Description

1. Introduction

ML Macadamia Orchards, L.P. (NUT) is a publicly traded partnership in the business of growing and farming macadamia nuts in Hawaii.

NUT is one of the world’s largest growers of macadamia nuts. NUT sells its production exclusively to Mauna Loa, the nut processor whose products you may have seen squirreled away in a corner at the local grocery. NUT provides about two-thirds of the nut crop that goes into Mauna Loa’s nut products.

NUT has been a perma-value stock with a price-to-book ratio consistently in the range of .4x to .5x over the past ten years. A majority of free cash is returned to shareholders, with the company paying out between $1.4M - $3.6M per year in dividends. Variation in yearly results is due primarily to changes in crop sizes and nut prices.

How, then, will NUT graduate from perma-value status?

There are two catalysts:

1) This week, Hershey’s announced that it is acquiring Mauna Loa. This provides a much needed boost to the marketing of the nuts in North America, which was never very effective under Mauna Loa. Hershey’s also provides a more financially secure purchaser of NUT’s crop.

2) Macadamia nut prices have risen sharply in 2004 due to very high interest in the nuts because of their nutritional value, in addition to the usual factors causing commodities to rise in dollar terms this year. This price rise is not yet reflected in NUT’s financial results.

* Hey, Macadamia: The Business

Macadamias are generally the highest price tree nut. They can only be produced in climates that feature heavy rainfall, good drainage, and moderate temperatures. Planting is only recommended outside 0 and 25 N or S latitude. Key growing regions are Australia, Hawaii, South Africa, Kenya, and Guatamala. Crop size at any farm varies from year to year according to rainfall.

As a result of their high price and lackluster marketing, macadamia nut sales comprise less than 5% of sales of branded premium nuts on the U.S. mainland. The nuts are similarly obscure in European markets. Japan has been a better market for the nuts historically.

Yet, as we all know, disposable income is increasing. There is a certain cache to macadamias (it’s a luxury nut). Adding to this cache is recent focus on the nutritional benefits of the nuts. Starting from such a low market share position, these trends suggest it is reasonable to expect elevated levels of demand for the nuts well into the future.

Demand changes cannot quickly be reflected in supply. Nut trees can begin bearing a small crop in the fifth year after planting and are not fully mature until 12 to 15 years at the earliest.

In July the Hawaii Agricultural Statistics Service reported that farm prices for the 2004 season averaged 61 cents per pound, 4 cents above last season and the highest since 2000. More recently, macadamia prices have accelerated. Farm prices as high as 95 to 99 cents per pound are being reported.

(For those interested in additional historic perspective on “normal” macadamia nut prices, farm prices have ranged from about 50 to 70 cents per pound since 1996.)

While Hawaii has historically been a major provider of macadamias to the world, the island was overtaken as the top global producer in 1997 by a burgeoning Australian industry. The maturation of Australian trees may have caused some oversupply in recent years, leaving nut prices relatively weak. In addition, new orchards are maturing in Africa and Central America.

Yet historic statistics show that the total number of planted hectares in major growing regions has shown a shown a pattern of relatively stable and moderate growth in recent years from about 34,000 hectares in the 1996/1997 growing season to about 44,000 hectares in the 2003/2004 season. I think there is more fear about overseas competition than the historic data supports, though I have yet to find an accurate source of data for global maturing acreage.

Hawaiian productivity seems to be as strong as or stronger than other leading regions. In-shell nut yields vary from 5200 lb/acre to 7000 lb/acre versus just 4000 – 5000 lb/acre in Australia. With its large share of the world market still in place and a sinking dollar, I believe things are looking up for Hawaii.

A fair amount of data on the global macadamia trade is assembled by the USDA and freely available on its website.

* NUT Properties

NUT owns or leases orchards totaling 4,169 acres on the Island of Hawaii.

Wholly owned orchards account for 2,221 of these acres. The majority of this acreage is located approximately 10 miles south of the city of Hilo, and directly east of the Mauna Loa, earth’s largest volcano. As an aside, the land is on the outer edge of the possible lava flow zone should Mauna Loa erupt again. At any rate, I believe the risk to a specific property is quite small. The many real estate developers who have been building on and around the volcano in recent years must agree.

The majority of the owned acreage was acquired in 1986, with small plots added in 1989 and 1991. Land is carried on the books at $8.2M (as of 12/31/2003), or roughly $3,692 per acre. I believe the book value of the land significantly understates its market value.

