Seneca Foods NASDAQ: SENE.A – Canning Cash

Provided to subscribers August 27th.

Here’s the latest from Canadian Value Investors!

Seneca Foods NASDAQ: SENE.A – Canning Cash

Disclosure: We own this one.

Seneca is our kind of boring company. It produces canned and frozen vegetables and fruits and has been operating since 1947. It has historically not been a great business to be in, but recent performance, share buybacks, and industry dynamics have made it interesting. We argue:

-The industry has continued to consolidate, and it appears that competitors are becoming a bit more rational. The Company, and industry in general, have been acquiring competitors and then consolidating operations to improve costs (in fact, Seneca is one of two companies making up 90% of canned vegetable production in the U.S.). For example, at Senenca, full-time and seasonal staff headcounts are down 15% and 50% since 2010 on higher sales.  

-The Company’s LIFO accounting obscures underlying performance.

-It is trading at low adjusted earnings multiple, can be argued to be a net-net depending on your perspective of inventory and physical assets. More importantly, with continued share buybacks this might be quite good. But, earnings volatility and tough industry dynamics do give us pause.

Seneca 101

There are two pitches we want to point you to:

-Overview of the idea - https://www.overlookedalpha.com/p/seneca-foods-stock

-Harris Perlman notes and related X thread - https://twitter.com/OtterMarket/status/1687608891348025344

This article is meant to supplement their work. Now let’s get into the details. Here’s the last decade of performance. What is our adjusted P/E? See next.

The Company and industry in general have been acquiring competitors and then consolidating operations to improve cost. There have been a lot of acquisitions and a lot of plant closures.

“In August 2006, the Company acquired Signature Fruit Company, LLC, a leading producer of canned fruits located in Modesto, California which was sold during 2019. In 2013, the Company completed its acquisition of 100% of the membership interest in Independent Foods, LLC. In April 2014, the Company purchased a 50% equity interest in Truitt Bros. Inc. In 2016, the Company acquired Gray & Company and Diana Foods Co., Inc., each leading providers of maraschino cherries and other cherry products. The plants acquired are in Hart, Michigan and Dayton, Oregon. During 2018, the Company purchased the remaining 50% equity interest in Truitt Bros., Inc. making it a wholly-owned subsidiary. During 2019, the Company sold its Lebanon frozen packaging operation and its Marion Can Plant. During 2020, the Company sold part of its Rochester, Minnesota Plant and exchanged its Sunnyside, Washington Plant for part of its investment in CraftAg. Also during 2020, the Company acquired a plant from Del Monte Foods in Cambria, Wisconsin”

As noted by Harris Perlman, a key competitor seems to be getting smarter (see article for additional discussion of competition).

After a few years of [aggressive pricing/promotion] Del Monte Pacific had managed to nearly kill itself in an effort to win market share. It had taken on a lot of debt to buy the US business, and by 2017/2018 the US business was making an operating loss. Something had to change. The company brought in new leadership, and started restructuring. They stopped competing against Seneca in private-label manufacturing. In 2019 they closed some of their plants, and even sold a couple to Seneca. New management raised prices and turned their focus towards higher-value packaged foods.

See the “new” Del Monte turnaround pitch per their IR team. https://www.delmontepacific.com/hubfs/pdf/DMFI_presentation_FINAL.pdf

Adjusted earnings – “LIFO Reserve Adjustment”

Seneca uses last-in-first-out accounting for their financial statements and taxes, while they use FIFO for financial covenants and management compensation.

An overview of LIFO vs FIFO be found here, but effectively this means that in an inflationary environment it helps Seneca reduce/delay cash taxes while understanding the current earnings power of the business. https://www.investopedia.com/articles/02/060502.asp

The impact is meaningful, particularly with the recent COVID inflationary bulge. Of course, this means that if tax rules change there is a tax bill due, and as of this spring, “should LIFO be repealed, the $41.4 million of postponed taxes, plus any future benefit realized prior to the date of repeal, would likely have to be repaid over some period of time.”

Interest rate risk real life example

They are being impacted by higher rates, but it appears manageable. Leverage is seasonal and the recent bulge, and leverage in general, is driven primarily by inventory and secondarily by acquisitions (more so in the 2000s).

