This is a story with lots of uncertainty but not much risk. I expect a double or triple over the next twelve months; losing money is possible but unlikely.

INTRODUCTION

Overhill Farms is a contract frozen food manufacturer that's mildly profitable while operating at 50% of capacity. They've just started shipping product for two new accounts that should boost revenues by some 40-50%. Given the operating leverage, EPS should go up a lot -- like 2-4x. At ~5.5.x adjusted TTM EBITDA/~13.5x adjusted EPS, the stock has a lot of room to run. The downside risk comes from high degrees of customer concentration.

Here's a summary of my scenario analysis over a one year investment horizon:

As you can see, I think things are a bit, ahh, asymmetrical. There's a 3% chance of losing money, 25% chance of being disappointed with 36% returns, and everything else is different flavors of gravy.

Here's a financial summary of their most recent quarter, annualized, which I'll be using for projections; note that revenues are the lowest they've been for quite some time:

I'd like to present some background, then step through the numbers driving the scenario analysis, and finish up with miscellaneous stuff.

BACKGROUND

OFI makes frozen food out of a couple of buildings in Vernon, CA for customers such as Jenny Craig, Safeway, Panda Restaurant Group and American Airlines. They went through some bad times earlier in the decade because they borrowed heavily to finance facility consolidation, only to watch demand from their airline customers plummet after 9/11. This was followed by a few good years ending in 2008; since then revenues and earnings have declined.

The industry they're in -- food processing -- is regarded as "defensive", because people have to eat, which means that demand is fairly steady, and the "processing" part provides some insulation from changes in commodity prices. Heinz, for instance, trades at roughly at 17.5x earnings, 11x EBITDA, with a 3.6% dividend yield. I don't think those are crazy numbers. OFI shouldn't command these multiples because they're a teeny company that works for hire, not a huge multi-national that owns some of the world's top food brands -- but they might, if investors conclude that they're a fast growing food processor.

OFI's 3% margins show that this is a no-moat business. On the other hand --

-- This isn't rocket science, but it is food science. OFI can make frozen food palatable; if you've eaten a Banquet TV dinner circe 1972, you'll agree that isn't easy. They can even make frozen diet food palatable (the Jenny Craig account) or frozen in-flight meals palatable, or as palatable as possible anyway.

-- They're trying to partner with their customers, not just make food to order. They have chefs available to mess with recipes, will advise on marketing or packaging, etc. This is the "value added" part of their self-description of their being a "value-added manufacturer of high quality, prepared frozen food products"

-- OFI's customers rely on them to preserve their own brands and reputations. It's not worth it to switch just to save a couple of bucks.

These are important considerations, because for 2010 the top 3 customers account for over 60% of revenue:

Industry conditions have been tough for the last few years. The environment has been promotional, with Nestle having been particularly willing to cut prices to maintain market share.

SCENARIO ANALYSIS

The key drivers are customer retention rates (i.e., the chances of losing an existing customer), what OFI will do with it's nearly debt free balance sheet, and estimates of the size/margins of the new business. There's a lot of guess-work here; one of the reasons the opportunity exists is because management has not been forthcoming with details or projections. In some cases, I'm going to be estimating numbers higher than what management has hinted at. In other places, I'm going to be taking some shortcuts. As long as I'm in the ballpark, I'll excuse myself with the old joke about the Black-Scholes formula, "We put the wrong numbers into the wrong equation to get the right answer".

Customer Concentration

OFI's customer relationships are pretty sticky. On their web site, they reveal that ,"The average tenure of our top 10 customers is over nine years, and many of our customers have been with us for 15 to 20 years".

A bit of math reveals that the implied retention rate for a 9 year tenure is 91.6%. We'll use a 10% defection rate, which gives us the following odds over the next year:

• Disaster! Two of top 3 customers defect: 2.7%
• Disappointment: One customer leaves: 24.3%
• Expected: Retain all customers: 72.9%

I divide the "expected" case into our base and upside scenarios by arbitrarily assigning a 20% chance to OFI picking up an additional $30MM revenue from some combination of new customers, recovery of orders from existing customers, or conservatism in my projections.

I know this all sounds highly precise and thus suspect -- well, it is, no one can really know whether they're going to lose a big customer or not. The main point is that, at this price, you make money unless they lose TWO customers, which is unlikely. I'm appending 10 years of customer concentration data for you to eyeball. I think the historical record supports using a high retention rate.

