BABB Vs PARF Conclusion Article

This article is the culminating piece that will talk about and compare BABB’s and PARF’s margins, weigh the pros and cons of each company, talk about each companies float, and decide which one, if either of the two companies I plan to buy into.  Originally I had planned to write articles on another two companies but was asked by a fellow value investor who recommended them to me to please not write an article on them since he was planning to.  Of course this is only right since he is the one who mentioned those two companies to me.  I still plan to research both of those companies to see if I would want to invest in either one of them and will let you know if I decide to buy into either of them when I make that decision.

Margin Comparison

BABB Margins PARF Margins
Gross Margin TTM 96.2 28
Gross Margin 5 Year Average 88.64 26.32
Gross Margin 10 Year Average 79.25 26.37
Op Margin TTM 17.9 9.9
Op Margin 5 Year Average -0.76 5.9
Op Margin 10 Year Average 6.75 4.24
ROE TTM 15.51% 8.31
ROE 5 Year Average -2.80% 5.064
ROIC TTM 14.51% 7.59
ROIC 5 Year Average -17.20% 9.278
My ROIC TTM With Goodwill Using Total Obligations 24.39% 11.09%
My ROIC TTM Without Goodwill Using Total Obligations 88.11% 11.29%
Earnings Yield EBIT/TEV 14.15% 19.91%
FCF/Sales TTM 15.02 -5.55
FCF/Sales 5 Year Average 13.296 3.116
FCF/Sales 10 Year Average 15.658 2.828
P/B Current 1.47 0.55
Insider Ownership Current N/A N/A
My EV/EBIT Current 6.58 4.95
My TEV/EBIT Current 7.07 5.02
Working Capital TTM 1 mil 15.62 mil
Working Capital 5 Yr Avg 1 mil 12.2 mil
Book Value Per Share Current 0.43 39.72
Book Value Per Share 5 Yr Avg 0.498 36.254
Total Executive Compensation as a % of Sales 26.17% 6.00%
Total Executive Compensation as a % of Gross Margin 26.17% 21.00%
Total Executive Compensation as a % of Market Cap 15.91% 16.00%
Total Executive Compensation as a % of Total Enterprise Value 19.65% 11.47%
Debt Comparisons:
Total Debt as a % of Balance Sheet TTM 3.05% 10.12%
Total Debt as a % of Balance Sheet 5 year Average 4.88% 2.64%
Current Assets to Current Liabilities 2.17 4.25
Total Debt to Equity 4.84% 12.56%
Total Debt to Total Assets 3.74% 11.70%
Total Obligations and Debt/EBIT 30.36% 98.78%
Costs Of Goods Sold As A % Of Balance Sheet TTM 0 71.98%
Costs Of Goods Sold As A % Of Balance Sheet 5 Year Avg 10.60% 73.54%

Keep in mind while looking at these margins that PARF is an extremely seasonal business so it margins will probably look different in a month when the company reports its full year results, and probably for the better, at least marginally.

Margin Thoughts

  • BABB’s gross margins are phenomenal which should be expected from a company whose only business right now is to sit and collect royalty and franchise fees.
  • BABB has superior operating margins, ROE, and ROIC in comparison to PARF.  Again, this should be expected with its business model in comparison to PARFs.
  • PARFs earnings yield, in this case EBIT/TEV, is superior to BABBs by about 25%.
  • Since this is a new metric I am using I went back and calculated this for the two most recent companies I have bought stock in, STRT and BOBS, and here is how the earnings yields compare: 1) STRT-20.79% 2) PARF-19.91% 3) BOBS-14.80%, 4) BABB-14.15%.
  • As I talked about in both of the previous articles both companies ROIC could be higher if executive pay and overall payroll were not at the excessive levels that they are at currently.
  • Earnings yields is a rough estimate of the kind of return you may be able to expect in the future by buying the company at its current price and is compared to the current 10 year treasury yield.  I have seen prominent value investors say they like to buy companies with earnings yields at least 3X to 4X higher than the 10 year yield.  Current 10 year treasury yield is 2% currently so all of these companies surpass the 3X to 4X benchmark with Strattec leading the way.
  • BABB’s FCF/Sales is exceptional and PARF’s is currently negative but that should change once the full year results are announced.
  • PARF’s P/B ratio is incredibly low as the company is selling for only half of its current book value and this value is likely a bit undervalued which would mean PARF is currently selling at even a lower true P/B.
  • PARF’s current estimated book value per share is around $40 per share and the company is selling at $22 a share currently.
  • Both companies are selling for EV/EBIT and TEV/EBIT ratios fewer than 8 which is again what I want them to be under.
  • Both companies executive pay is excessive in my eyes especially BABBs.  Remember also about BABBs is that its entire payroll structure is inflated and the above calculations are not including overall payroll.  Including overall payroll for BABB and its payroll and executive pay take up more than 50% of the company’s gross margin; absolutely insane in my opinion.
  • Both companies have minimal debt and have stellar balance sheets.
  • PARF’s total obligations and debt/EBIT is too high in my opinion but again this should be at least somewhat corrected when the full year numbers are released.
  • COGS for BABB is completely irrelevant now that they do not directly operate any of its restaurants.
  • PARFs COGS has been coming down over recent years which have been why margins rose in recent years.

Float Analysis Comparison

BABB Analysis

Financial assets: Cash and cash equivalents=1,256+prepaid expenses of 66+ deferred income taxes 248=1,570.

Operating assets: Accounts receivable of 86+inventories of 27+other current assets of 393+net property, plant, and equipment of 11+goodwill of 1,494+intangible assets of 505+other long term assets of 4=2,520.

  • Total assets=4,090

Liabilities:

  • Equity=3,158
  • Debt=125
  • Float=accounts payable of 14+deferred revenues of 71+other current liabilities of 722=807

Total liabilities=923

Float/operating assets=807/2,520=32.02%.  Float is supporting 32.02% of operating assets.

Pretax profits/total assets=ROA

  • 434.15/4,090=10.62%

Pretax profits/(total assets-float)=ROA

  • 434.15/3,283=13.22%

PARF Analysis

For this analysis I used PARFs 2011 full year numbers because of the extreme seasonality of its business and to get an idea of what the company may look like when its 2012 full year numbers come out in March.

Financial assets: Cash and cash equivalents=7,469+deferred income taxes of 235+ prepaid expenses of 295=7,999.

Operating assets: Accounts receivable of 2,579+inventories of 6,197+net property, plant, and equipment of 4,184+goodwill of 413+intangible assets of 566+other long term assets of 223=14,162.

  • Total assets=22,161

Liabilities:

  • Equity=19,734
  • Debt=313
  • Float=accounts payable of 359+taxes payable of 371+ccrued liabilities of 1,218+deferred tax liabilities of 166=2,114

Total liabilities=2,427

Float/operating assets=2,114/14,162=14.93%.  Float is supporting 14.93% of operating assets.

Pretax profits/total assets=ROA

  • 1,929.29/22,161=8.71%

Pretax profits/(total assets-float)=ROA

  • 1,929.29/20,047=9.62%

Float Thoughts

  • BABBs float is supporting more of the company’s operations than PARFs is.
  • Other than the directly above, the companies have pretty similar ROAs and amount of float and neither one a distinct advantage in this area.

Conclusion

Combining the above with the information in the previous two articles I have come to some conclusions and about the companies.  BABB has the better business model that leads to generally higher margins and minimal work for the company.  PARF has dominated its market for years, still does and it has found a small niche that has led to great profitability over the years.  Both companies have excessive executive pay in my opinion that if lowered could help each company’s operations become more profitable.  Both companies look like potentially good investment candidates right now so how have I decided which is the better one to buy into at the current time with the companies being very even overall?

With these two companies being so even overall, even in terms of overall undervaluation, how did I come to a conclusion about which company was the better buy now?

  1. BABB has a lot of competition in its industry, has been having to close restaurants, and has been losing its miniscule market share to other companies.  Meanwhile PARF has only a few minor competitors and dominates its industry with an estimated 80% share of its market.  Another major positive is that it dominates a very niche industry which should keep competition out of its market further cementing its hold on market share.
  2. PARF owns land, building, and property that are conservatively estimated to be worth about $10.40 per share and partially protects the company’s downside. BABB has no such downside protection and if it continues to lose franchisees shareholders are completely out of luck and could stand to lose all of their investment in the company.

So having stated this you would assume that I would no doubt be buying into PARF at this time right?  Normally you would be right to assume so but I have recently had an epiphany about investing and how that relates to my overall health, which has been horrid for the past four month or so, and I have now realized that I have to make changes to what I am doing or I will end up feeling horrible forever.  I did buy PARF and a not yet disclosed company for a couple of accounts I manage but not for myself and I will explain why in the coming days.

My next post I will be talking about the epiphany I had, what I plan to change in the short term to hopefully fix my horrible health of the last several months, the business my brother and I have started, and the investing book I am writing.

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Unico American Corporation $UNAM: A Company I Would Love To Own Outright

Introduction And History

When I first started out reading about Unico American Corporation $UNAM I was expecting to just use this as a learning experience since this is the first insurance company that I have truly evaluated.  I was planning on learning the important insurance industry terms, what they meant, how they affected the company in question, what the float was and how that affected the company’s operations, etc, and analyzing the company using all the knowledge I have gained lately from my recent foray into studying float and put those findings into an article.  I was not expecting to find what I did: A company that is undervalued by EVERY ONE of my estimates of value, a company that has been for a number of years very disciplined and conservative in its estimates, which I found are of utmost importance in the property and casualty insurance business, and a company that has had underwriting profits every year since 2004, which I found out is really hard to do.  If I had the capital available I would love to own this entire company and to build my investment firm with this company at the core, a la Warren Buffett with Berkshire Hathaway and its insurance companies.  However, unless someone out there would like to endow me with nearly $100 million I will just have to be happy buying shares in UNAM and watching my money compound into the future.

