Description

Limoneira (NYSE: LMNR, price: $23.00) has 50%+ appreciation potential over the next 6-12 months as the company converts book assets into earning assets. The impact of the conversion is not readily apparent due to GAAP’s use of historical cost (which in some cases for LMNR, dates back to 1893) thereby skewing the earnings power of assets.  The company’s multi-year strategic plan is at an inflection point, which will transition $9/share of real estate “book” assets into $3/share of earnings power. The economics should become apparent when the monetization process commences, which we expect prior to the City of Santa Paula’s Commission meeting in November 2014.

The near-term situation is further compelling due to our expectation that 1) Limoneira should receive a $50mm cash payment (16% of market cap) in conjunction with its monetization strategy, and 2) Q3/FY14 earnings (driven by strength in the current agribusiness) should be 50% higher than consensus estimates. Both should provide support for the stock as it migrates to our $35 price target after asset sales commence.

Background

Limoneira has agricultural and real estate assets across 10,600 acres of land primarily in Ventura, California. Its agribusiness is one of the largest lemon and avocado growers in the US and operates across 8,600 of those acres, and also includes 28,000 acre feet of water rights on its land and 8,600 acre feet of adjudicated water rights in the Santa Paula basin. On average, the company has held each acre of land for over 40 years.

From a macro standpoint, agricultural land values have benefited from a multi-year cyclical bull market, with per acre values increasing 20% annually over the last five years alone. Additionally, lemon prices have benefited from tightening supply, which has driven prices up 50% over the last year. Despite this, the enterprise value of LMNR has stayed fairly consistent around $380mm, leaving many to wonder what weeds are thwarting growth.

Why Does the Situation Exist?

For investors farming for new opportunities, Limoneira does not make it into many portfolio baskets, mostly owing to the company’s 1) small market cap ($320mm), 2) limited analyst coverage, 3) understated earnings and book value (which distort valuation screens), and 4) appearance of a leveraged balance sheet (5x net debt/LTM EBITDA).

For investors that peel away at the company, the gap between the book value of real estate assets ($9/share) and the equity value ($23/share) does not seem justified given the earnings of the agriculture business ($0.40/share). Fundamental investors seem un-enthralled by the earnings power of the agribusiness and asset based investors seem underwhelmed by the real estate value. Hence, many investors do not believe LMNR stock is ripe for picking.

Key Investment Points

Limoneira is an asset rich company with significant earnings power, the value of which should become evident through both near-term agribusiness earnings growth and monetization of its undervalued real estate assets. A multi-year strategic plan has reached an inflection point and the company is on the cusp of a virtuous cycle that will transition $9/share of real estate assets into $3/share of earnings power. Our key investment points are:

1.      Assets are valued at 30-cents on the dollar and near-term monetization should unlock value

2.      Strong lemon pricing should drive 50% Q3/FY14 earnings surprise while capacity additions support long-term growth

3.      Balance sheet leverage appears artificially high and should improve with asset sales and cash flow generation

Investment Point #1: Assets are Valued at 30-Cents on the Dollar

Limoneira owns 10,600 acres of agricultural land, real estate development opportunities, and water rights in Southern California and Arizona. Many of these assets are held on the books at historical cost of $133mm (side note: the company has other assets but we exclude them since they do not pertain to our thesis). Since some of these assets were purchased as far back as 1893, there is little relevance to today’s value. Our due diligence suggests fair market value is closer to $460mm (net of taxes and debt), which is greater than the company’s $380mm enterprise value without accounting for other assets. Additionally, this analysis excludes a $50mm upfront payment we expect the company to receive when the monetization process begins. The assets provide downside protection as we wait for the company’s real estate strategy to bear fruit.

We believe management is close to monetizing “East Areas I and II”, roughly 550 acres of residential and commercial real estate in Ventura County valued on the books at $53mm. Under a variety of scenarios, we estimate the real estate is worth 3-5x more. Management issued an RFP several months ago to solicit proposals from industry on the best use of the land. We believe the company received 49 qualified responses that met the company’s criteria and signed NDAs with these groups to proceed to the next round of bidding. Based on our conversations with management, the interested parties included land developers, home builders, and equity investors -- their proposals ranged from outright purchases to development opportunities.  Limoneira’s board and management team are currently reviewing the bids and we expect a final decision to be announced before the November 2014 Santa Paula Counsel & Planning Commission hearing where East Areas I and II tract maps will be approved for development. 

Each proposal has varying cash flow profiles and levels of risk. Based on conversations with management over several months, we believe they are assessing the proposals based on the following criteria/penchants:

1. Upfront payment: management would like to choose a proposal that includes an upfront payment. We believe this could be in the vicinity of $50mm.
2. Partnership opportunity: we believe management would like to underwrite some risk in a development partnership in order to reap higher returns.
3. Overall fit: this is going to be a multi-year partnership and given LMNR’s corporate culture, the necessity to find a “good fit” is important.

