Thesis

Seneca Foods Corporation (SENEA) owns and operates 20 vegetable and fruit canning plants, making it the largest vegetable canner in the U.S and the second largest fruit canner. SENEA may be purchased for 8.0x trailing earnings, 0.8x tangible book value, a fraction of replacement cost and just slightly more than liquidation value.  This is remarkable because the business generates good returns on capital (13 year average of 15% EBIT / capital employed) and appears to be the low cost producer.  While per capita consumption of SENEA’s products has declined over the last 40 years, it is reasonable to assume that people will continue to consume canned vegetables and fruits, especially as consumers work to stretch their food budgets.

Note regarding adjusted numbers: We have made two types of adjustments to the earnings figures (as well as numbers derived from earnings, e.g., EBIT) used in this report:  

The restructuring charges are for plant closures resulting from the Chiquita acquisition (5/27/03) and the signature fruit acquisition (8/18/06); these costs have declined to zero and appear to be non-recurring. SENEA changed their inventory accounting method in 2008 and these adjustments are made for the purpose of comparability – this is discussed in further detail below.

Capital structure and valuation

SENEA’s capital structure features two series of common shares (both exchange traded, Class A has 1/20^th vote per share, Class B has one vote per share) and five series of preferred shares, four of which are convertible into common shares.  Here is a summary of their capital structure:

Since the preferred shares are convertible and pay no dividend (there is one minor exception to this statement) we have based our analysis on the assumption that all convertible preferred shares have been converted to common (this results in a more conservative valuation, i.e., suggests a higher price / earnings multiple).

Normally we disqualify companies that have multiple series of common shares with varying voting rights; however, in this instance, since both series are publicly traded, we have no problem with the two-tiered voting structure (those wishing to have superior voting rights may elect to buy the less liquid Class B shares).

We think that SENEA’s equity capital structure is more complex than it needs to be, especially the two series of preferred shares held primarily by the Wolcott family (the 6% and 10% cumulative preferred shares).  Mitigating this is the fact that the 6% and 10% cumulative preferred shares are not material in the overall capital structure of the business, e.g., the 10% convertible preferred convert into 68,000 shares of common worth about $2 million.  Of the other three series of preferred, they are in the process of being converted to common and being sold, a process that will be mostly completed by year end.

SENEA’s Return on Capital

We judge the quality of a business by the return on capital that it produces, i.e. higher returns suggest higher quality (this is capitalism after all).  The canning business is considered to be a low margin business, but this statement is only true to the extent that it applies to gross margins (SENEA’s gross margin averaged 8% over the last 13 years).  The following table summarizes SENEA’s return on capital since 1998.

Return on Capital

The table indicates that SENEA’s return on equity has average about 9.5% since 1998. Note that their returns increased dramatically since 2005, averaging 16% over the last five years. The higher returns correspond to higher gross margins (gross margins averaged 10.3 percent since 2005, up from 7.2% during the period 1998-2005). Of course, the question becomes: what caused the higher returns and how sustainable are they?  Here is how SENEA management explains the returns:

2006 vs. 2005

The improved operating performance in the very competitive and challenging canned vegetable industry is the result of several factors including very good growing conditions, expected synergies from our most recent acquisition, and an improved mix of sales resulting in higher gross margins………. The summer and fall of 2005 was one of the better growing seasons in memory ………. Over the past few years, Seneca has work hard to integrate the Chiquita Process Foods acquisition…….  We have invested millions of dollars in new harvesting and processing equipment, and simultaneously closed several plants that did not fit in the company’s post-acquisition production plans.  [Please note the charges in 2005 and 2006 for plant closings in the adjustment table on page 2 of this report].

2007 vs. 2006

The synergies of combining our fruit [the Signature Fruit acquisition in August of FY 2007] and vegetable operations have been quite substantial and continuing. We moved rapidly to consolidate administrative, sales, and technical service functions and are in the process of gaining distribution benefits through joint shipping of fruits and vegetables that our customers strongly desire ……. Turning to our core vegetable business, Seneca experienced another very good growing and processing season last year [2007], resulting in competitive costs and continued strong earnings.

Based on these statements, we conclude that SENEA’s returns are likely to fluctuate with growing conditions (something that we will refrain from handicapping other than to say they will vary) but may well remain higher than earlier in the last decade due to their increased scale of operations and reduced competition which are the result of the Chiquita acquisition (5/27/03) and Signature Fruit acquisition (8/18/06). 