UNAM is a relatively small (Current market cap around $65 million) holding company whose main subsidiary, Crusader, is a property and casualty insurance company who writes insurance only in the state of California.  The vast majority of its operations (around 98%) are in commercial multi peril insurance writing.  UNAM also has some other subsidiaries that operate in various insurance related industries, but for this article I am only going to concentrate on Crusader and UNAM as a whole as its other subsidiaries contribute only fractionally to UNAM’s results.  UNAM used to write insurance in a number of other states but decided to concentrate only on California as it was generally losing money on its insurance operations in those other states.  UNAM is still licensed to write insurance in several other states so it may choose to expand back into those areas but at this time it appears to be content expanding throughout California.  The below quoted areas are from UNAM’s annual reports about the previous business in other states and why its management decided to stop those operations.

In 2002 the Company began to substantially reduce the offering of insurance outside of California primarily due to the unprofitability of that business.

In 2004 all business outside of California had ceased.  In 2002, primarily as a result of losses from liquor and premises liability coverage which had rendered much of the Company’s business outside of California unprofitable, the Company began placing moratoriums on non-California business on a state-by-state basis. By July 2003, the Company had placed moratoriums on all non-California business. The Company has no plan to expand into additional states or to expand its marketing channels. Instead, the company intends to allocate its resources toward improving its California business rates, rules, and forms.

The Company incurred underwriting losses in 2000, 2001, and 2002. As a result of these underwriting losses, management analyzed and acted upon various components of its underwriting activity. The Company believes that the implementation of these actions contributed to the improved underwriting results. This is reflected in the decrease in the Company’s ratio of losses and loss adjustment expenses to net earned premium from 139% in 2001, to 98% in 2002, to 85% in 2003, and to 69% in 2004.”

As you will see throughout the rest of this article, UNAM’s operations have changed drastically for the better since those decisions were made.

Overview Of Operations

Below are descriptions of UNAM’s insurance business taken from its annual reports.  Emphasis is mine.

The insurance company operation is conducted through Crusader. Crusader is a multiple line property and casualty insurance company that began transacting business on January 1, 1985. Since 2004, all Crusader business has been written in the state of California. During the year ended December 31, 2011, approximately 98% of Crusader’s business was commercial multiple peril policies. Commercial multiple peril  policies  provide  a  combination  of  property  and  liability  coverage  for  businesses.  Commercial property coverage insures against loss or damage to buildings, inventory and equipment from natural disasters, including hurricanes, windstorms, hail, water, explosions, severe winter weather, and other events such as theft and vandalism, fires, storms, and financial loss due to business interruption resulting from covered property damage. However, Crusader does not write earthquake coverage. Commercial liability coverage insures against third party liability from accidents occurring on the insured’s premises or arising out of its operation. In addition to commercial multiple peril policies, Crusader also writes separate policies to insure commercial property and commercial liability risks on a mono-line basis. Crusader is domiciled in California; and as of December 31, 2011, Crusader was licensed as an admitted insurance carrier in the states of Arizona, California, Nevada, Oregon, and Washington.

The property casualty insurance marketplace continues to be intensely competitive as more insurers are competing for the same customers. Many of Crusader’s competitors price their insurance at rates that the Company believes are inadequate to support an underwriting profit. While Crusader attempts to meet such competition with competitive prices, its emphasis is on service, promotion, and distribution. Crusader believes that rate adequacy is more important than premium growth and that underwriting profit (net earned premium less losses and loss adjustment expenses and policy acquisition costs) is its primary goal. Nonetheless, Crusader believes that it can grow its sales and profitability by continuing to focus upon three areas of its operations: (1) product development, (2) improved service to retail brokers, and (3) appointment of captive and independent retail agents.

The property and casualty insurance industry, P&C insurance, has been in what is considered a “soft market” since 2004.  UNAM has been disciplined enough during this “soft” insurance market of the past 8 years to achieve underwriting profits every year since 2004.  As I will detail later that feat has been very hard to come by for other P&C insurance companies and is extremely impressive.  The strict discipline to keep prices high enough to retain that underwriting profit has led to loss of business since 2004; net premiums written have dropped from $33 million in 2007 to just under $27 million in 2011.  All numbers throughout this article are in millions $US unless otherwise noted.

011513_1652_UNAMPremium1.png
011513_1657_UNAMLossand1.png
011513_0413_Underwritin1.png

The surplus ratio is supposed to be under 300% so UNAM is well underneath that.  The underwriting profit as a % of net premium has consistently been between 9%-20% since 2007.  Very impressive profit margins especially in comparison to some of the other insurance companies I researched and will talk about later who of underwriting losses.  The statutory capital and surplus numbers is the amount of extra money after all liabilities and assets have been properly calculated according to the accounting standards.  Generally the higher the better and the more money the company has to potentially invest and pay out claims with.  Dividends can be paid out of the surplus capital as well.

I estimated what its profit numbers are for the whole of 2012 and I estimate an underwriting profit of 4.92, net premiums written of 33.21 and underwriting profit as a % of net premium of 14.81%.  I did not include those in the above chart because those numbers are not official.

Last week I wrote about my conversation with Mr. Lester Aaron the CFO of the company and wrote my notes in this post.  After thinking about it some more and after further research I am glad that UNAM has taken the attitude it has to be extremely disciplined and conservative in its investments as those decisions have generally paid off as I will show below.  After looking at some of its competitors I also noticed that P&C insurance companies generally invest 5% and less of their investment funds in equities to be sure that they have funds on hand in case of a catastrophic insurance event so UNAM having no investments in equities does not appear to be as out of line with industry norms as I first thought.  However, I think that UNAM should invest its $2 million self imposed limit in equities to earn at least a somewhat better return than the about 1% it is earning now—If UNAM management is interested and listening I could send some ideas to them, companies that I think are good long term bets that are undervalued 🙂 — or at the very least get a bit more aggressive with buy backs and/or pay out more consistent special dividends with that money so that shareholders can put it to use.  Earning 1% on investments is pretty much useless over the long term so I hope management continues to do or starts doing some of the above things.  In the past several years UNAM has occasionally paid out special dividends and bought back some of its shares.

Float Analysis

Unico American Corporation $UNAM

  • Financial Assets: Total investment 124.84+cash 0.09+accrued investment income 0.27+premium and notes receivable 6.02+unpaid loss and loss adjustment expense 7.81+defered policy acquisition costs 3.93+deferred income taxes 1.84=144.8
  • Operating Assets: PP&E net 0.66+other assets 1.4=2.06
  • Total Assets=146.86

Liabilities

  • Equity of 75.23
  • Debt of 0
  • Float: Unpaid losses and loss adjustment expense 51.03+unearned premiums 16.6+advance premium and premium deposits 0.93+accrued expenses and other liabilities 3.1=71.66

Total liabilities are 71.66

Float/operating assets=71.66/2.06=34.79.  Float is supporting operating assets almost 35X.  Float is considered to be “free money” in this case because UNAM earns an underwriting profit and has since 2004.

Full year 2012 estimate of underwriting profit/total assets=ROA

  • 4.92/146.86=3.37%

Full year estimate of underwriting profit/ (total assets-float) =levered ROA

  • 4.92/75.2=6.54%

Competitors Info And Ratios And Comparison To UNAM

As I found out while researching other insurance companies to compare to UNAM, underwriting profit over a sustained period of years and the discipline to achieve that is very difficult.  I looked at around 5-7 other insurance companies combined ratios and underwriting profits and found that only a couple of them had underwriting profits for more than two out of the last five years, and generally their combined ratios got much worse in the last three years.  All of that makes UNAM’s sustained underwriting profits since 2004 all the more impressive.  Below are two of UNAM’s competitors that I compared it to and their ratios.

011513_0455_HallsRatios1.png

011513_0448_EIGsRatios1.png

Of particular note is the giant leap in both companies Loss and LAE and combined ratios since 2007.

Those numbers are generally much worse than UNAM’s ratios as you will see below.

011513_0429_UNAMLossExp1.png

UNAM’s ratios have generally either stayed the same or gotten better since 2007.  A drastic contrast to the other insurance companies I looked at, almost all of whose combined ratios have gotten worse since 2007.

Also of note are how the companies risk based capital ratio compares.

011513_0500_UNAMRiskBas1.png

Numbers are supposed to be over 200% or insurance regulators may sanction or even take over the company as the company is deemed to be under potentially serious financial risk if its ratio is below 200%.  Employer’s Holding’s $EIG does not state what its RBC ratio is and only says that it exceeds the minimum requirement.  I found that a lot of the other insurance companies I looked into also did not state what their RBC ratio was.  As you can see Hallmark Financial $HALL ratio has been under the minimum recommended 200% for a few years now.

I found out pretty quickly into my research that of paramount importance in the insurance industry is management discipline and conservatism.  UNAM’s management has shown an impressive amount of both and it has paid off as all of the company’s ratios have improved, sometimes substantially for the better as a lot of its competitors ratios are getting worse.

I found it very curious that pretty much all the insurance companies I looked at said that they were more primarily concerned with underwriting profits even if that meant that the number of premiums written declined.  The reason I found that curious is because almost all of those other companies had underwriting losses going back several years, sometimes while premiums written had been growing.  So in some cases the other companies managements are at worst outright lying to its shareholders or at best being disingenuous with their stated underwriting policy as it relates to profitability.  UNAM’s managements focus, discipline, and conservatism appears to be an amazingly exceptional outlier in comparison to the other P&C insurance companies I looked at in terms of producing consistent underwriting profits.

