Description

Recommendation: Long Seneca Foods (NASDAQ: SENEB), Price Target: $121.17 (141.8% upside) over the next 2-3 years.

Before discussing Seneca Foods, it is helpful to briefly touch upon the history of the industry that Seneca primarily competes in: U.S. canned vegetables.

Industry Overview:

Early 1900s: The U.S. canned vegetable industry was very fragmented with thousands of small players, intense competition, and low returns.

Late 1990s: The industry is an oligopoly with four large players. The first is Del Monte, which pursued an aggressive roll-up strategy throughout the 20^th century and has the leading non-private label brand in the space. Seneca, which also pursued an aggressive acquisition strategy throughout the later part of the 19^th century, is another large player, which supplies the canned vegetables for the second-largest brand (Green Giant) and owns the third-largest brand (Libby’s) in the category. Chiquita also emerges as a large, albeit debt-heavy competitor, particularly after becoming a frequent acquirer of smaller competitors in the 1990s. Lakeside Foods is a smaller competitor, largely due to the company’s lack of acquisitions.

2003-2013: Chiquita’s high levels of debt cause the company to declare bankruptcy in 2003. Most of the company’s private-label canned vegetable assets are sold to Seneca, with a smaller portion being sold to Lakeside. As a result, Seneca became the leading player in the U.S. private-label canned vegetable market. Seneca went from a sub-scale player competing in a four-player oligopoly to an at-scale player competing in a three-player oligopoly, which translated to much-improved ROIC levels: 8.4% on average from 2003-2013 (about equal to the company’s cost of capital), as compared to an average of 5.7% from 1996-2002 (significantly below the company’s cost of capital). This delta is even more impressive when taking into account that Seneca’s competitively disadvantaged fruit business, which dragged down profitability and returns, made up ~16% of Seneca’s sales from 2007 onwards.

2014-2020: In 2014, Del Monte Pacific acquired the American Del Monte canned vegetable business (whenever I refer to Del Monte in the rest of this write-up, I am referring to the acquired canned vegetable business and to Del Monte Pacific) and, in an attempt to gain market share, began irrationally competing with Seneca on price, despite Del Monte having the higher cost structure. Seneca needed to match Del Monte’s new lower prices in order to preserve its market share and, as such, significant value destruction occurred for both companies. However, it is clear that the value destruction was significantly worse for Del Monte Pacific’s canned vegetable business, which lost >$275M over this period (despite having the higher revenue base, as Del Monte’s revenues included its branded canned vegetables), as compared to the $135M of profits that Seneca raked in during this time (albeit with a 3.4% ROIC). In FY2020, Del Monte’s management, desperate to stop the bleeding, decided to completely exit U.S. private-label canned vegetables, selling their assets at bargain prices to none other than their previous top competitor: Seneca. As a result, the U.S. private-label canned vegetables industry became a duopoly, with Seneca having a >60% market share as compared to Lakeside’s 15-20% market share.

2021-2023: Seneca’s strengthened market position led to the company’s record gross margin levels in FY2022 and FY2023, as well as a 10.9% average ROIC level during this period (significantly above the company’s cost of capital).

November 2023: Seneca acquires the second-largest brand, Green Giant, in the U.S. canned vegetables space for an absolute bargain: essentially at the value of the inventory that Seneca acquired (this low acquisition price was due to B&G viewing the segment as non-core, B&G wanting to reduce its high leverage level of 7x net debt/EBITDA, and Seneca being by far the most natural buyer of the asset). Seneca is now the largest U.S. private-label canned vegetable manufacturer, as well as the #2 and #3 player in branded canned vegetables. In addition to the acquisition raising Seneca’s overall margin profile (branded canned vegetables typically have higher profit margins than private-label), there are several synergies that are likely to result from the acquisition. SG&A expense was 5-6% of revenue under B&G (Green Giant’s previous owner), Seneca can largely integrate this cost into its own overhead (leading to several hundred bps of margin expansion). Additionally, Seneca’s greater economies of scale and lower logistics costs, when compared to those of B&G, should also lead to margin expansion. Finally, it is important to recognize that this acquisition has minimal integration risk: Seneca has already been manufacturing the canned vegetables that B&G uses for Green Giant products for the last several decades (ever since B&G entered into a cost-plus manufacturing agreement with Seneca in the 1990s). As such, Seneca will continue to use its existing production facilities for Green Giant and simply begin selling the product directly to retailers rather than having B&G as an intermediary.

