Lifecore Stock: Getting Closer To Massive Improvements In Earnings Power (NASDAQ:LFCR)

The following segment was excerpted from this fund letter.

Lifecore Biomedical (NASDAQ:LFCR)

Lifecore, discussed above, is our fill-finish CDMO that also has a dominant position in pharmaceutical grade hyaluronic acid production. The company is presently bringing on additional capacity that was planned for ~4 years ago. You likely recall that over the last year, Lifecore had been running a strategic review of their business, which I believed would result in a sale, likely to a private equity buyer. While I would have been very happy to pull forward value realization at Lifecore through a sale, at no point was our investment entirely dependent on a sale being realized, and in late March the strategic review ended without a sale.

As is typical when this happens, shares sold off hard on the news as some portion of the shareholder base was made up of “event driven” investors who were only interested in a potential sale. When it became clear a sale would not happen, these investors headed for the exits.

From my perspective, a sale only made sense if prospective buyers were willing to pay a full price for Lifecore’s future earnings power. I believe that a sale was not consummated because the bid x ask spread between buyers and sellers was simply too wide. Importantly, board members own 40+% of the equity, and they have an inside view of how customer demand is developing, and are thus better able to probability weight the likeliness of future earnings power developing than the market. Additionally, when Lifecore first announced capacity additions a few years ago, they believed that the new equipment they were purchasing would take capacity from 22M units to 45M units. This estimate was deliberately conservative as Lifecore deals with a lot of high viscosity product, and they could not be certain how quickly the machines could process this highly viscous material. Now that the machines have been installed and tested, they have realized that their initial estimates were far too low, and actual updated capacity is 70M units. Clearly this additional unexpected capacity has some value.

At the same time, my research suggests that several of the most likely private equity buyers have been in digestion mode following past acquisitions, and with an uncertain interest rate environment, it seems as if they took a “show me” approach to Lifecore’s earnings power, rather than giving credit for business which is still in the mixing bowl rather than fully baked. They were thus unwilling to pay the seller’s number. Again, when possible I always prefer to pull future value to the present, but what matters now is how our investment in Lifecore appears today… and I think it looks very attractive.

First, we know that shares have been under pressure from noneconomic selling tied to event-driven investors aggressively exiting. Second, while I cannot say for certain, I believe that Lifecore received bids at prices higher than where shares are currently trading, but chose not to accept them. I believe that barring some total disaster, these buyers would gladly own this asset, suggesting that we have a put of sorts, which theoretically protects any downside. Third, a new CEO, Paul Josephs, has been named and will be starting in May. I am still doing channel checks on him, but based on what I have heard thus far, I think we can expect a real upgrade in management quality.

Importantly, this new CEO is strongly incentivized to focus on share price. As part of his employment, he was granted 1,500,000 Performance Stock Units that vest in tranches based on share price. The highest tranche is $40, and if Mr. Josephs is able to steer the Company anywhere near those levels, he has the opportunity to make generational wealth. We are along for the ride.

Fourth, there has been an information vacuum around Lifecore in recent quarters as the company has been restating its financials. I suspect that within a few months of Mr. Joseph’s arrival he will host an investor day, and give the world a view toward the internal developments that have not yet been revealed, and perhaps have been deliberately concealed. For example, Lifecore has been run-rating at 10-11M units on an existing ~20M unit capacity, and capacity has gone to 70M units. Yet, recent commentary from the company has been limited to suggesting that “revenue generating capacity” has “tripled.” This is true, but drawing one’s attention to what has happened to capacity rather than what can happen to revenue seems like clear misdirection.

If revenue capacity has tripled, but the company has been run-rating around 50% of capacity, then surely current revenue has the potential to more than triple. I believe that these numbers are being deliberately sandbagged in advance of a new CEO starting in order to smooth his path. Fifth, Lifecore is primed to be shortly added to the R2000, and based on JP Morgan’s preliminary estimates, the indexes will be forced to buy ~20 days of volume.

In sum, I was wrong in my belief that Lifecore would be sold and we would pull forward our returns; timing is always the hardest part of investing. But I do not think I am wrong about the value here, and at present the bar for LFCR stock to succeed appears very low, while at the same time industry developments, management developments, and capacity developments are all very favorable. The company has not issued guidance for the coming year claiming (and I agree) that it would be inappropriate for them to set targets and then hand those targets to a CEO who has not yet started. However, they had previously indicated that they expected to ~double their run rate unit count over the next 2+ years, more recently they have indicated that the business is clearly inflecting from temporary problems faced in fiscal 2023, and they have noted that approximately one third of the later stage conversations they are having with prospective customers are with larger pharmaceutical companies that could quickly soak up capacity. This has been a frustrating investment to date with wild ups and downs, but we are getting closer to massive improvements in earnings power.