Monday, October 28, 2013

Hanover, still cheap; do changes signal a possible acquisition?

In a market that isn't bursting at the seams with cheap companies it's often worth revisiting older holdings that might still be attractively priced.  One such company is Hanover Foods (HNFSA, HNFSB), I previously posted on them over a year ago in a series of two posts (post 1, post 2).  In the ensuing year the company has continued to perform as expected yet the stock price has barely budged.  Additionally one of the largest items holding potential shareholders back from investing has been resolved.

Hanover Foods is a vertically integrated food manufacturing company.  They grow vegetables in Central America, ship them to the US, process them, package them and ship them to grocery stores.  Hanover's brands are distributed mainly in the Eastern US.  Readers who live in the East would probably recognize their frozen food packaging with a little dutch boy next to the logo.

The company's business hasn't changed since I last posted about them, they are still producing frozen vegetables, snack food, and frozen meals.

The company is clearly cheap, here are a few relevant metrics (most recent price $109.89):

  • Book value $285 p/s
  • NCAV $130 p/s
  • P/E 6.82
  • EV/EBIT 7.97
As seen above the company is clearly cheap, I would consider them one of the cheapest companies I'm familiar with in the market right now.  Of course with cheap companies, there is always a reason they're trading at a low valuation.

Hanover's Board and executives were involved in a messy legal battle before the company delisted in 2004.  The founder's grandchildren inherited the business, but couldn't agree on how the company should be run after their father passed away.  John Warehime, the oldest son took the reigns of the company by controlling the family voting trust.  John tried to vote himself excessive pay packages and perks, which his siblings vehemently disagreed with.  The ensuing legal battles left the family shattered, the siblings haven't spoken in years.

Through the family voting trust John Warehime had a complete lock on the company.  The voting trust was a strange creation, the trust 'owned' a number of B shares, which are the shares with voting rights, yet according to the company's auditors the trust B shares held zero economic value.  That is if the company were to merge with another company the trust shares would essentially disappear.  The voting trust also ensured that no activist shareholder could ever gain control, or significantly influence the company, a major hurdle for value realization.

A company is eligible to delist when they have fewer than 300 (potentially 1500 with the JOBS ACT) shareholders.  The company is considered 'private' in the eyes of the SEC, even though shares continue to trade on the over the counter market.  Reporting requirements for dark companies vary and are determined by the state of incorporation.  Some companies continue to send quarterly releases and annual reports, other companies shut down all reporting whatsoever.  Hanover was in the habit of mailing quarterly financials and an annual report, although this year they skipped a quarter.  The financials they send are functional, but they don't contain any management commentary about the business, any business changes are to be inferred from the notes, or other subtle clues.

This year's annual report contained two giant surprises for shareholders, the first was that John Warehime stepped down as CEO and his son took his place.  The second change was included in the notes, the company wound down their ESOP and voting trust.  Additionally for the first time since going dark the company reported the number of shares authorized and outstanding in the annual report.  If you go back to my previous posts I spent a lot of mental energy trying to calculate the number of shares outstanding, this is no longer necessary.

I can't overstate how significant these changes are.  Neither is more important than the other, but together, with the addition of additional disclosure in their annual report I get the sense something is changing at Hanover.

The elimination of the voting trust potentially removes the voting lock that John Warehime had on the company.  It's anyone's guess who the largest shareholders are at this point since the last proxy for the company came out in 2004.  I have heard through sources that Michael Warehime, John's brother, has been selling down his stake over the years.  Until someone sues the company in Pennsylvania for a shareholder register this item might remain a mystery.

The problem with Hanover is almost every investor who looks at the company recognizes there is value, but most believe the value will never be unlocked so the investment isn't worth a spot in their portfolio.  I believe that value is always realized given a long enough time frame, and I hold out that hope for Hanover, and the hope the time frame isn't too long.  Fortunately the recent changes have simplified the ownership structure, and opened the door for a potential activist, or acquisition.

What might an acquirer see in Hanover?  They would see a brand name food company selling at a very depressed valuation.  An acquisition at book value might seem like a stretch to some readers when compared to the company's earning power.  What they're missing is that the company's earnings are artificially depressed due to a transfer of wealth from Hanover's customers to their executives.  Executive compensation isn't broken out explicitly, but based on the note detailing the company's golden parachute it's reasonable to estimate that numerous executives are earning at least a million dollars a year or more.  If a company were to acquire Hanover and pay the golden parachute they could instantly unlock a 20-30% earnings gain on the back of reduced executive compensation alone.  Add in synergies and suddenly an acquisition at book value starts to look like a bargain.

The obvious question someone might ask after reading this far is: "what are the downsides?"  The company has a significant amount of debt as of the annual report, mostly related to inventory financing.  There is also a single line in the notes that states that the company tripped a covenant, but the bank waived it.  It's hard to imagine how such a strong company could trip a debt covenant.  My guess is one of their subsidiaries tripped the covenant, and any trouble at a subsidiary is masked once consolidated with much stronger subsidiaries for reporting.