Upside: 25% - 100% Downside: 21%

Probably the most comparable company to SENEA is Del Monte Foods which is in the process of being purchased by KKR. At $18.83 per share and negative tangible book value, DLM is currently trading at 16x trailing earnings and 8x trailing EBITDA.  For SENEA to trade at similar valuations implies a share price of $29 (to reach 8x EBITDA) and $42.50 (to reach 16x earnings).  In both cases, buying SENEA at today’s price implies substantial upside, i.e., 25% in the first instance, 80% in the second.  Another way to think about SENEA’s current valuation is to consider it in relation to replacement cost and liquidation value.  The following table summarizes such an analysis:

SENEA Replacement Value & Liquidation Value

The analysis suggests that SENEA shares would appreciate 100% to reach parity with replacement value (this assumes their equipment is valueless).  On the downside, this analysis suggests the company could be liquidated and net shareholders about $18 per share.  We think this is a compelling valuation, especially for a business that generates good returns on capital selling food staples at such a modest earnings multiple (8x TTM).

FIFO to LIFO

Effective 12/30/07, SENEA switched from the First In, First Out inventory accounting method (FIFO) to the Last In, Last Out method (LIFO) method. Here is management’s explanation for this shift:

In the high inflation environment that we are experiencing, the Company believes that the LIFO inventory method is preferable over the FIFO method because it better compares the cost of our current production to current revenue.

While this makes sense, SENEA management goes on to say that they lacked the data necessary to retrospectively apply this change to previous financial statements, e.g., FY 2005-2007. However, we are able adjust the LIFO earnings (2008-2010) making them comparable to the FIFO earnings because SENEA discloses the difference, both on a pre-tax basis and after tax basis.  The table on page two of this report summarizes the after tax effect of switching to LIFO; the following table shows the cumulative effect on a pre-tax basis.

LIFO Reserve Build

We have adjusted the earnings figures in this report to reflect what SENEA’s earnings would have been had they stuck with LIFO (on an after tax basis).  The reason for doing this is that this allows us to compare SENEA’s performance over the last five years – without such an adjustment, the numbers would not be comparable. In point of fact, the transition to LIFO had the superficial effect of depressing SENEA’s financial performance, while in fact, the business performed very well over the last three years, i.e., if the next three years look anything like the last three years, this is likely to prove to be a very good investment.

Things we don’t like

No investment is perfect, and there are four things that we don’t like about SENEA.

1. SENEA has a very small aircraft business which consists of leasing private aircraft and fixed based operations.  We are interested in SENEA’s canning business and would prefer to leave aircraft leasing to NetJets.

2. As discussed above, we prefer simple capital structures.  SENEA’s dual share class plus five classes of preferred shares is more complex than it needs to be.  On the other hand, the complexity of the capital structure is partly an artifact of the fifty acquisitions made since 1949 by Arthur Wolcott, SENEA’s founder and chairman. The preferred shares stand as a testament to Mr. Wolcott’s ingenuity and thriftiness: with so many acquisitions, SENEA has no goodwill on its balance sheet. 

3. The canning industry is faced with a controversy over the use of Bisphenol A (BPA) which is used to line cans. We do not have an opinion about the health hazards of BPA, but we prefer less chemicals in our food and presume others do as well. Here is what SENEA management has to say about BPA:

 The Company, in collaboration with other can makers as well as enamel suppliers, has decided to aggressively work to find BPA-free alternatives for its products.  However, commercially acceptable alternatives are not immediately available for some applications and there can be no assurance that these steps will be successful. Canning existed before BPA existed, so we suspect a solution will be found.

4. Per capita consumption of canned vegetables has been declining for decades, e.g., canned corn consumption is down 40% since 1970, beans down 14%, peas down 67% and sauerkraut down 47%.This decline has played well to SENEA’s strength as the low-cost operator and, now, SENEA is the last man standing.  Here is a summary of SENEA’s market share of its key canned products:

Share of Canned Vegetables

All things being equal, we would prefer to see some per capita consumption growth in SENEA’s markets.  This reminds us of Joel Greenblatt’s parable about the importance of return on investment in which he sites two hypothetical businesses: Jason’s Gum Shops and Broccoli-is- Us.  However, in this real life example, the vegetable company generates respectable returns on capital (15% EBIT / capital employed) and may be bought at a modest valuation (8x earnings).  We conclude that SENEA is likely to prove to be a good investment.