February 2024: Del Monte announces that it will be closing two of its three (in Washington and Wisconsin) remaining vegetable canning plants, including the entirety of its corn and pea production capacity. The plants will start winding down operations in April: before the main packing season that occurs during the summer and fall. Del Monte specifically mentions that its rationale behind the decision is to “align and streamline operational capacity with consumer demand.” This is a very positive move – the most irrational player in the canned vegetable industry is outsourcing the majority of its production to more rational players (Seneca is likely to handle the majority of this outsourced production, with Lakeside accounting for a smaller amount). Del Monte is set to release results this Friday and to host a conference call the following Tuesday; I will update the comments section of the write-up with my takeaways from these events.

Seasonality trends in the industry are the following: January/February is when the planning/forecasting is conducted for the upcoming year (what vegetables to plant, in what quantities, what types of seeds to use, etc.), the summer and fall is when the harvesting and canning of products takes place, and sales tend to be the highest during the last quarter of the calendar year (Seneca’s third fiscal quarter) due to Thanksgiving and the December holidays. As such, inventory and accounts payable tend to reach their lowest point in the spring and their highest point in the fall.

Cyclicality trends are also present in the industry and are primarily influenced by Mother Nature. Depending on weather conditions, the quantities of vegetables grown can be below expectations (due to poorer than normal weather conditions) or above expectations (due to better than normal weather conditions). Lower quantities tend to lead to higher prices and, therefore, higher margins and vice versa. The duration of such cycles tends to be 3-4 years.

In terms of market share trends over the last decade, Del Monte (the largest branded player) has retained stable market share, Green Giant (the second-largest branded player, recently acquired by Seneca) has lost market share, Libby’s (the third-largest branded player, owned by Seneca since the 1990s) has slightly increased market share, and private-label (including Seneca’s and Lakeside’s offerings) has also taken share. Seneca as a whole (including the company’s private-label and branded canned vegetable offerings), has been growing its market share, maintaining roughly constant sales volumes in an industry that has volumes shrinking ~0.6%/year.

Threat of Entry: Essentially non-existent. There is a huge cost differential between the historical cost of Seneca’s production facilities and replicating those facilities nowadays (the latter would likely be 100-300% more expensive). Taking this into account, a new entrant into the industry would likely earn a low-to-mid single-digit ROIC at best, making such a proposition extremely unattractive.

Company Overview: Besides the canned vegetables segment, which was discussed extensively in the Industry Overview Section and which makes up 83% of Seneca’s revenue, Seneca also has several smaller segments. As a result of the relative insignificance of these other segments, I will briefly discuss them in this section of the write-up and then focus the remainder of the write-up largely on the canned vegetables division. The other segments are frozen vegetables (8% of sales), fruit products (6% of sales), chip products (1% of sales), and other (2% of sales). In regard to frozen vegetables, Seneca is fairly competitive in the Northwest region of the United States and can earn acceptable returns selling the same kinds of vegetables that it usually uses for its canned vegetable offerings (though the profits from selling such vegetables as frozen are lower than if canned, so Seneca primarily freezes excess quantities of vegetables from unusually good growing seasons, partly in order to help to protect the company’s core business). The fruit business primarily consists of maraschino cherries, in which Seneca rolled up the industry (through five acquisitions) to acquire the vast majority of market share in retail (this business has struggled historically, but integration efforts are now largely complete and margins should improve to healthy levels). Seneca also has some snack offerings, which span across several of its divisions and are unique branded products with healthy margins.

Thesis: Seneca is a competitively advantaged company that is misvalued due to surface-level accounting complexity and the company’s disappointing results the last two quarters. Seneca has strong downside protection and significant upside potential.

Thesis Point #1: Competitively Advantaged

As the market leader, Seneca’s competitive advantage stems from #1) the company’s leading economies of scale and #2) the company’s strong vertical integration, which includes seed operations and research, steel can manufacturing (the steel costs of the can make up ~35% of the cost of a canned vegetable and Seneca is the 4^th largest steel can manufacturer in the U.S. and the largest self-manufacturer, leading to significantly lower can costs versus competitors), and 30 manufacturing plants on 9,860 acres of land, as well as 8 million sq. ft. of warehouses, a company-owned network of trailers, and 20 rail cars for product distribution. I project Seneca’s normalized ROIC to be in the low double digits (significantly above the company’s cost of capital).

Thesis Point #2: Surface-Level Accounting Complexity

In 2008, Seneca implemented LIFO accounting, which has saved the company ~$80M in taxes since then. However, due to the very nature of LIFO accounting (the most recent inventory produced being the first to be counted in COGS), such a system significantly depresses profits and margins in a highly inflationary environment. In addition to this, the seasonality within the vegetable canning business leads to prices only being negotiated with Seneca’s customers every 6-12 months. As such, a highly inflationary environment will penalize Seneca twice, once due to the company’s choice of LIFO accounting and once due to the noticeable lag that the company faces in passing through higher input costs. This can be seen in the table below (Seneca’s last two quarters are excluded from the chart below due to reasons discussed later in this writeup):

* Seneca’s suppliers, creditors, etc. largely view the company on a FIFO-basis.