Portfolio Update, PBR, odd lots, and pitches

Provided to subscribers August 8th.

Here is the latest from Canadian Value Investors!

  • Portfolio update

  • PBR update

  • Another odd lot TNET

  • Quick pitches from around the web

  • Other bits - Short selling is getting more dangerous, Canadian accounting shenanigans, and some investing history

Portfolio Update

There have been a few changes since the last update:

PBR Dividend Policy, Credit Rating Upgrade

Disclosure: We remain long PBR.A.

Since our last update, Petrobras has announced a few things. Most importantly:

1)  Their highly anticipated new dividend policy. It sounds just fine; a middle ground we expected and not the dire outcome some expected. The new shareholder remuneration is based on 45% of Operating Cash Flow minus investments vs 60% of Operating Cash Flow minus capex. The quarterly distribution model is maintained and Q2 has been announced (see table). They have also incorporated the ability to now repurchase shares and these repurchases would be considered as part of shareholder remuneration. We are fine with some repurchases at current multiples, but would not want to see the dividend replaced exclusively by repurchases (which does not appear to be the plan). The buyback program will be done under a pilot of the net twelve months and expected to buy back 157MM preferred shares or 3.5%.

2) They also announced their sustainable capex target. Again, in line with our assumptions (assumed 20% FCF disappears, actual number 6-15%). These investments are supposed to be profitable per their guidelines, but we assume they will not be and hope to be wrong. As a side note, we expect Canadian large cap / integrated oil companies will ultimately spend similar levels (just look at the Pathways Alliance CCS budget, never mind other initiatives) and do not think this is fully priced in by the market yet.

3) S&P changed the outlook of its credit rating from stable to positive as a “reflection of the improved outlook of the Federative Republic of Brazil”.

Here’s the new plan, and the new dividend policy.

“Rio de Janeiro, August 7, 2023 – Petróleo Brasileiro S.A. – Petrobras, in relation to the news released in the media and as disclosed to the market on 06/01/2023, informs that the Strategic Plan 2024-2028 will have as a driver, among others, the forecast of low-carbon CAPEX for the range between 6% and 15% of the total CAPEX for the first five years of the new Plan, in compliance with current governance practices, the commitment to value creation and the Company's long-term financial sustainability.

This driver is aligned with the strategic elements that should be included in the plan, allowing the Company to (i) act in low-carbon businesses, diversifying the portfolio in a profitable way and promoting the perpetuation of Petrobras; (ii) operate in our businesses in a safe and sustainable manner, seeking decreasing emissions, promoting diversity and social development, contributing to a just energy transition and to the training of sustainability experts; and (iii) seek innovation to generate value for the business, supporting operational excellence and enabling solutions in new energies and decarbonization.”

For those keeping track, dividends are ~18% yield so far this year if you bought in the spring like we did while the stock is up 20-40% depending on the purchase. We still like the company at the current price.

For context, even with the increase in share price, this is how it is trading relative to a few well-known names using recent analyst estimates available to us. They have different assumptions than we do, but directionally it provides an indication of how they are being priced relatively using similar analyst assumptions for oil prices. Should PBR trade like Saudi Aramco or Chevron? Probably not, but maybe not so relatively cheap either. The key concern remaining for us is will their domestic diesel/etc pricing remain profitable, or will political pressure crush margins?

Maybe Lula isn’t so bad. “Brazil’s Leftist President Is Getting Things Done. The Markets Love It.” https://www.marketwatch.com/articles/brazils-leftist-president-is-getting-things-done-the-markets-love-it-9124bffa

Another odd lot - TNET

Disclosure: We do not currently own this but might purchase.

TNET is repurchasing shares at $107 vs ~$105.50 currently and they have an odd lot provision. Upside is ~US$149, closing by as late as September 13th. ~17% IRR. Do your own due diligence. We are on the sidelines due to account rebalancing and transfers. Details here: https://www.bamsec.com/filing/110465923086012/2?cik=937098

Quick Pitches from around the web

These are ideas we are evaluating, but currently have no position.

