Description

Lance inc. is a very uninteresting snack food company, with only 60% of revenue coming from branded products, which has historically earned less than 10% returns on capital and is trading at 4.5x tangible book value with arguably very little intangible book value that can be attributed to its brand name (premium above book for brand value in a liquidation). Moreover, in the face of rising commodity prices and the blowup of Chiquita, the company should miss their $0.70-0.80 2008 EPS guidance, but is even still trading at 27.5x the high end of guidance without taking into account commodity price pressure.

Just under 50% of Lance's product sales is distributed through its direct store delivery method over 1,400 sales routes in 23 states. Lance owns 94% of the trucks through which it delivers to convenient stores, gas stations...etc through its direct story delivery method. The company stated that in their Q1 08 earnings call that a $1 increase in gas prices per gallon results in $8mm/yr in additional opex or $0.25/share. Just over 50% of sales, mostly to large retailers, is done through direct shipment or customer pickups directly from Lance manufacturing facilities.

Major inputs to Lance's products include, in order from greatest to least, flour, vegetable oil, sugar, potatoes, peanuts, cheese and seasoning, and thus cost of goods is highly correlated to wheat and soybean oil commodity prices; the company's hedges ended in Q3 2007. Moreover, the company has guided that a $1 increase in wheat per bushel results in $0.16 drop in EPS and a $0.10 increase in soybean oil pricing results in a $0.24 decrease in EPS. Also, a 1% change in gross margins results in a $0.17 change in EPS.

Factoring in commodity price increases, margins have come down from a 42% range in mid 2007 to 37% in Q1 2008. Given the input pricing changes above, we can assume that through the rest of 2008 gross margins will continue to be in the 37% range and any SG&A improvements, as the company has guided, will be offset by an additional dollar/gallon in gas price (2% of revenue), resulting in about 37.2% gross margins and 36% of revenue in SG&A costs, yielding 0.5% net income margins and $0.10 in EPS, since the company is a full tax payer. This is based on 5-6% revenue growth due to volume and pricing increasing, which is very liberal. Further, in a best case scenario, if we normalize gross margins in 2009 back to 2007 levels, though I highly doubt commodity prices will come down 50% to 2007 levels given the recent Midwest floods and global demand, the result is 42% gross margins and SG&A at 34% of sales (assuming management guidance of opex reductions), thus 5% net income margins (comparable to KFT, though I’d argue KFT’s brand name allows for greater pricing power and scale allows for lower proportionate opex) and $1.37 in sales, assuming all works out for the company in terms of SG&A cuts and margin improvements. Such a scenario in which a company earning 8% returns on capital and 5% long term EPS growth, should result in a 12x PE or $16.40/share, or 22% downside (assuming best possible case, where the probability in my opinion is below 30% of this occurring). Realistically, commodity prices will not recover and the company shouldn’t see more than $0.13 in EPS from 5% revenue increases from additional volume and pricing.

Moreover, from a free cash flow perspective, given the capital intensiveness of the factories and trucking routes, the company has guided $45-50mm in capex, resulting in $-14mm in FCF or -2.2% FCF yield. In the best case scenario for 2009, even assuming capex decreases to $35mm, we get a FCF yield of 6% for a business growing at 5% per year in the long run.

Based on the scenarios above, assuming 2009 GMs normalize back to 42% levels, pre-commodity price decreases and the company is able to cut costs so as to reduce SG&A to 34% of revenue, EBITDA margins increase back to 11.5% and a 12x PE would result in $16/share and an 8% FCF yield would result in $15 stock price. Should food and oil prices not stabilize in the near term, the potential normalized earnings power of the company that would yield $14-16 stock price will be pushed back even further.

The bull case to justify the high multiple lies in price increases in branded and non branded items, a return to normalized gross margins as commodity prices return to lower levels and an improvement in operating expenses from supply chain improvements resulting from better inventory management and overtime production for out of stock merchandise. In terms of price increases, the company raised prices in Q1 08 in order to offset commodity price pressures, which resulted in 3.5-4% of the 5.4% yoy increases in branded product revenue and 6% of the 14% increases in non-branded product revenue. The company believes that they can meet 2008 EPS guidance with continual price increases, though the guidance should be back half loaded and will be very accretive to net income margins in 2009 once commodity pricing pressure decreases. However, as mentioned above, Lance sells commoditized products and the only brand of any value, Cape Cod, represents a small portion of total sales. Also, with Wal Mart representing 20% of sales, and the top 10 customers representing 40% of sales, will the company really have pricing power for non-branded products that will result in their meeting guidance this year? Management also noted in the Q1 08 call that a majority of the 14% increase in non-branded revenue in Q1 08 resulted from customers buying products ahead of a Q2 price increase. That leads me to believe that there really is no pricing power in this business and that buyers will simply buy less products from Lance as pricing goes up and management will not be able to fully pass on commodity price increases to customers.

Catalyst