Other Things Of Note

  • Generally there aren’t any barriers of entry into the P&C insurance industry.  The main advantage a company can gain is to be the low cost operator, but that sometimes comes with an underwriting loss as well.
  • UNAM is a controlled company as Mr. Erwin Cheldin-former CEO, president, and chairman of the board of UNAM, Founder of UNAM, and father of Cary; Cary L. Cheldin-Chairman of the board, president, and CEO of UNAM, son of Erwin Cheldin; Lester A. Aaron-treasurer, director, and CFO of UNAM; and George C. Gilpatrick-director of UNAM, hold approximately 53.20% of the voting power of the Company and have agreed to vote the shares of common stock held by each of them so as to elect each of them to the Board of Directors and to vote on all other matters as they may agree.
  • Biglari Capital, run by activist investor Sardar Biglari who tries to emulate Warren Buffett, owns 9.48% of UNAM.  His fund has had recent discussions with UNAM.  Nothing to report yet but Mr. Biglari has already tried to buy an insurance company before.
  • Schwartz Value and Ave Marie Catholic Values combined own 8.51% of UNAM.
  • Dimensional Fund Advisors owns 8.73% of UNAM.
  • All of the above shareholders combine to own 79.92% of UNAM.  Combine that with various other funds that own smaller portions of UNAM and probably under 10%, less than 500,000 shares, of the company’s shares are truly outstanding.
  • Cary Cheldin and Lester Aaron, both of whom are executives of UNAM, are also on the company’s competition committee.
  • On September 29, 2003, the Company borrowed $1,000,000 from Erwin Cheldin, director and the Company’s principal shareholder, president and chief executive officer, and $500,000 from The Cary and Danielle Cheldin Family Trust. Very dedicated and committed shareholders and owners.
  • Book value per share has been rising.  The nine year average book value per share is $11.36 per share and currently UNAM’s TTM book value per share is $14.12 per share.  UNAM is currently selling for less than its book value per share.
  • Revenues have dropped every year since 2004 when the soft insurance market started from a high of 62 down to a present TTM of 33.
  • UNAM has a negative EV, TEV/EBIT, and EV/EBIT.
  • UNAM’s AM Best rating is A- which is deemed excellent.  The AM Best rating is a measure of financial strength.
  • UNAM has four reinsurers all of whom have AM Best ratings of A of higher.
  • UNAM looks to be properly covered if a catastrophic insurance event happens as it carries a substantial amount of short term investments, currently worth more than its entire current market cap, it has substantial statutory capital and surplus, also currently worth more than its current market cap, and adequate reinsurance.

Valuations

These valuations were done by me, using my estimates and are not a recommendation to buy stock in any of the companies mentioned. Do your own homework.

Valuations were done using UNAM’s 2011 10K and 2012 third quarter 10Q. All numbers are in millions of US$, except per share information, unless otherwise noted.

Absolute Minimum Valuation

This valuation is expecting 1% interest rates for the long term and no growth in float over time.

  • (float X 10%) + Equity=estimated value/number of shares.
  • (71.66 X 10%) +75.23=82.40/5.3=$15.55 per share.

Base Valuation

  • Float + Equity=estimated value/number of shares.
  • 71.66+75.23=146.89/5.3=$27.72 per share.

High Valuation

Assets: Book Value: Reproduction Value:
Fixed Maturity Securities

47

40

Short Term Investments

78

78

Premiums and Other Receivables

6

3

Deferred Policy Acquisition

4

2

Deferred Income Taxes

2

1

PP&E Net

1

0

Other Assets

9

4

Total Assets

147

128

Number of shares are 5.3

Reproduction Value

  • 128/5.3=$24.15 per share.

This valuation does not take into account any of UNAM’s float at all.  Add float onto that asset reproduction value gets us to:

  • 128+71.66=199.66/5.3=$37.67 per share.

Valuation Thoughts

  • Current share price is $12.25 per share.
  • UNAM appears to be massively undervalued.  There is a 22% margin of safety to my absolute minimum estimate of intrinsic value.  I actually think UNAM’s true intrinsic value is somewhere in the $25-$35 range which would either be a double or triple from today’s prices.  These estimates of value do not even count the companies potential future growth in float, premiums, and investable money over time.  My estimates of value also do not count on the insurance industry as a whole improving either, which will happen eventually.
  • UNAM’s downside is at least somewhat protected by its investments as well as it is currently selling for less than just the value of its short term investments, which mostly consist of cash, cash equivalents, and CDs.  Current per share value of short term investment is $14.72 per share.
  • I also found UNAM to be undervalued with every one of my other valuations.
  • UNAM is selling for less than just what its float is worth per share at book value, $13.52 per share.
  • UNAM is selling for less than the per share value of just its net assets after subtracting all liabilities including float, $14.15 per share.

Pros

  • UNAM is undervalued by every one of my estimates of intrinsic value.  As an example, UNAM’s per share price is lower now than the per share value of JUST its short term investments.
  • UNAM’s management looks to be very disciplined and conservative, which I found is of absolute importance in the insurance industry.
  • Sardar Biglari, an activist investor, has recently bought just fewer than 10% of UNAM and may look to buy it outright as Mr. Biglari has already tried to buy an insurance company before.  At the very least he could try to help unlock some of the value of UNAM’s shares by working with management and has already had contact with UNAM management.
  • UNAM has a negative enterprise value.  This article from Greenbackd explains why that can be a good thing for shareholders as a negative enterprise value can mean a value dislocation.
  • UNAM has earned an underwriting profit every year since 2004.  More impressive is that 2004 started a soft market in the insurance industry which generally means it is harder to earn an underwriting profit.
  • Even though UNAM is only earning 1% on its investments currently, UNAM still should have enough funds on hand to pay claims if a catastrophic insurance event happens as its surplus and statutory capital has grown substantially in recent years.  UNAM actually has more in just statutory capital and surplus than its current total market cap.  UNAM also has more in short term investments than its current entire market cap and it also looks to be adequately reinsured.
  • Book value per share has been rising in recent years.
  • UNAM’s management seems to be dedicated to the company as the current CEO and his wife loaned the company money in 2003 when it was having some problems.
  • Although UNAM’s CEO and CFO are on its compensation committee, their pay seems to be fair to me.
  • The former CEO, former president and founder, current CEO and president, and CFO own substantial portions of UNAM.
  • In recent years UNAM has bought back some of its shares and paid special dividends on occasion because “We think that the shareholders can put the dividends to better use than I think that we can currently in the market.”  Very shareholder friendly.
  • My entire conversation that I had with Mr. Aaron that I linked to above gave me confidence in management and laid some of my concerns to rest.
  • All of UNAM’s risk and insurance industry related ratios are far in excess of what they need to be and far better than its competitors that I looked at.
  • UNAM’s float should be considered as free money and looked at as kind of a revolving fund since it earns, and has earned since 2004, underwriting profits.
  • UNAM has no debt.  Some of the other insurance companies I looked at had to take on debt just to keep their operations out of regulators hands in recent years.

Cons

  • Revenue and premiums written have generally dropped every year since 2004.
  • UNAM is currently only earning 1% on its investments.  This could mean that if a catastrophic insurance event happens in the future that UNAM may not have enough money to pay claims.
  • UNAM may be too conservative with the investments it owns and the company seems to have a lot of excess capital not being utilized at all currently.
  • The current CEO and CFO are on UNAM’s compensation committee.
  • Some would say that UNAM’s special dividends in recent years are just being paid to further pay the insiders of the company who own large portions of the company.

Catalysts

  • Mr. Biglari could try to influence UNAM’s management to help unlock some of the value of its shares, or buy the company outright as Mr. Biglari has already tried to buy an insurance company before.
  • An improvement in the overall insurance industry could help unlock the value of UNAM.
  • A catastrophic insurance event in California would harm UNAM’s results.

Conclusion

This experience of learning about float over the last month or so has been an amazingly rewarding experience. As a relatively new investor I am always looking for opportunities to learn new things and expand my circle of competence and I think that I will look back years from now and see that this time period of my value investing journey was a turning point in getting me closer to my ultimate goals of opening up my own investment firm.  As icing on the cake I also ended up finding another company to invest in as UNAM is a company that is undervalued by every one of my estimates of intrinsic value, has potential catalysts in place to help unlock value, has had underwriting profits since 2004, and has very focused, disciplined, and conservative management.  For all of the reasons I list above, UNAM is a company that I would like to own all of and build my investment firm around.

Update as I was getting ready to publish the article.

After I finished up writing the article at the end of last week I started reading The Davis Dynasty and realized I had a lot more I needed to learn about the insurance industry as a whole before being comfortable enough with my knowledge to make the decision to buy into UNAM.  At this point I do not think that I have enough overall insurance industry knowledge to be able to make a definitive buy or sell decision so for now I am going to continue to learn about the insurance industry and when I feel I have enough knowledge, at that point I will make a definitive buy or sell decision about UNAM.

Hopefully UNAM’s shares do not pop before I gain more knowledge as they are by far the best insurance company I have found up to this point but I do not want to repeat some of the mistakes I made in the past and buy something before I fully understand the business and industry.

Brazil Fast Food Company Is Substantially Undervalued and Has A Moat

In this article I will be talking about Brazil Fast Food Company (BOBS.OB).  Bob’s was founded in 1952 by American tennis player Bob Falkenberg and serves hamburgers and sandwiches with a Brazilian twist, shakes, French fries, and other typical fast food offerings.  BOBS has grown to become the second biggest fast food chain in Brazil with operations in every state of the country, Angola, and Chile.

When I talk about BOBS in all capital letters I mean the company as a whole.  When I refer to Bob’s it means just the fast food burger chain.

A fellow value investor mentioned on my blog that I should research BOBS as a possible investment since I have already researched and written articles on a couple fast food companies; Jack In The Box (JACK) and Wendy’s (WEN).  Also with my recent turn towards concentrating on micro caps he thought I might find this company interesting.

I have found BOBS to be very interesting and it has turned into only the fifth company I have bought into this year as it meets most of my criteria for things I look for in a potential investment.  Some main points of interest are: I have found BOBS to be substantially undervalued, I believe BOBS to have a competitive advantage, or moat that has been growing in the past several years, the company is very small and under followed, and its sales and margins have also been growing in recent years.

