Description

Seneca Foods is North America’s largest provider of packaged fruits and vegetables.  It is best known for the Libby’s brand, but it also packs Green Giant for General Mills and other private label brands.  Seneca’s earnings and balance sheet can be a bit difficult to follow because they publish constant references to their earnings net of the income tax benefit of their LIFO (Last In, First Out) inventory accounting.  Nonetheless, with the stock having interesting fluctuations in earnings and trading below book value, it warranted a closer look.

Seneca Foods fiscal year 2014 (ended 3/31/2014) earnings per share was $1.27 versus $3.53 in the prior year.  Normalizing over the last two years, earnings averaged $2.40, giving a two year trailing implied P/E ratio of 12.6x.  Still, on a trailing twelve month basis, the P/E is a lofty 23.9x.  So what is the best way to look at earnings at Seneca?  And why does the company think their stock is cheap?

On May 27^th, the company announced that they were expanding their stock buyback plan.  The new plan would amount to approximately 9% of all outstanding shares.  The press release was accompanied by this statement from the CEO:

"Since we went on LIFO seven years ago, our net worth tax adjusted for our LIFO reserve has increased 97%, while the share price has increased just 16%, therefore, we view our shares to be a very attractive investment at current share price levels."

As a reminder, under LIFO, the latest goods purchased are the first to be sold.  Therefore, the ending inventory consists of the earliest purchased goods.  Given SENEA’s Enterprise Value of approximately $550 million, the $450 million listed as inventories seemed significant for closer examination.

Looking at the just completed FY 2014 (ending 3/31/2014), the company lists considerable detail in their footnote about inventories.  Note that Bloomberg buries the adjustments to these numbers—one has to look deeper for the as-reported figures to match the correct values from the 10-K’s footnote:

Hello.  $153.4 million of LIFO benefits in their inventory.  Normalizing to a 35% tax rate, that adds an additional $99.7 million to their net worth.  This is the “net worth tax adjusted for our LIFO reserve” that the CEO was referencing in their buyback announcement.

Without this adjustment, one might wonder about the company’s use of capital.  Here is the growth in book value (note that the LIFO accounting was adopted in fiscal year 2008):

This is admittedly a very modest growth rate.  The 41% increase since FY 2008 amounts to a 6% compounding IRR.  In reading through the annual reports, their statement that they switched to LIFO in anticipation of inflation rang a bit hollow, as we’ve seen enough bond market prognosticators get smashed against those inflations expectations for the last decade.  However, in the case of Seneca Foods, their inputs—namely produce and a bit of steel and energy, have indeed risen significantly.  The resulting adjustments look like this:

Note that over the aforementioned 2008 to 2014 period, adjusted book value grew from $279 million to $493 million.  This 77% gain over six years represents a compounding gain of approximately 10% annually.  Versus the current market cap of $330 million, an investor is getting a significant discount on adjusted book, paying approximately 67% P/B.

It turns out that Seneca made a great call.  Not only do the financial statements more correctly align current revenues with current costs, but the $153 million LIFO excess represents an amount that defers taxes on their growth in net worth.  Brilliant.

Getting back to the growth rate, granted, 2009 and 2010 showed significant growth in book value.  It has been more modest since.  While the current valuation discount is still considerable, what drives such fluctuations in their business?  What is the earnings power going forward?

As a food processor, Seneca’s fortunes can swing with the weather.  Given the crop cycles, Seneca is attempting to smooth revenues of the course of the year.  Bumper crops result in downward pressure on their products, while poor crop yields result in Seneca raising prices so that they can have supply to last through to the next harvest.  Thus their annual report is full of references to the peach harvest and their many other fruit and vegetable products.  Given their prominence in North America, SENEA has tremendous pricing power when nature allows, but only modest power when swamped with a bumper crop, as the food business is very competitive and their products compete with fresh and frozen (btw,  they have recently made some expansion to their frozen lines).

Therefore, it makes sense to look at this business on a seven to ten year basis rather than the last few years.  Indeed, there will always be a time period where SENEA looks more or less attractive on an earnings basis. 

