Tuesday, February 22, 2005

Getting Around Sarbanes Oxley:
Follow up to 12/22/04 report
Hanover Foods

Since our first report on this subject, in which we discussed the growing trend of smaller companies opting out of filing with the SEC, and avoiding Sarbanes-Oxley compliance in the process, more companies have taken the same road, and this report will focus on one of them.

As our 12/22/04 column stated, due to the relatively high costs of filing documents with the SEC (including sending reports to shareholders), as well as the additional costs associated with Sarbanes-Oxley compliance, small companies are making good use of a loophole. To avoid filing, and complying with Sarbanes, they need to have less than 300 shareholders. Those that are below that level simply need to file form 15-12G with the SEC, and no longer need to report. Those that are nominally above 300 have found interesting ways to reduce their shareholder rolls (namely through the combination of reverse stock splits, and buying odd-lot shareholders out. Whether you own 100,000 share or 1 share, you are still just one shareholder.)

Hanover Foods Corp
Price: $90.50 (Class A)
Market Cap: $97.3
Shares Out: Class A non-voting: 288,000(actual)
Class B voting: 781,600(actual)
Average daily volume: 59 (actual, Class A)
No recent trades (Class B)
Book Value per Share: $99.09
Dividend Yield: 1.21%

Hanover Foods Corp is a small Pennsylvania based processor of and distributor of vegetables, founded in 1924. Still, the company ranks as the largest independently owned food processor in the eastern US. Fiscal year 2004 sales were $318 million, up 10 percent from 2003 ($290 million). Net income was $11.4 million in 2004, up 13 percent from 2003 ($9.9 million).

The company had about $3 million in cash, and $21 million in long term debt as of its last reported quarter (Aug, 2004). Currently, the company trades below its most recently reported book value of $99.09.

Admittedly, this is not the most exciting company, but by now avid readers of this site are used to that. It is, however, a consistently profitable one-17 straight profitable quarters-and that’s as far back as the data goes, (that I can find, anyway), so the run may extend far beyond that.

What is interesting about this company, though, is how they went about achieving the sub 300 shareholder plateau. In December, 2004, the company announced its intention to ultimately end filing with the SEC, commencing a tender offer to any shareholders holding 15 shares or less. At a time when the stock was trading around $84, the company offered $131.00 per share, a 55 percent premium! Although, this was not going to make anyone rich, as it only applied to shareholders owning 15 or fewer shares, it was still a nice premium.

The company was very clear about its reasons for the tender offer, and intentions to terminate registration of its stock, and with that, end SEC filing responsibility. It was also clear about the associated cost savings of doing so: The following is from the company’s SC 13E3, dated 12/6/04:

"We estimate that the costs of compliance have been at least $80,000
annually, in addition to onetime increased costs to document and test our system
of internal control over financial reporting, estimated to be approximately
between $344,000 to $961,000 in fiscal years 2005 and 2006 and ongoing increased
annual costs to document and test internal controls estimated to be
approximately $198,000 on an annual ongoing basis. Our management (in particular, Gary Knisely and Pietro Giraffa) has periodically and informally discussed with members of our board of directors the relative advantages and
disadvantages of being a reporting company for a number of years. The estimated
one-time costs to document and test our system of internal control over
financial reporting, the estimated ongoing costs to document and test our system
of internal controls and our estimated expenses of compliance as a reporting
company are as follows:"

Estimates from Consultants to Establish Internal
Controls and Documentation Procedures(1) ............. $ 174,000 - $561,000
Hanover Staff(2) ..................................... $ 120,000 - $200,000
Additional Audit Fees(3) ............................. $ 50,000 - $200,000
TOTAL INCREMENTAL COSTS .............................. $ 344,000 - $961,000
Hanover Internal Staff Time and Expenses ............... $ 133,000
Internal Controls Audit Fees ........................... 65,000
TOTAL ESTIMATED ONGOING COSTS .......................... $ 198,000

Annual Audit Fees ......................... 45,000
Annual Legal Fees ......................... 25,000
SEC EDGAR Printer Costs ................... 10,000
TOTAL ESTIMATED ANNUAL COSTS .............. $ 80,000

In summary, this move saves the company $278,000 per year pretax, plus one-time costs from between $344,000 and $961,000-not insignificant amounts for a company which earned $11.4 million last year. The filing goes on to mention other savings, specifically management’s time and attention:

“In addition, management devotes a significant amount of time and
attention to the preparation of the periodic and current reports required under
the Exchange Act and to compliance with the SEC rules and regulations
promulgated under the Sarbanes-Oxley Act. We estimate the time devoted to tasks
associated with public reporting as approximately 10% for the Chief Executive
Officer, 28% for the Chief Financial Officer, 37% for the Chief Accounting
Officer and 10% for the Treasurer. Management believes this time could be spent
more efficiently on operating our business and evaluating business

Finally, the company cited cost reduction of no longer having to administer small shareholder accounts:

“The expense of administering the accounts of small shareholders is
disproportionate to their ownership interest in us. As of the record date, we
had 287,996 shares of our Class A common stock outstanding. We had approximate
101 shareholders of record that held 15 or fewer shares of our Class A common
stock, holding an aggregate of approximately 718 shares. As of the same date,
estimated 265 shareholders of record held 16 or more shares, holding an
aggregate of approximately 287,334 shares of our Class A common stock. As a
result, approximately 33% of the administrative expense relating to our
shareholder accounts relates to the administration of shareholder accounts
constituting .2% percent of our outstanding shares.”

The Offer itself
Perhaps the most interesting part of this entire story is the tender offer price, and how it was derived. The company hired Gocial Gerstein LLC to calculate a fair market value for Hanover’s Class A shares. In summary, based on Hanover’s EBITDA(earnings before interest, taxes, depreciation, and amortization), sales, book value and operating cash flow, as applied to selected multiples, total equity value was placed at $138.9 million. A 25 percent marketability discount factor was then applied, to arrive at $104.17 million. Then, Gocial Gerstein made some further adjustments to arrive at $100.12 million. That figure was divided by shares outstanding, to arrive at $138.00 per share. Finally, a 5 percent discount was applied to account for the fact that Class A shares do not have voting rights. The result? $131.00.

What are the shares really worth? Well the market says $90.50, the current trading price. But these shares trade on the pink sheets, and trade infrequently. Does the market have it all wrong? Are the shares really worth $131.00, the price Hanover was willing to pay to small shareholders? Are they worth more? Time will tell.

The end result of this story is that after the tender offer, Hanover was able to reduce its number of shareholders to 289, filing its Form 15-12G on January 10th, 2005. This is a story we’ll no doubt be following.

You probably won’t read about this company, or this story, anywhere else. Analysts have no reason to cover this stock, and for the most part, institutions are not interested because of the company’s size, and small float. But we here at Cheap Stocks see the potential opportunity in situations such as this. It is our purpose to educate our readers about “off the beaten path” investment concepts and ideas, such as this.

That being said, please understand the risks of investing in illiquid securities such as Hanover. Only a small portion of your portfolio should be dedicated to such investments. Such companies may be difficult and expensive to buy, and sell. When investing, be careful not to place a market order for illiquid stocks, as the bid/ask spreads tend to be wide.

*The author does not have a position in this stock. This is neither a recommendation to buy or sell this security. All information provided believed to be reliable and presented for information purposes only.

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