Description

Never heard of Lancaster Colony (LANC)? You’re not alone. It is an under-followed and under-appreciated company that won’t show up on value screens and doesn’t fit squarely into any specific industry bucket…yet.  However, looking beyond the surface reveals a very attractive risk/reward. LANC shares embody many of the characteristics of a classic value investment including a stable, free-cash generating core business, an inexpensive valuation, consistent share buybacks, strong insider alignment,  limited sellside coverage, and importantly, very strong downside protection.

 

What makes LANC particularly interesting is a combination of very strong downside protection (less than 10%) and potentially considerable upside (30%-100%). Driving the upside are several identifiable financial and operational catalysts (I walk through them in detail below), many of which are within management’s control and already under consideration. Of note, the #1 outside shareholder, a reputable fund with a track record of successfully agitating management, recently filed a 13D addressing some of the shareholder value-enhancing opportunities that follow.

 

COMPANY BACKGROUND

 

Lancaster Colony was founded in the 1960’s by John Gerlach Sr., whose son took the reigns as CEO in 1997. Mr. Gerlach Jr. had acted as President prior to 1997 and as a director since 1985. The Gerlach family retains more than 26% of the company.

 

At its inception, Lancaster was a compilation of acquired glass and housewares manufacturing businesses. It went public in 1969, and acquired a specialty foods business (T. Marzetti) in the same year. Since then the company has made a number of smaller acquisitions to create what exists today, a conglomerate type structure that operates in three very distinct business segments: (1) specialty foods, (2) candles and glassware, and (3) automotive parts and accessories. It is structured as a holding company, whereby each business unit is operated by separate management teams and overseen at the corporate level by CEO Gerlach and longstanding CFO (who are both located in the corporate HQ office in Columbus, OH along with a corporate staff).

 

The company has aggressively and consistently repurchased shares over the years, with roughly $250mm in buybacks over the past 5 years. It also pays a 2.5% annual dividend and is one of only 22 US companies to have increased its dividend for 44 consecutive years.

 

LTM segment revenue and EBIT contribution are as follows:

 

	June	June	June	June	June	June	Mar
	2001	2002	2003	2004	2005	2006	LTM
Segment	Sales Contribution
Specialty Foods	47.4%	51.3%	55.1%	58.3%	59.6%	60.2%	61.0%
Glass and Candle	30.8%	27.8%	22.7%	21.1%	20.6%	18.4%	18.4%
Automotive	21.8%	20.8%	22.2%	20.7%	19.8%	21.3%	20.6%
Total	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%
	EBIT Contribution
Specialty Foods	71.5%	84.6%	82.9%	87.7%	94.5%	100.3%	108.3%
Glass and Candle	31.9%	7.8%	8.9%	7.5%	6.1%	3.2%	4.6%
Automotive	0.5%	11.5%	12.4%	9.6%	5.2%	2.6%	-5.9%
Corporate	-3.9%	-4.0%	-4.2%	-4.8%	-5.8%	-6.1%	-7.0%
Total	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%

 

 

As you can see, the composition of EBIT contribution was markedly different 5 yrs ago. The Glassware and Candles business, in particular, has seen its revenue base shrink dramatically due largely to competitive dynamics (imports), which have also severely impaired what were once very healthy margins. As a supplier into the domestic OEM auto channel, the Automotive segment has suffered greatly as well.

 

Specialty Foods, on the other hand, is a very attractive business characterized by steady and consistent revenue growth, robust margins, and modest (normalized) capital spending needs. Similar to other packaged food companies, margins have been under pressure due to rising input costs, but are still very healthy and possibly bottoming.

 

In April 2006, management announced it was beginning to explore strategic alternatives for its “non-foods” operations (G&C and Auto). Little meaningful progress has been made of yet, but recent activity, albeit small, may be pointing to more imminent action on a larger scale.

