled after he joined the company in 2005.  Prior to Singer's arrival the company under-invested, poorly allocated capital and failed to innovate.  The Board decided to make a change at the executive management level in 2005 and brought on Singer.  Soon thereafter he put together a team that boast impressive resumes.  The list of new executive management including Singer are as follows:

David Singer - CEO since 2005; formerly CFO of Coca Cola Bottling 

Rick Puckett- CFO started in 2006; formerly CFO of United Natural Foods

Blake Thompson- SVP of the Supply Chain since 2007; formerly held same role at Tasty Baking and prior to that was VP of Operations at Frito Lay

Glenn Patcha- SVP Sales and Marketing since 2007; formerly SVP Marketing of Conagra 

Prior to new management, it's important to note LNCE lack of investment in its business.  In the 2000-2003 timeframe capex ran significantly lower than depreciation.  In 2003, LNCE spent a mere 3% of revenues on capital expenditures.  In 2006, 2007 and 2008, as new management began to implement its transformation plan, capex ran at 6.4%, 5.2% and 4.6% of revenues.  Packaged food company peers typically spend roughly 4 to 4.5% of revenues on capital expenditures.  In 2010, as revenues approach $1bn, up from $600mn in 2004, management has guided for $40-$45mn in capex, which is inline with its peer group. 

Since 2005, Lance has gone through a massive undertaking of streamlining its business.  The increased investment spend and highlights of management actions are listed below.

• Investing in its direct store delivery (DSD) system. Roughly 40% of LNCE revenues are generated through its DSD system. Further, 60% of its branded revenues are via its DSD network. The DSD system is a high fixed cost distribution method, yet, it is substantially incremental to margins as revenues grow and routes are optimized. We'd note that David Singer came from Coca Cola Bottling where the company's bottling DSD network was considered best-in-class. Since Singer has joined LNCE, optimizing this network has been a majority priority and a very difficult endeavor. LNCE has reduced its number of DSD routes to 1,100, down from 1,800 in 2005. LNCE exited its vending business in 2007, which was very inefficient. The company has invested in e-vans which allow drivers now to make 1.25 trips for every 2 it was making prior. LNCE has upgraded its entire truck fleet. Additionally, delivery drivers now have Motorola (Symbol) handheld devices to enhance their efficiency whereas they had archaic, and often non-functioning, devices prior. Per management guidance, LNCE is now roughly 70% complete with its DSD transformation. We'd note that while this platform will be vitally important going forward, it has been disruptive and one of the reasons why performance suffered in 2009. As we enter the 2^nd half of 2010 (possibly Q2) and this transformation is complete, we expect to see meaningful benefits to the company's margin profile.

• ERP system. Given the heroic efforts to optimize the DSD system, it is equally impressive management has replaced seven distinct software systems. In 2008 and 2009, LNCE management implemented a new Oracle ERP system to effectively manage and maintain its finance, manufacturing, shipping and procurement platforms.

• Streamlining manufacturing coupled with acquisitions. We discuss these together because LNCE made a few opportune acquisitions that allowed for additional capacity in well-placed geographic areas that enabled the company to add both manufacturing capabilities and revenue opportunities. In October 2005, LNCE acquired Tom's out of bankruptcy. This acquisition added four salty snack production and distribution centers, as well as additional capacity for candy manufacturing and peanut processing. This acquisition was important because it enabled the company to add capacity and revenue at a lower cost than building it themselves. LNCE recent acquisitions of Brent & Sam's, Archway and Stella D'Oro are also value added as they have added a revenue boost and additional manufacturing at a low cost. LNCE spent $31mn on Archway (also out of bankruptcy) which included its Ashland, OH plant. LNCE paid $24mn for Brent & Sam's (a premium private label cookie manufacturer) and shortly thereafter shut down its Little Rock, AR bakery and moved it to Archway's Ashland, OH facility. Finally, LNCE bought Stella D'Oro (LNCE acquired the brand only) for $23.9mn and began manufacturing Stella at its Ashland factory as well. Since management has joined, LNCE has made four acquisitions, closed four factories and consolidated its Canada operations to two plants from three.

