Harry & David Is An Overlooked And Undervalued Post-Bankruptcy Play

| About: Harry & (HARR)
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Harry & David (OTCPK:HARR) continues to trade at a distressed multiple despite exiting from bankruptcy with its strong brand name intact, a significantly lower cost structure and high free cash flow (FCF).

Company overview

HARR.OB is a vertically integrated, multi-channel specialty retailer and producer of branded premium gift-quality fruit, food products and gifts marketed under the Harry & David, Wolferman's and Cushman's brands. HARR.OB sells its products through catalogs, online, business-to-business, consumer telemarketing, 50 Harry & David retail stores, a Cushman's seasonal store as well as wholesale via other retailers. HARR.OB ensures high quality products by growing much of what it sells.

The three reporting segments are direct marketing, stores and wholesale.

Note: Although HARR.OB no longer files reports with the SEC, audited (by BDO) financials are available on the company website.

Investment thesis

HARR.OB is significantly undervalued due to a lack of investor following (including no analyst coverage), its OTC exchange-traded status, microcap valuation and the general stigma of the bankruptcy process. HARR.OB has a number of similarities to Otelco (NASDAQ:OTEL).

However, the bankruptcy process eliminated the bad (e.g. unsustainable debt load) while preserving the good (e.g. strong brand name and customer base). In this instance, the bankruptcy should be viewed as positive (unless you were a creditor obviously) and necessary rather than negative.

HARR.OB survived multiple near-death experiences since its founding

HARR.OB was founded in the early 1900s by the sons (Harry and David) of Samuel Rosenberg, who traded his luxury Seattle hotel (Hotel Sorrento) in 1910 for 240 prime acres of pears in Southern Oregon's Rogue River Valley. Harry and David built a successful business of exporting high quality Comice pears under the brand name Royal Riviera to European hotels and restaurants. However, the great depression caused a significant decline in demand and the brothers decided to sell pears by mail (initially marketed as business gifts). This ability to quickly react to a changing market environment would be useful decades later.

In 2004, Wasserstein & Co. and Highfields Capital Management acquired HARR.OB for $253 million. In early 2005, the firms sold $245 million of bonds, partly to finance a dividend to themselves. This high and unsustainable debt load led HARR.OB to file for bankruptcy in March 2011. HARR.OB continued to operate during the reorganization through the use of a $100 million debtor in possession (DIP) credit facility and a $55 million junior term note facility.

In August 2011, the bankruptcy court approved the reorganization plan. In September 2011, HARR.OB emerged from bankruptcy after only six months. The DIP facility was replaced by a $100 million senior secured facility while the junior term note facility was extinguished. As of 3/30/13, there were no borrowings under the credit facility (excluding $1.5 million in letters of credit). The credit facility is used to finance increases in working capital from July through early December in preparation for the holiday season.

Under the reorganization plan, HARR.OB issued 957,631 shares of new common stock to the following groups:

  • Senior noteholders received 907,631 shares (includes backstop of 50,000 shares)
  • Wasserstein Capital (WC) received 50,000 shares. WC also receives an annual management fee up to $625,000 contingent on meeting EBITDA targets. The fact that WC received a majority of this fee in the nine months ended 3/30/13 for meeting the target is a positive.

HARR.OB terminated its defined benefit pension plan through a settlement with the Pension Benefit Guaranty Corporation (OTC:PBGC) consisting of an ~$8.7 million premium (payable in 12 equal quarterly installments with the last payment due 8/15/14) and a ~$3.3 million unsecured claim payment to be paid in full August 2013.

Furthermore, HARR.OB closed 56 underperforming retail stores, eliminated several senior management positions, introduced orchard-themed pop-up stores (operate for one or two months during peak selling times), improved call center training, increased sales and marketing efforts, consolidated purchasing and improved internal communication.

This significantly lower cost structure (e.g. lower interest expense, no required pension contributions* and lower store count) should drive high operating leverage and provide the ability to operate profitably on a sustainable basis, even with lower revenues.

*Salaried and hourly employees (including management) now participate in a 401(k) plan. HARR.OB did not make any contributions for the nine months ended 3/30/13.

Slimming down and bulking up

Several years before the bankruptcy, HARR.OB decided to focus on its core business and sold the Jackson & Perkins subsidiary (marketer of premium rose plants) in April 2007.

