Description

Penford Corporation (NasdaqGM: PENX)

Penford is an under-the-radar, dramatically mispriced micro-cap company with a very near-term catalyst for revaluation and that is presently trading at only 1/3 to 1/2 of its private market value.  PENX is ignored, misunderstood and undervalued because (i) with an $80mm adjusted market cap it is too small for most investors to dig in; (ii) its complex capital structure, including an expensive, debt-like preferred issue owned by a Zell fund, has depressed reported earnings and is confusing to many investors; (iii) its high-volume, low margin industrial/ethanol business masks the company’s hidden gem – its highly profitable, fast-growing food ingredient business; and (iv) its run-rate revenues and profitability are substantially higher than LTM metrics.  Key tenets of the investment thesis are as follows:

• Trading at only 0.9x Book Value and 1.0x Tangible Book Value, providing margin of safety.

• Highly valuable, fast growing, high margin Food Ingredients business is worth more than the entire Enterprise Value of the company on a standalone basis, but is masked by the company’s larger, low margin Industrial Bio-Products (ethanol) division. 

• As the Food Ingredients business is conservatively worth at least 7.0x EBITDA (a likely minimum for a private equity buyer), you are getting the $259mm sales, $13.6mm Run-Rate EBITDA Industrial business for free or better.  It is a near certainty that a strategic buyer (i.e. ConAgra http://www.conagrafoodscompany.com/corporate/b2b/foodingredients.jsp) would assign an 8-10x EBITDA multiple to the Food Ingredients business unit alone.  To put this in perspective, PENX trades at 7.1x Consolidated EBITDA and 6.76x Food-only EBITDA (excluding Industrial and Corp O/H) on an LTM basis, and 4.6x Consolidated EBITDA and 5.5x Food-only EBITDA on a Run-Rate Basis.

• Very likely redemption (on or shortly after April 7^th) of all or a significant portion of the Series A 15% cumulative non-voting, non-convertible preferred stock (“Series A Preferred Stock”) (owned by Zell’s credit fund), whose non-deductible dividends and discount accretion have caused an unusually high effective tax rate (70% in Q1 2012) and negative reported net income.  On the 1/9/12 Q1 call, the CFO indicated that they are likely to use at least a portion of their liquidity to retire this preferred: “We have a number of choices facing us with the money that's available under our existing credit facility.  We have less than $20 million drawn on a $60 million facility. The preferred stock is redeemable at par in early April 2012.  The use of our liquidity will certainly reflect a number of choices between taking that preferred and redeeming some of that, our capital spending program, as well external opportunities.  We are well aware that the economic impact of the preferred stock on our reported results is significant and that will factor into those considerations.”

• Meaningful open-market insider purchases in January and February by the (i) Chairman, Paul Hatfield, (ii) CEO, Tom Malkoski and (iii) Director, James Warjone, totaling 15,700 shares in that 11 day period.

• Business momentum, with strong recent growth in revenues and profits in both business units.  From the Q4 conference call, CEO Malkoski noted “I think we're going to see some pretty robust growth and part of it is, as I talked on the previous 2 or so conference calls, it's really generated from new business, new products and new business. And the level of trial activity and the level of ramp up of some of these commercial conversions is very high. And so we are quite optimistic that the Food business will continue some very strong growth rates.” 

• This business momentum has driven management’s decision to increase total capex to $16mm in 2012, vast majority of which is growth capex, roughly equally split between divisions.  Historically, total capex was $5.4mm, $6.0mm and $8.3mm in 2009, 2010 and 2011, respectively.

• Management “expects to realize significant improvement in pricing by the end of our second quarter (Feb 2012) versus 2011” due to a new industrial starch contract.

• Recently closed (1/12/12) acquisition of Carolina Starches, a $25mm revenue business that sells industrial-modified starches into the paper and packaging markets, for $8.5mm in cash (which includes the retirement of debt), which is expected to be accretive to PENX earnings in the first year.

Company Overview:  A very good overview presentation can be found here: http://www.penx.com/pdfs/investor-presentations/Jefferies_&_Company_2012_Clean_Technology_Conference.pdf

PENX engages in the development, manufacture, and marketing of specialty natural-based ingredient systems for food and industrial ingredient applications primarily in the United States.  It develops and manufactures ingredients with starch as a base.  The starch products are manufactured primarily from corn and potatoes, and are used as binders and coatings in paper and food production, as well as an ingredient in fuel.  The company’s Industrial Ingredients segment provides specialty starches to the paper and packaging industries in ethylated, oxidized, and cationic forms.  Its ethylated and oxidized starches are used in coatings and as binders, providing printability to fine white, magazine, and catalog paper; and cationic and other liquid starches are used in the paper forming process in paper production, providing the bonding of paper fibers and other ingredients.  This segment also produces and sells fuel grade ethanol.  The company’s Food Ingredients segment offers specialty starches and dextrins to the food manufacturing and food service industries.  Its specialty starches are used in coatings for various products, such as French fries sold in restaurants, as well as used as moisture binders in a range of foods, including canned products, sauces, whole and processed meats, dry powdered mixes, and other food and bakery products.  PENX sells its products through a direct sales force, as well as through distributor agreements to manufacturers and processors.  The company was founded in 1894 and is headquartered in Centennial, Colorado.