• Commodity purchasing and hedging. Immediately after joining LNCE, Singer centralized the commodity purchasing function. Prior to 2006 commodity purchasing was done by each manufacturing location. By centralizing purchasing, LNCE has been able to have more bargaining power with its suppliers. Additionally, LNCE had no commodity hedging programs in place prior to the end of 2008. A quick look (see below) at the gross and operating margin profile since 2005 shows a dramatic increase in gross margins (to 44.5% in Q2 2007) and operating margins (8.2% in Q2 2007) and then a subsequent several quarter decline until we entered 2009. This decline was directly related to commodity inflation. LNCE is especially sensitive to wheat prices as every $1 move up in wheat translates into $8mn more in operating costs or $0.16 in EPS. Other notable commodities include soybeans, potatoes, sugar and natural gas. We note that Q4 2009 operating margins have returned to the 8.1% level and 2009 full year margins reached 6.6%. This is up from 3.6% in 2008 when no hedging was in place until 2^nd half of the year. Admittedly, LNCE did a poor job of managing commodity inflation (and deflation) in the 2007-2009 time period. Gross margins suffered dramatically. Pricing generally takes up to 90 days to implement, so as wheat, soybeans and other commodities ascended in 2008, LNCE had no protection to escalating prices. In 2009 LNCE began a hedging process. Unfortunately, as commodity prices fell in 2009, LNCE was locked in at prices substantially higher than spot prices. We expect that as hedges roll off to lower levels in Q2 2010 and beyond, the operating improvements LNCE has implemented will be much more transparent. We expect the 2^nd half margins to be appreciably higher than 2009 levels and 1^st half 2010 levels. 

Prospects for the company going forward

Essentially, much of the heavy lifting to right-size the business has been made and we expect the final hurdle - the completion of the transformation of the DSD network- is just around the corner.  Interestingly, despite the company's increased spending, LNCE maintains one of best balance in the packaged food space.  LNCE has maintained its dividend as well.  Below see LNCE debt profile versus its peers.

              Debt/EBITDA              Debt/Capital

HAIN               4.0x                 26.9%             

KFT                 3.0                   42.2

HNZ                2.9                   80.8

RAH                2.8                   38.0

GIS                  2.6                   56.6

CAG                2.4                   42.5

SJM                 2.4                   23.7

THS                 2.3                   34.7

K                     2.0                   68.2

DMND             2.0                   39.9

SLE                  1.9                   57.8

CPB                 1.8                   78.3

MKC                1.7                   42.6

LNCE              1.2                   29.1

FLO                 0.9                   25.7

JJSF                 0.0                   0.1

LANC              0.0                   0.0

LNCE has the infrastructure in place, revenue opportunities available both organically and through additional acquisitions and a solid balance sheet in place to provide flexibility.  Much of this write-up has focused on capital spending to align costs, but LNCE has also taken steps to innovate.  Specifically, LNCE has unveiled new packaging and introduced new products both in branded and private label.  Branded innovations have been focused in the Cape Cod (additional flavors) and Lance lines (whole grain sandwich crackers).  Private label introductions have been focused on moving up the value chain into mainstream and premium products (Brent & Sam's).  LNCE net revenue growth is evidence of its success.  Revenues grew 11.8% in 2008 (half of which was from pricing) and 7.3% in 2009 (very little from pricing).  Branded revenue growth stagnated in 2009 while private label picked up the slack, but we attribute weakness in branded to disruptions in the DSD system and to some waning of demand in the convenience channel.  As the DSD transformation is complete, our thesis hinges on improvement in the branded category as the system is optimized.  We will be monitoring branded closely.    

LNCE Valuation:

Based on 3/16/10 prices

A quick look at LNCE market valuation today:

Stock Price                                            $22.38

Shares Outs                                           32.2mn

Market Cap                                          $721mn

Cash & Equivalents                            $5.4mn

Total Debt Outstanding                      $113mn

Total Enterprise Value                        $829mn

On a relative valuation basis, LNCE looks reasonably priced versus its peers on a TTM basis, but looks cheap when considering any increases in its margin profile.

