Tuesday, October 24, 2017

Hanover Foods Corp - 2017 Annual Report

We mentioned Hanover as a possibly cheap company in August. Nate at Oddball Stocks has written about this one four times (1,2,3,4) over the years and others have written up as well (CoBF, BB, TIE, etc). The company has been in business in Pennsylvania for a long time selling frozen and canned vegetables.

Check out these fantastic photos of green beans being harvested - apparently for Hanover!

Highlights from this annual report (FY 2017, they have a weird fiscal year):

Cash 10,593
A/R 31,302
Inventories 117,021
Other assets 17,261
Current assets 176,177
Net PP&E 81,910
Other assets 25,505
Total assets 283,592
Current liabilities 40,864
Other liabilities 14,547
Shareholder equity 228,181

Series A $25 pref 156
Series B $25 pref 208
Series C $25 pref 250
Preferred liquidation pref 614

Common equity 227,567

Net current assets are $120 million.

Here's a summary of the capital structure - as best I understand it. I have never received a proxy statement so there is opacity as to who owns all the different layers of the capital structure.

Preferred Par Value Issued Outstanding Liq Pref
Series A 25 14,948 6,228 155,700
Series B 25 16,108 8,336 208,400
Series C 25 10,000 10,000 250,000


Issued Outstanding Price
A – nonvoting
349,353 285,174 98
B – voting
850,572 432,362 105


The preferred stock have $614,000 of liquidation preference, making them not very important for the valuation metric calculations. If you take the market value of the voting and nonvoting shares, then the market capitalization is $70.3 million.

That would make the price to net current assets ratio 0.59x, which means Hanover is a net-net play. In addition, the price to book ratio is only 0.31x.

Net sales for FY 2017 were $385 million, with $41.4 million of gross profit (11% gross margin). Net income to common stock is $4.9 million (1.3% net margin), which results in a poor return on common equity of 2.2%. Companies with low ROEs tend to trade at low price to book multiples, as Hanover does. Also notice that Hanover's market cap is only 0.18x sales!

A potential comp to Hanover is Pinnacle Foods - although much bigger, with a $6.7 billion market cap. Pinnacle's revenue for 2016 was $3.1 billion with $916 million of gross profit (30% gross margin). Net income for Pinnacle was $211 million, a 6.8% net margin. Thanks to much higher margins, Pinnacle trades at more than 2x revenue. Pinnacle has bigger scale than Hanover, plus they are selling more than just frozen vegetables: frozen complete bagged meals, frozen prepared seafood, frozen and refrigerated bagels, frozen pizza, full-calorie single-serve frozen dinners and entrées, and frozen pancakes/waffles/French toast.

There are two different ways you could look at Hanover's earnings power: net income to common shareholders, and also free cash flow.

FY 2017 FY 2016 FY 2015 FY 2014 FY 2013 Average
Net earnings to common 4,917 9,825 5,616 5,685 12,053 7,619

FY 2017 FY 2016 FY 2015 FY 2014 FY 2013 Average
CFO 8,402 31,438 12,653 32,780 -12,414 14,572
CapEx -11,094 -7,084 -2,861 -5,115 -20,312 -9,293
FCF -2,692 24,354 9,792 27,665 -32,726 5,279

The CFO and CapEx fluctuate pretty wildly. If you sum them, you get a number that, over the past five years, has averaged $5.3 million, which is 30 percent less than the trailing five year average net income of $7.6 million.

If you take the average of the two averages (NI and CFO) for past five years, you get $6.4 million which could represent the current "earnings power" of the business. The market cap is just shy of 11x this earnings power figure.

So, you have a company that's trading at very low balance sheet metrics and low-to-reasonable earnings metrics. That and the low ROE mean that, as business analysts and investors, we need to ask: why doesn't Hanover earn a higher net income margin, which would translate to higher ROE and more normal P/S and P/B and P/TBV ratios.

The answer may be in two places: the history of minority shareholder litigation, and certain footnotes to the financial statements.

Note 5c discloses the Company's Employment and Deferred Compensation Agreements. Key officers get an annual raise that is the greater of 5% or CPI - generous! They also get five years of pay as a golden parachute. There are also supplemental pensions for these unstated key officers. The benefits are equal to 60% of final three years' pay payable for the life of employee after retirement. This is recorded on the balance sheet as a liability of $15.6 million as of June 2017.