 

Below are historical financials by segment:

 

	June	June	June	June	June	June	Mar-07
	2001	2002	2003	2004	2005	2006	LTM
Sales:
Specialty Foods	$518	$580	$610	$639	$674	$708	$724
Glass and Candle	$336	$315	$251	$231	$234	$217	$218
Automotive	$239	$235	$245	$227	$224	$251	$245
Total	$1,093	$1,130	$1,107	$1,097	$1,131	$1,175	$1,187
Operating Income
Specialty Foods	$106	$114	$116	$109	$111	$114	$111
Glass and Candle	$47	$11	$12	$9	$7	$4	$5
Automotive	$1	$15	$17	$12	$6	$3	($6)
Corporate	($6)	($5)	($6)	($6)	($7)	($7)	($7)
Total	$148	$134	$140	$125	$118	$113	$103
EBITDA
Specialty Foods	$115	$124	$124	$118	$121	$124	$122
Glass and Candle	$64	$27	$28	$24	$24	$18	$20
Automotive	$10	$24	$25	$20	$13	$11	$2
Corporate	($6)	($5)	($6)	($6)	($7)	($7)	($7)
Total	$183	$170	$172	$156	$151	$146	$136
Capex							E
Specialty Foods	$13	$5	$14	$9	$15	$48	$48
Glass and Candle	$12	$14	$8	$4	$4	$4	$5
Automotive	$5	$4	$8	$5	$4	$10	$7
Corporate	$0	$0	$0	$0	$0	$0	$0
Total	$30	$23	$30	$18	$23	$62	$61
Sales Growth
Specialty Foods		12%	5%	5%	5%	5%	3%
Glass and Candle		-6%	-20%	-8%	1%	-7%	-1%
Automotive		-1%	4%	-8%	-1%	12%	3%
Total		3%	-2%	-1%	3%	4%	1%
EBIT Margin
Specialty Foods	20%	20%	19%	17%	17%	16%	15%
Glass and Candle	14%	3%	5%	4%	3%	2%	2%
Automotive	0%	7%	7%	5%	3%	1%	-2%
Corporate	-1%	0%	-1%	-1%	-1%	-1%	-1%
Total	14%	12%	13%	11%	10%	10%	9%

 

 

 

 

SPECIALTY FOODS BUSINESS DESCRIPTION:

Generating 60% of sales and more than 100% of EBIT, the Specialty Foods business is the crown jewel of the Lancaster portfolio. Given the company’s long-term objective of focusing around businesses with better growth opportunities (i.e. Specialty Foods), management dedicates about 80% of its capital spending budget here. Not surprisingly, this is where the large majority of LANC’s underlying value can be derived.

 

The Specialty Foods business manufactures and markets consumable foods into both the retail and foodservice channels, with each channel representing roughly 50% of segment sales.

 

While its retail brands are not blockbusters, most generally hold leading market positions in niche areas of large and stable categories. For example, the company’s New York brand holds the #1 position in the frozen garlic bread area of the $1.4bn “Frozen Goods-Baked” category. Its line of retail products are largely in two areas: (1) pourable and refrigerated salad dressings, refrigerated veggie dips and croutons (mostly under the T. Marzetti label) and (2) frozen foods such as garlic breads, frozen rolls and noodles (labels include New York, Sister Schubert’s, Mama Bella).

 

The other 50% of the food business is sold into the foodservice channel. Products are branded packaged and bulk private label salad dressings sold to chain restaurants. The next time you get a salad from Au Bon Pain at the airport, check the salad dressing package…it’s likely to be produced by T. Marzetti.

 

In my view, the primary risks to the food business are (1) raw material cost inflation, (2) private label penetration., and (3) food safety issues—the spinach recall negatively impacted produce salad dressing sales—but these tend to be more transitory.