Different structures will obviously yield varying cash flow profiles. Our analysis of the most likely outcome indicates that each 100 lots of development land (fully taxed) could purchase 375 acres of agricultural land, which in turn would produce $0.10 of EPS. With 1,500 total residential lots plus 650,000 sq/ft of commercial/industrial space, the residential piece alone will produce $1 of annualized agricultural EPS (discounted), which should add $15/share at a market multiple. Our analysis below excludes an upfront payment (management is seeking $50mm) as well as commercial development.  Under various scenarios and as the company begins to develop other parcels of land, we believe it could add another $2 of EPS.

Based on our due diligence, we assume average gross proceeds per lot of $125,000 increasing 1.5% annually and a tax rate of 40% (the first $50mm of cash flow is non-taxable). On an after-tax basis, this analysis yields $145mm of after-tax proceeds or $175mm including our estimate of an upfront payment (fully taxed). This compares with the $53mm book value of the assets today.

While we expect this to be a 7-10 year project, investors will begin to reap the rewards in year 1 as cash flow is deployed to parcels of earning assets, which will be more easily valued flowing through the P&L. We estimate these parcels are purchased at a cost/acre of $20,000 and generate EBIT/acre of $4,500, both increasing at 1.5% annually. We assume a 40% corporate tax rate.

Conclusion: the key conclusion with this particular analysis is that East Areas I and II are held on the books at $53mm ($3.70/share) while we believe the residential assets alone are worth closer to $175mm after-tax ($12.50/share). As the company deploys this capital, we believe it will produce $1/share of normalized earnings (discounted), which at a market multiple should add $15 to the stock price. Again, this is for the residential piece alone and assumes no leverage (which would add another $1/share of normalized EPS if the company uses 50% debt). Additionally, our analysis of varying outcomes on the commercial piece and other real estate holdings yields as much as $2/share of incremental earnings power.

Investment Point #2: Lemon Pricing Should Drive 50% Earnings Surprise

Based on a confluence of factors -- tight supply, weather, and drought conditions -- lemon prices per carton have increased from $17 to as high as $28, which should drive a 50% EPS near-term earnings surprise based on our estimates when the company reports Q3 earnings September 9. Additionally the company has made several investments to both increase long-term growth and margins that should sustain profitability if prices decline. We believe the fundamental strength in the agribusiness should support the stock price while the real estate monetization strategy bears fruit.

The dynamics that support improved pricing are typically offset by decreased production. However, Limoneira has a competitive advantage in that it has water rights on its land, thereby insulating it from other growers who are affected by drought shortages. Additionally, recent acquisitions and production improvements should drive longer term earnings growth. Our 2014 EPS estimate of $0.71 is nearly 50% higher than consensus estimates and we believe capacity additions will grow earnings next year even if prices fall. We expect this to drive the stock higher in the near-term.

Limoneira achieves 100% of the pricing benefit on 65% of their quarterly carton volume (35% is third-party contracted).  Current 2H14 consensus EPS estimates embed lemon prices of $17-$18 per carton.  We believe lemon prices averaged around $24 per carton in Q3, which should drive ~$0.17 EPS upside [+43%] vs the current $0.40 estimate.  For Q4, we take a conservative approach and model $21 per carton (vs $24 spot), which equates to $0.09 EPS vs $0.04 consensus.  Our full year 2014 EPS estimate of $0.71 is 46% above the current $0.49 consensus.  Our assumptions and EPS bridge are below:

Investment Point #3: Balance Sheet Should Significantly Improve

On the surface, the company’s balance sheet could draw concern -- net debt stands at $63mm and LTM EBITDA at $13mm, exhibiting 5x of leverage. Additionally, the cash flow profile has been less than stellar as exhibited below.

There are several items fraught in this analysis. First, since the book value of assets is understated, the company’s debt looks overstated relative to the capital structure. Net debt of $63mm may seem high for a company with real estate assets of $130mm but would be quite low for a company with fair market value assets of $640mm. Second, cash flow has been depressed over the last few years due to artificially elevated capex as the company prepares for development of East Areas I and II. Even considering both these factors, net debt / EBITDA has still declined from 14x to 5x over the last two years.

Looking forward, we expect net debt to end the year closer to $40mm, with EBITDA around $17mm, cutting the leverage ratio in half. This also excludes the $50mm upfront payment the company should receive with the monetization process. We expect 2H FCF of $10mm and are estimating $13mm of asset sales (management has discussed selling off small pieces of non-core assets).

Risks:

1. Monetization Event is Delayed: A transaction event is required to revalue the assets. Any delay in such a transaction would likely cause the share price to remain depressed.
2. Lemon Pricing: over time, we expect lemon pricing to normalize back to $18/carton. While this will pressure profits, the company’s capacity expansion and manufacturing improvements should offset most of the pricing decline. We estimate it would take over 1 million of additional carton capacity to make up for the shortfall. Recent acquisitions close that gap, albeit the pricing structure of those companies provide for below average margins. However, to make up the shortfall, the company has identified several million dollars in manufacturing savings. The cost savings + incremental profit from acquisitions would more than offset profit losses from pricing declines.

Catalyst