Description

 
BACKGROUND
Overhill Farms was formed in 1995 as a Nevada corporation, with the acquisition of substantially all of the assets of IBM Foods, Inc., founded in 1968. Overhill began trading as a separate public entity in 2002, following a spin-off from TreeCon Resources. The company manufactures prepared frozen food products for branded retail, private label, foodservice, and airline customers in the United States. Its product line includes entrees, plated meals, bulk-packed meal components, pastas, soups, sauces, poultry, meat and fish specialties, and organic and vegetarian offerings. 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 Jenny Craig, H. J. Heinz Company, American Airlines, Safeway, Pinnacle Foods Group LLC and Panda Restaurant Group. The company was founded in 1995 and is headquartered in Vernon, California. The company has been in business since 1968, with many of its largest customers having been with the company for 10 years or more.

 
Overhill markets products through its internal sales force and outside food brokers. Customers include foodservice, retail and airline accounts. A significant portion of sales are derived from five customers: Jenny Craig (24%), Heinz (18%), Panda Restaurant Group (16%), Safeway (13%) and American Airlines (7%). Some of Overhill's customers and suppliers operate through purchase orders or short-term contracts.

 
The company's products compete with those produced by numerous regional and national firms. Many of these companies are divisions of larger highly integrated companies. Competition is strong, with many firms producing alternative products for the foodservice and retail industries. Competitive factors include price, food safety, product quality, flexibility, product development, customer service and, on a retail basis, name recognition. Overhill believes it is competitive in this market because of its ability to produce mid-sized to large custom product runs within a short time frame on a cost-effective basis and provide ancillary support services such as R&D, regulatory assistance, production planning and logistics.

 
Private label secular trends are favorable. Historically, private label foods were generally cheaper than their national brand counterparts and were often regarded as somewhat inferior in quality. Beginning in the middle part of this decade, private label sales started expanding rapidly as a new generation of shoppers started showing less loyalty to established national brands. Overhill entered this market just as the shift was gaining steam. The company's big break came in 2006, when Safeway launched a major private label line called Safeway Select and Overhill won the fight to supply much of its frozen food. Just two quarters ago, Safeway CEO Steve Burd cited "an extraordinary shift in our business to corporate brands."

 
When possible, OFI negotiates both the cost and sales side of its contracts concurrently, so that the cost of an input, such as chicken, for the life of a production run is known and priced into OFI's contract with its customer. This provides some, but not absolute, margin protection.

 
Overhill has an R&D department that formulates recipes and upgrades specific products for current and prospective customers and establishes production and quality standards. The company develops products based upon customers' specifications, conventional recipes, new product trends or its own product initiatives. Overhill also maintains a quality control department for inspection, testing, monitoring and compliance to ensure that products are produced consistently in accordance with customer standards.

OFI's primary production facility runs at 75% capacity currently and management believes this plant is adequate to meet its requirements for the near future. OFI also operates a second facility that makes foods items that don't require further processing. As the company's sales of cooked protein grow, it may become necessary to augment the cooking capacity at Plant #2, which could cost $5-$10mm.

Is Overhill an acquisition candidate?
In February 2008, Overhill board member Louis Giraudo resigned as Director. Upon resigning, Mr. Giraudo cited a disagreement with the Board which included the Board's refusal to sell the company to a private equity firm GESD Capital Partners, for $4.40 per share. According to the 8-k, GESD was one of two groups competing to acquire Overhill Farms. The board rejected the offers as insufficient. Management and the board owns 11% of the company. CEO James Rudis owns 605k shares, of which 400k are option-related, so his direct ownership is 205k shares, or $1mm of OFI stock.

 
2003-2004 were transition years. Prior to FY 9/03, Overhill ran its business using four smaller manufacturing plants. In calendar 2002, the company began consolidating all manufacturing operations, together with its home office, warehousing, product development, marketing and quality control facilities into a new facility in 2003. The company ran these one-time expenses through GAAP which is what created the losses in FY '03 and '04. It is worth noting that OFI's current #1 plant, is 170,000 square feet; it's prior four plants ranged from 20,000 - 33,000 square feet. At the time, OFI expected this footprint rationalization to create operational efficiencies, which has indeed been the case. OFI had very high interest expense in FY'03; $4mm of this $11mm was non-cash amortization of deferred financing costs associated with the refinancing of OFI's debt agreements. In summary, FY'03 and FY'04 weree transition years in which OFI moved its business from a 4-plant system to a 1-plant system and also refinanced its capital structure. Shareholder's equity went negative due to net losses in FY '03 and FY'04.

 
Key Questions
Is Overhill's product important? Yes, particularly to its largest customers.

 
Can it be done in-house? In some cases, yes (Heinz); in other cases, no (Panda, Jenny Craig don't have in-house capabilities).

 
Can it be easily replaced? Again, in some cases, yes (Heinz); in other cases, no (Panda, Jenny Craig, Safeway).

 
Does OFI produce an easily replicable commodity offered by a very small company with no deep pockets that relies on a handful customers than could walk? Yes, all of these assertions are true. I would submit that OFI is fairly entrenched with Panda, Jenny Craig, Safeway and Pinnacle, which in aggregate comprise over 73% of sales. With Heinz and American Airlines, OFI's proposition seems somewhat fragile. The risk is that one of the big 4 walk away (Panda, Jenny Craig, Safeway, Pinnacle). Let's examine each:

 Panda (24% of sales): owns Panda Express, Panda Inn (quick serve Chinese restaurants - 35 yr history). When OFI raised prices a few years back, Panda tried to go to a 2-supplier setup several years ago but their new supplier couldn't execute so Panda came back to its sole-sourcing arrangement with OFI and now does more business with OFI than previously.

 
Jenny Craig (17% of sales): Seems stable.

 
Safeway (17% of sales): OFI now produces two brands for Safeway: Eating Right and O Organics; Safeway is growing rapidly in this area. I see Safeway as a growth partner. Safeway could buy OFI at some point.

 
Pinnacle (15% of sales): Pinnacle produces frozen foods like Hungry Man meals.

 
What are some justifications for OFI's current stock price?
1) Fears of a sizable customer loss. 

 
3) Management and communication issues. Chairman, President and CEO James Rudis, 59, has been on the Board since 1995, Pres since 1997, and CEO since 1998, yet he commutes to Vernon, CA from New York and maintains an office in NY. OFI's former CFO left in September 2007 to become CEO of a non-food company in Southern California. OFI has employed an Interim CFO since then - Tracy Quinn, 52, who spent 21 years with Heinz, most recently as Corporate Controller and Chief Accounting Officer. She works on a monthly retainer basis and commutes to Vernon, CA from Pittsburgh, PA.

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