The expected cash cost of the supplemental pensions for FY 2018 is $1.18 million. If I'm understanding this correctly, it means there were one or more top employees, now retired, who were making just shy of $2 million in salary and bonuses during their final three years, on average. That seems like a TON of money for a company earning only $5.3 million average cash flow and 2.2% ROE!

Until we find a better hypothesis, my guess will be that profits and ROE are being siphoned off by overpaid management.

Further evidence in support of this: the company owns (in its Sunwise Co. subsidiary) a 1999 Cessna Citation (Model 560XL) business jet that they keep at York Airport in Pennsylvania. According to one data source I have seen, this plane gets flown all the time - apparently 200 flights YTD in 2017 and 275 flights in 2016. I'm not sure whether that's all Hanover & executives flying or if they lease it out, but at normal hourly costs for a business jet this is quite an expensive way of visiting Rogers, AR for WalMart meetings. A diligent analyst might ask the company why the plane has been photographed in San Diego in February and at the Ohio State U airport on the same Saturday as a football game.

Here's another puzzle by the way. In note 3 (Capital Stock), the company discloses that,
"During fiscal year 2001, the Company established an Employee Stock Trust (the "Trust") to fund future stock-related and other obligations of the Company's compensation and benefit plans, including a concurrently established Employee Stock Ownership Plan ("ESOP"). For financial reporting purposes, the Trust is consolidated with the Company. On April 26, 2013, the Company purchased for its treasury, from the Trust, all 340,180 shares of Class B Common Stock owned by the Trust for $110 per share and issued a Promissory Note ("Note") for $37,419,800 representing the full purchase price. All proceeds of such Note are to be used by the Trust to fund and/or to facilitate the operations of Designated Employee Benefit Plans maintained or to which there is an obligation to contribute for the benefit of employees of the Company or any of its subsidiaries (regardless of tier) who continue after the date of the Note to remain beneficiaries of the Trust."
I haven't noticed any of the other authors of writeups commenting on this before. The $37.4 million Note amount does not appear as a liability on Hanover's balance sheet. If the only beneficiary of the Trust is the Company, then I can see how it would be eliminated as an intracompany payable from the consolidated balance sheet. But the footnote implies that there are other beneficiaries of the Trust. If so, then is the holding company shareholder equity overstated to the degree that not all of the $37.4 million liability is intracompany?

The company owes a better explanation of the $37.4 million note and the Employee Stock Trust.

The other aspect of Hanover to know about is the history of bitter litigation with family and minority shareholders. In the case of Michael WAREHIME, v. John A. WAREHIME, the Superior Court of Pennsylvania summarized as follows:
These appeals concern the future control of the Hanover Foods Corporation ("HFC"). Michael Warehime appeals from the denial of his motion for preliminary injunction, through which he sought to enjoin certain actions of appellee John Warehime and HFC's Board of Directors that would perpetuate John's control of HFC. We must determine whether appellee John Warehime, the voting trustee of the Warehime voting trust, breached his fiduciary duty to the beneficiaries of that trust. As we conclude that this duty was breached, we reverse the orders entered by the trial court and remand for further proceedings.

The pertinent facts, as found by the trial court, are as follows. Alan Warehime is the father of appellee John Warehime, appellant Michael Warehime and Sally Warehime Yelland. He served as chairman and chief executive officer of Hanover Foods Corporation ("HFC") from 1956 to 1989. On May 26, 1989, by appointment of Alan Warehime, John Warehime became chairman and CEO of HFC.

The Warehime family established two voting trusts, dated April 5, 1988 and December 1, 1988, which controlled a majority of the voting stock (Class B) of HFC. The first trust was established by Alan Warehime and his three children; it controls 199,496 shares of HFC Class B voting stock.[1] The second trust was established by Alan Warehime and five of his grandchildren; it controls 15,025 shares of HFC Class B voting stock.[2] Until his death on March 24, 1990, Alan Warehime was the sole voting trustee of each voting trust. Thereafter, John Warehime, in accordance with Alan Warehime's designation, became the sole voting trustee of each trust. During his life, the voting trusts gave Alan Warehime complete control over HFC. By virtue of Alan Warehime's designation of John Warehime as sole successor trustee, he succeeded to and possessed the same power to control the voting trust and, consequently, HFC. The voting trusts expire in 1998, ten years after their respective creation.[3]