Introduction

For the better part of the last 60 years Brazil Fast Food has been operating and franchising only its Bob’s fast food burger chain and expanding the chains reach throughout Brazil.  Here is a history of BOBS up to 2004 that goes over its many struggles and near death multiple times. Very interesting read especially when you consider what they have become now.  After updating its stores, changing the Bob’s logo, enacting cost cutting and efficiency measures, and changing its strategy to become a multi-brand restaurant company with partnerships to bring KFC and Pizza Hut restaurants to Brazil, and through acquiring Doggi’s and Yoggi’s, BOBS has expanded its restaurant count dramatically and expanded from just selling burgers, sandwiches, shakes, and fries, into selling KFC’s chicken related products, pizza’s, hot dogs, frozen yogurt and smoothies to become the second largest fast food chain in Brazil.

As we found out in my Wendy’s article, growth is not always a good thing if your cost of capital is very high due to debt and other costs.  Luckily, BOBS debt is at a very manageable level and BOBS has been lowering its costs over the last few years.  The growth in the amount and type of products along with the growing restaurant count has helped grow revenues and margins at pretty substantial percentages over the last several years.  Most importantly of all, I believe BOBS is growing at less than its cost of capital because as it has grown its store count and sales it has become more profitable.

Also helping to grow BOBS as a whole is that I believe that it has at least some minor competitive advantages which it has had for a while now but has only recently been fully unleashed due to BOBS growing scale as it pertains to its growing number of restaurants, and its cost cutting and efficiency measures over the last several years.  At this point I cannot say for certain whether the small moat I see for BOBS is sustainable for the long term, but this is the first company I have evaluated in a while where I see some kind of very clear moat.

Overview of Operations and Subsidiaries

Before 2007, Brazil Fast Food Company just comprised of Bob’s burger chain which I described above.  In 2007 BOBS as a whole started on its path towards becoming a multi-brand restaurant operation as it agreed with Yum Brands (YUM) to open KFC restaurants in Brazil.  In 2009 BOBS further expanded to include operating some Pizza Hut’s in Brazil and it also acquired Doggi’s hot dog chain.  In 2012 BOBS further expanded as it acquired Yoggi’s frozen yogurt and smoothie company.  Since its beginnings as a regional company in Brazil with the bulk of its operations in the Southeastern portion of the country, BOBS has grown into the second biggest fast food chain in Brazil behind only McDonald’s (MCD) with operations in every state in Brazil.  BOBS has also started to grow outside of Brazil as it now has operations in Chile and Angola.  Below is a chart showing how BOBS has grown its restaurant count since 2007.

122112_0045_NumberofRes1.png

Restaurant count has grown by 7% annually since 2007.  Its growing size and now countrywide operations have enabled BOBS to sign some very favorable agreements with suppliers.  Here are some direct quotes from BOBS 3Q 2012 10Q about the favorable relationship with its trade partners.  Emphasis is mine.

“We enter into agreements with beverage and food suppliers and for each product, we negotiate a monthly performance bonus which will depend on the product sales volume to our chains (including both own-operated and franchise operated). The performance bonus can be paid monthly or in advance (which are estimated), depending on the agreement terms negotiated with each supplier. The performance bonus is recognized as a credit in our Consolidated Statements of Operations (under “Revenues from Trade Partners”). Such revenue is recorded when cash from vendors is received, since it is difficult to estimate the receivable amount and significant doubts about its collectability exists until the vendor agrees with the exact bonus amounts.”

‘The rise in the number of franchisees, from 774 on September 30, 2011 to 916 on September 30, 2012, together with the expansion of the multi-brand concept, has given the Company’s management greater bargaining power with its suppliers. Such increase of point sales did not derived an increase on Revenue from Trade Partners from 2011 to 2012, because the Company had agreements with new trade partners during 2011 and 2010 which originated bonus paid in advance. The bonus recorded during 2012 was from the regular business since no further advances were received during 2012.”

BOBS also has several exclusivity agreements including with Coca-Cola (KO).

“We participate in long-term exclusivity agreements with Coca-Cola, for its soft-drink products, Ambev, the biggest Brazilian brewery company, Farm Frites, the Argentinean producer of French fries, and Sadia, one of the biggest meat processors in Brazil, as well as with Novartis Nutrition for its Ovomaltine chocolate. These agreements are extensive from four to five years. The Coca-Cola agreement was amended in 2008 to extend the exclusivity period to April 2013.”

“Amounts received from the Coca-Cola exclusivity agreements (see note 12) as well as amounts received from other suppliers linked to exclusivity agreements are recorded as deferred income and are being recognized on a straight line basis over the term of such agreements or the related supply agreement. The Company accounts for other supplier exclusivity fees on a straight-line basis over the related supply agreement. The Coca-Cola agreement was amended in 2000 to extend the exclusivity period to 2008.  Later amended and extended until April, 2013. Performance bonuses may also include exclusivity agreements, which are normally paid in advance by suppliers.”

Due to its growing size and economies of scale BOBS has gained a competitive advantage over competitors by being able to receive “bonus payments” in advance from some of its suppliers.  Its size and scale has enabled the company to sign these preferential and exclusive agreements, which have helped expand BOBS competitive position and moat in my opinion.  Another reason I think BOBS has at least a minor moat is because it has been able to raise prices in recent years without losing sales which has helped to raise margins.

BOBS has had these preferential agreements in place for years, and hopefully will be able to continue them for years to come.

Due to BOBS growing store count, the agreements above, and the moat that I think it has, BOBS has been able to improve its sales, reduce its costs, and improve margins in recent years.  Numbers in below charts are taken from Morningstar or BOBS filings.

122012_0603_BOBSRevenue1.png

122112_0359_BOBSCOGSand1.png

122012_1741_BOBSMargins1.png

As you can see in the above charts as BOBS restaurant count has grown, it sales have gone up, costs have gone down, and margins have gone up, substantially so since 2008.  As BOBS continues to grow the same three things should continue to happen as BOBS should continue to compound its economies of scale: More restaurants means more sales, more restaurants means more compact grouping of restaurants which means lower costs and higher margins.  It seems that BOBS has taken some lessons on how to cultivate and grow competitive advantages from companies such as Wal-Mart (WMT).

Margins

All numbers are taken from Morningstar, Yahoo Finance, or BOBS financial reports unless otherwise noted.

Gross Margin TTM

28.00%

Gross Margin 5 Year Average

24.12%

Gross Margin 10 Year Average

24.53%

Op Margin TTM

8.43%

Op Margin 5 Year Average

7.26%

Op Margin 10 Year Average

5.39%

ROE TTM

31.64%

ROE 5 Year Average

31.35%

ROIC TTM

23.76%

ROIC 5 Year Average

21.43%

My ROIC Calculation With Goodwill

45.10%

My ROIC Calculation Without Goodwill

48.30%

My ROIC TTM With Goodwill Using Total Obligations

15.56%

My ROIC TTM Without Goodwill Using Total Obligations

15.25%

FCF/Sales TTM

-3.54%

FCF/Sales 5 Year Average

-1.43%

FCF/Sales 10 Year Average

-1.39%

P/B Current             2.5
Insider Ownership Current

70.36%

My EV/EBIT Current

2.72

My TEV/EBIT Current

6.75

Working Capital TTM      22 $R Million
Working Capital 5 Yr Avg     0.4 $R Million
Working Capital 10 Yr Avg    -3.1 $R Million
Book Value Per Share Current

$3.17

Book Value Per Share 5 Yr Avg

$1.89

Float Score Current

0.88

Float Intensity

0.6

Debt Comparisons:
Total Debt as a % of Balance Sheet TTM

16.78%

Total Debt as a % of Balance Sheet 5 year Average

16.40%

Current Assets to Current Liabilities

1.56

Total Debt to Equity

1.71

Total Debt to Total Assets

72%

Total Obligations and Debt/EBIT

4.36

Margin Thoughts

Please reference my Wendy’s or Jack in the Box articles linked above to see how BOBS compares to the other fast food companies.  TEV/EBIT and last three debt numbers talked about also include total obligations.

  • Almost across the board BOBS margins have been improving over the 5 and 10 year periods I looked at.  Especially impressive are its ROE and ROIC.
  • In comparison to the other fast food companies I have evaluated, BOBS margins are at worst about at the industry average or better than those companies.
  • My estimates of ROIC make the company look absolutely exceptional as I estimate that without total obligations its ROIC is 45.1% with goodwill, and 48.3% without goodwill.  Even if I count total obligations its ROIC with goodwill is 15.25%, and without goodwill is 15.56%.  Numbers that are close to McDonald’s ROIC.
  • Even if we just count BOBS 5 years average ROIC using Morningstar’s numbers of 21.43%, which is what I used when I evaluated the other fast food companies, its margin is 6.35% points better than the industry average, and better than McDonald’s by 4.05% points.  Its ROIC is only bested by Yum Brands ROIC which is inflated by debt unlike BOBS.
  • FCF/Sales for BOBS is worse than the industry average by 8.78% points and regularly negative over the past several years, and still negative this year.
  • I think that its FCF/Sales margin is negative due to cap ex related to renovating and updating some of its restaurants.
  • BOBS P/B is lower than the other fast food companies by a substantial margin.  The only company with a lower P/B is Wendy’s which as I talked about in my article on them, should be higher.
  • Insider ownership above 70% for BOBS is fantastic, especially in comparison to the other fast food companies.  BOBS is effectively a controlled family run company as four individuals own a combined 63.2% of BOBS as of the 2011 annual report: Ricardo Figueiredo Bomeny; the CEO and CFO of BOBS.  Jose Ricardo Bosquet Bomeny; father of Ricardo and brother of Gustavo, business partner with Romulo and owns 20 of BOBS franchised restaurants.  Romulo Borges Fonseca; owns 22 of BOBS franchised restaurants and business partner with Jose.  Gustavo Figueiredo Bomeny; brother of Jose and uncle of Ricardo.
  • I am estimating BOBS EV/EBIT to be only 2.72 and it’s TEV/EBIT to be only 6.75.  BOBS EV/EBIT is lower than any company I have evaluated thus far and it is lower than the other fast food companies I have evaluated whose EV/EBIT average including Wendy’s is 20.12.  As I have stated before, I like to buy companies that have EV/EBIT and TEV/EBIT ratios lower than 8 so BOBS on a relative basis looks very cheap, especially when you consider it’s very high ROE and ROIC and other margins that have been growing.
  • Book value has been growing and BOBS debt levels look very sustainable to me.