Gulf Island Fabrication turnaround

No Called Strikes Investing @NCSI_SA - $GIFI. Fabrication company that sold off an unprofitable shipyard division, made an accreditive acquisition, and is building a more robust backlog. All kick-started by a new CEO who I have a lot of respect for. Downside protection is a healthy cash balance and undervalued assets

CVI note: Market cap $57MM, but EV only $15.4MM considering net cash. New CEO (2019) turnaround three years in.

https://seekingalpha.com/article/4576264-gulf-island-fabrication-overlooked-unloved-and-undervalued

A quick look at the numbers.

Alto Ingredients ALTO– Jeremy Raper

Founder of Raper Capital is pushing for change at Alto Ingredients, Inc. (NASDAQ: ALTO), a producer and distributor of specialty alcohols and essential ingredients. On June 29, 2023, Jeremy published "An Open Letter to the Board of Alto Ingredients, Inc." on his website. An interview of the situation can be found here. https://youtu.be/yj3mg-r6q9E

Just yesterday, the CEO stepped down. Maybe something will come of this push indeed. https://www.globenewswire.com/news-release/2023/08/07/2719709/0/en/Alto-Ingredients-Announces-Executive-Leadership-Changes.html

Short selling is getting more dangerous

Another case study of the increasing dangers of shorting failing businesses. Yellow Corp declared bankruptcy, but not before its stock rallied 170% or so, reportedly due to “meme” investors. We continue to not short companies, maybe the odd put.

Example of what the discussions are like - https://www.reddit.com/r/DishTards/comments/15dwqp5/final_yellow_company_dd/

Background article - https://www.bloomberg.com/news/articles/2023-08-06/dan-loeb-surrendered-but-meme-army-still-hits-bears-for-millions

Accounting shenanigans overseas? How about right here at home in Canada

Hay & Watson has been blackballed. Thankfully, it is not the auditor of any of our holdings. We checked. In general, we are concerned about looser accounting and the regrowth of cancers like fifteen row “adjusted EBITDAs”. Maybe we are overdue for another big scandal and accounting standards overhaul.

TORONTO, August 5, 2023 – The Canadian Public Accountability Board has terminated the registration of Vancouver-based accounting firm Hay & Watson, Chartered Professional Accountants as a participating audit firm with the national audit regulator. The termination, which comes almost one year after Hay & Watson was banned by the CPAB’s counterpart in the United States, the Public Company Accounting Oversight Board, effectively bans the accounting firm from audit engagements of public companies.

https://www.canadian-accountant.com/content/profession/cpab-bans-hay-and-watson

A little bit of investing history

St. James Investment Company did a great quarterly letter covering a little bit of investing history.

https://stjic.com/wp-content/uploads/2023/07/STJIC-Adviser-Letter-2023-Q2-Final-3.pdf

If the S&P 500 was weighted equally, rather than by market capitalization, its performance over the last three years looks anemic. The equal weight index provides a better understanding of the breadth of the market and the economy. Of course, not all stocks are equal, as some hold greater significance than others. Some businesses are poised to benefit and grow more due to the ongoing AI revolution. One could argue that the aforementioned five companies provide substantial exposure to AI, potentially unleashing a wave of creative destruction. However, caution is warranted when 25% of the entire U.S. stock market capitalization is concentrated in just seven technology companies, trading at materially different earnings multiple of the remaining 3,687 businesses.

At its current price of $423, Nvidia is valued at forty times its annual revenue. If one heroically assumes that the company manages to compound revenue by 50% per year for three years, it will "only” trade at a multiple of twelve times hypothetical sales in 2026...hardly a screaming bargain. Of course, market history has an interesting way of repeating itself. The most exaggerated technology bubble occurred in 1928-29 when the Radio Corporation of America (RCA) captured the imagination of every speculator on Wall Street. RCA’s trading volume sometimes accounted for 20% of the total volume on the New York Stock Exchange. At the stock price peak in September 1929, the company was "valued" at $665 million. Sales increased from $65 million in 1927 to $102 million in 1928 to $182 million in 1929. Therefore, at the peak of the RCA stock buying frenzy, the company was "valued" at a multiple of "only" 3.6 revenue. Forty-five years later, in 1974, RCA’s annual sales were $4.6 billion, yet the stock price bottomed that year at $38, about one-third of its 1929 stock price high.2 While most rational investors consider Nvidia ‘slightly’ overvalued, market momentum could push fantasy valuations higher. Comparing the 1929 period of RCA and the current situation with Nvidia in 2023, one observes a similar pattern where most stocks experience decline while a handful of large companies powered the major indices higher. In both instances, unsuspecting investors maintained the illusion that the "market" was healthy.