 

Rising input costs are an issue for the entire packaged food industry. Lancaster’s largest raw material costs are soybean oil, dairy/eggs, and wheat. Soybean oil is the largest, representing over $30mm in COGS annually at current soybean oil futures prices. Increased demand for corn-based ethanol has had a particular impact on Lancaster by creating dramatic inflation in soybean prices.  For perspective, from mid-2001 to now, soybean oil futures have increased from $0.16/lb to over $0.33/lb. For Lancaster, every $.01/lb price increase negatively impacts COGS by $1mm--meaning this input alone is accountable for over 200 bps of margin contraction. Wheat, dairy, and oil prices (large packaging input) have experienced dramatic increases as well.

 

With respect to private label, there is no doubt that it has taken its fair share on supermarket shelves. However, Lancaster’s leading or premium brands in niche categories positions it better than most. Its produce/refrigerated salad dressings and dips as well as frozen bread products are particularly well positioned. Its grocery/shelf-stable (around 10% of food sales) salad dressings are more susceptible to private label penetration.

 

 

LONG INVESTMENT THESIS

In a nutshell, LANC shares provide an extremely attractive risk/reward profile, offering strong downside protection, a solid probability of achieving base case returns of 30-50%, and upwards of 100% in a plausible upside scenario. Achieving the base case (and then some) depends on actions that are entirely within the company’s control.  The upside case would require some external assistance (such as easing input prices or retail price increases) to offset raw material cost pressure and enhance margins.

 

Below, I have outlined in detail the “sources of value” for the shares, starting with my views on downside protection and progressing to what needs to happen for incremental upside to materialize and what the business is worth in that scenario. There is reason to believe that many of these developments are currently being considered by LANC’s management and Board. Thus, in my view, there is a better probability than not that some or all will take place in the near future. And again, the beauty of the story is that should none of them materialize, a conservative sum of the parts, with the majority of the value coming from a stable, FCF generating food business, provides for strong downside protection at very close to the current level.

 

 

SOURCES OF VALUE

 

1) Specialty Foods Business as it stands today (LTM Sales $724mm, $111mm EBIT, $11mm estimated D&A, and normalized capex of $15-$20mm):

 

What is this business worth as it exists today? Listed below are packaged food company multiples, segmented by market cap. Lancaster Colony would clearly fall in the smaller cap category. As one point of reference, LANC could be considered most comparable to McCormick given a similar sales mix into both the food retail and food service channels.

 

			EV as multiple of LTM:				LTM CAPX as
Company	Mkt Cap	EV	EBIT	EBITDA	2007 P/E	2008 P/E	% of Sales
Large Cap:
KFT	$53,497	$63,788	12.2x	10.4x	18.1x	16.9x	3.4%
GIS	$21,780	$28,629	12.9x	10.8x	19.0x	17.6x	3.4%
HNZ	$15,395	$19,895	13.2x	11.2x	19.5x	18.0x	2.6%
CPB	$15,484	$17,857	14.2x	11.6x	20.1x	18.5x	4.5%
CAG	$12,718	$15,701	12.2x	9.6x	18.7x	16.9x	3.7%
SLE	$12,915	$14,644	10.6x	7.4x	21.2x	19.9x	3.8%
High			14.2x	11.6x	21.2x	19.9x	4.5%
Median			12.6x	10.6x	19.2x	17.8x	3.6%
Low			10.6x	7.4x	18.1x	16.9x	2.6%
Small/Mid Cap:
MKC	$5,019	$5,740	14.1x	11.6x	19.8x	18.0x	3.1%
SJM	$3,289	$3,563	13.7x	10.9x	20.9x	19.5x	2.9%
RAH	$1,576	$2,317	13.6x	9.6x	18.3x	16.8x	1.2%
HAIN	$1,216	$1,391	16.2x	13.9x	24.5x	21.0x	2.0%
THS	$870	$1,061	12.6x	9.5x	21.6x	18.6x	1.7%
LNCE	$690	$737	16.6x	10.3x	24.9x	20.5x	6.0%
BGF	$582	$1,190	18.7x	16.5x	NA	NA	2.3%
High			18.7x	16.5x	24.9x	21.0x	6.0%
Median			14.1x	10.9x	21.2x	19.0x	2.3%
Low			12.6x	9.5x	18.3x	16.8x	1.2%