Due to the sales and margin growth mentioned above, working capital has gone from negative for the better part of the past decade to now being solidly positive, BOBS accumulated deficit has almost disappeared and shareholders equity has improved drastically, all of which can be seen in the chart below.

122012_0555_WCSEandAD1.png

Other Things Of Note

  • BOBS intends to focus its efforts on expanding both the number of its franchisees and the number of its franchised retail outlets, neither of which are expected to require significant capital expenditure. In addition, the expansion will provide income derived from initial fees charged on new franchised locations.
  • BOBS franchise agreements generally require the franchisee of a traditional Bob’s burger restaurant to pay us an initial fee of $R 60,000, which is lower for kiosks and small stores, and additional monthly royalties fees equal to 5.0% of the franchisee’s gross sales.  Bob’s fast food burger restaurants make up the vast majority of total restaurants in BOBS system.
  • Lowered franchise fee in recent years from $R 90,000 to $R 60,000 to help attract more franchisees.
  • BOBS has bought back shares recently and is authorized to buy back more shares.  I think management has bought back shares at reasonable prices and I think now would be a good time to buy back even more shares.  On December 5th, 2012 Mr. Romulo Borges Fonseca bought an additional 30,500 shares in the open market.  I love to see buys from insiders who acquire their shares in the open market.  Insiders generally only buy for a couple reasons: They think the company is undervalued, and/or that the company is going to perform well into the future.
  • Operating margin for franchises used to be over 80%.  Recently it has dropped into the mid 60% range and it seems to have stabilized in that area.  It looks like the drop in franchise operating margin is due to franchise related costs rising.
  • BOBS has been an OTC listed company for years, and this year it deregistered its shares with the SEC to save money every year, approximately $300,000.  BOBS management says that it will continue to provide quarterly and annual reports to shareholders and that it will retain its reporting standards at the level they are at now.  BOBS management has been in place for nearly 20 years so these things do not bother me that much as management has done a good job running the company over the years.
  • There are only 51 current shareholders of BOBS stock so the company is very under followed.
  • BOBS has substantial tax loss carry forwards NOL’s: As of December 31, 2011 relating to income tax were R$31.6 million, $1.88 per share, and to social contribution tax were R$57.6 million, $3.42 per share.  Social contribution tax is similar to the corporate tax here in the US.
  • Due to its small size with a market cap around $65 million, only 51 shareholders, and it being a controlled company with 70% of BOBS owned by insiders and/or affiliates of the company, average daily volume is only 2,000 shares, and in the past two weeks about half of the days the market has been open there have been no shares traded.
  • Same store sales have been rising in the 4% range every year since 2007.

Intrinsic Valuations

These valuations were done by me, using my estimates and are not a recommendation to buy stock in any of the companies mentioned. Do your own homework.

Valuations were done using BOBS 2011 10K and 2012 third quarter 10Q. All numbers are in millions of Brazilian Real, except per share information, unless otherwise noted.

Low Estimate of Intrinsic Value

Numbers:
Revenue:

237

Multiplied By:
Average 5 year EBIT %:

7.26%

Equals:
Estimated EBIT of:

16.99

Multiplied By:
Assumed Fair Value Multiple of EBIT:                  8X
Equals:
Estimated Fair Enterprise Value of STRT:

135.92

Plus:
Cash, Cash Equivalents, and Short Term Investments:

28.4

Minus:
Total Debt:

21

Equals:
Estimated Fair Value of Common Equity:

143.32

Divided By:
Number of Shares:

8.1

Equals: 17.69 R$ per share.
Equals: $8.48 per share.

Base and High Estimate of Intrinsic Value

EBIT and net cash valuation

Cash and cash equivalents are 28.4

Short term investments are 0

Total current liabilities are 38.7

Number of shares are 8.1

Cash and cash equivalents + short-term investments – total current liabilities=

  • 28.4-38.7=-10.3/8.1=-1.27 R$ per share=-$0.61 per in net cash per share.

BOBS has a trailing twelve month EBIT of.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:

  • 5X21.2=106+28.4=134.4/8.1=16.59 R$ per share=$7.93 per share.
  • 8X21.2=169.6+28.4=198/8.1=24.44 R$ per share=$11.69 per share.
  • 11X21.2=233.2+28.4=261.6/8.1=32.30 R$ per share=$15.45 per share.
  • 14X21.2=296.8+28.4=325.2/8.1=40.15 R$ per share=$19.20 per share.

From this valuation I would use the 8X and 11X estimates of intrinsic value as my base and high estimates of intrinsic value respectively.  None of the above valuations takes into account BOBS $5.30 per share worth of NOL’s or BOBS future growth.

Relative Valuations

  • As I said above, I like to buy companies whose EV/EBIT and TEV/EBIT ratios are lower than 8 and BOBS ratios are at 2.72 and 6.75 respectively.  BOBS EV/EBIT ratio is the lowest I have found out of the companies that I have done full evaluations on.
  • Its P/B ratio is also quite a bit lower than other fast food companies.
  • BOBS P/E ratio of 9.1 is less than half of the industry P/E of 19.8.

I found BOBS to be cheap on an intrinsic value basis and it also looks to be equally cheap on a relative valuation basis.  On an EV/EBIT basis, BOBS is the lowest valued company I have fully analyzed which is a bit shocking considering its high ROIC and other margins, and the moat that I think it has.

Competitors

  • McDonald’s (MCD): The number one fast food chain in Brazil and fast food behemoth around the world always provides stiff competition to smaller companies.  Here is some information on Arcos Dorados (ARCO)the largest operator of McDonald’s restaurants in Latin America and the world’s largest McDonald’s franchisee.  As of its 2011 10K it had 662 McDonald’s restaurants in Brazil.  Arcos Dorados’ margins are quite a bit worse than BOBS margins.  Overall McDonald’s has more than 1,000 restaurants in Brazil.
  • Giraffas: A private company with around 400 restaurants most of which are in Brazil, it has recently started opening restaurants in South Florida.  Serves similar food as Bobs burger chain.
  • Yogoberry: Another private company who has more than 100 restaurants in Brazil.  Will be competing with BOBS latest acquisition Yoggi’s in the frozen yogurt and smoothie arena.
  • Various other fast food offerings including from Japanese, Middle Eastern, and other typical fast food restaurants.

The fast food service industry is very competitive in Brazil as it is here in the US with peoples income being sought after by a plethora of restaurants and fast food companies.  I think the major threat is of course McDonald’s as BOBS other local competitors are generally quite a bit smaller than it.  I think that due to the moat I see within BOBS, along with its growing size, and expansion into pizza, frozen yogurt, and chicken, that it can compete very well with the competition it has in Brazil, and continue to grow its store count profitably.

Pros

  • BOBS is cheap on an intrinsic value and relative value basis.
  • I think BOBS has a small and growing moat that should continue to grow as BOBS restaurant count gets bigger.
  • BOBS margins generally have been growing over the past five years.  In some cases by multiple percentage points.  Some of BOBS margins are even better than McDonald’s and quite a bit better than Arcos Dorados’ run McDonald’s restaurants in Latin America.
  • BOBS has signed exclusivity agreements with several companies including Coke, and also enjoys preferential agreements with its suppliers.
  • BOBS has $5.30 per share worth of NOL’s that are not even counted in any of my valuations.
  • BOBS has a low and sustainable amount of debt.
  • Its book value per share has been growing.
  • BOBS has almost eliminated its accumulated deficit, made its working capital positive after it being negative for most of the last decade, and substantially increased shareholders equity.
  • COGS and total restaurants costs and expenses as percentages of sales have been lowered by multiple percentage points in recent years.
  • The company is effectively controlled by four individuals who have thus far done a very good job of running the company.
  • BOBS has bought back some shares and has the authorization to buy back more shares.
  • BOBS can grow its restaurants through franchisees at minimal cap ex expenses.  Franchise operating margin has been in the mid 60% range recently.
  • Brazil has a growing middle class that should help grow sales further.

Cons

  • Although I think BOBS has a small and growing moat, it may not be a long term sustainable competitive advantage due to competition and possible loss of exclusivity and preferential trade partner agreements.
  • BOBS does not create consistent positive FCF.
  • BOBS FCF/Sales margin is below the average of the other fast food companies I have evaluated and it is also negative.
  • Franchise operating margin has dropped from over 80% to the mid 60% range in recent years.
  • Stiff competition including McDonald’s in Brazil.

Potential Catalysts

  • Confederations Cup in 2013, FIFA World Cup in 2014, and the Olympics in 2016, all of which are in Brazil, will bring millions of tourists to Brazil which should help grow BOBS revenues further in the short and medium term.
  • BOBS growing franchise store count will help grow BOBS moat as margins are very high and cap ex is very low when opening new franchised restaurants.
  • BOBS moat may not be sustainable over the long term due to competition and possible loss of exclusivity and preferential trade partner agreements which would most likely hurt the company.
  • Brazil’s growing middle class should also help grow sales.

Conclusion

Brazil Fast Food Company, BOBS, has turned out to be a very interesting company to me. From its near death experiences in the mid 90’s and early 2000’s, to now being the number two fast food chain in Brazil, its growing store count and margins, and the various other things I have talked about in this article I have come away very impressed with BOBS as a whole and its management.