When the first trust expires in April of 1998, both Michael Warehime and Sally Warehime Yelland want to remove John Warehime as chairman of HFC. Although Michael Warehime would like to succeed John Warehime in this position, it is claimed that neither he nor the other plaintiffs have developed any future plans for the company or identified the management they intend to install. This uncertainty is said to have caused instability within the company and uncertainty about its future. To compound matters, John Warehime, Michael Warehime and Sally Warehime Yelland, do not communicate with each other and have not spoken in over three years.[4]

In late 1996, an Independent Directors Committee was formed by several of HFC's directors.[5] It was formed for the primary purpose of considering strategic alternatives for HFC in light of the pending expiration of the voting trust agreements in 1998. The decision to form this committee was made solely by its members without advice or input from counsel or John Warehime. As evidence of the directors' independence, in face of the fact that HFC's entire Board of Directors was elected solely by John Warehime, the trial court noted that the Board rejected proposals made by John Warehime on numerous occasions and will only continue to support John Warehime as chairman of HFC if he continues to perform well.

In considering the alternatives open to HFC, the Committee retained several firms and individuals to evaluate the company, including its employees, financial information, production facilities and business plan. This review acknowledged that HFC was a well-managed company and that it was equal or superior to its peer companies. It went on to recommend, however, that in order for HFC to sustain its business strategy of being the low-cost producer, it would require approximately $30 million in new capital. Because of the uncertainty raised by the 1998 expiration of the voting trusts, raising this capital would likely prove difficult, at least until HFC's governance structure stabilized. It was felt that if the present uncertainty would persist, HFC's business would likely deteriorate and it would be impossible to conduct business in a manner beneficial to the long-term interests of the company.

In light of this situation, the Committee considered three strategic alternatives for the future of HFC: (1) do nothing and allow the voting trust to expire; (2) sell the company or a control position in the company; or (3) adopt an amendment and restatement to HFC's Articles of Incorporation to provide a stable governance structure. Because of the substantial problems which would be caused by the persistence of an unstable governance structure, the Committee chose the third option.

The proposed amendments to HFC's Articles of Incorporation permitted the issuance of 10,000 shares of Series C Convertible Preferred Stock to be issued to the HFC 401(k) plan, provided that the majority of the trustees of that plan are "disinterested directors" of HFC as defined in § 1715 of the Pennsylvania Business Corporation Law ("BCL"). See 15 Pa.C.S.A. § 1715(e). In the event of a dispute among any of the five members of the Warehime family over the management of HFC, the amendments provided a method for resolution of such a dispute. The trial court summarized this mechanism:

In the event of a dispute among members of the Warehime family with respect to the election of directors or other related matters during the five years after the issuance of the stock, the Series C would be entitled to 35 votes per share. If there is no such dispute, the Series C shares are non-voting. The Series C Stock is convertible into Class A common stock.

The court also noted that the Series C shares must be voted by "disinterested directors" who have no relationship to John Warehime (who may not vote Series C shares) and who must vote as fiduciaries of the 401(k) plan. Finally, the court noted that the 350,000 votes the Series C shares control can be outvoted by approximately 80% of Class B stock and a majority of the Class A stock.[6] The outside consultants retained by the Committee opined that the amendments would provide a stable governance structure for the company and would permit the implementation of HFC's capital raising plan. The Board of Directors was further advised that adoption of the amendments would be consistent with their fiduciary duties under the Pennsylvania BCL. The factual findings of the trial court notwithstanding, the fact of John Warehime's control over the election of the Board of Directors, and the application of this mechanism clearly serves to perpetuate the total control of John Warehime over the corporation.

The shareholders of HFC were given formal notice of the proposed amendments. In response, Michael Warehime and several other shareholders immediately moved for a preliminary injunction, requesting that John Warehime be prohibited from voting the shares in the voting trusts in favor of the proposal. They maintained that the amendments were merely a device to extend John Warehime's control beyond the termination of the voting trusts to the detriment of the voting trust beneficiaries and the other shareholders of HFC. Following a hearing on the matter, the trial court denied the requested relief. The day after this ruling, John Warehime convened a meeting and voted all of the voting trust shares in favor of the proposed amendments. John Warehime was the only shareholder at the meeting and the only shareholder to vote for the amendments. This appeal followed. [...]
The litigation seemed to stem from the compensation desires of John Warehime (case):
Alan Warehime, the father of appellant Michael Warehime and appellee John Warehime, instituted two voting trusts in 1988 to control the majority of voting stock (Class B common stock) in Hanover Foods Corp. (HFC). Alan Warehime established the first trust with his three children[1] and the second with five of his grandchildren.[2] John Warehime succeeded his father as trustee upon his father's death in 1990. The trusts expired in 1998. John Warehime was appointed chairman and CEO of HFC in 1989. Since then, there have been a considerable number of disputes among the Warehimes, other shareholders, and the directors.