Capital Structure and Segment Data:

Valuation Data Tables:  The following tables illustrate potential valuation of PENX based on assigned valuation multiples for the Food Ingredients business (ranging from 7.0x-10.0x) and the Industrial business (ranging from 3.0x-6.0x).  The first table applies these multiples to LTM reported data, while the second table applies the same multiples to the Run-Rate EBITDA, which we believe to be fair given the growth trajectory of the businesses and the lack of meaningful seasonality.

Preferred Stock:  On April 7, 2010, the Company issued $40 million of Series A 15% cumulative non-voting, non-convertible preferred stock (“Series A Preferred Stock”) and 100,000 shares of Series B voting convertible preferred stock (“Series B Preferred Stock”) in a private placement to Zell Credit Opportunities Master Fund, L.P., an investment fund managed by Equity Group Investments, a private investment firm (the “Investor”). The Company has 1,000,000 shares of authorized preferred stock, $1.00 par value, of which 200,000 shares are issued and outstanding at November 30, 2011 in two series.

The Company recorded the Series A Preferred Stock and the Series B Preferred Stock at their relative fair values at the time of issuance. The Series A Preferred Stock of $32.3 million was recorded as a long-term liability due to its mandatory redemption feature and the Series B Preferred Stock of $7.7 million was recorded as equity. The discount on the Series A Preferred Stock is being amortized into income using the effective interest method over the contractual life of seven years. At November 30, 2011, the carrying value of the Series A Preferred Stock liability of $40.3 million includes $6.3 million of accrued dividends, and $1.7 million of discount accretion for the period from the date of issuance to November 30, 2011. The accrued dividends represent the 9% dividends that may be paid currently or accrued at the option of the Company. Dividends on the Series A Preferred Stock and the discount accretion are recorded as interest expense in the Condensed Consolidated Statements of Operations.

The holders of the Series A Preferred Stock are entitled to cash dividends of 6% on the sum of the outstanding Series A Preferred Stock plus accrued and unpaid dividends. In addition, dividends equal to 9% of the outstanding Series A Preferred Stock may accrue or be paid currently at the discretion of the Company. Dividends are payable quarterly.

The Series A Preferred Stock is mandatorily redeemable on April 7, 2017 at a per share redemption price equal to the original issue price of $400 per share plus any accrued and unpaid dividends. At any time on or after April 7, 2012, the Company may redeem, in whole or in part, the shares of the Series A Preferred Stock at a per share redemption price of the original issue price plus any accrued and unpaid dividends.

The Company may not declare or pay any dividends on its common stock or incur new indebtedness that exceeds a specified ratio without first obtaining approval from the holders of a majority of the Series A Preferred Stock.

Risks:

• Customer concentration in the Industrial business, where its sole ethanol customer, Eco-Energy, represented 34%, 27% and 21% of consolidated revenue for 2011, 2010 and 2009, respectively.  Penford’s second largest customer, Domtar, Inc., represented 8%, 8% and 11% of consolidated revenue for 2011, 2010 and 2009, respectively.  There is no customer concentration in the Food business.
• Inability to pass along an increase in the cost of corn, potato starch and other raw materials.
• Disruption of manufacturing due to natural disaster, such as the 2008 flood in Cedar Rapids.
• Market decline could affect pension obligations, which presently include an $11mm pension benefit liability and $16mm of other postretirement benefits.  The company presently expects to book pension expense of $2.8mm for 2012.

Catalysts:

• Retirement of a significant portion or all of the Series A 15% Preferred Stock, removing a significant drag on reported earnings and cash flow.  View this as highly likely.
• Sale of the Food Ingredients business, whose private market value would likely exceed the company’s current total enterprise value.  View ConAgra as a potential strategic buyer, while many, many private equity firms would compete and bid up the price of this business unit.  Food-related businesses typically command the highest level of interest and valuation by private equity funds due to their high margins, strong cash flow and recurring revenue characteristics.
• Continued growth of both the Industrial and Food business units, with improved margins due to higher volumes and new industrial starch contract.

Disclaimer:  The author of this idea presently has a long position in securities of this issuer and may trade in and out of these positions without notice.

Catalyst

• Retirement of a significant portion or all of the Series A 15% Preferred Stock, removing a significant drag on reported earnings and cash flow.  View this as highly likely, would be highly accretive to earnings and cash flow, and would improve the company's screening characteristics.
• Sale of the Food Ingredients business, whose private market value would likely exceed the company’s current total enterprise value.  View Cargill as a potential strategic buyer, while many, many private equity firms would compete and bid up the price of this business unit.  Food-related businesses typically command the highest level of interest and valuation by private equity funds due to their high margins, strong cash flow and recurring revenue characteristics.
• Continued growth of both the Industrial and Food business units, with improved margins due to higher volumes and new industrial starch contract.
• Investors beginning to peel back the onion and understand the massive valuation discrepancy due to the company's hidden gem, the Food Ingredients business.