John B. Sanfilippo & Son Inc. JBSS
October 18, 2006 - 8:17am EST by
kalman951
2006 2007
Price: 10.48 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 112 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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  • Food Manufacturer
  • vertically integrated
  • Family Controlled
  • Commodity exposure

Description

John B. Sanfilippo & Son Inc. (JBSS) is more than 50% undervalued at its current stock price.  Six months have past since Stockguy910 initially wrote up the company, which I recommend as it touches on many of the reasons I will also discuss.  Since the time of that write-up, commodity prices have decreased as expected, which is a great thing for JBSS, and the company’s higher-than-market-cost inventory of almonds continues to decrease.  Meanwhile the stock price has further declined from $16 to $10.50 at the market close today; investors would realize a 50% return just to get back to that price. 

 

John B. Sanfilippo is the largest domestic nut producer measured by volume with the second largest full-line nut brand (Fisher).  Prior to the recent rise in commodity costs, the company’s stock traded above $55, more than 4x the company’s current stock price.  Due to increased demand created by the Atkins Diet and constrained supply arising from crop shortages, high nut prices have decimated the company’s gross margins.  Over the past ten quarters, gross margins have been 20.4%, 19.2%, 14.5%, 15.3%, 12.6%, 13.7%, 13.3%, 14.3%, 8.4%, and 3.8% in the most recent quarter.  Prior to the past two years, average gross margins have been around 17%.  As a result of depressed earnings over the past couple of years due to high commodity prices, the company’s stock today trades at 0.6x tangible book value, 0.2x sales, and 5x my estimate of normalized earnings power. 

 

The company should see dramatic earnings improvement as nut prices moderate and gross margins return to normalized levels, and the market is pricing the company assuming that current margin trends will never improve.  The nut industry has always been cyclical, but the past two and a half years have been unusual in that many nuts have increased to record high levels for a sustained period of time.  At the same time, the company played the almond market incorrectly, creating an excess inventory situation which has dragged down margins for the past year. 

 

These issues, while unfortunate, are temporary, and we should start seeing year-over-year improvement in EPS beginning in the September quarter (Q1 FY 07).  The company sold a significant portion of its excess inventory of almonds at a loss last quarter, but by the end of October they will have sold off all of the company’s high cost nut inventory.  The company does not provide guidance, but you can infer quarterly guidance from the quarterly debt covenants it established with its lenders: ($0.30) per share in Q1 ending in September, $0.08 per share in Q2, $0.15 in Q3, and $0.31 in $Q4.  Those numbers are much improved from last year, and FY 08 should look even better as the company will be able to sell and promote nuts which are far less costly during the busy season in the Fall.   

 

Company Background

John B. Sanfilippo is a vertically integrated nut manufacturing company, adding value at every step in the supply chain between growers and retailers, including shelling operations.  The company processes peanuts, pecans, cashews, walnuts, almonds, and mixed nuts.  The company develops nut products and nut packages for retail chains, for other manufacturers, for food service customers, and for export.  In a couple years, when the company’s new plant is up and running, JBSS will also be the industry’s low-cost producer.  While the company produces more nuts than any other manufacturer by volume, Planters generates more revenue.  JBSS has a 40%+ market share of the private label nut business, and Ralcorp has about the same share as John B. Sanfilippo.  The company provides 65% of the private label nut products for Wal-Mart stores, and Wal-Mart is the company’s largest customer representing 18% of JBSS revenues.  While the majority of the company’s revenues are unbranded sales, the company also owns the Fisher brand, which is the #2 full line nut brand.

 

The nut industry saw dramatic growth during the Atkins Diet craze, as nuts represent a source of low-carb protein with healthy fats.  Despite the end of this fad, long-term nut growth should continue, at a lower rate, due to increasing awareness of the health benefits of nuts.  The FDA has approved the following qualified health claim for placement on nut packages: “Scientific evidence suggests but does not prove that eating 1.5 ounces per day of must nuts, such as peanuts, almonds, hazelnuts, pecans, pistachio nuts, and/or walnuts, as part of a diet low in saturated fat and cholesterol may reduce the risk of heart disease.”  Increasing awareness of the health benefits of nuts, along with increasing consumption of snack foods, bodes well for the future growth of nuts.

 

Management

The company is run by two families related through marriage, the Sanfilippo family and the Valentine family.  Together they own virtually all of the company’s voting rights, so it’s worthwhile to think about John B. Sanfilippo as a semi-private company.  Based on the pending retirement of the company’s CEO, Jasper Sanfilippo, and the company’s President, Mathias Valentine, the company recently rolled out a new retirement plan which will cost the company $2.2 million ($0.21 per share) in additional expense per year.  Stock options are expected to run at $520,000 ($0.05 per share) per year, although options will be granted almost exclusively to non-management team employees.  To management’s credit, they didn’t pay themselves a bonus over the past two years due to the company’s dreary results.  In order to earn a bonus, the company needs to generate earnings growth in the mid to high-teens.  