Food Services East, Inc., a company wholly owned by John Warehime, ran into financial difficulties in late 1992 or early 1993. John Warehime's ailing company owed approximately $4 million to HFC by June of 1993. However, John Warehime did not initially post sufficient collateral to cover the monies owed. In fact, the directors were not made aware of the money John Warehime's company owed to HFC until early 1993. The directors promptly remedied the situation by requiring John Warehime to post sufficient collateral for the loans. Plaintiff's Exhibit 26, Minutes from Directors' Meeting of 6/4/93, at 1.

Another dispute involved the compensation paid to John Warehime. On September 15, 1994, after months of negotiation, the directors of HFC approved a compensation package for John Warehime that he accepted under protest.[3] Plaintiff's Exhibit 50, Memo from Michael Warehime to John Warehime of 4/25/94, at 1; Plaintiff's Exhibit 68, Minutes from Directors' Meeting of 9/15/94, at 1-2. John Warehime, unhappy about the size of the compensation package and frustrated with several members of the board including Michael Warehime, stated in his notes on the situation that "[s]omething must be done." Plaintiff's Exhibit 69, John Warehime, Review Notes of My Compensation Employment Package with the Family at 1-5 (Sept. 21, 1994).

Shortly thereafter, a proposal to eliminate cumulative voting was drafted so that with the shares from the trusts, John Warehime could choose all the directors himself. On October 18, 1994, the shareholders voted on this proposal. While only John Warehime supported it, the proposal passed since he was able to vote the shares from the trusts. No longer constrained by cumulative voting, he immediately removed Michael Warehime, Sally Warehime Yelland, and an independent director from the board. The present action was initially filed in response to the loss of cumulative voting.

On June 12, 1995, the directors elected by John Warehime approved a new compensation package for him. Plaintiff's Exhibit 102, Hanover Foods Corp. Form 10-K at 93 (July 3, 1995). Under the new package, he received a $650,000 base salary adjusted for inflation along with significant bonuses.[4] Id. at 93-94. He was to receive 60% of his compensation for the longer of his life or his wife's life even if he were terminated. Id. at 99. Subsequent to another action initiated against John Warehime and HFC, this time led by the holders of the nonvoting common stock (Class A common stock), Stipulation, 4/25/97, at 15, John Warehime's compensation was reduced, Defendant's Exhibit 10, Amendment No. 1 to Employment Agreement Between Hanover Foods Corporation and John A. Warehime at 1-5 (Feb. 13, 1997).
This litigation is the most like Dickens' Bleak House of any micro cap I've ever looked at.

Interestingly, according to Oddball's first comment on the CoBF thread, when the company went dark in 2004 they paid $131 for the A shares. I found the details for the tender, and that price is correct. Note that the offer was only for holders of fewer than 15 shares as of November 22, 2004. Anyway, 13 years later the stock is offered at $93!

Here's what company performance was like back then:

(millions) FY 2000 FY 2001 FY 2002 FY 2003 FY 2004
Revenue 277 294 290 290 318
Net Income 9 7 7 10 11
NI % 3.1% 2.3% 2.5% 3.4% 3.6%

Sales have grown since 2004, but the net income margin has fallen.

I'd love to hear anyone else's opinion on this company. Hanover is still a net-net play but the ROE is low. The business doesn't seem to be getting any better, either.


Anonymous said...

It seems that the only (or at the least, most likely) way you win is if the company is sold.

So, I'd calculate how much management is benefitting from its ownership (could be done by taking HNSFA's NI % vs. a "normal" NI % (4% maybe?)and assuming mgmt is getting the "missing" income). Compare that to the passive income mgmt could make on their proceeds of the sale of the company. That could give you some idea of the likelihood of a sale.

Midwest said...

First thing I thought was how old is John?

LinkedIn says he's worked there since '64. Ugh. To the surprise of no one, another friggin' Boomer burning through the seed corn put up by Dad. Figure he was born in '42+/-, so that puts him at ~75. Geez. Go home, Boomers, you're drunk.

Slightly O/T, but bears mentioning, Trump really does deserve every prop, and then some, for having seemingly such a well-adjusted, tight-knit set of kids. Every odd was against it.

Anonymous said...

Do you have a link to the Annual report? Thanks

Anonymous said...

He's actually pushing 90