Description

It’s finally time to buy BOBE, which could rise 39% to $60 over the next year as the company executes on turnaround initiatives, pursues sale-leaseback transactions for their owned real estate, and uses the proceeds from real estate monetizations to fund share repurchases. The company is in a transition year where they are (i) replacing the CEO, (ii) cutting SG&A, (iii) benefitting from a large  year over year decline in sow prices, and (iv) moving forward with strategic actions for their owned real estate. BOBE is pursuing sale-leaseback transactions for their corporate headquarters and two production facilities, and is also likely to pursue them for 30-60% of their 480 owned restaurant locations, as the board has already authorized a monetization. We estimate that these transactions could provide them with ~$421m in after tax proceeds that can be used for buybacks, allowing them to repurchase up to 39% of their shares outstanding. Furthermore, incremental upside could be realized as BOBE executes on turnaround initiatives leading to higher margins and multiples, and with a potential longer-term separation of their Foods business. In summary, the stock is cheap, expectations are extremely low, guidance looks achievable, sow price headwinds have turned to tailwinds, SG&A is set to decline, and real estate monetization and share repurchase  catalysts are quickly approaching.

Company Description

Bob Evan’s Farms Inc is a full service restaurant company and a leading producer and distributor of pork sausage products and a variety of refrigerated and frozen side dishes under the Bob Evans, Owens and Country Creek brand names. The revenue mix on a TTM basis is 72% Restaurants and 28% Foods. The adjusted EBITDA mix on a TTM basis is 78% Restaurants with a 9.8% margin, and 22% Foods with a 7.1% margin.

Restaurant Operations

The Restaurant segment operates 562 restaurants in 19 states, primarily located in the Midwest, mid-Atlantic, and Southeastern US. 70% of their restaurants are in their top 5 states of OH, IN, MI, FL and PA. They own the real estate for 480 of their locations (85%), with the remainder leased. Their restaurant concept is to provide reasonably priced items in a family friendly setting. The average guest check is around $9.00, and the day-part mix was 33% breakfast, 37% lunch, and 30% dinner. BOBE also offers a variety of take-out items, with off-premise sales at ~13% of Restaurant revenue. The breakfast day-part has historically been BOBE’s strength, and breakfast items are served all day.

BE Foods

The BE Foods segment produces home-style food products that they sell to retail and food service customers, with their retail food products sold under recognizable brands such as Bob Evans, Owens and Country Creek. They offer 155 different varieties of pork products, and over 140 different refrigerated and frozen food items such as mashed potatoes, macaroni and cheese, and microwavable sandwiches. In FY2Q15, the mix of pounds sold by category was 46% refrigerated side dishes, 24% food service products, 21% pork sausage products, 5% frozen products and 5% other.

BE Foods has four main production facilities in the US, which are wholly owned. Fresh sausage products are produced at two plants in MI and OH, ready-to-eat products are produced at one plant in TX, and refrigerated sides are produced another plant in OH. In recent years, BE Foods implemented a plant optimization program focused on identifying operational gaps and opportunities to improve production efficiencies at their production facilities. The stated goals were to maximize operational efficiency, increase returns on invested capital, and position them for future growth. This program resulted in the closure of 2 production facilities in FY2011, and the closure of 3 additional production facilities in FY2014. Since 2013, BOBE has consolidated their production operations from 7 plants to 4, selling 2 production plants in 2013 and 1 in early 2014.

Background

The bull thesis for BOBE has been in play for some time, but has yet to come to fruition as the company has been plagued by persistently high input costs (sow prices and more recently egg prices), a CEO who refused to cut a bloated SG&A structure, and a board that would not pursue strategic alternatives to create shareholder value. Such was the case in August of 2014 when VIC member Chalkbaggery first recommended buying BOBE with the thesis that activists would be successful in their proxy battle, getting enough board members elected to implement the activist’s agenda. However, activist firm Sandell Asset Management only got 4 of its nominees elected to the board, 1 seat short of a majority (see his report for a summary of Sandell’s proposals). Sandell’s presentation decks can be downloaded at www.refreshbobevans.com.