 

 

Using an EBIT or cash flow multiple seems most appropriate given Lancaster’s modest (normalized) capital spending requirements (about 2.0% of sales). Excluding outliers such as BGF and LNCE, the median small/mid cap multiple is slightly under 14x LTM EBIT. To be conservative, assume for now that the food business continues to be discounted given LANC’s conglomerate structure:

 

Food Segment LTM EBIT: $111mm

Current Total Company Net Debt: $(8)mm

Shares Outstanding: 31.3mm

 

EV/EBIT Multiple                 Equity Value / Share

                10x                                                          $35.70

                11x                                                          $39.27

                12x                                                          $42.81

 

Thus, applying steep valuation discounts vs its peer group still implies an equity value of $36-$43/share, only 0%-15% below current levels.

 

Note that the previous analysis is on an LTM basis, and excludes highly probable and material annual FCF generation in coming years. Valuing the business on a 2-year forward basis (FYE June 2009) and incorporating a range of EBIT margins yields the following:

 

	Equity Value / Share
	FYE June 2009E EBIT Margin (Current: 15%-16%)
EV/EBIT	14%	15%	16%	17%	18%
10	$35.47	$37.99	$40.51	$43.02	$45.54
11	$39.00	$41.76	$44.53	$47.30	$50.07
12	$42.52	$45.54	$48.56	$51.58	$54.59
			+
2008E+2009E FCF	$2.88	$3.19	$3.50	$3.81	$4.11
			=
EV/EBIT	2009 Equity Value / Share
10	$38.36	$40.87	$43.39	$45.90	$48.42
11	$41.88	$44.64	$47.41	$50.18	$52.95
12	$45.40	$48.42	$51.44	$54.46	$57.47
2008 & 2009 revenue and cash flow assumptions:
-sales growth of 4% in both years
-Capex $25mm in 2008 and $20mm in 2009
-Tax rate: 37.5%
-Working cap change=0

 

  

 

Note that the lowest outcome in this range assumes a pretty somber scenario including (1) an additional 150 bps of EBIT margin contraction and (2) the business continues to be valued at a steep 30% discount to the peer group (10x vs the current 14x for the small cap comparables) for the next two years. Still, the per share price in this scenario is over $38, 11% below current levels. And this is before ascribing any value to the Automotive and G&C businesses.

 

 

2) Divestiture of Glassware & Candles and Automotive segments

 

These two businesses have already been designated by management as non-core. Five yearrs ago, both the Glassware & Candles and Automotive segments were relatively healthy. Both have experienced a severe erosion of fundamentals since then. G&C sales have suffered through a deflationary environment as production has shifted overseas and input costs, such as paraffin wax, have inflated dramatically. It has rebounded lately, but profitability levels are a fraction of where they were five years ago. Automotive segment margins have suffered along with the rest of the domestic auto industry.

 

Management has recognized the long-term challenges of these two businesses and, in April 2006, announced an exploration of strategic alternatives for both of them, including potential divestitures, and the hiring of Goldman Sachs to manage the process. To date, little progress has been made, and only very recently did the company announce the shuttering of the industrial glass division in the G&C segment and divestiture of an accessory business in the Automotive segment to the private equity firm Kinderhook Industries.  Combined sales of these two announcements represented well under 8% of non-core revenues. Thus, given what’s been disclosed, much work remains to be done on the restructuring front.

 

However, in every quarter since the announcement, management has reiterated its commitment to this process, and recently has been speaking to more urgency/focus on the Automotive business. While it’s difficult to predict how long it will take (it’s already been a year), I do believe management still intends to focus the business around Specialty Foods longer term.