Balance Sheet

OFI has de minus net debt and $50MM of borrowing capacity under "certain conditions". They've retained Merrill Lynch to advise them on a particular acquisition. In all scenarios, I assume they use their balance sheet to make a $50MM acquisition at 8x EBITDA, winding up with something like this:

Acq @ 8x EBITDA

• Revs 50
• EBITDA 6
• D&A 1
• Interest 2
• Op. Income 3
• Net 1.86
• EPS 0.116

This adds ~$0.12 EPS but is dilutive to EV/EBITDA in all but my "Upside" scenario. I'm using 8x EBITDA because anything lower looks like I'm trying to cook the books in OFI's favor, and anything higher just highlights that OFI is cheap.

Margins

I ran a regression on a couple of years of quarterly revenues/gross profits. The somewhat noisy results suggest 19% incremental gross margins. This may be a bit low, because a lot of the revenue loss came from Heinz, a low margin account, and management claims that they've been improving efficiency as revenues have declined. I assume that all the gross profit drops straight to operating income with no additional SG&A.

Revenues

The two new accounts are Boston Market and Customer X, who the lads on the Yahoo! message board plausibly speculate is actually Target Corp.

Boston Market:

Boston Market is the big one both in terms of revenue and strategically. OFI has a 15 year contract to produce Boston Market frozen food in return for 4.5% of net revenues. BM is a well known national brand that OFI will own for a long period of time, adding some revenue stability and raising the profile of the company.

I'm going to put BM down for $50MM, which I think is conservative.

• Heinz, which lost the business to OFI, has referred to it as a $100MM account.

• In 2008, BM ran $120MM retail revenue ex Wal-Mart. Assuming 25% share for Wal-Mart, that's $160MM retail. Retail gross margins for frozen food are around 30%, supporting ~$100MM revenues to Heinz. I don't know that OFI can sell as much as Heinz does; let's say retail revenues drop to $100MM. Then, -$30MM retail cut - $5MM to BM - $5MM brokerage - $10MM miscellaneous leaves $50MM for OFI.

• The contract with BM includes minimum royalties with implied revenue of $61MM in 5 years and $72MM in 10, or 20% growth from year 5 to year 10. Running that backwards implies $50MM today.

Management's only comment on the size of BM has been, when asked if it could replace revenue from Heinz (which peaked at $42MM in 2008), to reply, "We hope so."

Customer X:

I'm guessing $20MM here. OFI has only announced that this is $7MM for the first year,  with "the opportunity for growth over time", but in a conference call acknowledged that the actual numbers would be higher, and that they said $7MM due to excess caution on Customer X's part. They've also said that Customer X could wind up being a significant as Safeway. $7MM is just too low for a 1,000 store account -- like, why bother?

I get to $20MM like so:

16 items stacked 15 deep in a cooler = 240 items on the floor + 240 items in storage to refresh the cooler = 480 items/store * 1,000 stores * 13x inventory turns = 6.24MM units/year * $5 retail ASP * 0.7 cost of goods to the grocer = ~$22MM to OFI, which we'll round down to $20MM.

Pulling it all together, we get:

Everything up to the "EPS" row is exclusive of a possible acquisiton; everything after includes it and the associated debt.

So what's it all mean? Obviously I think the stock is cheap here. But if it went to $8 overnight, I'd probably sell down to maintain my current dollar exposure. At $10, I'd reduce significantly and at $12 I'd be gone.

In the 3 months, I'd gladly hold at $8 if there was no adverse news, because, given the lead tines involved, we'd know by then if any of the three significant customers were planning on cutting orders in 2012.  If in 6-9 months it looks like my base case is going to work out, I'd find the stock comfortable at 12x earnings/6.x EBITDA.

OTHER STUFF

There are some yellow flags here. Both the CEO and CFO live on the East Coast and commute to California on the company dime, which is insane. The CFO was "interim" CFO for years; I don't know why you'd do that, unless you were trying to weasel out of a non-compete or had been barred from serving as a corporate officer.

It's not part of my thesis, but if the company can pull off a few good years, the stock could go much higher. Their current facilities can do something like $320MM revenue/$1.50 EPS. If they can grow to the point where customer concentration is no longer an issue -- say, $500MM revenues -- I'd expect them to trade in line with the rest of the industry. $500MM isn't as out of reach as you might think; retained earnings will pile up fast, and banks seem to be willing to lend up to 2x EBITDA/0.25x revenue.

Here's the historical customer list:

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Hope you like the idea; let me know if there are any questions.

Yours,

Bowd