Cracking open John B. Sanfilippo & Son, Inc.

January 28, 2012
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I have a soft spot in my heart for companies that are out-of-the-way, meaning that no one thinks about what they do. CSG Systems, for example, does nothing but handle the billing paperwork for other companies. And John B Sanfilippo & Son, Inc. (JBSS), is a producer of nut products. Owing to high levels of excess depreciation, the company has excellent free cash flow performance. I will note, however, that capital expenditures have been significantly below historical levels (which is tautologically true, otherwise there would be no excess depreciation), which could affect future sales. Even so, the company’s explanation for the dropoff is its recent consolidation of its four Chicago area facilities into one large facility as the result of a restructuring plan, and sales have been more or less flat after the restructuring, as have operating expenses not including depreciation, as a percentage of sales. However, the savings in capital expenditure cannot be overlooked.

John B San Fillippo & Son is a vertically integrated nut company, which controls the production process from purchasing nuts from growers to the end user; they do not actually own nut plantations. Their products include peanut products, tree nut products including pine nuts, and also a line of trail mixes, dried fruit, and sunflower and sesame products. In 2010 the company acquired Orchard Valley Harvest, a producer of nuts and dried fruits, which expanded their presence to the produce aisle, but the wisdom of that acquisition remains to be seen. They produce a variety of nut products; plain, roasted, flavored, and sugared. There is significant customer concentration, with about 20% of their sales going to Wal-Mart and about 12% more going to Target.

John B Sanfilippo’s biggest issue is gross margins; there is no futures market for nuts, even peanuts, and so the company is forced to buy its inputs in the spot market. In fact, gross margins slipped in fiscal year 2011, which ends in June, as compared to 2010 because the company was slow to enact price increases and was actually forced by unexpected orders to purchase nuts at a higher price than they could be sold for, an occurrence which I hope the company will not repeat. The company claims that it is encountering difficulty as consumer preferences are shifting towards lower-priced private label products rather than branded products that offer higher margins.

Turning now to the figures, in fiscal year 2011 sales were $674 million, gross profit margin was 12.5%, operating income net of goodwill impairments was $15.9 million, excess depreciation was $11.8 million, producing operating cash flow of $27.7 million. Interest expense was $7.5 million, leaving $20.2 million in pretax cash flow, or $12.6 million after estimated 38% tax rates. Set against the current market cap of $106 million as of this writing this is a free cash flow yield of 11.9%. The cash conversion cycle based on the beginning of the year data was 92.1 days. I am aware that it is customary to incorporate figures over the course of a year when calculating the cash conversion cycle, but for comparative purposes the beginning of year figures should be adequate.

In 2010, sales were $562 million, gross profit margin was 16.9%, operating income was $29.7 million, and excess depreciation was $7.3 million, producing operating cash flow of $37 million. Interest expense was $6.8 million, producing pretax cash flow of $30.2 million, or $18.7 after estimated taxes. The cash conversion cycle based on the beginning of year figures was 87.3 days.

In 2009, sales were $554 million, gross profit margin was 13.1%, operating income was $15.6 million, excess depreciation was $10 million, producing operating cash flow of $25.6 million. Interest expense was $8.9 million, which produces $16.7 million in pretax free cash flow, or $10.3 million after estimated taxes. The cash conversion cycle was 99.8 days.

I should point out that excess depreciation is not taxable, which would increase estimated free cash flows by an $4.5 million in 2011, $2.8 million in 2010, and $3.8 million in 2009. We may also expect it to improve free cash flows in the near future as well until depreciation falls back in line with the new level of capital assets. However, if we are using these the recent figures as a guide to the firm’s long-term earnings power it may be more appropriate to treat excess depreciation as taxable and calculate the present value of the excess depreciation as a one-time benefit. I would estimate this present value to be at least $10 or $15 million.

The company also owns an office building that was acquired along with the new Chicago area location which currently stands 75% vacant and produces rental income of roughly $1.5 million per year. This building is carried on the balance sheet at $30 million, which appears to be a reasonable price based on its square footage, although the company noted in its 2011 10-K that the building may require additional capital expenditures in order to attract tenants. At any rate, either adding tenants or divesting the building would probably strengthen Sanfilippo’s performance.

Based on these figures as presented, it would seem that John B Sanfilippo is an attractive company, and I would agree that on the whole it has a number of advantageous points. However, I am concerned about the company’s ability to control its margins. As I stated above, the company was forced to answer a large unexpected order by by purchasing nuts on the spot market at prices equal to or higher than the final sale price, and of course the company admitted to being slow to roll out a price increase, both of which cut into gross margins as compared to the previous year. Even if we grant that these were temporary aberrations that are hopefully not to be repeated, the company reports that consumer preferences are shifting to cheaper private-label products as opposed to brand-name products, and although Sanfilippo has a private label business, margins are lower than in the branded sector. Also, the Chinese seem to have developed a considerable appetite for American nuts, which further tightens the supply.

It is, of course, possible that John B. Sanfilippo will ride through these concerns; after all, the situation described above has been true in 2010 and 2011 and the company still produced what seems to be an adequate return even with filling the unexpected, unprofitable order and the lateness of the price hike. However, I will still say that the ability of the firm to earn an adequate margin in future seems to be more questionable than I would like to see. As a result I cannot recommend John B Sanfilippo as a value investment, but I can recommend it as an attractive speculation for those readers who are interested in one.

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