 

In terms of why the process is taking so long, management has revealed little. There are a few possibilities: (1) LANC’s price sensitivity—it may not be getting what it deems to be attractive offers, particularly for the Automotive business, (2) G&C sales and margins have rebounded in the past 2 quarters, so management may be temporarily reluctant to divest prior to letting fundamentals fully improve, and (3) they are exploring alternatives that are on a larger scale than what has been publicly announced (i.e. exploring alternatives for the food business as well—it’s a long shot but possible—more on this later).

 

What are the two non-core businesses worth? As displayed earlier, only basic segment data is available:

 

Glassware & Candles:

Sales: $218mm

EBIT: $5mm

Est EBITDA: $20mm

Est Capex: $4-5mm

 

Automotive:

Sales: $245mm

Est EBIT: $(4)mm (excludes one time strike costs)

Est EBITDA: $3mm

Est Capex: $7mm

 

 

Given no segment level balance sheet disclosure, an EBITDA valuation seems most appropriate. Using a simplistic and conservative range of multiples implies the following values:

 

Automotive Segment:

 

EV/EBITDA Multiple                          Pre-tax Proceeds                   Equity Value / Share

                3.5x                                              $10.5mm                                                            $0.34

                4.5x                                              $14mm                                                               $0.45

                5.5x                                              $17.5mm                                                            $0.56

 

Glassware & Candles:

 

EV/EBITDA Multiple                          Pre-tax Proceeds                   Equity Value / Share

                5.0x                                              $97.5mm                                                            $3.11

                6.0x                                              $117mm                                                             $3.73

                7.0x                                              $136mm                                                             $4.36

 

 

The mid-point of the range implies about $130mm in pre-tax proceeds, or .28x combined revenues. The majority of the proceeds are likely to be derived from the sale of the G&C business, as Automotive barely breaks even on a FCF basis, if at all. Note that Yankee Candle was recently acquired by Madison Dearborn for 10x LTM EBITDA (12x EBIT) and Blyth currently trades at EV/LTM EBITDA of 9x. Thus, my estimate for the G&C business could prove conservative, but I think it’s appropriate given the length of time it’s taking for this process to materialize.

 

Assuming the carrying value for both businesses is zero and that the divestiture proceeds would be taxed at 20%, LANC would realize $104mm (using the midpoint of the aforementioned range), or over $3.32/share.  

 

Recall from above that a steeply discounted food business in a downside margin scenario is worth around $38. Thus, a conservatively valued sum-of-the-parts implies over $41/share, or about 5% below current levels. Combined with the fact that management tends to support the stock with share repurchases around $40, I believe this level represents a fairly good indicator of downside support.

 

 

3) Revaluation of the Specialty Foods business

 

The divestitures of the Automotive and G&C businesses should have a deeper impact than the value of the divestiture proceeds alone, as their existence is suppressing the underlying value of a very solid specialty foods business. LANC’s conglomerate structure impedes the market’s visibility into and interest in their food business. There are only 2 smaller brokers providing sellside coverage and many investors, including consumer staples sector analysts, have not even heard of Lancaster Colony. Its latest conference call lasted a whopping 20 minutes, including Q&A, when only one sellside analyst ventured a few questions.

 

The divestiture of the “non-core” businesses, I believe, will act as a catalyst for the shares. It will (1) demonstrate management’s long-term commitment to the food business, (2) allow management to focus exclusively on improving one well-positioned business, (3) remove the operating uncertainty and lack of visibility associated non-core businesses and (4) improve market visibility into the quality of their food franchise. Once this happens, investors can better assess the underlying value of their packaged food business.

 

How will LANC look post-divestitures?

 

Given a debt-free balance sheet, declining capital spending requirements in 2H 2007, and management’s penchant for share repurchases, I assume the proceeds of the divestitures will be deployed through buybacks.

 

LANC (PF for divestitures and share buyback) would look as follows (March 2007 LTM basis):

 

Revenues: $724mm

EBIT: $111mm

Est EBITDA: $122mm

Est normalized capex: $20mm

UFCF: $60mm

Debt: $0

Cash: $8mm

Shares Outstanding: 29mm (a)

 

(a) Assumes after-tax proceeds from divestitures deployed for stock repurchases at 5% above current price.

