This $276m Company Is Trading Below Liquidation Value

Highlights:

• This overlooked food business has no sell-side coverage and minimal institutional ownership.

• The stock looks like a pandemic winner, but when understanding a key accounting issue, underlying performance is better than it looks.

• Mechanical selling following an index removal has pushed the stock down even further.

• The stock is now a “net net” and trades at a clear discount to replacement value.

  ---

We talked back in November about the long-term underperformance of value stocks versus growth plays. That underperformance seems to have returned here in 2023.

Save for a brief blip last year, what has worked in the market for a decade-plus is focusing on the business over the stock. Buying deep value stocks just hasn’t worked out particularly well in recent years. And that’s what makes our recommendation of vegetable processor Seneca Foods SENEA 0.00%↑ SENEB 0.00%↑ feel a little risky.

But there are clear fundamental factors here that the market might be missing. There’s also a short-term catalyst that has pushed the stock to unprecedented valuation based on one key metric. And current valuation ignores some of the key challenges that Seneca has overcome during the past three-plus years. All told, there’s evidence that SENEA should be able to buck the disappointing trend in deep value, and provide strong returns from here.

(Author’s note: Thanks to Gabriel Tamez and Harris Perlman who called SENEA out on Twitter. Obviously, the work here is our own, but both investors surfaced the idea and provided some intriguing aspects of the case with which to begin. Who says there’s nothing good on social media?)

Introducing Seneca Foods

Seneca Foods is a vertically-integrated processor of fruits and vegetables. The company’s 26 plants source from some 1,400 farms, with peas, green beans, and corn the company’s primary products. Seneca also manufactures its cans, produces seed, and farms its own products; there’s even a small trucking and aircraft business.

In fiscal 2023 (ending March), 83% of revenue came from canned vegetables; 8% from frozen vegetables; 6% from fruit, and 1% from snacks (most notably Seneca apple chips).

Just shy of half of sales go to private-label consumers including store brands. Seneca’s own brands, the most well-known of which is Libby’s, comprise over 9% of revenue. So-called co-pack agreements, in which Seneca packages product for another branded company, drive a little over 20% of sales, with B&G Foods BGS 0.00%↑ unit Green Giant the biggest and best-known customer. Seneca also gets about 10% of revenue from the foodservice channel and ~7% from overseas.

source: company website.

A Pandemic Winner?

Seneca’s business is hard. Glassdoor reviews describe a 12-hour/7-day per week schedule through “pack season” (June through October). The stock has the financial profile of a classic “value play or value trap?” argument.

Based on GAAP results for fiscal 2023, SENEA trades at 8.6x earnings per share, and 6.3x EV/EBITDA. But on both fronts, there’s reason for concern:

source: YCharts

From a distance, the company looks like a classic pandemic winner. And if you think through the business model, that makes some sense. (Notably, gross margins generally hover in the 10% range and at that level, it doesn’t take much of a change in end markets to have a material impact on the bottom line. 100 bps of gross margin improvement, alone, suggests a ~10% increase in EBITDA.)

Seneca had a huge jump in demand, in the form of a global pandemic that in the U.S. (over 90% of sales) shut down restaurants and spiked demand for groceries, including canned vegetables. It’s not surprising that, amid that demand, EBITDA went from basically zero to an all-time record.

But the world has normalized. In this environment, Seneca’s profits presumably return toward pre-pandemic levels, which is still below the $101 million generated in FY23. In that scenario, the company in fact is overearning. In which case the single-digit multiples currently applied to SENEA are not only justified, but possibly still too high.

From that perspective, the YTD plunge is justified. It’s simply the market catching on to the fact that profits still have further to fall:

source: YCharts

A Point For The Bulls, A Point For The Bears

As we shall see, the SENEA story is more complicated than that. But the relatively simplistic view through GAAP does highlight two key points with divergent implications for the stock.