Ticker              Market Cap      EV                   EV/S    EV/EBIT          EV/EBITDA    '10 P/E

KFT                 $43,924            $60,909          1.5x     11.1x               9.5x                 14.4x  

GIS                  24,056             30,142             2.0       13.2                 8.9                   15.9

K                     20,124             24,673             2.0       12.3                 10.3                 14.7

HNZ                14,967             19,284             1.9       12.9                 10.5                 16.5

CPB                 11,930             14,470             1.9       12.2                 8.9                   14.3

CAG                11,396             14,390             1.1       12.6                 8.8                   14.7

SLE                  9,832               11,343             1.0       11.4                 7.0                   13.6

SJM                 7,139               7,923               1.7       14.8                 7.8                   14.6

MKC                5,110               6,062               1.9       12.6                 10.5                 15.3

RAH                3,671               4,950               1.3       11.0                 7.9                   13.6

FLO                 2,315               2,560               1.0       12.6                 9.0                   16.1

LANC              1,661               1,569               1.5       12.0                 7.8                   13.8

THS                 1,424               1,822               1.2       13.9                 10.2                 16.6

DMND             885                  971                  1.6       21.2                 14.9                 22.8

JJSF                 813                  724                  1.1       10.8                 7.3                   17.5

HAIN               710                  919                  0.9       20.9                 10.7                 16.5

Mean                                                               1.5       13.4                 9.4                   15.9

LNCE              721                  829                  0.9       13.6                 8.9                   15.5

Applying a multiple at the mean of its peer group on $980mn in estimated 2010 revenues generating an EBIT margin of 8% in 2010 we arrive at $78mn in EBIT, $113mn in EBITDA and $1.50 in EPS.  That would translate to a 0.8 EV/S, 10.6x EV/EBIT and a 7.3x EV/EBITDA multiple, all discounts to the group.  At 1.50 in EPS it is inline with the group.  Assuming a higher 9% EBIT margin would result in $88mn in EBIT, $123mn in EBITDA and a $1.70 in EPS or EV/EBIT, EV/EBITDA and P/E multiples of 9.4x, 6.7x and 13x.  All discounts to the group.

On a DCF basis we believe shares have little downside and high reward if margin improvements are achieved.

Base Case:  we assume normalized operating margins should reach 9%.  We estimate revenue growth of 7% in 2010 trending down to 3% at terminal value in 2014.  We assume that margins trend up to 9% and then assume 9% for our terminal value calculation.  We assume a discount rate of 8%.

Value per share:                 31.43

Shares Outstanding:            32mn

Total Value:                         1,115     

Total Debt                             113

Total Cash                            5.4

Equity Value                        1007.7

Base Case                             2010       2011       2012       2013       2014       Terminal

Revenue                                982         1041       1103       1170       1228       1265

EBIT                                      79           86           94           102         111         114

Less Cash Taxes                      27           29           32           35           38           39

NOPAT                                   52           57           62           68           73           75

Plus D&A                                35           39           43           45           47           49

Plus Chg WC                           4              4              4              4         4             4

Less Capex                           44           44           47           50           52           54

Free CF                                39           48           54           58           63           67

PV FCF +TV                          36           41           43           43           43           904

Bull Case:  we assume normalized operating margins of 10% revenues grow 5-7% and then 3% at TV.

Value per share:                  36.78

Shares Outstanding:            32mn

Total Value:                         1287      

Total Debt                             113

Total Cash                            5.4

Equity Value                        1179

Bull Case                              2010       2011       2012       2013       2014       Terminal

Revenue                                982         1041       1099       1156       1214       1250

EBIT                                      78.6        89           99           110         121         125

Less Cash Taxes                  27           30           34           37           41           43          

NOPAT                                  52           59           65           72           80           82

Plus D&A                              35           39           43           47           51           53

Plus Chg WC                        4              4              4              4              4              4             

Less Capex                           44           44           47           49           52           53

Free CF                                  39           49           57           66           75           78

PV FCF +TV                         36           42           45           49           51           1064

Bear Case:  we assume normalized operating margins of 7%, revenue grows only 5% per year and 3% at TV.