 

So now let’s revisit the valuation exercise from #1, valuing LANC on 2009 margin scenarios as a pure play packaged food company:

 

	Equity Value / Share
	FYE June 2009E EBIT Margin (Current: 15%-16%)
EV/EBIT	14%	15%	16%	17%	18%
12	$45.89	$49.15	$52.41	$55.67	$58.92
13	$49.69	$53.22	$56.75	$60.28	$63.81
14	$53.49	$57.29	$61.10	$64.90	$68.70
			+
2008E+2009E FCF	$3.11	$3.44	$3.77	$4.11	$4.44
			=
EV/EBIT	2009 Equity Value / Share
12	$49.00	$52.26	$55.52	$58.77	$62.03
13	$52.80	$56.33	$59.86	$63.39	$66.92
14	$56.60	$60.40	$64.20	$68.01	$71.81

 

 

 

The multiples in this scenario have increased, as this range seems more appropriate for a pure-play food company. Note that the range is still conservative, with the peer group median used for the high end of the range. And similar to previous examples, the downside scenario assumes: (1) margin contraction and (2) a 12x EBIT multiple, a full turn lower than the lowest comparable.

 

The downside case ($49) is now 14% above the current price. And in a base case of steady state margins and a peer group multiple, the shares will be worth over $60/share in less than 2 years, representing 40% upside.

 

 

4) Leveraged recap: With stable revenues and relatively modest maintenance capital spending requirements, almost all food companies should and do carry some level of leverage. Below are debt levels for both large and small cap packaged food companies:

 

Company	Total Debt/EBITDA	Debt/Total Capital
BGF	8.8x	90%
RAH	3.1x	61%
HNZ	2.8x	69%
GIS	2.3x	47%
HAIN	2.2x	25%
SLE	2.1x	61%
CAG	2.1x	43%
CPB	1.9x	66%
KFT	1.7x	27%
THS	1.7x	25%
MKC	1.5x	43%
SJM	1.3x	20%
LNCE	0.7x	18%
Average	2.5x	46%
LANC	0.0x	0%

 

 

LANC holds no debt and is not maximizing its capital structure. In fact, it is quite the opposite. As of mid-2005, the company had built a sizeable net cash position. Management made several public pleas on quarterly conference calls looking for block repurchases. Presumably either unwilling to pay a premium or unable to locate sellers in size, it subsequently paid a $2/share one-time cash dividend at the end of 2005.

 

The company has expressed a comfort level with carrying some level of leverage. Management has also expressed a desire to maintain the flexibility to make debt-financed acquisitions. However, given the small size of deals they typically review ($10mm-$30mm in sales), the addition of meaningful leverage would have to materialize through a recap. I can envision this materializing in the near future.

 

Excluding LNCE and BGF, the peer group average debt-to-LTM EBITDA is roughly 2.0x. Given LANC’s extremely conservative nature, I’m not expecting anything overly aggressive. But something in the 1.5x range seems very manageable. In this scenario, assuming LTM specialty foods EBITDA of $122mm, the company would add $183mm of debt. LANC’s cash flow dynamics can more than support this level of leverage.

 

What would this mean for the shares? I’m looking at it in two separate ways. First, EPS accretion. On LTM numbers, a leveraged recap would add about $0.11 in EPS. The lowest trailing 2006 P/E for the peer group is greater than 20x. Under this logic, it would generate at least a $2 one-time boost to the shares.

 

The second piece depends on (1) how the company deploys the proceeds and (2) what happens to EBIT margins. Clearly, a lower share count creates more operating leverage for shareholders. Again, I’m assuming a share buyback would play a significant role. There could also be a sizable increasing of the annual dividend.