FY2022 was likely the first full FY that is representative of the new status-quo industry duopoly. Consistent with what was discussed earlier in this section, overall margins are suppressed and LIFO margins are lower than FIFO margins during the highly inflationary fiscal years of FY2022 and FY2023.

In trying to estimate a normalized margin going forward, it is helpful to use FY18 as a base, which had a gross margin of 7.8%. This margin, however, was dragged down by 260bps due to Seneca’s subscale canned fruit business, which was discontinued and shutdown in FY2019. And, as previously discussed, margins were also dragged down during FY2018 by Del Monte Pacific’s irrational price wars. Fast forward to FY2023, and Del Monte Pacific’s margins in North American vegetable canning (which no longer consists of private-label) are 23.8%: up 8.1% from 2018, despite a similar revenue base. Assuming that Seneca is able to capture two-thirds of this margin uplift through price increases (as a result of weaker competition post-Del Monte’s exit from private-label), a 15.8% FIFO gross margin level looks reasonable.

Thesis Point #3: Disappointing Results the Last Two Quarters Due to Temporary Issues

Seneca’s sales volumes over the last two quarters have been disappointing. The number of units sold declined significantly, approximately 10% YoY for the quarter ended September 30^th, 2023 and 11% YoY for the quarter ended December 31^st, 2023. This was due to larger industry dynamics, specifically, a highly successful packing season (due to good weather conditions and overoptimistic projections by competitors), which led to excess inventory for the industry’s largest players. Del Monte and, to a lesser extent Green Giant, decided to pursue an irrational strategy of aggressive retail price cuts, in many cases by 25% or more (this decision for Green Giant was likely made before Seneca acquired the company’s canned vegetable division). Seneca, as the more rational player in the industry, has decided to cede market share temporarily in response to this, instead of significantly lowering its profitability. Seneca’s 16.5% and 16.6% FIFO gross margins over the last two quarters, above the projected normalized gross margin level of 15.8%, support this action. Furthermore, while Seneca’s strategic action leaves it with unusually elevated levels of inventory, Seneca can, and likely did, target lower-than-normal production this coming packing season, so as to help return inventory to normalized levels without sacrificing profitability. This is supported by my findings that retailers will typically agree to buy canned vegetables from not just the most recent packing season (the most recent summer/fall), but also the one the year prior. As such, I do not anticipate significant spoilage concerns with Seneca’s inventory and would note that a significant amount of Seneca’s elevated inventory is simply from elevated levels of steel on hand (Seneca is diversifying its steel supply, which used to come almost solely from a single supplier and, therefore, temporarily needed to increase its steel orders to build up relationships with various suppliers).

All in all, many of the aforementioned retail price discounts from competitors have greatly decreased in the last one to two months and I expect that Seneca will return to normalized sales volumes within the next several quarters. I would also note that, with Seneca’s Green Giant acquisition and Del Monte’s large outsourcing of production, industry behavior will likely be much more rational going forward.  

Thesis Point #4: Strong Downside Protection

Adjusted for the value of the company’s LIFO reserve, Seneca’s book value is $915.5M: ~150% more than the company’s current market cap. Furthermore, Seneca owns 9,860 acres of manufacturing plants and warehouses and, as GAAP accounting calls for these buildings to be depreciated and land to be recorded at historical cost (some of which is from the 1990s), the book value of these assets substantially underestimates their realizable value. To be clear, these assets should be primarily viewed in the context of hard-asset downside protection and will NOT be monetized through a leaseback (inconsistent with the conservative way in which the company is run). However, there is potentially the opportunity to monetize a small amount of land that the company owns and is not using.  

Thesis Point #5: Significant Upside Potential

Based on my estimate of normalized earnings, Seneca currently trades at a Price/Normalized Earnings of 3.4x. An 8.2x P/E (based on a 9.0x EV/NOPAT multiple) is more appropriate, in my opinion, which results in ~141.8% upside over the next 2-3 years.

The $300M line item above is a benefit to enterprise value (lowering it by $300M). This is due to the anticipated normalization of Seneca’s working capital levels, which is driven by lower normalized canned product inventories, lower normalized steel inventories, and the deflation that occurred in some of Seneca’s key input costs (such as steel) in 2023. This is a cash benefit that is not captured by Seneca’s NOPAT.

Note: The above valuation excludes the benefit of Seneca’s Green Giant acquisition, as there is currently limited information to estimate the associated revenue and margin uplift. My preliminary estimates are an $85M revenue uplift and 9% net income margins (higher than Seneca’s ~7%), this is a >7% uplift in net income.