The earnings profile is much more positive than GAAP figures would suggest. Even so, the charts above get to the core risk: that the 41% YTD decline in SENEA is due to the market, correctly, pricing in weaker performance from the underlying business going forward.

After all, this is a tremendously volatile business (as seen above), and it’s always going to be a tremendously volatile business. Earnings are based on a number of factors: crop yields, which are always inconsistent; the ability of farmers to capture profits in other crops; variable input costs including diesel fuel and tinplated steel (used for cans); labor expense; and the market prices of a whole host of commodities, including those that Seneca actually sells and those which can serve as substitutes for consumers.

But it’s tempting to look through that volatility and make a simple argument: Seneca saw an unprecedented and unsustainable spike in demand, and as that demand normalizes earnings are going to fall to where they were before the pandemic. And if earnings fall to that point (another 20%-plus decline, at least) SENEA is simply not going to be a very good stock.

Not only has GAAP profit moved in the wrong direction in recent quarters, but at first glance the balance sheet also looks fragile. At the end of FY23, net debt was $430 million. That’s more than 1.5x the market cap of $276 million. And it’s more than 4x GAAP EBITDA. A leveraged, declining, low-margin business might not even be good enough to be called a ‘value trap’; it’s usually just an obvious sell¹.

As we shall see, however, looking at SENEA through GAAP financials makes the stock look worse than it actually is.

Has Index Exclusion Driven SENEA Down?

SENEA has no sell-side coverage and minimal institutional ownership. Anecdotally, on retail-focused sites (including Twitter), investors are quick to dismiss the stock based on the factors we’ve highlighted to this point, most notably the recent decline in profits. Still, the stock did fall after Q4 earnings in mid-June (on light volume — roughly $2 million), suggesting at least someone is paying attention.

There’s another factor here, however, that may be driving selling pressure. As Harris Perlman noted on Twitter, after the close on June 28, Standard & Poor’s announced that SENEA would be removed from the S&P SmallCap 600 before trading opened on July 6. SENEA fell 9.5% the next day and another 3.6% during the following session.

The impact is likely to be material: as of June 14, BlackRock and Vanguard combined owned 18.5% of outstanding shares. Perhaps not coincidentally, on July 5, SENEA’s last day in the SmallCap 600, volume was enormous: nearly 20% of total shares outstanding (and 25% of the class) changed hands. That’s about twenty times three-month average daily volume.

Much of the downward move has been recaptured in recent weeks. But SENEA is still down 4% since the index rebalancing was announced. And given how many hedge funds have targeted rebalancing as a strategy, it’s possible the impact of the index removal began even before that removal became official. At the least, there’s likely some level of short-term dislocation in SENEA that is still in the process of being repaired.

LIFO Accounting

But what’s more important here is the company’s ‘true’ fundamentals. In this environment, GAAP reporting simply doesn’t show Seneca Foods’ actual earnings power.

The biggest issue is in terms of inventory accounting. Seneca uses LIFO (last in, first out), which expenses the costs of the most recent products first. In this inflationary environment, those more recent products can have substantially greater cost than those units produced even a few months earlier.

Seneca actually runs its books on the FIFO (first in, first out) method during the year, and then takes a non-cash charge (or receives a non-cash benefit) at year-end based on changes in the LIFO reserve, or the difference between inventory costs reported under FIFO and LIFO assumptions. In an inflationary environment, that reserve increases, as it essentially “trues up” inventory carried at cost to adjust for the costs seen most recently, rather than the costs seen at the specific time each unit was produced.

Given soaring inflation, Seneca’s LIFO charge has become substantial: pre-tax, it was $100.0 million in fiscal 2023. Reported GAAP EPS based on LIFO for the year was $4.20. Under FIFO, per Seneca’s 2023 shareholder letter, it would have been $13.48, more than three times as high.