I think that BOBS is very undervalued on an intrinsic value and relative value basis and I think that it should conservatively be valued somewhere between $11.50 and $16.00 per share, not including the $5.30 per share in NOL’s that it currently has.  Adding the NOL’s to my estimates of value would take its estimated value up to between $16.50-$22 per share which is the range that I think BOBS should be selling at, and what I think its private market value is.  Even leaving the NOL’s out of the equation, BOBS is selling currently at only $8 per share which is a 32% discount to the absolute minimum I think BOBS is worth at $11.50 per share.  I think that BOBS has a moat that could possibly grow over time, and that the company has catalysts in the short and medium term that could help unlock some of its value.

Warren Buffett always says that if you buy good companies that have some kind of moat at fair prices, that you will do very well investing over the years.  I think BOBS is a good company with a moat that is currently selling at a very cheap price and I think I will do very well holding it over the years as I have bought its shares in my personal account and the accounts I manage.

A Portfolio Update And Two Powerful Insights Every Serious Investor Should Read

Portfolio Update

Yesterday I made some adjustments to my portfolio and the portfolios I manage and I just wanted to update those positions.

Personal Portfolio and Portfolios I Manage:

  • Bought Strattec Security Corporation $STRT

Personal Portfolio:

  • Sold Altria $MO up 18%.
  • Sold Philip Morris $PM up 24%.
  • Sold Intel $INTC up < 1%, could have sold a while ago up 30%, doh!

All sold positions are after fees but before taxes.  I never bought any of the above three positions for the portfolios I manage and I bought Altria, Philip Morris, and Intel before doing any kind of valuations or any kind of in depth research so I am a bit fortunate to end up anything in those positions.

I said a couple months ago that I planned to hold the above positions for the foreseeable future because I felt that I could have my results compound well over time in all of the three companies.  I still think that is true for all of the above companies but have still decided to sell them all.  Lately I have been gaining confidence in my abilities to analyze companies, and I now think that I am at the point where I am getting pretty good at analyzing companies and think I can find better opportunities in the smaller mid to nano caps that I am concentrating on now.

Also as Red reminded me of the other day, why would I try to compete with the millions of people who are invested in and analyze those massive companies when I can find less competition, potentially less efficiency, and more upside, in the much smaller companies.

After selling those companies to free up cash for future opportunities, my current portfolio stands as follows, ranked by position size.  Portfolio does not add up to 100% because of rounding:

  1. $VIVHY.PK-28% of portfolio.
  2. Cash-26% of portfolio.
  3. $STRT-16% of portfolio.
  4. $MAIN-11% of portfolio.
  5. $CMT-8% of portfolio.
  6. $DOLE-8% of portfolio.

Two Powerful Insights Every Serious Investor Should Learn From and Reread.

Fundoo Professor-Presentation On Moats And Floats.

The Red Corner Blog-Kfaftwerk; A look at economies of scale and how Wal-Mart changed its industry and made a ton of money.

I hope you enjoy the above links as much as I have.

I have already started researching another company and tomorrow I will post some links and ask your advice on something I have been thinking about quite a bit lately.

Strattec Security Corporation $STRT: Potential Double From Today’s Stock Price

Introduction, Overview of Operations, And Brief History

The company I will be focusing on in this article is Strattec Security Corporation (STRT).  Strattec is a nano cap with a current market cap around $75 million and it is in the very boring and shunned automotive parts industry.  The company has expanded to become a worldwide auto parts supplier through its various joint ventures and alliances.

The company makes and sells various automotive parts such as: Keys with radio frequency identification technology, bladeless electronic keys, ignition lock housings, trunk latches, lift gate latches, tailgate latches, hood latches, and side door latches.  With its acquisition of Delphi Corporation’s Power Products in 2009 it is now also supplying power access devices for sliding side doors, lift gates and trunk lids.

In 2001 Strattec formed an alliance with Witte-Velbert Gmbh.  The alliance allowed Strattec to sell Witte’s products in the US, and allowed Witte to sell Strattec’s products in Europe.  In 2006 the alliance expanded to include ADAC plastics and a joint venture with all three companies owning 33% was formed called VAST or Vehicle Access Systems Technology.  ADAC makes such products as door handles.  The VAST Alliance has helped Strattec become a worldwide auto parts supplier as the alliance allows all companies involved to market and sell each other’s products in various jurisdictions around the world including in the US, Europe, Brazil, China, Japan, and Korea.  The VAST Alliance should have its first profitable year as a company this year which would help Strattec’s bottom line.  Full complement of VAST’s products can be viewed here.

VastPlacemat

Picture taken from ADAC Plastics which shows how the VAST Alliance is structured.

ADAC and Strattec have formed a separate company, ADAC-Strattec de Mexico, ASdM,  whose operations are in Mexico due to cheaper labor prices, where the two companies separate expertise are combined to manufacture some of the above products for sale. In Strattec’s fiscal years ending 2012 and 2011, ASdM was profitable and represented $31.0 and $25.2 million, respectively of Strattec’s consolidated net sales.

With the help of VAST and its other joint ventures, Strattec’s export sales have risen to 37% of total sales which amounts to $107 million.  In 2001 exports only accounted for 14% of its sales which amounted to $29 million, which illustrates Strattec’s worldwide growth since then.

During the recession three of Strattec’s biggest buyers filed for bankruptcy protection, and the overall auto industry went to the brink of death before being saved by the US federal government.  Because Strattec’s major buyers were having so many problems, it also faced some very serious problems and had its only unprofitable year in 2009, lost more than $40 per share in value during the recession, about 2/3’s of its share price in total, and its share price has not recovered since.

Since that time Strattec restructured, improved its operations and expanded its product lines, signed various joint venture and alliance agreements which have allowed the company to become a worldwide auto parts supplier.  The restructuring, expanded product lines, and worldwide operations have helped Strattec become a more diversified auto parts manufacturer and has grown its sales and margins in the ensuing years.  With the help of VAST and its other joint ventures Strattec is a truly worldwide company with operations now in the US, Europe, Brazil, China, Japan, Korea, Canada and Mexico.

Strattec was spun off from Briggs & Stratton in 1995 as an independent company.  After Strattec was spun off from Briggs & Stratton, and through most of its entire history, it enjoyed massive market share of over 60% in the US and a 20% market share of the world’s vehicle lock and key operations.  With its huge hold of the market the company was able to dictate high prices to its buyers which enabled the company to enjoy a competitive advantage for a long period of time.

However, shortly after Strattec was spun off there were massive changes in the lock and key industry which deteriorated the company’s market share and competitive advantages. Due to Strattec’s managements excellent foresight and planning, it was well prepared for the change from basic locks and keys and the diminishing of the amount of locks and keys needed per vehicle, and has transitioned into the electronic key arena as well as expanding its operations into various fields though its partnerships with the VAST Alliance including: Door handles, power doors, trunk latches, lift gate latches, tailgate latches, hood latches, side door latches, ignition lock housings, sliding side doors, lift gates and trunk lids.  Since Strattec’s restructuring during the Great Recession, along with its VAST Alliance and other joint ventures, improved operations, and expanded product lines, Strattec’s sales and margins have both been growing and improving.  The trend of growing sales and margins should continue unless another recession hits.

Excellent Management

Due to the excellent leadership of Harold Stratton II, former CEO and current chairman, current CEO and board member Frank Karecji, and the other members of Strattec’s management team and board of directors, it has been able to adjust its original lock and key operations and changed massively to become a truly worldwide auto parts supplier with the products listed above.

Normally I do not talk much about management in my articles because I usually deem management to be either average or subpar, and as Charlie Munger says I want the business to be simple enough to be able to be run by the proverbial “idiot nephew” so management is generally not a factor in my analysis unless they are doing things that bother me quite a bit.

In this case I wanted to point out that I believe Strattec’s management to be excellent and I think that will continue now that Mr. Stratton has transitioned out of the day to day operations and handed the handling of those over to Mr. Karecji.  For the full view of why I believe Strattec’s management to be excellent I recommend reading its annual reports from 1999 to the present to get the true view of why I think its management has been fantastic, and to get a glimpse of the obstacles management has helped the company overcome to become an even stronger company.  Here is a profile of Mr. Karecji, Strattec’s new CEO from 2010 right after he joined the company.

For those who do not want to read all that information I will list a few pluses from management in recent years that I have not already talked about.

  • Strattec has bought back and reduced its shares outstanding by 3.66 million, or more than 50% of its original shares outstanding after being spun off, at a cost of approximately $136 million.
  • Most purchases have been at what I think are good prices to do buy backs.  I think now would be an even better time to buy back more shares (Strattec management has authorization to buy back more shares) because of Strattec’s current undervaluation which I will get to later, but I understand that it wants to put money into expanding its operations and product lines.
  • Another reason Strattec has not bought any shares back in the past couple years as it has been concentrating on reinstating its dividend and expanding its VAST Alliance operations. The company currently only has 3.3 million shares left that are outstanding.
  • Management compensation is fair and straight forward in my opinion which is another plus for management.

Insider and Fund Ownership

  • GAMCO Investors-Collectively Mario Gabelli’s Funds-Own 18.6% of Strattec.
  • T. Rowe Price and Associates through its Small Cap and Small Value funds own-15.5% of Strattec.
  • FMR-Fidelity Management and Research Company own-12.2% of Strattec.
  • Vanguard Horizon Funds own-6.2% of Strattec.
  • Dimensional Fund Advisors, a Small Cap Value Fund, owns-5.8% of Strattec.
  • Insiders Own-7.82% according to Reuters.
  • The above insiders and funds own a combined 66.12% of Strattec which partially explains why there is a very low average daily trading volume of around 2,000 shares per day in the stock.

Like I have said in my various other articles I love to see high insider and value oriented fund ownership of the companies I invest in so this is another plus for me.  Another possibility that might arise in the future is that due Strattec only having 3.3 million shares outstanding, its small overall size as a company, and some of the other factors I will mention or have mentioned in the article, I think that Strattec could be taken private or become a potential buy out target for one of the bigger automotive supply companies.

Competitors

The company faces stiff competition from the following three companies.