HARR.OB then strengthened its leadership position in the specialty foods and gifts market through two bolt-on acquisitions of companies with complementary products and strong brand names.

In January 2008, HARR.OB acquired Wolferman's, a privately held producer of dry seasonings and direct marketer of premium specialty food gifts founded in 1888. In August 2008, HARR.OB acquired Cushman Fruit Company, a privately held, multi-channel direct marketer of specialty foods (primarily Florida citrus) founded in 1945.

Being green saves more than just the environment

HARR.OB is one of the "greenest" specialty retailers that does more than merely pay lip service to being environmentally friendly. Since investors generally care more about saving money than the planet, below is a list of tangible and quantifiable ways HARR.OB benefits:

  • Reduced fuel costs. Increasing trailer load factors reduced fuel consumption by 333,000 gallons over the past three years.
  • Reduced utility costs. Upgrading irrigation systems reduced water consumption at its orchard properties by over 30%. High efficiency lighting, combustion improvements to steam boilers and computer-controlled HVAC and refrigeration systems save over 5,000 megawatt hours of electricity.
  • Reduced paper and printing costs. Moving catalog customers to the website eliminated over 37 million catalogs and reduced the amount of paper used by ~35%.

Furthermore, from an intangible standpoint, HARR.OB should benefit from consumer willingness to pay a premium for environmentally-friendly products (e.g. Tesla).

Improving financial performance and strong cash flow

In the most recent quarter, revenues rose 6.9% while SG&A decreased to 55.7% from 58.9%. Orders in its largest division (direct marketing) rose 21%.

In the direct marketing segment, revenue rose 5.9% due to improved web traffic, increased catalog circulation and improved response rates while gross margin fell slightly to 24% from 25.6%.

In the stores segment, same-store sales rose 2.5% due to improved conversion rates and higher average transaction size although gross margin fell to 30.6% from 35.6%.

In the wholesale segment, revenues rose 29.5% to $4.3 million while gross margin rose to 15% from 9.7%.

Furthermore, free cash flow should increase going forward due to lower restructuring expenses (in the nine months ended 3/30/13 HARR.OB paid $5 million in bankruptcy claims).

In November 2012, the board approved the repurchase of up to $2.5 million of stock and during the most recent quarter repurchased 12,179 shares for $1.1 million. The fact that HARR.OB went from bankruptcy to repurchasing stock in a little over a year speaks to the strong underlying business and cash flow.

Strong brand name provides competitive advantage and platform for growth

HARR.OB has a strong brand and growing customer base that it can leverage to continually increase sales of core products to existing customers while selling new products to new customers (e.g. in November 2012 HARR.OB launched a wine business). This should eventually result in a more stable revenue stream as sales are spread throughout the year as opposed to mainly the holiday season.

Its extensive customer database (online and catalog) as well as increasing shift to online (with the increased ability to track customer activity and offer promotions) should drive higher top and bottom line growth.

Furthermore, its strong brand name and customer base, along with its long operating history, provide a high barrier to entry.

Risks

Exposure to product recalls. In September 2012, HARR.OB initiated a voluntary recall in conjunction with the FDA after learning that Sunland (a former supplier of peanut-based spreads) recalled a number of products due to possible salmonella contamination. The Sunland recall affected multiple large retailers. This risk is mitigated by the product liability insurance used to cover the costs of the recall as well as the prompt response by HARR.OB. Management does not expect the costs to have a material impact.

Dependent on consumer spending. The discretionary nature of its products leaves HARR.OB vulnerable to an economic downturn, which would negatively affect sales.

Dependent on holiday sales. HARR.OB (like most specialty retailers) is heavily dependent on holiday sales and generates ~two-thirds of its revenue in calendar year 4Q (especially between the Thanksgiving and Christmas holidays).

Dependent on favorable growing conditions. HARR.OB would be negatively affected by a delay in the ripening of seasonal fruits (e.g. due to extreme weather), which could cause shipment delays during the critical holiday season.

Conclusion

A conservative price target of $136.13 is based on a 3.5x EBITDA multiple.

Important note regarding execution: Due to the low float and low volume, the bid/ask spread is unusually wide. A position should be taken cautiously (e.g. using limit orders) and over several weeks and months.

A stop loss of 5% should be placed below entry. The time frame is 12-18 months given the time required for increased investor awareness of the HARR.OB story.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.