Value per share:  22.87

Shares Outstanding:            32mn

Total Value:                         841        

Total Debt                             113

Total Cash                            5.4

Equity Value                        733

Bear Case                             2010       2011       2012       2013       2014       Terminal

Revenue                                963         1012       1063       1116       1172       1206

EBIT                                      68           71           74           78           82           85

Less Cash Taxes                  23           24           25           26           28           29

NOPAT                                  45           47           49           52           54           56

Plus D&A                              35           39           43           45           48           51

Plus Chg WC                        4              4              4              4              4              4

Less Capex                           43           44           45           47           50           51

Free CF                                  32           39           43           45           49           51

PV FCF +TV                         30           33           34           33           33           703

Private Market Value of LNCE

We believe the LNCE branded businesses (which comprise 60% of LNCE revenues) maintain 60% gross margins and high market shares in their product categories.  These are very relevant brands that maintain significant brand equity.

Key points:  

Cape Cod - 20% market share nationally

Lance- 40% market share in sandwich crackers in the southeast

$150-$200mn revenues at Cape Cod, $250-350mn for Lance (note these are our estimates as LNCE does not break out the components of its branded businesses). 

It is difficult to assign a value to Cape Cod or Lance, but we do note the recent Kettle transaction.

  -Kettle was acquired for 2.4 revenues or 10x EBITDA (total price was over $600mn)

  -Kettle's market share is less than Cape Cod (we believe it to be low teens in potato chips)

While not necessarily an exact science a 2x multiple to the branded business topline would result in $1.1bn market valuation, a 1.5x multiple $825, and a 1x multiple of $550.  Given the current EV is $833, we'd argue that provides a fair amount of margin of safety.  EBITDA is more appropriate, but it is difficult to apply given management does not break it out by brand. 

Conclusion:

Management has put infrastructure in place to be a greater than $1B revenue company.  As we approach the second half of 2010 (and potentially Q2 2010) we believe Lance will finally reap the benefits of its investments.  LNCE has substantial earnings leverage as it grows its top-line.  We feel shares reflect a compelling value with little downside with potentially high rewards.  Given its solid balance sheet, dividend yield and growth prospects we feel the risk/reward is favorable to own shares at current levels.

Risks:

• Outstanding $250mn shelf-  The company has been considering acquisition opportunities and filed a $250mn shelf last year.  We feel this is a necessary and important step in leveraging the DSD platform as additional revenue via an acquisition would meaningfully enhance margins given the high cost of maintaining the DSD network.  We do worry that LNCE may make a poor acquisition or overpay given the pickup in M&A activity.  Also, there is some concern that LNCE may dilute current shareholders with an equity offering.  In conversations with management, we feel that the equity offering at current levels is not likely.  Additionally, given LNCE current low leverage multiple, we welcome a potential debt issuance for a value creating acquisition.
• Macroeconomic- Clearly, branded is at risk if there are additional headwinds and consumers trade down.  We would note that LNCE has done a very good job with its private label business as evidenced by its accelerating growth rate.
• Customer Concentration- Walmart represents 22% of revenues.  Any disruption with this relationship would have negative consequences.  We would note that 37% of all grocery sales today are now made at WMT, so LNCE is not unique its exposure.
• Addional hiccups in transformation- Given the fits and starts LNCE has had over the last several years, this is always a concern.  We worry that credibility of management may drive sentiment in LNCE if the company has additional margin pressures this year.
• Commodities- LNCE now hedge 90%+ of its needs at least 1 quarter out and 60%+ of its needs 6 months out.  If there are abrupt changes in commodity prices, especially, wheat or soybeans, it could negatively impact the company.

ROIC Trends

A look at Lance's returns on invested capital (note they are trending upward since 2008 and we expect it to continue to get better in 2010 and beyond):

                        1999    2000    2001    2002    2003    2004    2005    2006    2007    2008

ROIC               11.3     9.0       11.2     9.9       9.2       11.4     8.1       7.1       8.9       5.6      

                        Q1 09  Q2 09   Q3 09  Q4 09

ROIC               7.0       8.8       9.4       9.9

Catalyst

• Increasing margins driven off completion of the DSD transformation and lower commodity prices
• Investor appreciation in business transformation
• Increasing ROIC