  • Magna International (MGA)-I talked about Magna a bit in my Core Molding Technologies (CMT) article and how I did not think that Magna was a major threat to CMT’s area of operations.  The story as it pertains to Strattec’s operations is different however.  Magna competes with Strattec in several of its product lines including the power access area and Magna appears to be a major player in those areas.  In 2009 Strattec bought the Power Access portion of Delphi’s business segment after it went bankrupt and renamed the unit Strattec Power Access.  For fiscal years ending 2012 and 2011, Strattec Power Access was profitable and represented $62.7 and $62.8 million, respectively of Strattec’s consolidated net sales.  Just for comparison Magna did $1.2 billion in sales just in its closure systems (power access) business in 2011.  Magna could present a problem for future growth of Strattec’s product lines as it will have to compete vigorously on price and quality for contracts.  It could also present a potential opportunity as with CMT, I could see Magna possibly buying out Strattec to expand its operations into more product fields.  This makes further sense since Strattec is such a small company in comparison to Magna and it being an $11+ billion market cap company.
  • Huf huelsbeck & fuerst-Huf and its various subsidiaries including Huf North America is a privately held company with operations worldwide and whose product lines compete directly with Strattec’s on almost every product around the world.  This company presents the same problem as Magna does to Strattec, but the same potential buy out opportunity exists as well.
  • Tokai Rika-This is a Japanese publically traded company who competes directly with Strattec on several products and who also has operations around the world.  Tokai Rika, like the two companies mentioned before, also dwarfs Strattec in size which could present problems to Strattec’s growth.

Strattec faces much stiffer competition from multiple much bigger competitors, sometimes directly on the same products than CMT did, who I thought carved out a bit of a niche in its industry.

Strattec’s Margins

Gross Margin TTM 18.50%
Gross Margin 5 Year Average 15.32%
Gross Margin 10 Year Average 18.25%
Op Margin TTM 6.20%
Op Margin 5 Year Average 0.44%
Op Margin 10 Year Average 5.18%
ROE TTM 12.11%
ROE 5 Year Average 3.59%
ROE 10 Year Average 9.91%
ROIC TTM 11.90%
ROIC 5 Year Average 3.49%
ROIC 10 Year Average 9.85%
My ROIC Calculation With Goodwill 25.90%
My ROIC Calculation With Goodwill If EBIT% Reverts to 3 Yr Avg 15.41%
My ROIC Calculation Without Goodwill 25.82%
My ROIC Calculation Without Goodwill If EBIT% Reverts to 3 Yr Avg 15.37%
FCF/Sales TTM 2.25%
FCF/Sales 5 Year Average -3.49%
FCF/Sales 10 Year Average 1.71%
Cash Conversion Cycle TTM 54.43 days
Cash Conversion Cycle 5 Year Average 48.97 days
Cash Conversion Cycle 10 Year Average 42.42 days
P/B Current 0.9
Insider Ownership Current 7.82%
My EV/EBIT If EBIT% Reverts to 3 Yr Avg 5.77
My EV/EBIT Current Unadjusted 3.43
My TEV/EBIT If EBIT% Reverts to 3 Yr Avg 8.09
My TEV/EBIT Current Unadjusted 4.81
Working Capital TTM $46 million
Working Capital 5 Yr Avg $48.6 million
Working Capital 10 Yr Avg $60 million
Book Value Per Share Current $25.25
Book Value Per Share 5 Yr Avg $24.54
Book Value Per Share 10 Yr Avg $24.78
Float Score Current 0.53
Float Intensity 0.77
Debt Comparisons:
Total Debt as a % of Balance Sheet TTM 0.88%
Total Debt as a % of Balance Sheet 5 year Average 0.66%
Total debt as a % of Balance Sheet 10 year Average 0.33%
Current Assets to Current Liabilities 1.79
Total Debt to Equity 45%
Total Debt to Total Assets 22%
Total Obligations and Debt/EBIT 2.1
Total Obligations and Debt/EBIT If EBIT Reverts To 3 Yr Avg 3.53

All numbers were taken from Morningstar or Yahoo Finance unless otherwise noted.  Final four debt calculations are including total debt and obligations.

Margin Conclusion Thoughts

  • The very first thing that popped out to me from the above margins is that across the board Strattec has improved its margins, sometimes by multiple percentage points, in comparison to its 5 year and 10 year averages.  Looks like the restructuring that took place during the recession, the various joint ventures including the VAST Alliance, and branching out to new product lines has helped the company immensely.  Improvements in operating margin, ROE, and ROIC have all been especially impressive
  • My ROIC calculations make the company look even better as even if Strattec were to revert to its 3 year average EBIT, which I don’t think it will unless another recession happens, I am estimating it to have an ROIC of 15.37% without goodwill.  If Strattec is able to keep up its EBIT margin to current levels I estimate that without goodwill its ROIC is 25.82%, an astounding ROIC margin.
  • Also positive as it pertains to ROIC is that in Strattec’s case it is not being artificially inflated by high amounts of debt.
  • The cash conversion cycle has gotten worse over the years, meaning less efficiency in the company, which I generally do not like.  That is to be expected in a company that has expanded operations overseas though so no red flag there.
  • Its P/B ratio at 0.9 is less than half that of its industry P/B at 2 which means that at least on a relative basis Strattec is undervalued in comparison to its industry.
  • My current unadjusted EV/EBIT ratio estimate for Strattec is 3.43.  Unadjusted TEV/EBIT estimate is 4.81.  Generally I like to buy companies selling at an EV/EBIT ratio of 8 or less so again Strattec appears to be undervalued.
  • Even if Strattec’s EBIT margin were to revert back to its three year average, which as above I do not think it will do unless there is another recession, its EV/EBIT ratio is 5.77 and TEV/EBIT is 8.09, again undervalued or about fairly valued at worst.
  • Book value per share has grown slightly over time, and should grow further with its improved operations.
  • The company has minimal debt and even if we include its total contractual obligations and debt its total obligations/EBIT ratio is a paltry 2.1.  Much improved from some of the other companies I have evaluated and its current total debt and obligations should be nothing to worry about going forward.

Below numbers in graphs are taken from Morningstar.

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As you can see in the above graphs Strattec’s share price has not improved as its operations and sales have.  The last year Strattec had comparable margins to what it had this year is 2006, when Strattec was selling for between $33 and $50 a share. As I found after doing my valuations, which I will show below, I think Strattec should be selling somewhere in that range now.  Sales are actually almost $100 million more than they were in 2006, and margins should continue to improve as Strattec’s now worldwide operations and expanded product lines become more efficient.

Valuations

These valuations were done by me, using my estimates and are not a recommendation to buy stock in any of the companies mentioned.  Do your own homework.

Valuations were done using 2012 10K and 2013 first quarter 10Q.  All numbers are in millions of US dollars, except per share information, unless otherwise noted.

Low Estimate Of Intrinsic Value

Numbers:
Revenue:

284

Multiplied By:
Average 3 year EBIT %:

3.77%

Equals:
Estimated EBIT of:

10.71

Multiplied By:
Assumed Fair Value Multiple of EBIT: 8X
Equals:
Estimated Fair Enterprise Value of STRT:

85.68

Plus:
Cash, Cash Equivalents, and Short Term Investments:

12.94

Minus:
Total Debt:

1.5

Equals:
Estimated Fair Value of Common Equity:

97.12

Divided By:
Number of Shares:

3.3

Equals: $29.43 per share

Base Estimate Of Intrinsic Value

Assets:                  Book Value:                    Reproduction Value:
Current Assets
Cash And Cash Equivalents

16.3

12.94

Accounts Receivable (Net)

45.1

38.34

Inventories

25.5

15.3

Other Current Assets

17.1

8.6

Total Current Assets

104

75.18

Deferred Income Taxes

9.7

4.9

Investments In Joint Ventures

8.4

4.2

Other Long Term Assets

0.5

0

PP&E Net

47.6

28.6

Total Assets

170.6

112.88

Number of shares are 3.3

Reproduction Value

  • 112.88/3.3=$34.21 per share.

High Estimate Of Intrinsic Value

Cash and cash equivalents are 12.94

Short term investments are 0

Total current liabilities are 57.8

Number of shares are 3.3

Cash and cash equivalents + short-term investments – total current liabilities=12.94-57.8=-44.86

  • -44.86/3.3=-$13.59 in net cash per share.

Strattec has a trailing twelve month EBIT of 18.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:

  • 5X18=90+12.94=102.94/3.3=$31.19 per share.
  • 8X18=144+12.94=156.94/3.3=$47.56 per share.
  • 11X18=198+12.94=210.94/3.3=$63.92 per share.
  • 14X18=252+12.94=264.94/3.3=$80.29 per share.

From this valuation I would use the 8X EBIT+cash estimate of intrinsic value of $47.56 per share.

I discounted the cash a bit in the above valuations because about 55% of Strattec’s cash is in Mexico so if Strattec wanted to bring the funds to the US it would have to pay taxes on that portion of cash.

  1. Strattec is undervalued by 23% using my low estimate of value, which assumes that Strattec will revert back to its 3 year average EBIT margin, which as I stated above, I do not think will happen unless there is another recession.  This is the absolute minimum I think Strattec should be selling for.
  2. Strattec is undervalued by 33% using my base estimate of intrinsic value on a pure asset reproduction basis.
  3. Strattec is undervalued by 52% using my high estimate of intrinsic value with EBIT and cash at current levels.  Now that Strattec has restructured itself and made itself a worldwide company with expanded product lines and improved operations I actually think that EBIT should rise over time meaning Strattec’s intrinsic value could continue to grow and it would become even more undervalued.