 

It’s worth mentioning that management seems to operate the business in a frugal manner.  I have visited management at the company’s headquarters outside of Chicago, and the office is a very no-frills, bare-bones space.    The CFO, Michael Valentine, greeted us both times we met with him wearing a lab coat.  We asked him whether he was doubling as the company’s R&D lead, and he told us that he wears the coat around the office to keep him warm (because the temperature in the office is turned down so much) while he's in the office.   

 

Commodity Costs

Commodity costs have been declining, and I expect to soon see the flow-through of these declines on the income statement.  Nut costs represent 80% of the company’s COGS, which in turn represents 85% of company revenues, so a significant reduction in commodity costs should have a corresponding significant positive impact on the company’s bottom line.  Current price trends have been driven by supply shortages combined with a surge in Atkins-driven consumer demand.  Both the supply side and demand side factors have for the most part subsided, and in all likelihood nut prices should remain at moderated levels unless there’s an unforeseen crop shortage.

 

On a nut-by-nut basis, I have heard the following from nut brokers recently--   Pecans (24% of sales) are in the off year in a bi-annual on-year-off-year cycle.  The crop comes in during the latter part of October and is expected to be priced in the $4.50-$4.85 range, versus $5+ a year ago.  Next year, during the on year, prices should be in the $3 to $3.50 range, weather permitting.  Cashews (22% of sales including mixed nuts) are selling for around $2.15/lb, which is about $0.45 lower than it was a year ago.  Peanuts (23% of sales) have not experienced cost increases recently, and brokers expect that the price should remain stable through 2007.  Almonds (13% of sales) have historically been priced in the $1.25 to $1.75 per pound range, but last year almond prices were over $4/lb as growers stored some of their crop to keep up prices.  As a result of leftover nuts from a year ago and a record crop expected this year, almond prices have been decreasing steadily and are now around $2.20/lb.  Unfortunately, the company and all of the other major producers bought a large amount of almonds last year at (high) fixed prices.  Walnut (9% of sales) prices are expected to be slightly higher due to a hot summer in California.

 

As commodity prices remain moderate in 2007 and 2008, the company should realize increasing volume due to reduced retail prices, an increasing awareness of the health benefits of nuts, and increasing promotional activity among private label retailers.  Last year, volume declined at double digit rates in because retailers have stopped promoting nuts and consumers have reduced their nut purchases due to prices that were too high.  With lower than normal margins on private label nuts, retailers have been reluctant to promote nuts.  Finally, manufacturers have been reluctant to develop new products with nut ingredients, despite the positive health benefits, because costs have been prohibitive.  Lower commodity costs will allow the company to charge lower prices but at better margins, and those lower price will improve retailer gross margins, which will cause retailers to promote nuts more, which will drive consumer sales.

 

Increased efficiency 

The company is in the second year of a three-year facility expansion project.  The company is spending $105 million to consolidate six Chicago-area manufacturing plants into one facility.  This project will expand capacity 40% and, assuming volumes do not decline, the new production facility should create cost savings by reducing overhead redundancies, direct labor, and transfer freight costs.  For example, management expects its indirect labor costs to decline by 1/3 once the new plant is up and running.  After the plant is built, maintenance capital expenditures are expected to be around $8 million per year.

 

Valuation

John B. Sanfilippo is the only pure play nut producer, so it’s difficult to base a valuation on comparable companies.  A couple of years ago, Hershey’s bought Mauna Loa for 1.4x revenues.  In comparison, today you can buy the Fischer brand, which is a $110 million brand, for 1.0x sales, and get the $470 million unbranded nut business for free.

 

I also valued the company by applying a conservative PE multiple to normalized earnings levels.  Based on a return to historical 17% gross margins and 9% operating expenses on flat revenues, the company should earn $2.35 in normalized earnings per diluted share in the year ending June 2008.  When the market begins to anticipate this recovery next summer, applying a 10x forward P/E, the company should trade at $23-$24 per share.    

 

Risks

• Commodity prices:  The most significant risk facing JBSS is commodity pricing risk.  Poor weather conditions and/or tree nut disease reduces the supply of nuts.  If nut prices remain at previous levels or, worse, increase, the company’s profits will remain low.

 

• Competitive risk:  As commodity costs decline, an irrational price war among the company’s competitors could reduce the benefits of lower costs.  This is unlikely given that there are only a few major nut producers remaining. 

 

Conclusion:

The risk reward profile for the company seems very favorable at current prices.  The company has a leading position in the industry but has been hit by high commodity costs.  Its market share is intact, its competitive position is strong, and nuts are not going away.  Once commodity nut costs fully return to historical levels, I expect the company’s gross margins and net margins to also return to historical levels.  When that happens, its stock price shouldn’t be too far behind.

 

Disclosure:  We own shares of John B. Sanfilippo, and we may buy more shares or sell our existing shares at any time.

Catalyst

- Increased investor awareness of positive commodity cost trends which will have a positive impact on the company’s gross margins
- Improved earnings this year
- Completion of the facility integration project and the realization of cost savings created by the project.
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