The situation has changed dramatically in the last year. Despite lacking a majority of Sandell nominees, the board voted unanimously in December to replace CEO Stephen Davis and is now searching for a new permanent CEO, with CFO Mark Hood acting as the interim CEO.

Update

In March, right as investors started getting excited about the story again, BOBE reported a fiscal 3Q15 (quarter ended 1/31/15) that was a total  disaster. The company missed estimates and lowered guidance, and gave an underwhelming strategic update where they took a near term separation of the Foods business off the table. In the strategic update, they announced that they would not pursue a separation of the Foods business “at this time”, that they’ve hired JPM to evaluate a potential sale-leaseback or REIT spin, and that they’re undertaking a $35m SG&A cost cutting program which they expect to realize over 3 years. Further complicating matters was that this came at a time when BOBE should have been outperforming expectations due to lower sow prices and a stronger Restaurant performance due to their broasted chicken initiative. Instead, they unexpectedly missed on higher restaurant labor costs despite a +3.8% comp, had a lower than expected restaurant gross margin, and higher healthcare costs.  BOBE’s stock subsequently dropped 22% from $59 to $46.

Since then, management has increased their focus on the company’s turnaround efforts, concentrating on operational efficiency (cutting labor costs), reduced discounting, menu simplification, a greater emphasis on the breakfast day part, and an expanded emphasis on farm fresh food. They actually delivered an acceptable fiscal 4Q15 (quarter ended 4/30/15), but with conservatively set guidance that was slightly below the street. In the most recent quarter, they had improvement in the wage line at restaurants, better gross margins, and excellent margins in the Foods business due to lower sow costs. We believe that the company is starting to turn the corner.

BOBE is also moving on strategic initiatives, pursuing a sale-leaseback for their corporate headquarters and two manufacturing facilities, with the proceeds to be used for share repurchases. The board has also approved a strategic transaction to monetize 30-60% of the owned restaurants, through either a sale-leaseback or a tax-free REIT conversion and spin. We believe that a sale-leaseback is the more likely option, and would expect the proceeds to be used to fund share repurchases.

Summary of recent developments:

• Amended the credit facility to allow for more share repurchases- On May 15th, BOBE announced that they amended the existing $750m credit facility allowing for the repurchase of up to $150m of share repurchases in FY2016 (15.5% of the market cap), subject to a maximum leverage ratio restriction which is 4.5x in FY2016, 4.25x in FY1H17, and 4.0x in FY2H17. The company released a statement with the interim CEO Mark Hood saying that this allows the company to continue returning capital to shareholders while also providing the flexibility necessary to complete restructuring and turnaround efforts.

• Retained CBRE to monetize the corporate headquarters and 2 BE Foods manufacturing plants- On May 28th, BOBE announced that they retained CBRE to pursue sale-leasebacks for the corporate headquarters, and for the BE Foods manufacturing facilities in Lima, OH and Sulphur Springs, TX. In the release, the company says they expect to use the net proceeds to reduce leverage, which indirectly funds share repurchases as permitted by their credit agreement. The company also commented that they expected to complete the repurchase of $50m of the $150m authorization by 6/1/15, under a 10b5-1 program that was initiated 5/1/15. BOBE also said that they continue to actively evaluate various strategic alternatives for the Bob Evans Restaurants real estate. They

• Announced the intention to pursue a strategic transaction for Restaurant properties-  On June 11th, BOBE announced that the board has authorized the company to pursue a strategic  transaction for 30-60% of their owned restaurant properties, and that this could take the form of either a sale-leaseback or a tax-free REIT conversion and spin-off, with any proceeds used for capital deployment.  They also added that in structuring any transaction, they would seek to maintain the flexibility to pursue a separation of the Foods and Restaurants businesses “at some point in the future if advisable at that time”.