What to do next?  If any of this post, or the previous two whet your appetite for Hanover shares the next step is to probably get a copy of their annual report.  I do not have a digital copy of Hanover's annual report, and I do not plan on scanning in my paper copy, please don't ask.  The easiest way to obtain an annual report is to purchase a single share or more and call the company as a shareholder and ask for the annual report.  Be forewarned the woman you will need to talk to will probably be "on vacation" each time you call...  

I'm still bullish on Hanover, and just as exited as I was when I first found them over a year ago.  Except with the recent changes at the company it appears gears might be in motion that could potentially unlock value sooner rather than later.  I always have my eyes out for shares of Hanover when they come on the market at the right price.  Shares can be hard to obtain, but patience is rewarded.


Disclosure: Long Hanover, actively buying if the price is right.

14 comments:

  1. Nice post, Nate. Thanks.

    Do you recommend buying A or B shares?

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  2. Nat,

    It's a matter of preference, I only own the B shares, but I know others who went for A shares. The B shares have voting rights attached, so my thinking was there might be some premium for them in an acquisition. When I purchased the share prices were the same, so I picked up voting rights for no premium. I keep my eye on both share classes, when one is trading at a discount to the other I will put in an order. The A shares are often cheap by a few dollars a share.

    Nate

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  3. Remember to place your orders fill or kill!

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  4. How would an activist enough shares to make his effort worthwhile or what's even more difficult obtain enough B-shares to gain influence. The volume is so pathetic that this is impossible, unless done in private transactions.
    I think us shareholders should push for disclosure of executive paypackages. I think a lot if good things would flow out of shining some light in the dark corners.

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  5. Thank you Nate for sharing info on Hanover. Have you ever looked at Reddy Ice? Looks like an oddball.

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  6. Thanks Nate! Is there anywhere online that the annual reports are able to be viewed by the general public? Or is it for shareholders only? Thanks!

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    1. The only way I know of obtaining it is by being a shareholder, there is nothing online.

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  7. I think another significant change was hiring of David Shaqfeh as CFO. Linkedin shows some great experience in the food industry and Big 4 experience.

    The earnings were subpar, especially when you factor in the 2,900,000 gain due to reduction of benefits (page 18).

    As far as the ESOP, I am pretty certain John Warehime's heirs will continue to dominate. This really removes a lot of obfuscation imo. Why do this? An optimist might hope the company is planning to re-register with the SEC.

    But anyone who has been a shareholder for long should use some Bayesian reasoning to temper that optimism.

    Finally, Mike Warehime will be free to sell tens of millions of dollars worth of Lance stock within the next year or so. Perhaps he and his nephews can patch up some family scars and work out a deal.

    Finally, you are not the only one to notice...stock is up 10% since the annual report came out.

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    1. I didn't notice the CFO change, great catch! I wonder if that's what drove the changes to the annual report.

      I agree on the earnings, they haven't been that great the last few years, without further details it's hard to know if it's a volume thing or if it's a product mix thing.

      I highly doubt that re-listing is their endgame. Listing would bring a lot of additional disclosure requirements and Hanover seems almost allergic to something like that. My guess is we eventually see a sale.

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  8. Nate, I failed to notice the CEO change so thanks for pointing it out. It sure was not trumpeted ... but then again, nothing ever is at Hanover.

    I am skeptical about your conclusions re. the collapsed trust though. My interpretation is that these shares were essentially treasury shares that were technically issued and reserved for the employee trust. Consistent with this interpretation, Hanover never diluted their reported book value as a result of these oddball shares and the shares had no economic value, just like treasury shares. The collapse of the trust and their transformation into full-fledged treasury shares is inconsequential. I do not see it signaling any favourable development, but I'd love to be convinced otherwise.

    I was a shareholder as far back as 2004, so I have really suffered. Margins and ROE used to be robust, but profits have been atrophying ever since at a remarkable steady rate. I think it is a race against the calendar ... at the rate we are going, we have about ten years before earnings disappear completely, so something really needs to happen before then or else shareholders may all get wiped out.

    I agree that an acquisition at or above book could probably be effected if management willed it. But this would require the disenchanted family members start start punching near their weight. I don't see this happening, so change may not happen for another generation. The share price discount seems to indicate that this is the general consensus among investors.

    The danger with this kind of company is the shareholder never gets anything back. Such a shame. If they paid even 20% of earnings as dividends rather than ploughing every cent of earnings into unprofitable acquisitions waiting would be more tolerable and this would be a very attractive investment.

    BTW if you want to see how a situation like Hanover and Hammond can play out, check out H. Paulin, a company with almost identical financials (6% ROE and less than .5 p/book). It was bought out a couple years ago for a hefty premium to book value. Inspirational. You must have been just hitting your stride with two-pillar stocks when this opportunity closed.


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    1. Patrick,

      Thanks for the comment, always good to hear from a long time holder of a stock.