I have found one acre fruit farm “homesteads” (properties that include a residence) close to the NUT properties that are selling for $325,000. The real estate fundamentals of the area are good. The island economy is driven by tourism and agriculture, with an increasing number of retirees seeking refuge on its idyllic shores and farms. Population growth has been strong and is expected to remain strong. That said, I can’t predict when NUT’s real estate value will be realized. In the near term, I expect them to keep farming and selling nuts.

In addition to the land, NUT owns the nut trees on land that is leased under long-term arrangements. In total, producing orchards (trees) represent $67M of the $83M un-depreciated value of NUT’s PP&E. The capital investment in harvesting equipment required for NUT to farm is modest.

In addition to owned orchards, NUT farms about 2,645 additional acres of orchards for other orchard owners on the island, earning a moderate income.

A good thing about NUT is its low leverage. At 9/30/2004 the company had just $2.5M of long-term debt and $1.6M on a revolving line of credit used to support seasonal cash needs. The revolver was paid off as of 11/2/2004.

* NUT Contracts

A discussion of NUT is incomplete without addressing the long-term nut purchase contracts between NUT and Mauna Loa, its sole nut customer. About 70% of NUT’s production is sold to Mauna Loa under contracts that expire in December 2006. The remaining 30% is sold under a contract expiring in 2019. The current pricing of nuts under the Mauna Loa contracts is based about half on the current-year processing and marketing results of Mauna Loa and half on the two-year trailing average of the U.S.D.A. macadamia nut prices.

As owner of Mauna Loa, Hershey’s will continue to honor existing purchase contracts. Following the December 2006 expirations, I would hazard a guess that future contracts will be based heavily on trailing U.S.D.A. nut prices, reflecting the global commodity nature of the modern macadamia industry.

Also, one contract feature that is important to understanding the quarterly reported results of NUT. Mauna Loa typically pays NUT a price for macadamias based on nut prices in the first quarter of the year and holds that price steady until the year is complete. Once the year is complete, Mauna Loa pays an adjustment for the actual price of nuts throughout the year.

For example, in Q3 of this year, NUT received from Mauna Loa an estimated average price of under 50 cents per pound for its nuts- a price based on market rates as calculated in the first quarter. Therefore, NUT’s results have not yet reflected the recent surge in macadamia prices that was discussed above. NUT will be due a substantial adjustment payment from Mauna Loa. NUT will also benefit from this year’s increased pricing at least through 2005, since prices are based on two-year trailing averages.

Recently, NUT incurred significant one-time legal expenses in an effort to block a planned merger between Mauna Loa and the #2 nut processor on Hawaii, MacFarms. Mauna Loa buys 53% of supply on the Island of Hawaii, and MacFarms controls about 13%. NUT argued that if the combined company controlled 66% of nuts grown on the island, pricing to the nut growers would become uncompetitive. NUT’s threat to pursue anti-trust litigation apparently was a factor in the deal being terminated.

Shortly after this success, Mauna Loa announced the Hershey’s transaction. This result is a more favorable development for NUT and the other growers on the island, maintaining competitive local buyers on the island as well as adding Hershey’s marketing strength to the macadamia market.

While it is certainly desirable for NUT to have competitive local buyers, there is nothing to prevent NUT from exporting should favorable local contracts not be available. U.S. exports of macadamias have been increasing for the past 4-5 years and currently represent about 8,000 metric tons of macadamias annually, or about 1/3 of production.

* Summary

Conventional wisdom has held that the risks to NUT have been increasing foreign competition and a limited market for macadamias. These are probably key reasons the stock has been locked in a trading range of about .4x - .5x book value for many years.

However, the recent price rises in macadamias show that demand is strengthening in advance of existing supplies. The market for the nuts is growing ahead of supply.

The acquisition of Mauna Loa by Hershey’s is a significant catalyst for NUT, helping to grow its addressable market, since Mauna Loa buys all their nuts. Furthermore, NUT results will soon begin to show the benefits of the recent increases in macadamia nut prices.

And if that’s not enough to get your interest, NUT's value is backstopped by appreciating real estate in a market with some very favorable fundamentals- plus a nice dividend while you wait.

NUT could be a perma-value poised for a break-out.

Disclaimers: I own shares. I may buy or sell whenever I like. This is not a recommendation to buy or sell.

Catalyst

There are two catalysts:

1) This week, Hershey’s announced that it is acquiring Mauna Loa. This provides a much needed boost to the marketing of the nuts in North America, which was never very effective under Mauna Loa. Hershey’s also provides a more financially secure purchaser of NUT’s crop.
2) Macadamia nut prices have risen sharply in 2004 due to very high interest in the nuts because of their nutritional value, in addition to the usual factors causing commodities to rise in dollar terms this year. This price rise is not yet reflected in NUT’s financial results.