Gravity Co. NYSE:GRVY and Activision-Blizzard NYSE:ATVI – Thinking about relative value

Provided to subscribers July 19, 2023. Disclosure: We own both GRVY and ATVI at time of posting.  

What is Gravity Co? It was founded in April 2000 and is known for its popular online role-playing game (RPG) called "Ragnarok Online." Ragnarok Online was one of the first successful Korean MMORPGs (Massively Multiplayer Online Role-Playing Games) and gained significant popularity both in South Korea and internationally. However, is a bit of an orphan, being controlled by its ~60% shareholder GungHo Online Entertainment, Inc. (also publicly listed and in Japan). The world thought GRVY had a tired franchise, Ragnarok Online, and was in decline. However, over the last few years they have launched several sequels to the original, as well as other unrelated games, and have ramped up annual revenues to the US$400MM range from ~$40MM in the 2010s. Now they are sitting on a few hundred million dollars while their market cap is only a few hundred million more.

When you see a company with a market cap of $555MM (at $79), $287MM of cash, ~$75MM of annual FCF, and a growing twenty-year-old franchise, we take a look.

We only came across this company very recently (we don’t spend much time on Korean ADRs), and find the timing a bit prophetic. One of our largest holds, Activision-Blizzard, looks to finally be crossing over and will become part of Microsoft shortly. Here is a comparison of where they are today; is GRVY trading at the right relative price? We do not think so.

First - Quick update on ATVI

-The FTC tried to block the merger and lost - https://www.bloomberg.com/news/articles/2023-07-12/ftc-to-appeal-judge-s-go-ahead-for-microsoft-activision-deal

-The FTC tried to appeal, and was blocked https://www.bloomberg.com/news/articles/2023-07-14/ftc-loses-appeals-court-bid-to-pause-microsoft-activision-deal  “Court ruling is a blow to the US agency and Chair Lina Khan” – We agree. It is probably better that the FTC focuses on more important things than many gaming consoles kids can play Call of Duty on.

-Last stop is the UK Competition and Markets Authority CMA. This is a very awkward stop, given they initially tried to block the deal (assuming FTC would have some success), but are now the last regulator standing in the world. https://www.eurogamer.net/microsoft-and-uks-cma-get-two-more-months-to-reach-agreement-in-activision-blizzard-deal 

-The deadline for the deal was July 18th and was extended by both parties. In consideration, MSFT is letting $0.99 out the door as a dividend in August. “On July 18, 2023, the Company’s Board of Directors declared a cash dividend of $0.99 per share of the Company’s outstanding common stock, payable on August 17, 2023, to shareholders of record at the close of business on August 2, 2023.” The termination fee also increased – “the Company waived any right to the Parent Termination Fee during the Waiver Period, after which the Parent Termination Fee, if payable under the Merger Agreement after (x) August 29, 2023, shall be increased from $3,000,000,000 to $3,500,000,000 and (y) September 15, 2023, shall be increased from $3,500,000,000 to $4,500,000,000;” https://www.sec.gov/ix?doc=/Archives/edgar/data/0000718877/000162828023025102/atvi-20230719.htm  Amended agreement - https://www.sec.gov/ix?doc=/Archives/edgar/data/0000718877/000110465923082205/tm2321522d1_8k.htm

ATVI is trading at ~$92 vs the offer of $95 plus $0.99 dividend. With an expected timeline of three months or less your IRR is ~17% if you buy today.

Ragnarok

Gravity Co is most famous for Ragnarok online and it is long-lived. My goodness. Originally released in 2002 (and continually updated), the game is still played.

