Village Farms International (TSE:VFF)

VFF is a name I’ve run across in the past but didn’t spend much time analyzing until it hit my radar with disappointing results and a swift sell-off in May. Since that time, the stock has done nothing but go down – off over 50% in the last 3 months as the news just gets worse and worse. Suffice to say, we have a company with bad news in the short-term offset by solid operating results historically; a one-time act of God disaster severely impacting operations; and a stock price falling through the floor. Isn’t this the definition of a value stock? That’s where I started my analysis . . .

VFF bills itself as “a leading grower and marketer of branded, high-quality hydroponic greenhouse grown produce in North America.” Basically, the company grows tomatoes (and to a lesser extent cucumbers and bell peppers) on a large scale. When I say large, I really mean it – these aren’t your typical local flower farm greenhouses. VFF’s 8 facilities in British Columbia and Texas cover a staggering 262 acres. Go to Google Maps and search for Village Farms in towns like Fort Davis, TX or Marfa, TX to get a real appreciation for the size of these 40+ acre buildings.

The VFF story is an attractive one in terms of sustainability and long-term production growth. Greenhouse grown tomatoes yield over 50x per acre that of traditional field grown plants and use an estimated 85% less water (via water recycling). With growing demand for arable land and drinking water, the long-term trend seems to favor high impact growers such as VFF. On top of this, greenhouses can be located adjacent to key population areas and/or low cost energy sources - reducing food miles, carbon footprint, and meeting a growing “buy local” trend among North American consumers.

VFF also owns a propriety technology known as GATES (Greenhouse Advanced Technology Expert System) – a fully enclosed greenhouse technology capable of sustaining year round production at feasible cost and scale levels (as compared to traditional greenhouse production which goes “dark” for 3-4 months each year depending on location). GATES is so efficient that it is estimated to provide production levels 60% above traditional greenhouse systems. The company already has one greenhouse fully operational under GATES technology (Monahans, TX; 30 acres of tomatoes on-the-vine). Beyond the ability to expand its own production through greenhouse conversions or new builds (at considerable capital expenditures of course), VFF has the option to license GATES technology to competitors. To date, VFF has shown little interest in licensing GATES, but it remains an asset that doesn’t fully show up on the balance sheet.

Speaking of the balance sheet, what really sticks out on VFF is the valuation. At a recent close of $0.66, it trades at only 0.53x tangible book value ($1.25 as of 6/30/12). On top of the discount to TBV, the balance sheet likely understates the true replacement value of the greenhouses VFF owns.

We get a real time look at what the replacement value (using insured value as a proxy) of the greenhouses is due to recent damage on one of the facilities in Texas (see below). The damage resulted in receiving $18.7 million in insurance proceeds (with more pending/expected), but only a $3.9 million inventory write-down and an asset write off of $2.8 million – meaning the balance sheet had been undervaluing the greenhouse(s) in Marfa, TX by at least $12 million (assuming management has taken appropriate balance sheet write downs – a question I have not specifically addressed with them).

At stated balance sheet levels, to get a 10% return on our investment at the current share price, all we need is for VFF to earn an ROE of 5.3% (10% * 0.53x P/B). Last year, reported ROE was 14.8%. Also in calendar year 2011, VFF earned EBITDA of $15.5 million. At a current enterprise value of $104.983 million (38.873 million fully diluted shares outstanding at $0.66 per share plus $80.654 million in debt less $1.327 million in cash) we get an EV/EBITDA ratio of 6.8x – cheap for a growing enterprise.

Yet, as I noted above, things have not been going well for VFF. For the quarter ended March 31, 2012, VFF announced a 17% decrease in the average selling price of tomatoes year-over-year. The second quarter was no better, with management announcing that tomato prices were off 24% year-over-year. Intense pressure from field grown Mexican tomatoes (VFF management goes so far as to define the Mexican production as “dumping”) has been the primary culprit behind the weakness in tomato prices.

On top of this, a hail storm passed through Marfa, TX on May 31, 2012 severely damaging the 82 acre facility located there. Although insurance proceeds have been received (with the potential for further receipts) and one greenhouse (approx. 40 acres) has been repaired and is again operational, the fate of the remaining 42 acres in Marfa is up in the air.

This leads me to the three things keeping me out of this stock right now:

1. The balance sheet: debt to capital sits at 60%. For calendar year 2011, Times Interest Earned (TIE) was 3.1x, but the weakness in tomato pricing has caused TIE to go negative in recent quarters (net of the insurance proceeds in Q2). The weakness has so depressed operating earnings that VFF is nearly in violation of its debt covenants. Management was specifically asked about this on the recent quarterly conference call, and noted they were within all parameters currently – but didn’t go into detail on whether the covenants had been restructured or were in danger of being enforced.  If the market is right and the assets of VFF are not worth the balance sheet values but are rather worth $0.53 on the dollar (a case in which management should hope for further hail storms given the insurance proceeds they’ve received to date), then the debt/capital ratio would jump to nearly 77% - not much margin of safety.
2. Live by the government, die by the government. VFF is a leader in lobbying to regulate / legislate the “illegal dumping” of Mexican tomatoes into the U.S. Whether such lobbying is good/bad/indifferent, I’m not a fan when a company’s business plan requires government intervention to eliminate lower cost producers – in fact, it’s a red flag. With one stroke of the pen government intervention can create a competitive advantage, with another stroke of the pen it can completely destroy that competitive advantage (ok, I’ll admit that I’ve been burned by similar circumstances in the past and am cynical!).
3. The lack of a clear future operating strategy. As of today, even management doesn’t know (or at least isn’t saying) if they’ll rebuild the second greenhouse in Texas damaged by hail earlier this year. They may use further insurance proceeds to pay down debt, they may rebuild, or they may build a new GATES facility. The lack of clarity on the operating strategy – more than likely influenced by an already leveraged balance sheet with little room for additional borrowing – is a red flag that VFF may not have a sustainable competitive advantage in its current form (GATES may be a sustainable competitive advantage, but if management would need to issue (dilute) equity to realize the benefit, is it a real advantage in its current form?). 

Bottom line, I think VFF is extremely attractive in terms of historic earnings power, potential growth, and the value of assets on the balance sheet. In fact, it likely presents an asymmetric risk/reward payoff (downside of $0.66/share and upside of $2.00/share+). However, when the downside is a complete loss of capital, I’ll pass. Until we get some clarity on the future operating strategy of the company, until the impact of Mexican tomato production is better known, and until the balance sheet is stronger (or at least some combination of those three criteria), I’ll sit on the sideline.

Disclosure: No position in VFF but I reserve the right to implement one at any time.

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