In the 12 months since June 2011, in its 90th year of business, John B. Sanfilippo & Son, Inc. (JBSS) earned $17.1m. The company produced almost $9m in free cash (which is depressed due to high commodity costs and 'carry-over' of pecans, contributing significantly to an increase in inventory on hand of $17.5m year on year), and increased book value of equity by $17m on record revenues of $700.6m.
The common equity of the enterprise trades at a 25% discount to book value. Given the outlook for lower commodity costs as more raw material capacity comes online, the opportunities presented in the bakery segment due to troubles afflicting Diamond Foods, Inc. (DMND), increased penetration in fresh produce sections, and a rationalization and fine tuning of strategy - this family owned and controlled branded nut company continues to represent substantial value.
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Source: S&P Capital IQ
JBSS is a vertically integrated branded nut company. Its business operations include procurement directly from growers (in some cases partly financing farmers) and traders (in the case of imported produce); processing, packaging and marketing nut products. It sells via the consumer and commercial ingredients channels, as well as contract manufacturing and export channels. In the consumer channel, the products are sold under the Fisher, Orchard Harvest and Sunshine Country brand names. Targetable revenue of the sector is estimated to be $8b. JBSS's net revenues of $700m represents close to 10% market share. It is a significant player, but there is room to increase share through strategy, execution and situation.
Sales composition in 2007:
Sales Composition in 2011:
** Combination of industrial and foodservice channels
Source: Investor Presentation
The greater contribution to sales by consumer products represents partial achievement of the company's five year strategic plan, formulated during fiscal 2009. The goals of the plan included attaining recognition by global retailers, food service providers and consumers as a world class nut partner. The consumer channel sales are those with highest margins, and JBSS has been dedicating more resources in advertising to improve penetration of the Fisher and Orchard Harvest brands.
The commercial ingredient channel supplies nut-based products to other manufacturers (a nut product equivalent to OEM sales) to use as ingredients in their final food products. Sales in this channel are through Fisher and private label brands. The contract manufacturing channel produces and packages nut-based snacks for third parties under their brand names. Wal-Mart (WMT) and Target (TGT) are JBSS's two biggest customers, accounting for 36% of net sales under private label offerings.
JBSS's main competitors are Diamond Foods, Inc. and Kraft Foods Group, Inc. (KRFT) (Planters brand) in branded nut products, and Ralcorp Holdings, Inc. (RAH) in private label brands, as well as multiple regional snack food producers. Diamond and Kraft have greater resources and can impose reduced margins on JBSS depending on their pricing strategies, but JBSS's slightly different approach sets it apart.
Nut consumption has been increasing in the U.S. over the last three decades due to the growing recognition of health benefits, higher per capita disposable income spent on health food and snack items, and a growing potential consumer base. It is useful to know the recent trend in breakdown of net sales by product type, since along with the breakdown by sales channel, this determines gross margin performance to a significant extent.
Cashews & Mixed Nuts
Trends visible in this data are the growing importance of almonds as a percentage of sales, and the declines in sales (dollars) of peanuts, pecans and walnuts. The declines are offset by sales of 'other' products, which include pistachios and dried fruit / nut mixes etc. These trends have been present across the industry - with people turning away from cashews and pecans, choosing less expensive options.
Nut consumption and pricing
Nut consumption per capita in the U.S. is lower than in Europe. GDP per capita in the U.S. is roughly $45k while that of Europe is $30k. Despite this, Greece - for example - consumes 37lbs of tree nuts per capita per year, the highest in the EU, followed by Spain and Italy (data from this website). In the U.S., tree nut consumption is 3.5lbs per capita. The three most popular tree nuts in the U.S. are almonds, followed by English walnuts and pecans - together these make up 25% of JBSS's sales. European consumption of peanuts is over 44lbs per capita per year, as opposed to 7.0lbs in the U.S. (half of which is used in peanut butter). The U.S. is the world's third largest producer of peanuts, behind China and India (which produces half as much as China). Most of Europe's consumption is fueled by imports, so pricing pressure per unit will remain. If unit nut consumption on this side of the Atlantic does increase over time, JBSS may be positioned to benefit.