But they are also working on sequels that have been successful (see chart below). They have moved from being a one trick pony in 2018 to having several revenue generating games on the go. Is this revenue diversification? We acknowledge it is still driven by their one key franchise. But, they are also working on new games and franchises. Our favorite is their just released Whale in the High (WITH). We downloaded the game and can confirm it is extremely cute. https://apps.apple.com/us/app/with-whale-in-the-high/id6446757241 To be clear, their products are an Asia phenomenon, originally Korea/Japan/Taiwan, but now also Thailand is material (see sales breakdown by sales by country at end).

On to the actual numbers. Ragnarok is now a franchise with multiple offshoots. Revenue is growing, revenue is coming from more games, and the margins are holding. An important thing to keep in mind is net income is not bad at approximating free cash flow as R&D development is expensed and not capitalized. In fact, net income can arguably be understated as some of that R&D is for the future growth, but we won’t get into this. The nice thing is you do not have to worry about these details if something is cheap.

Solitron Devices, Inc. (OTCPK:SODI) Is Tim Eriksen building a baby Berkshire?

Provided to subscribers June 22nd.

Here’s the latest from Canadian Value Investors!

  • Graftech Note Issuance – Oof

  • Need to park cash? Use SHV

  • Solitron Devices, Inc. (OTCPK:SODI) Is Tim Eriksen building a baby Berkshire?

  • Bonus Bloomberg – Defense spending is booming

Graftech NYSE:EAF New Note Issuance

Disclosure: We do not own this.

We posted about Graftech on May 28th (see member post). Oof. First, operational hiccups at Graftech $EAF last year are still hanging around causing sales problems almost a year later, and now another $25MM a year of CF disappearing to higher interest costs vs a year ago. This effectively covers the term facility so at least covenants probably aren’t a concern now. Still on the sidelines. https://www.graftech.com/investors/news/news-details/2023/GrafTech-Prices-Offering-of-450-Million-of-Senior-Secured-Notes/default.aspx

Need to park cash? Use SHV

We usually do not carry much cash, but sometimes we are between ideas and trades. One place to park your cash is ishares short-term treasury ETF, SHV. Why SHV? It only holds U.S. Treasury bonds that mature in less than 1 year, so you have very little duration risk. Current yield to maturity is 5.11%.

This is the best we have found for a as close to riskless ETF to park cash. We have not been able to find a Canadian dollar equivalent; all of the ETFs we have looked at have long duration and/or corporate issuances. We have no interest in taking on either of these risks with our cash. If you have a better U.S. dollar ETF or an idea for a Canadian dollar denominated one, please let us know!

https://www.ishares.com/us/products/239466/ishares-short-treasury-bond-etf

Solitron Devices, Inc. (OTCPK:SODI) Is Tim Eriksen building a baby Berkshire?

Disclosure: We currently own this.

For readers that have been around for awhile, you know that we have been following Solitron Devices, Inc. for a few years now. Our first article was May 2022 - Reading the Turnaround Tea Leaves - followed by an update in July. Our writings have typically focused on things that we have acquired but have had several requests for articles covering what we have not purchased and why. This is a great example. We think there might be something here, but have not yet pulled the trigger. Here’s why.

Since our last update, CEO Tim Eriksen and company have been busy.

As a quick refresh:

-Solitron makes power control modules/junctions/etc, for weapons systems and airplanes like the B-52 bomber. This is typically sticky business supporting the life of the system, so long as you perform. And lives can be long, shown best by the B-52 that has been around in one form or another since 1952.

-Tim Eriksen, activist investor turned CEO, is a few years into a turnaround with major step changes, including moving their facility to a cheaper/better owned facility and is in the middle of rationalizing and improving production.

-The U.S. government continues to prioritize smaller contractors as part of their Increasing Opportunities for Small Businesses policy (see original article).

-We stayed on the sidelines last year primarily because 1) we were unsure of the success of their plant move (i.e. what true run-rate sales and costs would become), and 2) we were unsure where they would put their cash. We now have an answer to one and almost both questions.