Chris815 has a VIC write-up from 2010 that discusses the company, which is a worthwhile read, and he discusses the company’s return on equity from 2005 to 2010, a period in which they averaged a 16% ROE.  In the entire 1998 to 2010 time period, they averaged 9.5%. 

He also discusses a bit of the secular decline in canned goods, and Seneca’s then significant market share in corn (50%), peas (56%), green beans (36%), and peaches (27%).

Further info on their current product lines and business dynamics will be provided below.

VALUATION:

In a nutshell, this is a business that in the very, very long-term can produce 10% ROE’s and grow book value accordingly.  Today, an investor gets to buy that at 2/3rds of adjusted book value, which suggests an approximately 15% IRR to the very patient investor.  In addition, should the company successfully repurchase significant amounts of stock at these levels, the stock could perform even better.

OPERATIONS:

Seneca Foods Corporation’s business is very straightforward.  Their facilities include 22 packaging plants, two can manufacturing plants, two seed packaging operation, a small farming operation and a support network.  The company also maintains warehouses adjacent to its packaging plants.  The company was founded in 1949 and during its 65 years of operations has made over fifty strategic acquisitions.

The Company’s product offerings include canned, frozen and bottled produce and snack chips and its products are sold under private label as well as national and regional brands that the Company owns or licenses, including Seneca®, Libby’s®, Aunt Nellie’s®, READ®, and Seneca Farms®. The Company packs Green Giant, Le Sueur and other brands of canned vegetables as well as select Green Giant frozen vegetables for General Mills Operations, LLC (“GMOL”) under a long-term agreement.

The Libby's ® brand license is renewable until March, 2081 and had a royalty fee last year of just over $400k.  The company has 3,500 employees, nearly all of which are in food packaging and 90% of which are full-time.  In addition, the number of employees increases by approximately 7,000 due to seasonal employees during their peak pack season.  Thirty percent of their full-time employees are union, but the agreements are essentially comparable with the compensation for the non-union employees.

There is a pension shortfall, but as that does not impact the book value analysis above (the shortfall is an offsetting liability included in the calculation), it can be discussed in the thread if interested.

Core canned fruit and vegetables accounts for approximately 80% of their sales.  90% of their revenues comes from the U.S., and the product breakdown is 69% vegetables, 19% fruits, 11% frozen fruits and vegetables, and 1% fruit chips.

The letters that accompany each annual report are very informative and get a good year-to-year picture of supply and demand due to crop cycles.  Keep in mind that it’s one thing to read a decade’s worth of letters in an hour, and it’s another thing to sit through it year after year with a stock that has seen very little performance over this time.  Seneca’s website is www.senecafoods.com.

LIFO ANECDOTE:

Here is a description of Warren Buffett’s foray into LIFO accounting on the back of a superb investment initiated by the legendary Jay Pritzker.  Here’s Buffett’s description from the 1988 annual report:

Some offbeat opportunities occasionally arise in the arbitrage field. I participated in one of these when I was 24 and working in New York for Graham-Newman Corp. Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted [last-in, first-out] inventory valuation in 1941 when cocoa was selling for 50 cents per pound. In 1954 a temporary shortage of cocoa caused the price to soar to over 60 cents. Consequently Rockwood wished to unload its valuable inventory – quickly, before the price dropped. But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

The 1954 Tax Code came to the rescue. It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation’s business. Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity. Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share. For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts. The profits were good and my only expense was subway tokens.

The architect of Rockwood’s restructuring was an unknown, but brilliant Chicagoan, Jay Pritzker, then 32. If you’re familiar with Jay’s subsequent record, you won’t be surprised to hear the action worked out rather well for Rockwood’s continuing shareholders also. From shortly before the tender until shortly after it, Rockwood stock appreciated from 15 to 100, even though the company was experiencing large operating losses. Sometimes there is more to stock valuation than price-earnings ratios.

That last sentence seems like an apt description for Seneca’s current stock valuation. 

DISCLAIMER:

This is not meant to be a buy or sell recommendation, and my firm frequently has both long and short positions in many of the securities mentioned.

Catalyst