      I believe your interpretation of the trust might be incorrect. My understanding is from talking to someone who had an extended discussion with the auditors concerning it. The trust shares were 'real' shares, they had full votes and were owned by John, but had no economic value. I'm not sure of the legality of the structure, because if it were legal other CEO's could lock up their companies for free by devising something like this.

      The biggest consequence of the trust being removed is that John no longer has control. None of the family owned enough of a controlling stake through ordinary shares, the only reason John (and Alan and Harry) remained in control was through their trust shares. With these shares gone it's anyone's guess who the biggest owners are, but I doubt it's the Warehimes. I know as of the going dark transaction John's children all owned 3,000 shares, that was it.

      Right now we're in the fourth generation of Warehimes running the company. Historically family companies fall apart in the third generation. At each generation there are more people who want to get their hands on the wealth.

      I think shareholders will eventually be rewarded for their patience. The company isn't a figment of value, there is true value here, both in their assets and earnings. This is a epitome of a one day stock. Hanover might trade at $100 for the next five years, then suddenly overnight all value is realized in a day when they announce a merger or acquisition. Being patient is tough. I agree though it would be nicer if they paid out a higher dividend.

      I have heard of H. Paulin, but you're right I missed it. I know I'm known as a net-net guy, but I think the best value investments are really the two pillar stocks. These are higher quality companies and have more justification for why book value or higher is a reasonable valuation.

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    2. Thanks to all for the awesome posts and insight from those who have held for longer than the three months I have. I did buy the stock in time to receive the 2013 Annual Report to Shareholders; since receipt, two accounting matters have perplexed me.

      First, after some figuring, it appears that the accountants missed some parentheses on the statement of cash flows, so that cash was actually (used in) operating activities of ($12,414,000), rather than the $12,414,000 the accountants characterize as “provided” in the year ended June 2, 2013. So that explains some of the need for the funding on the $77,500,000 line of credit.

      The other thing that puzzles me is what happened to the Promissory Note originated on April 26th to repurchase the shares owned by the Trust. Since the repurchased shares were placed into Treasury Stock, this implies that the offsetting journal entry would be a liability (debt) in the name of the company. While this liability does not appear on the consolidated statements, it also does not appear to me that it would be eliminated in a consolidation?

      When a company terminates an ESOP, all participants are generally deemed 100% vested, with benefit distributions from the ESOP eligible to be rolled over into an IRA. It appears that that the benefit distributions were made in the form of cash rather than company stock. Consequently, it appears that the company would need liquidity.

      This implies that funding was also made on the unsecured bank lines of credit for the purpose of liquidating liabilities to the ESOP participants, resulting in a corresponding reduction and potential elimination of the Promissory Note due to the Trust. And I'm wondering whether you agree with this interpretation?

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  9. Thanks Nate for your explanation of source. You are getting much better information through your grapevine than the rest of us are getting via the annual report which in fact contains no management discussion whatsoever. Maybe you are onto something here ... it may be more productive to talk to the auditors of these dark companies, rather than management. I shall try it, nothing to lose and besides it is good to let the auditors know someone else is peering over their shoulders besides management.

    I sure hope you are right about Hanover being a one-day stock (like H. Paulin). It may pop in the present century.

    BTW I think Hanover is the blandest company I have ever owned. Are you aware of anything even more soporific?

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  10. As a holder of the “A” shares, I am pleased with the recent turn of events, not only because the repurchase price of $110 per share was well below book value, but also because an impediment to takeover was resolved.

    Just my humble opinion, but here’s why: In order to satisfy IRS guidelines, an ESOP must cover a substantial percentage of non-highly compensated employees who have obtained age 21 and completed a year of service (the Hanover ESOP was established in 2000, as I recall).

    An economic interest in the ESOP might roughly approximate the underlying employee’s salaries, which would be weighted towards the Warehimes. But, while the IRS requires that company stock in the ESOP has full voting rights, in a proposed sale employees in the ESOP have much more leverage: case law suggests that that even one employee (or small group of employees) could find legal grounds to object.

    Therefore, the dissolution of the ESOP / Trust neatly resolves two potential barriers to a sale: (a) prospective tension among the larger holders in the ESOP, the Warehime family, and (b) possibility for the smaller (i.e. non-family) holders to intervene.

    To repurchases shares, the company would have to obtain an independent appraisal from a qualified appraiser. In this case, I wondered about the $110 per share purchase price for voting shares, until I realized that this may reflect not only the minority discount (i.e. discount from the price set for control, 50.1% of the “B” shares), but marketability discount.

    For companies with relatively few shares outstanding or few shareholders, marketability discount reflects that a buyer would only be willing to pay a price which assumes the difficulty he / she would face in liquidating the shares (which I believe is certainly quite evident to everybody who buys this stock!)

    Marketability discount exists even for large blocks of shares (such as the ESOP “B” class, which would have some ability to influence corporate affairs) because it is difficult to trade a large block of shares without affecting the market price.

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