Headquarters and Production Facility Sale-Leaseback

For BOBE’s corporate HQ and their food production plants identified for sale-leasebacks, we estimate that a transaction could bring in $148.5m in after tax proceeds which could be used for share repurchases. We base our estimated values on unadjusted acquisition or construction costs to get a ballpark estimate, and assume an 8.0% cap rate to determine the rent expense. For tax purposes, we assume that the book value of these properties is 50% of the market value for the two food processing plants, and 90% of the market value for the newly constructed corporate headquarters. Assuming a $45 price for share repurchases, we see that a sale leaseback of these properties could fund the repurchase of 3.0m shares, or 13.7% of the 22.3m shares outstanding at the end of FY2015.  

• Corporate Headquarters in New Albany - According to press reports, BOBE spent $46.5m constructing a 154k square foot state of the art campus located on 40 acres in New Albany, OH (http://tinyurl.com/bobehq). Assuming they can recoup their $46.5m costs in a sale-leaseback, the additional rent expense at an 8.0% cap rate would be $3.7m.

• Lima, OH Food Production Facility- BOBE acquired its 100k square foot food production facility in Lima, OH with the  $50m acquisition of Kettle Creations in August 2012 (http://tinyurl.com/kettlecreations). This facility primarily produces potato and pasta-based side dishes. BOBE accounted for the vast majority of Kettle Creation’s sales, so we estimate the brand value to be minimal. In October 2013, BOBE completed a $24m expansion of this facility, adding 57k square foot for another production line. Assuming an 8.0% cap rate on BOBE’s $74m cost for this facility, we estimate a $5.9m rent expense.

• Sulphur Springs, TX Food Production Facility- BOBE acquired its Sulphur Springs, TX production facility in 2003 for $4m, which was 53k square feet at the time. In 2008, they invested another $16m, adding another 50k square feet of production space. In 2013, they completed an additional expansion estimated to be $23m, adding another 50k square feet of production space (http://tinyurl.com/sulphurplant).

Owned Restaurant Sale-Leaseback

On June 11th, BOBE announced that the board has authorized the company to pursue a sale-leaseback or other monetization for 30-60% of their owned restaurant properties, with proceeds going to “capital deployment” which we interpret as buybacks. Using the 45% midpoint, we estimate that BOBE could realize $310m in pretax proceeds, or $273m net of taxes (we assume that the BV is 50% of the market value). Using the 1-year average price for BOBE of $48.75, they could repurchase 5.6m shares, or 25% of the market cap.

Valuation

We value BOBE on a SOTP basis and under three different scenarios, (i) a base case pro forma for the sale-leaseback of the corporate headquarters and their two production facilities with the proceeds going to buybacks, (ii) a scenario pro forma for a sale-leaseback of 45% of their owned restaurant properties with the proceeds going to buybacks, and (iii) a scenario where we assume an HSH takeout multiple on BOBE’s Foods business.

In our two base case scenarios, we apply a 1 turn discount to peers for both businesses. For the Restaurants segment, we use an 8.8x EV/EBITDA multiple vs the 9.8x average multiple for non-franchised restaurants peers. For the Foods segment, we use a 12.8x multiple vs the 13.8x average multiple for non-chicken food processing peers. We believe that a discount to restaurant peers is appropriate given BOBE’s slow comp sales growth and troubled execution, and a discount to food peers is appropriate due to their smaller scale.

For our price target, we assign a 25% probability to our FY2017 base case target of $55, and a 75% probability to our $62 target which includes a sale-leaseback of 45% of the owned restaurant properties. All together, we get a $60 target for 39% upside.

Risks

Potential risks include higher food costs on the restaurant side, higher minimum wages (1.4% of restaurants are in NY), higher sow prices on the food processing side, a disappointing CEO announcement, operational issues like the restaurant wages issue in the March quarter, and higher gas prices which could hurt restaurant demand.

Catalyst

Catalysts include (i) the announcement of the new CEO, (ii) executing on turnaround initiatives, (iii) earnings beats, (iv) a sale-leasebacks of their owned restaurants, (v) share repurchases, and (vi) a spin of the Foods business.