Description

Overhill Farms is the single most interesting idea in my portfolio and you can look at my past postings to judge for yourself if that statement carries any weight. Overhill is a value added processor of prepared frozen food products. The investment opportunity is buying a business trading at ~7x normalized P/FCF, with 20% top line growth, potential for significant margin expansion (currently operates at only 70% of capacity), continued deleveraging, and several near-term catalysts (possible sale of company and/or refinancing of its 13.5% interest rate debt). Moreover, given Overhill’s non-cyclical nature, and visibility towards continued growth, we believe the company represents an ideal long investment in the current economic environment.

Overhill has been in business since 1968, with many of its largest customers having been with the company for 10 years or more. Overhill began trading as a separate public entity in 2002, following a spin-off from TreeCon Resources. Overhill processes a variety of foods including pasta, rice, protein, sauces, and soups with key customers in the foodservice, retail, and airline businesses. In addition to food processing, Overhill serves as the product development, regulatory approval, packaging, and logistics arm for many of its customers. Some of Overhill’s prominent customers include Panda Restaurant Group, Jenny Craig, American Airlines, and Safeway. The company’s management and board currently own ~27% of outstanding shares, closely aligning interests with shareholders.

Private equity firm, Levine Leichtman Partners, owns ~38% of OFI and also holds a sub note and term loan (totaling ~$44M) from Overhill due Oct. 2006. In April of this year, Overhill announced that it was pursuing strategic alternatives. The least dramatic of these would be a refinancing of their debt and secondary of Levine Leichtman’s shares, though we think this is unlikely. The most dramatic is a sale of the company, which we think is more likely.

Our rationale is as follows: Back in August, we had conversations with management about refinancing their debt. At the time, they said that they had attractive financing lined up and would likely prepay the existing debt despite an onerous penalty that would not apply if the debt were refinanced in November (so great were the interest savings). They did not, in fact, prepay the debt, nor have they called us back recently, which leads us to believe that other strategic options have moved to the forefront. In any event, we should have some announcement by the end of the calendar year.

Overhill stands to benefit from shorter product life cycles which create more demand for cost effective product development and food production. Overhill is well known within the industry for its R&D capabilities, and multiple channel-checks confirm that they are among the most highly-regarded firms in the industry in this capacity. Many of its largest accounts have been won by coupling high quality reverse engineered products with cost effective production runs. The company also stands to benefit from the growth in the food service industry and frozen food, both of which are growing in excess of total food consumption.

Since 2001, Overhill’s financial results have been disrupted by a major facilities consolidation in 2003, the loss of some $25M in airlines sales (due to airlines discontinuing many in-flight meals), and liquidity concerns (which resulted in egregious financing terms). Despite these issues, it is notable that Overhill maintained positive operating income in each year. The company is now just beginning to reflect its potential, and the market has yet to fully appreciate it. The financials tell most of the story as we will detail our FY 2005 and 2006 numbers.

FYE Sept. 2005E
Diluted Shares = 15.7M
Current Price = $3.47
Equity Value =$55 M
Est. Net Debt = $40 M
Enterprise Value = $95 M

Sales = $163M
EBITDA = $14M
EBIT = $12M
Interest Expense = $6M
Book Taxes = $2.4M (cash taxes are zero due to NOL)
GAAP Net Income = $3.6M
Operating Cash Flow = $7.1M
Capex = $1.3M

EV / Sales = 0.6x
EV / EBITDA = 7x
EV / EBIT = 8x
P / FCF = 8.5x


We believe Overhill falls into the extremely undervalued category based on 2006 numbers, when shareholders will realize a number of benefits. Our 2006 numbers include the following assumptions: debt refinancing at 7.5%, continued debt paydown (roughly $7M from free cash flow with utilization of NOL carryforwards), increased capacity utilization (20% sales growth to $195M – well below total capacity of $235M), and slight margin expansion (40 bps operating margins improvement to 7.7%) due to operating leverage.

We believe our fiscal 2006 numbers possess a high degree of visibility and are also conservative. The refinancing is a done deal unless management sells the company first. Then, looking at each of the remaining assumptions critically, the key assumption is really Overhill’s 20% sales growth, which we believe is actually conservative. Overhill’s largest customer, Panda Express (~30% of sales), is growing its store count by over 15% next year which provides 5% growth to OFI. Another large customer, Jenny Craig (18% of sales), is growing at 15% and our conversations with their head of food precurement indicates that they are pushing Overhill as fast as they can; this accounts for another 3%. Notably, both of these customers have been with Overhill for an average of ~10 years. In the last month, a large food service customer recently eliminated its second supplier and shifted 100% of its business to Overhill (NB- This was alluded to in the recent earnings press release but not specifically identified. Management is extremely conservative and will not announce a contract unless it is a) material b) guaranteed volume and c) with a new customer, which sets a very high hurdle). This is $16M, or 10% growth. This accounts for most of the 20% growth without any additional contracts, though we view this as extremely unlikely. Overhill has had tremendous success recently, and we have heard from other operators that Overhill is currently reviewing several very large new pieces of business which could add $20-50M each. Any new customer wins would be additive to our forecast and would substantially improve upon our estimates below. Note that the company can add processing lines to its existing facility to accommodate the anticipated volume increases

FYE Sept. 2006E
Diluted Shares = 15.7M
Current Price = $3.47
Equity Value =$55M
Est. Net Debt at Year End Sept. 06 = $33M
Enterprise Value by Sept 06 = $88M

Sales = $195M
EBITDA = $18M
EBIT = $16M
Interest Expense = $3M
Book Taxes = $4M (cash taxes are zero due to NOL)
GAAP Net Income = $7.4M
Maintenance Capex = $2M

EV / Sales = 0.45x
EV / EBITDA = 4.9x
EV / EBIT = 5.5x
P / E = 7x
P / FCF = 6.7x

There is not a great set of publicly traded midsized food processor comparables to help us value OFI. However, with some $70M of unused plant capacity, and potential margin expansion we believe a 15x multiple on 2006 GAAP earnings would be a reasonable starting point, which equates to a share price of $7.50.

The strategic alternatives process may provide an immediate catalyst in unlocking value. Given Overhill’s substantial excess capacity, acknowledged competitive advantage in food preparation, and some basic synergy assumptions (e.g. sarbox costs) it is our view a strategic buyer could pay a substantial premium to Overhill’s current price. If we assume Overhill continues to operate as a standalone public entity, shareholders will benefit from all of the aforementioned factors. Looking out longer term, the upside potential is more substantial. If we assume Overhill fully utilizes capacity (which we believe will happen by 2007 at the latest), the company would generate in excess of $11M in net income per year, which at a 15x multiple gives a $10 stock.



Disclaimer: We own shares of Overhill Farms. We may buy or sell these shares at any time without notice. The information contained in this write-up is believed to be correct, but should not be relied upon. We undertake no obligation to update the write-up if new information arises at a future date.

Catalyst

Conclusion of strategic alternatives process
Potential announcement of large customer contracts
Continued cash generation and debt repayments
Potential for wall street research coverage (management has expressed an interest if company is not sold)