-Since our initial check, the Ukraine war has create a bit of an embarrassing weapons stockpile problem for the U.S. “Slower manufacturing and expenditure of reserves in Ukraine have many worried about the state of U.S. munition stockpiles and military readiness.” https://www.heritage.org/defense/report/rapidly-depleting-munitions-stockpiles-point-necessary-changes-policy

Our initial analysis and July update was as follows. How have things gone? They just provided their (off-cycle February) 2023 year-end financials.

Key highlights:

1) The trickle down of the U.S. stockpile problem leading to sales – “As we noted in our fiscal third quarter release, in December 2022 the President signed the $1.7 trillion omnibus spending bill.  Included in the bill are appropriations to replenish supplies used in Ukraine and to increase stockpiles.  A number of programs are included in the spending, including two that represent Solitron‘s two largest revenue sources.  The increased stockpiles program is a multi-year program that we currently expect to add approximately $20 million in total revenues starting in late calendar 2024 and running through 2028, or approximately $4 million annually.  Actual contract awards are expected to occur by the fall of 2024.”

2) Sales were impacted by the plant move as expected. “Bookings were strong in the quarter, exceeding $3.5 million and backlog finished at $9.1 million, our highest quarter end level since February 2021.” We note that some 2022 sales were actually pulled from 2023 in advance of the move.

3) Most importantly, it looks like Tim and Co are indeed trying to use the company as platform to grow into something larger through public holdings and acquisitions (see notes below). They had $4.3MM of cash and investments at year-end. For us, this means we need to ignore the surplus cash and instead make assumptions about expected returns.

“We had significant unrealized gains on investments during the fiscal fourth quarter and fiscal year 2023. In the middle of the fiscal year the Board approved a revision to our approach toward investments to allow for more concentrated positions. We purchased 1.1% and 1.5%, respectively, of the outstanding shares of two small community banks that were recipients of the Emergency Capital Investment Program (ECIP). …

On June 1 Solitron signed a non-binding term sheet for a potential acquisition of a target company which produces electronic components primarily for the medical industry.  We are now in a due diligence process which is estimated to last approximately 75 days.   The terms set forth in the term sheet contemplate that, if completed, the acquisition would be funded from cash and securities on hand.  An initial payment of approximately $3.0 million would be due upon close.  Additional earnout payments of up to approximately $450,000 each would be payable over each of the next three years.   The target company produces electronic components primarily for the medical industry.  Revenue for 2022 was approximately $5.9 million as compared to $5.5 million in 2021.  One customer accounted for approximately 90% of revenues.   We can make no guarantees that the transaction will be able to be consummated, or if it is that it will yield the results or benefits desired or anticipated.”

They are also doing concentrated bets on holdings; these appear to crossover with Tim Eriksen’s fund. https://www.eriksencapitalmgmt.com/manager

We had significant unrealized gains on investments during the fiscal fourth quarter and fiscal year 2023.  In the middle of the fiscal year the Board approved a revision to our approach toward investments to allow for more concentrated positions.  We purchased 1.1% and 1.5%, respectively, of the outstanding shares of two small community banks that were recipients of the Emergency Capital Investment Program (ECIP).   Due to increased interest rates, we also moved most of our cash to treasury bills which is considered Short-term investments on the balance sheet.    

Our takeaways

-

Bloomberg - Defense Spending is Booming

Bloomberg - Has the Ukraine war started a new arms race? Yes, to judge by figures published on Monday by the Stockholm International Peace Research Institute, a think-tank. Global defence spending rose by 3.7% in real terms in 2022 to a record $2.24trn. It shot up by 9.2% in Russia and septupled in Ukraine. Farther west in Europe, military spending grew by 3.6% to levels unseen since the end of the cold war.

Yet the picture is fuzzy. The economic burden of armed forces, at 2.2% of GDP, remains close to its post-cold-war low. In part, the world economy has grown. Of the biggest arms spenders, America was flat and China dipped as a share of GDP. But many of the promised spending increases are yet to come. Inflation may abate. And geopolitical tension—a long war in Ukraine, and talk of a future one between America and China—will push countries to buy ever more weapons.