It’s a bit too simplistic to argue that “oh wow, SENEA trades at less than 3x earnings power excluding a non-cash charge!” The point of LIFO is, as the company writes in its annual report, is that it “better matches the cost of current production to current revenue.”² It’s great that Seneca was able to sell a can of peas at the Q4 price when it was produced at the costs required in, say, Q1. But that doesn’t mean the company will be able to benefit from a similar price/cost gap in FY24. Again, LIFO is a better representation of the costs at the end of the reporting period.

And those costs and revenues now look much more aligned. Indeed, Seneca appears to have had a disappointing Q4, one possible reason for the accelerated sell-off of late. Excluding pension movements, on a GAAP basis the company lost over $10 million net in the quarter against an $6 million-plus profit the year before. Adjusted for LIFO, net profit in the quarter was just $5 million, down in the range of 50% year-over-year.

To be sure, this business is incredibly lumpy. That year-over-year performance doesn’t mean Seneca is headed for a sharp full-year loss in fiscal 2024. But it does suggest a pullback from the $13-plus EPS figure adjusted for LIFO in FY23, and even the nearly $10 per share earned the year before on the same basis (also excluding an investment loss on a hemp startup).

The other issue here is that the inflationary environment, whatever the accounting, is soaking up an astonishing amount of capital. Inventory on a LIFO basis rose nearly $300 million year-over-year in FY23, a figure greater than the company’s current market capitalization. As a result, free cash flow was negative $284 million, which, too, is greater than the current market cap.

That inventory growth requires sharply higher working capital. Higher working capital means lower ROIC and a less attractive business, but more simply it also leads to sharply higher interest expense. The company’s revolving credit facility had a $21 million balance at the end of FY22, and had $181 million outstanding 12 months later. Seneca added another $173 million term loan as well. Interest expense was $5.6 million in FY22; it should exceed $20 million in FY24, depending on revolver usage. Incremental interest expense relative to FY23 alone suggests a ~$0.60 after-tax hit to FY24 EPS by our numbers.

Zooming Out

Even if there are offsets in terms of interest expense and working capital needs, it’s important to understand that Seneca’s earnings power is being obscured by accounting factors. Normalizing for full-year interest expense and adjusting out smaller one-time items, by our numbers, Seneca’s EPS actually increased roughly 30% year-over-year in FY23. On a GAAP basis, the figure declined 28%, and is down 70% since FY21 (when the company received a $15.6 million credit from LIFO accounting, a boost of about $1.29 per share).

One way to more broadly understand this fact is to look at the company’s book value. For such sharply cyclical businesses, book value can be useful as a way to gauge business success over time. Simply put, it shows whether the company is consistently adding to its asset base net of debt over time, no matter the variability of reported earnings between periods.

It does look like Seneca’s growth on that front has stalled out³ after a huge post-pandemic jump:

But, again, LIFO accounting is a key factor here. The LIFO reserve depresses the value of inventory carried at cost, since LIFO accounting assumes that the items produced most recently were sold first. In an inflationary environment, those items of course are the most expensive, leaving (in AccountingLand) the least expensive and, when carried at cost, least valuable products behind.

In reality, however, the items sitting in Seneca Foods warehouses have been produced across multiple months and at multiple costs. The FIFO method should in theory capture exactly those costs. And so, in the 10-K, Seneca discloses its inventory value at FIFO less the LIFO reserve to calculate the carrying value of total inventory for book value purposes:

source: Seneca Foods 10-K

It’s worth emphasizing that this is purely an accounting issue. The cost of these goods is not the same as their value. The value of these non-perishable goods (again, over 80% of revenue is canned vegetables) is based on what they can sell for in the market, and the market price is related to the cost to produce this year much more than the cost to produce last year.

Over the past two years, the LIFO reserve has increased by $136 million. As a result, Seneca’s book value has increased only $6 million over the same period. But if you adjust out that reserve, book value has increased by 24%.