 

For illustrative purposes, let’s assume the company performs a dutch tender with all of the proceeds and repurchases shares at 5% above the current price and again value the food business using the same parameters previously described above:

 

	Equity Value / Share
	FYE June 2009E EBIT Margin (Current: 15%-16%)
EV/EBIT	14.0%	15.0%	16.0%	17.0%	18.0%
12	$45.98	$49.76	$53.55	$57.33	$61.12
13	$50.39	$54.49	$58.59	$62.69	$66.79
14	$54.81	$59.22	$63.64	$68.05	$72.47
			+
2008E+2009E FCF	$3.61	$4.00	$4.38	$4.77	$5.16
			=
EV/EBIT	2009 Equity Value / Share
12	$49.59	$53.37	$57.16	$60.94	$64.73
13	$54.00	$58.10	$62.20	$66.30	$70.40
14	$58.42	$62.83	$67.25	$71.67	$76.08

 

 

 

Again, the risk/reward looks quite attractive. As described above, the downside case still generates 15% upside. Assuming steady-state EBIT margins of 15%-16%--the lower end of historical ranges and the low end of management’s long-term target--the shares are worth $53-$67, 25%-50% above the current level. If margins recover to historical levels, a plausible case can be made for the shares to nearly double.

 

 

4) Food segment margin recovery

 

As noted earlier, food segment EBIT margins have deteriorated significantly over the past 5 years from 20% in FY2001 to 15.4% in the LTM period. While the company does not publish a detailed income statement at the segment level, I’d guess that much is related to rising input costs. This is not a company specific problem, as the majority of packaged food companies have seen significant margin deterioration during this time as well.

 

So where might the margin improvement come from? There are a number of ways this could happen, some within management’s control and some outside of it.

 

First, plant capacity. I’ll start with this since it is probably the most predictable. LANC is in the midst of adding capacity through two new facilities, one for salad dressings and the other for Sister Schuberts frozen rolls. This explains the significant ballooning in capex in 2006 and 2007. The combined capital cost of the two plants is in the neighborhood of $50mm. The company asserts that ROIC, assuming current capacity levels, would be in the high single digits. Assuming a 7.5% ROIC, savings would be roughly $3.75mm. This translates into about 50bps of margin beginning in the 2H 2007. I’d venture to say that the company has visibility on incremental growth in these categories, or they probably wouldn’t have made the investments to begin with. Any additional capacity would have a much higher marginal return.

 

Second, input cost declines. This would likely have the greatest impact on margins. I’m not saying it will happen, as it’s impossible to predict and is currently trending in the other direction. But a 27 year soybean oil price history indicates that prices are closer to peaking than not. Current contracts trade at over $0.33/lb. Since 1979, the futures have dipped below $0.15 on two occasions and above $0.35 only once. The peak occurred in mid-1984, when futures eclipsed $0.40, only to subsequently plummet to under $0.13 over the following two years. I’m not making any predictions as we’re all aware of the fervor surrounding corn-based ethanol and the havoc it has wreaked on the food supply chain. But history would tell us that we’re closer to a peak than a bottom in soybean oil prices. Every $0.01 change impacts EBIT margin by roughly 15bps. And this doesn’t even account for dairy, wheat and energy prices. So there is obviously a lot of leverage here in both directions, but it’s difficult to predict direction, magnitude, or timing.

 

Third, retail price increases. In today’s competitive food retail environment, most packaged food companies have been reluctant to increase retail prices for fear of losing share to competitors or spooking the consumer. At some point, the rubber must meet the road, as neither manufacturers nor retailers can be expected to bear the burden of rising food costs indefinitely.

 

Last, expense control. Lancaster is run by nice guys. They run the business like a private company. There is no full P&L by segment, so it’s impossible to know how aggressive LANC has been on expense control. But I’m guessing that fat does exist in this organization. This may have to be pushed upon them, but there is likely opportunity there.  For context, note that LANC generated ~$210k per employee last year and this productivity/expense metric compares very poorly to selected small cap food comps like MKC ($362k), HAIN ($356k), SJM ($616k), and THS ($389k).  Although LANC’s figures are inclusive of the non-core business employees, the disparity pro-forma for just Specialty Food is likely also poor (although not as abysmal) and is indicative of additional margin upside.