Note: The above valuation excludes the benefit of Del Monte outsourcing production to Seneca, as I am waiting to gather more information from Del Monte’s results this Friday and conference call the following Tuesday. However, my preliminary estimate is that such an agreement could result in a >20% net income uplift for Seneca.

As such, I estimate that Seneca is trading at ~2.7x normalized earnings when factoring in the Green Giant acquisition and Del Monte’s outsourcing (>200% upside).

Management:

Kraig H. Kayser: Currently non-executive Chairman of the Board, previously the company’s CEO from June 1993 until October 2020. Together with his family, he owns approximately 10% and 26% of the economic and voting rights, respectively. Average annual compensation of ~$650k.

Paul L. Palmby: Current President and CEO of Seneca (since October 2020). Served as Executive Vice President and Chief Operating Officer of Seneca from 2006-2020. Owns approximately 2% and 3% of the economic and voting rights, respectively. Average annual compensation of ~$1M.

Michael Wolcott: CFO, Treasurer, and Senior Vice President of Seneca. Previous background includes other roles at Seneca and at Barclays Investment Bank. Together with his family, he owns approximately 4% and 8% of the economic and voting rights, respectively. Average annual compensation of ~$650k. Recently purchased ~$90k worth of shares at $45/share.

Donald J. Stuart: Currently Managing Partner at Cadent Consulting Group, previously a manager at Green Giant. Together with his wife, he owns approximately 5% and 12% of the economic and voting rights, respectively. Average annual compensation ~$30k.

Capital Allocation Framework:

Management’s top priorities are necessary maintenance CapEx in order to maintain the company’s best-in-class production facilities and no-brainer strategic acquisitions, such as the recent Green Giant acquisition. The next highest priority is share repurchases if those repurchases are value-accretive, which is certainly the case at today’s share price. Management has repurchased ~23% of shares outstanding over the last 5 years and >30% of shares outstanding over the last 10 years – always at prices below intrinsic value. In addition to this, the company attempted to repurchase $75M worth of shares in a modified Dutch action tender offer at prices between $40-46/share (only ~$23k worth of shares were tendered, but regular open market share repurchases have been highly effective since then).

Share repurchases have been temporarily paused after the Green Giant acquisition, likely to allow Seneca to prioritize using FCF to pay down debt, which is at very high levels compared to historical norms (still at a very manageable ~3x net debt/EBITDA level). However, taking into account the anticipated ~$300M working capital benefit discussed in the Valuation Section of the write-up, lower CapEx needs going forward (due to historical over-investment), and an apparent lack of additional no-brainer acquisitions, share repurchases are likely to be very significant in the next few years (albeit perhaps not in the next few quarters). This should serve as a hard catalyst for the stock price to re-rate.

Why Does This Opportunity Exist?:

• Seneca’s use of LIFO accounting, despite FIFO giving a better indication of the company’s profitability and balance sheet
• Volume declines the last two quarters due to temporary issues
• Limited investor relations activity (no conference calls)
• Essentially a complete lack of any sell-side coverage

Risks:

• Management control: Through the use of super-voting shares and control of Seneca’s pension plan assets, management controls the majority of the voting rights of the company (despite having closer to a one-third economic interest). This presents some level of risk, of course, but this risk is largely mitigated by the quality of management and their consistently fair treatment of shareholders. Management has managed organic growth well, made proper acquisitions at reasonable prices to become the largest private-label vegetable canning business in the U.S., divested the company’s canned fruit business, and repurchased ~23% of shares outstanding over the last 5 years – always at prices below intrinsic value. This fair outweighs the negative consequences of management, which, in my view, primarily consist of a small number of related-party transactions whose total negative annual impact is <$1M. Overall, management is a significant positive to the investment case.
• Valuation of inventory: This has long been identified as a Critical Audit Matter by the company’s auditor. This is due to the company’s use of LIFO accounting, which, according to the company’s auditor, allows for “significant assumptions, manual calculations, and judgements in the LIFO reserve.” In fact, the company was required to reissue its 2023 10-K due to an inaccurate valuation in inventories for FY2023 and FY2022. Yet, it is important to note that inventory was only overvalued by 5.7% and 1.6% originally, relatively small amounts. Management’s long-term significant economic stake in the company also means that it is likely in their best interest for the company to report financials fairly and accurately.
• Faster-than-expected decrease in canned vegetable demand: This is unlikely (5-year annual demand decrease for canned vegetables has only been 0.6%) and is mitigated by private-label canned vegetables being expected to gain market share within the overall canned vegetable industry.

Catalyst

• Value-creating share buybacks – primary catalyst
• Significant debt paydown – expected with high FCF generation and significant working capital benefit over the next 1-2 years
• The company is considering improving its investor outreach going forward
• Future results demonstrating the positive impact from the recent Green Giant acquisition and Del Monte agreement