Walnut consumption has been declining in popularity among U.S. consumers since the early 2000s. A graph of crop production and its value (figure 1) is the essence of commodity volatility over short time periods. There was a 50% increase in production in 2008 vs. 2007, which was accompanied by a decline in pricing - from $2,300/ton to $1,280/ton. Pricing recovered in 2010 to $2,200/ton and the sharp decline in production in 2011 vs. 2010 resulted in a price surge to almost $2,900/ton. The reduced 2011 peanut crop sent prices soaring, but the record crop in 2012 (2.8mm tons vs. a typical crop size of 2.1mm tons) will likely ease prices again.
This demonstrates the volatility to which nut companies are exposed, therefore JBSS's chosen strategy to lock in prices on a one year previous basis makes sense and will, in the long term, provide effective "smoothing" of the effects of this volatility. There may be years when this strategy fails to maximize profits if the market value of nuts declines significantly during the contracted period. Volatility in nut prices is typically passed on to consumers, and since nut consumption is generally elastic, people change their purchases depending on which type of nuts are most friendly to their wallet -- as evidenced by the year over year demand destruction in terms of unit sales accompanied by record dollar sales.
A USDA/NASS report notes that the almond crop forecast for 2012 is 2.1 billion pounds, which would be the largest almond crop on record with grower prices expected to remain stable at 2011 levels - $1.92/lb. Almond prices jumped in 2011 year over year, so stabilization is welcome, and JBSS will hope for consolidation in the trend in almond consumption.
In the medium to long term, lower commodity costs will benefit vertically integrated nut companies by stimulating demand. JBSS is currently running at a fraction of total productive capacity and can easily handle pent up consumer demand created by lower sustainable nut prices. It is not possible to bring extra capacity online on an industry wide basis in a very short period of time, so margins may improve substantially in the short term if demand is supported and created by falling nut prices.
Despite the higher commodity costs, and the blip in 2011, JBSS has managed to increase operating income per pound of nuts sold since 2008 (see figure 2). The company sold 5% less pounds in 2012 than in 2008 - but still made operating free cash flow of $46mm - excluding the increased inventory use of cash. One would expect that JBSS becomes better able to achieve efficiency in managing its working capital, and devises a system to avoid committing excessive net capital when there is volatility in nut prices. It has also incurred rising advertising expense per unit of nuts sold. This is in part due to the OVH acquisition, its five year plan, and attempts to build globally recognized brands.
Adjusted Income Statement
Unit Sales (thousands of pounds)
Sales per Lb.
Cost of Sales per Lb.
Gross Profit per Lb.
Advertising expenses per Lb.
Shipping and Handling per Lb.
Other operating exp per Lb.
Operating Income per Lb.
Depreciation & Amortization
Maintenance Capex per Lb.
FCF (ex inv needs)per Lb.
Notes: Other operating expenses excludes write down of asset in FY2011
The Ansatz on maintenance capital expenditure was 3% on Gross PP&E.
Using an arbitrary 10% cost of equity capital, an after tax cost of debt implied by the interest expense and average debt outstanding, and the current capital structure, one could sensibly postulate the weighted average cost of capital to be 8%. On that basis, in three of the last four fiscal years, JBSS's operations earned returns that compared well with the demands of the capital used to do so - again, the volatile and high commodity costs in that period prevented the business from performing on a consistent basis, which can be seen in gross margin performance throughout that time period. More stable or falling commodity prices going forward should afford management the opportunity to execute properly, in order to consistently exceed cost of capital charges.