 

EBIT margins in this segment are volatile, based on mix (foodservice is lower margin than retail), volume, and input costs levels. Quarterly margins have ranged as low as 12.4% and as high as 19% in the past four quarters. The LTM EBIT margin was 15.4%, but has been on a downward trend over the past several years. Management stands by its assertion that normalized (for input costs) LT EBIT margins are in the mid-to-high teens.

 

Let’s revisit the valuation matrix one last time, this time examining the potential upside assuming (1) margins increase from the current 15%-16% and (2) the company commands a median/above average multiple:

 

	Equity Value / Share
	FYE June 2009E EBIT Margin (Current: 15%-16%)
EV/EBIT	16.0%	17.0%	18.0%	19.0%	20.0%
13	$58.59	$62.69	$66.79	$70.89	$74.99
14	$63.64	$68.05	$72.47	$76.89	$81.30
15	$68.69	$73.42	$78.15	$82.88	$87.61
			+
2008E+2009E FCF	$3.61	$4.00	$4.38	$4.77	$5.16
			=
EV/EBIT	2009 Equity Value / Share
13	$62.20	$66.30	$70.40	$74.50	$78.60
14	$67.25	$71.67	$76.08	$80.50	$84.91
15	$72.30	$77.03	$81.76	$86.49	$91.22

 

 

 

*Assumes all actions previously discussed have taken place, including divestitures of non-core business and a leveraged recap, with the proceeds being deployed for share repurchases.

 

A 17%-19% margin seems very achievable, particularly with cooperation from input costs --a $0.10/lb decline in soybean oil alone would get them to 17%. An 18% EBIT margin and a peer group multiple implies 75% upside in the shares. A lot would have to go right to return to the 20% EBIT margin last achieved in 2001, but it’s not out of the question, and would likely lead to a doubling of the shares.

 

 

5. Going private transaction—a longer shot, but possible

LANC shares have done very little for almost 10 years. Excluding dividends, they have a 10 year CAGR of 3%. The 5-year CAGR is close to nil.

 

The Gerlach family is the company’s largest shareholder, retaining a 26% stake currently valued at $350mm. They collect over $8mm in annual dividends and were distributed $16mm through the one-time dividend in late 2005.

 

Perhaps management isn’t motivated by the stock price? Maybe they don’t care whether their stake is worth $300mm, $450mm or $600mm.  Perhaps management is more motivated by share repurchases than increasing the stock price. While the market typically applauds consistent share repurchases, it is also typically correlated with a rising share price.

 

They have a sweet deal as a public company—not only do they receive a sizable dividend regardless of share price performance, but they also have the opportunity, year after year, to acquire 3%-4% of the company by paying well under fair market value for a very solid business. It won’t take long before the Gerlach family owns over 50%.

 

One might assume that this would go on indefinitely, but events over the past year might lead one to conclude otherwise. An evolving shareholder base and a much less-forgiving market environment might be among the catalysts that force the issues I’ve laid out, sooner than later. The 13-D filed in March by the #1 outside shareholder would seem to support this thesis.

 

So Lancaster may be forced to do something to create shareholder value. Whether it’s accelerating the divestiture process, levering up the company, a large scale share repurchase, a dividend increase, or simply taking the company private.

 

There are multiple ways to win, and there is too much value for the shares to linger indefinitely.

 

 

Catalysts:

 

 

 

 

 

 

Catalyst

1) Divestiture of non-core Automotive and Glassware & Candles businesses
2) Stepped up share repurchases with proceeds
3) Revaluation and more visibility as a pure play packaged foods business
4) Leveraged recap and subsequent share repurchase/dividend increase
5) Specialty Foods segment EBIT margin recovery
6) Longer shot: Gerlach family takes the company private
7) #1 outside shareholder to agitates for change. 13D filed in March 2007