Description

Bob Evans (BOBE) represents an asymmetric risk/reward opportunity after the recent completion of a strategic company transformation.  Until earlier this year, Bob Evans was primarily known for its eponymous restaurants, which had been struggling for some time.  The restaurant business overshadowed the strong retail branded food division that was built inside the company.  The company faced years of investor pressure to separate the two businesses in order to unlock the value of the food division.  

Earlier this year, the company finally announced the sale of the restaurant business and purchase of a highly complementary food business.  The stock is up significantly from the announcement of its transformation and is expensive on near-term numbers.  However, we think the investment community is underestimating the potential for this high-quality company’s growth and margin expansion.  Also, we think it is highly likely that the company will be acquired by a larger food company and recent deal multiples could provide significant upside from today’s share price.

Company Transformation

In January 2017, the company announced the sale of the restaurant business to private equity for ~$480mm of net proceeds.  On the same day, the company also announced the acquisition of Pineland Farms for $115mm (with up to $25mm of earn-outs if certain milestones are hit within 24 months).  

Pineland farms produces various potato products (i.e. mashed, diced, shredded, etc.).  80% of the company’s sales are to the foodservice industry and 20% are to retail.  This revenue mix is just about the opposite of the Bob Evans legacy food business and will bring the mix closer to 50/50.  A key driver of this purchase is the fact that Pineland had already invested in a massive capacity expansion project that increases their capacity by ~40% and was just coming online in April 2017 (right around deal closure).  

In addition to the purchase of Pineland Farms, proceeds from the restaurant sale would be used for a $7.50/share special dividend (~$150mm, which was paid in May), leaving ~$55-60mm of net debt on the balance sheet (vs. guided EBITDA of ~$105mm).  

The company also announced a $100mm share buyback to be completed this calendar year and that leverage should move back to 1-2x with room up to 3.5-4x if the right M&A deal were to come along.    

Prior to the announcement, the restaurant business represented ~70% of company revenue and ~52% of company EBITDA.

New Company Overview

After shedding the struggling restaurant business and purchasing Pineland Farms, the company is now focused on its fast-growing, and dominant, refrigerated side dish business (i.e. mashed potatoes, mac & cheese, etc.).  BOBE holds ~53% national market share in this fast-growing category and they continue to take share.  As can be seen below, the next biggest player is Hormel at 13%:

                                                                       Source: company presentation

Refrigerated side dish revenue has been growing at a double digit CAGR for the past five years and is expected to continue to do so in the medium term.  The growth is due to the fact that refrigerated side dish penetration sits at only ~20% of households and the company believes that there is room for 3-4x growth in order to match other non-refrigerated side dish penetration levels:

                                                     Source: company presentation

This category has been successful due to the combination of, at least perceived, quality that is preferred over frozen and the convenience over fresh.  There is also significant room for product extensions to bring side dishes that are currently frozen or sitting in the middle aisle over to refrigerated section.  

Post the Pineland Farms deal, side dishes will represent ~58% of pounds sold and, due to growth, is expected to move towards 75% in the next couple of years.  This is significant as margins in this group are higher than in the rest of the food business.  

Breakfast sausage currently represents ~28% of pounds sold but is lower margin than side-dishes.  The company holds #1 market share in the markets that they are present but category is not growing as fast and this should represent less than 20% of pounds sold in the next couple of years.   

A key part of the thesis here is that BOBE’s food business has been capacity constrained for the past couple of years due to rapid growth.  In fact, ~17% of the company’s pounds were produced by co-packers in 2017.  However, the company just recently completed an expansion at its Lima, OH plant and the Pineland acquisition coincided with that company completing an expansion of its processing by 50mm pounds (for perspective, Pineland capacity before the expansion was 130mm pounds and legacy BOBE foods sold ~230mm pounds in 2017.  The company now has enough excess capacity for ~4 years of robust growth without having to spend on any expansionary capital for the core business.  As they fill this capacity and move away from co-packers, margins will likely increase at a higher rate than currently assumed.  Also, capital expenditures needs should remain low for the foreseeable future.

The company has guided for revenue growth in the mid-to-high single digit over the medium term and for EBITDA growth of high-single to low-double digit growth.  As refrigerated side dishes become more dominant in the company’s mix, these projections seem very attainable and, it would seem, there is clear upside to margins due to capacity expansion issues discussed above.    

Valuation

On near-term numbers, the company clearly does not look cheap.  The company has guided for FY2018 (year ending April 2018) revenue of ~$470mm, EBITDA of ~$105mm (~22.5% EBITDA margin) and GAAP EPS of ~$2.15/share.  This would place valuation on NTM numbers at ~14x EBITDA and ~32x EPS with a 2% div yield ($1.36).   This is clearly a premium to the closest peers of Lamb Weston (LW), Hormel (HRL) and Conagra (CAG), which are trading at ~11.5-12.5x EBITDA and ~19-20x EPS.  However, we think guidance is very conservative and does not include the impact of share buybacks.  Due to superior growth outlook, valuation becomes much more reasonable in FY2020 (really calendar 2019) when we think the company will be trading at ~10.5x EBITDA, which is too low for a dominant company within a consumer growth category that should have nice tailwinds for the foreseeable future.  

Due to the under-levered balance sheet, there could significant upside to EPS.  The company has already announced a $100mm buyback to be completed this year but after that, payment of the dividend, and free cash flow generation, leverage should only sit at ~1x.  The company could comfortably sit with another turn or two of leverage either for buybacks or strategic acquisitions.  If used for buybacks, we think the company could earn close to $5/share over the next few years.  

At the end of the day, we think the likely path of the company is to be acquired at some point over the next year or so.  The company only recently became a pure-play and large food companies are desperate for growth and companies with high gross margins (55%+) where an acquisition would result in large synergies through distribution, overhead and purchasing scale.   Hormel, which currently holds 13% of the refrigerated side dish market, seems like an obvious buyer as their balance sheet is clean and have been talking up M&A opportunities.  

An example of a recent acquisition in the space would be Tyson’s purchase of AdvancePierre (APFH) for 14x EBITDA.  APFH had a lower growth outlook and slightly lower margins that BOBE has.  On the deal, Tyson announced $200mm of synergies (~12.5% of APFH rev), which would result in a PF purchase multiple of ~8.5x.    

We think an acquisition of BOBE would likely occur ~14.5-15x EBITDA (premium to APFH), which would value the company at ~$90-95/share (~28-35% upside) based on our estimate of the company generating over $125mm in EBITDA within the next couple of years.  

Risks

• Increased competition (especially from Hormel)

• Commodity costs (specifically pork on the sausage side)

• Changes in consumer tastes, diet fads, etc.

Catalyst

- Acquisition of company