Adjusted Balance Sheet
Net Operating Assets
Net Financial Obligations
Market Cap / BV
(1) ROIC = (Operating Income + Depreciation - Maintenance Capex) after tax / (Period beginning Book value - operating current liabilities + NFO + write downs)
Further, the company's SVA -- the 'Sanfilippo Value Added Plan'-- demands year-over-year improvement on after-tax operating returns exceeding the cost of total capital. Note that there were no incentive compensation expenses in FY2011, as there was no year-over-year improvement in ROIC (see figure 3) - which may be used as a proxy for the SVA. Although SVA is not ideal - given that the cost of capital is based on expected returns (i.e. historical performance) - it is preferable to other types of compensation structures because it focuses management's objectives more closely on creating value for shareholders.
The results of the advisory vote in 2011 to approve executive compensation was 30.5 million votes "For" the compensation paid to named executive officers, and 0.5 million votes against. Adjusting this for the biased share structure (Class A shares having 10 voting rights), the result looks more like 6.6 million votes "For" - close to 10 shareholders in favor of executive compensation for every one against - compared to the 60 to 1 ratio suggested in the Proxy data - with 4 million votes missing. This is one of the corruptions that this type of ownership structure creates. One cannot help but feel that if there were some positive reforms implemented by the Sanfilippos and Valentines, the market would react positively.
Management has stated they are focused on accepting only contracts (generally private label) for which margins are sufficient to justify the commitment -- from customers who are keen on having the value added product innovation in terms of packaging, new mixes etc. This means that private label manufacturing will probably not perform as well as it might have otherwise in terms of revenue growth. But it is encouraging that management acknowledges they seek marginal returns on invested capital, not value destroying revenue growth. This is also the case with OVH offerings in the fresh produce sections; management has streamlined their offerings, cutting the number of skews per stand in half. This rationalization of products should provide increased opportunity for marginally higher returns.
One will also note that the Fisher brand name is now valued at zero on JBSS's balance sheet having been fully amortized, with the Orchard Valley Harvest brand carried at under $100,000 having suffered a $5m write down. This is a built in margin-of-safety when valuing JBSS based on its price to book value - and a reason why JBSS may trade to and above its book value of $17.60/share. One would have to contend that these real assets are undervalued according to their book value, given that these brands have proven earning power.
The difficulties that Diamond Foods has faced in the past year have presented JBSS with an opportunity which it has not failed to capitalize on. It has increased its share of the baking nut category to 15% according to management, Fisher having "over the past six months, [year ended FY2012] gained 2.2 share points in the baking category" according to Jeffrey T. Sanfilippo. Those Diamond associated uncertainties may continue to create prospects of increased market share at both the retailer and grower ends of the chain.
Regarding export operations, currently only 5% of sales are international. To base an investment thesis on those sales would be naïve. However, paying a price 25% below book value for current sales and assets in place grants a potential investor a free "call option" on increasing international sales, provided that management does not commit excessive capital to achieving those sales. Head of Sales in Asia has been appointed, and a base set up in Shanghai (and given the vertically integrated nature of JBSS) - the COGS are already turning toward the possibility of a payoff on that "option" being real.
On top of this, the appointment made in January 2011, which was promised to be a significant breakthrough for the Board of Directors, seems to be paying off. JBSS's brands have certainly seen some innovation with respect to marketing and packaging, and one would hope that Ellen Taaffe's significant experience in the brand strategy and marketing fields will continue to reap rewards for JBSS.
From Figures 2 and 3, and given management's discussion in the most recent earnings call, with relation to crop sizes and demand levels in late 2012 and early 2013, FY2013 free cash flow is projected to be in excess of $30mm again. The opportunity to buy JBSS at less than 9x cash flow and the continued improvement of the financial condition of the firm compels one to conclude that the equity is undervalued at the current price.
I am long JBSS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The security described in this article is owned by the contributor and clients of Milwaukee Private Wealth Management, Inc., an investment management firm owned by the contributor. Thus, the contributor has a financial interest in any future price increase of the security.