Where SENEA starts to get really interesting is by applying the same calculation to the current asset value. Add back the current LIFO reserve of $265 million to book value of $583 million, and ‘adjusted’ book value gets to $818 million. That’s more than $100 per share, and roughly triple Friday’s close. As Perlman has pointed out, on that basis SENEA in fact is a deep ‘net net’; net current asset value (current assets less all liabilities) is $56.55 at the share count reported on May 25.

This is a business now priced below replacement value, and almost certainly below liquidation value. In fact, on a GAAP basis, the discount to book value is as wide as it’s ever been:

source: YCharts

A Qualitative Case

It’s possible to argue that price-to-book should be at the lows. In a more inflationary environment and without substantial pricing power, those assets will generate less earnings per dollar value. That’s particularly true given how important inventory is to the book value calculation. Imagine, for instance, Seneca could generate net profit of five cents on a $1.25 can of corn last year, and net profit of five cents on a $1.50 can of corn this year. The value of the inventory has risen 20%; the value of the business from a cash flow/earnings perspective has stayed flat (or even, given cost of capital, declined). Book value increases thanks to the higher inventory, but the ‘correct’ market value of the business remains relatively flat, leading to a lower P/B multiple.

It’s a fair point. But from an asset perspective, SENEA is not just ‘cheap’. It’s ridiculously cheap. Again, NCAV (net current asset value) is $56 per share and it’s not terribly difficult to conservatively estimate liquidation value in the same ballpark. Even moving the stock to the low end of its multi-decade P/B range (and there was inflation during that period, as difficult as it is to remember sometimes) suggests a path back toward $50. (It’s worth noting as well that back in 2021, Seneca Foods tried to buy back shares via a tender offer between $40 and $46. Just 531 shares were tendered.)

But it’s also worth considering a key fact about the company’s earnings. The recent period has not been a matter of simply and easily satisfying a spike in consumer demand. Seneca has faced tremendous difficulties as well.

In calendar 2021, the company literally ran out of sweet corn. Seneca noted in its 2023 shareholder letter that in two years, payments to producers alone rose 50%, and the price of steel used in cans doubled. The year before, those two expenses accounted for 57% of the total cost of a can; the proportion in FY23 was likely even higher. Labor expense has been a huge issue too: Seneca uses over 3,000 temporary workers each year, and in FY22 spent more than $13 million in capital simply building housing for those workers.

Crop yields admittedly have been stronger, after a couple of miserable years toward the end of the 2010s. And, yes, demand was stoked by the pandemic (though the smaller foodservice business took a hit during that time). But it’s not as if that demand meant Seneca could just raise prices to boost margins. Owing to soaring costs, it’s raised prices to simply maintain margins. In some areas like frozen foods and snacks — the latter of which was unprofitable in FY23 — it hasn’t been able to do so fast enough.

Meanwhile, branded food companies have taken an astonishing amount of pricing — mid-teens percentage increases across the board in 2022 — without consumers really blinking. That willingness to spend is going to change at some point, and there is some evidence that it’s starting to change now: witness recent post-earnings plunges at Campbell Soup CPB 0.00%↑ and General Mills GIS 0.00%↑ amid fears of increased “trading down” by consumers.

Seneca Foods isn’t necessarily a “defensive” business in the way investors normally use that term, but its private-label bona fides mean it could, and probably, should benefit from trading down in its categories. There are also capital benefits if inflation continues to trend in the right direction, particularly in terms of production and steel costs.

As with earnings, Seneca’s food business is better than investors think. At a 36% discount to NCAV, the price is more than good enough as well.

---

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

1. Or a meme stock. We kid, we kid.

2. Seneca actually switched to LIFO back in 2007 because at the time its input costs were rising sharply.

3. Note that Seneca’s book value and tangible book value are the same. As a Value Investors Club article in 2010 pointed out, that’s actually pretty incredible; the company has made over 50 acquisitions and has no goodwill on its balance sheet.