Pros

  • Strattec has excellent management.
  • The company is undervalued by every one of my estimates of intrinsic value above and relative valuation estimates such as P/B, EV/EBIT, and TEV/EBIT.
  • Strattec restructured before and during the recession to cut costs, expand product lines, and became more efficient and less dependent on one single product line.
  • Strattec signed joint ventures, and created the VAST Alliance with two other companies that now allow Strattec to compete on a global scale.
  • Strattec’s margins have improved across the board in comparison to its 5 and 10 year averages and margins should continue to improve.
  • Sales have also been improving along with margins.
  • Strattec has almost zero debt.
  • Strattec management owns just fewer than 8% of the company.
  • Most importantly as it pertains to management is that I trust that they have shareholders best interests in mind.
  • Various value and small cap oriented funds own more than 50% of the company, including Mario Gabelli’s funds.
  • The VAST Alliance as a company should have its first profitable year this year which should help Strattec’s profitability even more.
  • My personal estimates of ROIC show that Strattec is even more profitable than I originally thought while looking at Morningstar’s numbers.
  • Strattec has a $25 million revolving credit facility if it wants to do any acquisitions, which the new CEO has said he will look into, or the $25 million could be used in an emergency situation if one arises.
  • Margins are not artificially inflated by debt so margins show a true picture of how Strattec is running.
  • Strattec has drastically reduced its share count in the past decade at what I think were good prices to be buying at.
  • Strattec is currently authorized to buy back more shares if it chooses to.
  • Strattec recently reinstated its quarterly dividend.

Cons

  • Strattec is highly dependent on only a few customers for its orders as General Motors, Ford, and The Chrysler Group combine for 68% of sales.
  • Strattec is highly dependent on how well the automotive industry and the overall economy as a whole are doing which can be seen in the above graphs.
  • Due to the cyclical nature of Strattec, if there is another recession or major problems in the auto industry again, its sales and profitability will be highly affected.
  • The company has some very stiff and much bigger competition.  The competition could possibly mean further price cuts on products in Strattec’s product lines if some kind of price war starts.
  • Due to competition and the overall cost reduction plans put into place by the big automotive companies, Strattec has had to drop prices on its products in recent years.
  • At this point I do not see any kind of long term sustainable competitive advantages within Strattec.

Catalysts

  • Since Strattec is very small in comparison to its competitors it could become a potential buy out candidate.
  • Strattec’s margins should continue to grow which could lead to the unlocking of value.
  • The new CEO Frank Karecji has said that he would like to do some kind of acquisition in the short term.
  • Strattec is authorized to buy back more shares.

Conclusion

With all of the above taken into account, I think that the absolute minimum Strattec should be selling for is $29.43 per share which assumes that Strattec’s EBIT margin will revert to its 3 year average.  I think that Strattec’s true intrinsic value is somewhere between $35 and $45 per share.  None of that is even taking into account that its sales and margins should continue to grow which would also grow the company’s intrinsic value.

The company does face some headwinds to future growth as I outline above, the biggest ones in my opinion is that Strattec has to compete with various bigger companies and I do not see any kind of long term sustainable competitive advantages within the company.

Normally I would want some kind of sustainable competitive advantage within a company that I am buying as a long term value hold, but at current valuations, with Strattec’s good and rising margins and other factors listed throughout the article, I think the risk/reward is in my favor by a substantial margin and I have already bought shares for my personal account and the accounts I manage making this only the fourth company I have bought into this year.

Portfolio Update and A New Dole Article Planned

I just sold my entire position in Taseko Mines (TGB).  TGB released its most recent quarterly report yesterday and yet again it was a disappointment.  It seems that ever since I bought into this company every quarter has been a disappointment at least on some level with excuses being given by its management for why it is not performing as good as it could.  Also of note is that TGB had to resubmit its New Prosperity mine assessment report at the end of September and now a decision will not be made until sometime in 2013 about if the mine will be approved or not.  The original plan was to have a decision by this month which was the only reason I had even held onto it this long.

This is yet another company I bought before doing any kind of valuations and only minimal research and again I paid the price with a total loss of 47%.  The only thing that again saved me was that at least I was smart enough to make my positions pretty small when I first started out so I didn’t lose a ton of money.

My portfolio is now 23% in cash and I am down to owning stock in only six companies. After clearing out the only remaining company that I knew for sure I was going to sell at some point, I now only own stock that I think are good companies and have the potential to continue to compound into the future.

The three remaining companies I own from before doing valuations and anywhere near the amount of research that I am doing now: $MAIN, $MO, and $PM, are all by my estimates either fairly valued or overvalued by quite a bit and I may sell stock in each of these three companies if I detect deterioration in any of their businesses.  If I do not see deterioration in the businesses I will most likely hold these companies for years because I think each of these companies will compound their results well into the future, unless of course I find a better company to put my money into.

The three companies I have bought into since doing valuations and the amount of research I am doing now are: $CMT, $VIVHY, and $DOLE.  At this point I still think that CMT and VIVHY are undervalued and will let you know if I decide to buy any more stock in either of those two.

This gets me to Dole.  I got a request from one of the readers of my original Dole article that I posted on Seeking Alpha who liked my original analysis series on Dole, Chiquita, and Fresh Del Monte and he was asking if I would do an updated valuation and analysis article on Dole now that it has sold some of its assets and is able to pay off most of its debt.

The reader asked if I would do an updated article giving my thoughts on how Dole stands now after it sold some of its assets and paid down debt, if I still think that it is undervalued, and what I think of its operations going forward now that it eliminated its biggest problem.

I have learned a lot since that time and hope to use some of my new knowledge to see what I think about Dole now, if I still think they are undervalued after rising in price as much as 75% at one point and currently still being up 47% since I originally bought into it.  I am researching its land, other assets, and history more fully now in preparation so that when its next quarterly report comes out on November 15th I am ready to value the company with updated numbers and post the article shortly after that.

In the mean time I will continue to post any updates and links that I think contain knowledge.  I may also every once in a while ask some questions of you since I know some of you are more knowledgeable in certain areas than I am.  Since I am planning on adding some new things to this article I may need some feedback making sure I am applying the new techniques correctly.

Main Street Capital Brief Thoughts and Valuations

Main Street Capital (MAIN) is the final company I have not talked about yet that I still own from before doing any type of valuations or anywhere near the amount of research I am doing now.

Main Street Capital is a business development company that provides long term debt and equity capital to lower middle market companies and debt capital to middle market companies.  Main Street seeks to partner with entrepreneurs, business owners, and management teams and generally provides “one-stop” financing within its lower middle market portfolio.  Main Street’s lower middle market companies generally have revenues between $10 million and $150 million.  Main Street’s middle market debt investments are made in businesses that are generally smaller in size than its lower middle market portfolio companies.  Description taken from its website here.

My reasons for originally buying into Main Street were its high margins, and its monthly and growing dividend.  I liked that it had seemed to find a niche in its business operations that made the company highly profitable, enabling it to pay out the dividends.  I also liked that around 90% of its investments in the companies it invests, in is first lien debt, meaning that if these companies do have any problems, that MAIN still has a very good chance of making its money back.  I also liked that only around 2.5% of its portfolio at that time was thought to be problematic.

What I see now are generally the same fantastic things about this company that is now up 50% since I bought into it, again fortunate due to not valuing the company.  My current cost basis is $19.03 per share and the current share price is $29.09 per share.  MAIN has recently been setting new 52 week highs on almost a daily basis.  The company seems to very well run and reports bigger profits on almost a quarterly basis.

Price to Book and Tangible Book Valuations

  • Low estimate is $16.30 per share.
  • Base estimate is $23.81 per share.
  • High estimate is $31.45 per share.

My concerns with MAIN now is that it appears to be overvalued, it has been recommended by Jim Cramer, and even though the company appears to be overvalued it keeps climbing higher and higher on almost a daily basis.

With my low cost basis in relation to current price, I am going to hold MAIN in my portfolio and hope to continue to collect and reinvest the dividends for the time being.  I am going to watch this company very closely as I like its prospects into the future, but if I see any kind of deterioration in the business, I am going to lock in my profits and sell my position.

Main Street Capital could be a very good long term dividend growth stock if it can keep making prudent and profitable investments but I would not recommend buying into the company at this time as I think MAIN is overvalued.  As with the last several companies I talked about, I hope MAIN can keep on its current path and I hope to have my investment compound well into the future.

Intel Brief Thoughts and Valuations

Intel (INTC) is another company I bought before doing any type of valuations.  Intel is one of the first companies whose annual and quarterly reports I actually read, and it was noticeable even then with my limited knowledge to see its massive competitive advantages, huge margins, the free cash flow it creates, etc.  The following are descriptions taken from Morningstar.

Intel holds long-term advantages over smaller rival Advanced Micro Devices AMD in the microprocessor industry. While there have been rising fears that Intel may have trouble competing against emerging processor design firm ARM ARMH, we believe such panic has been blown out of proportion.

Intel is the largest chipmaker in the world. It develops and manufactures microprocessors and platform solutions for the global personal computer market. Intel pioneered the x86 architecture for microprocessors.

Asset Valuations

  • With intangible assets and goodwill: $7.95 per share.
  • Without intangible assets and goodwill: $6.71 per share.

EBIT and Net Cash Valuations

  • Intel has $0.60 in net cash per share.
  • 5X=$19.00 per share.
  • 8X=$28.82 per share.
  • 11X=$38.65 per share.
  • 14X=$48.47 per share.

Revenue and EBIT Valuations

  • 5X=$14.23 per share.
  • 8X=$22.03 per share.
  • 11X=$29.82 per share.
  • 14X=$37.61 per share.

Operating Cash Flow and Free Cash Flow Valuations

  • Low estimate=$12.05 per share.
  • Base estimate=$17.62 per share.
  • High estimate=$23.18 per share.

Price to Book and Tangible Book Valuations

  • Low estimate=$11.51 per share.
  • Base estimate=$16.82 per share.
  • High estimate=$22.14 per share.

Debt Ratios

  • Current assets to current liabilities=2.45.
  • Total debt to equity=14.7%.
  • Total debt to total assets=9.9%.

Intel’s current only competitor in the computer chip area is AMD who has always been a distant second place to INTC.  Also of note is that AMD’s CFO just resigned which is never a good sign.  Intel has also been increasing its business in the server arena where it also has huge competitive advantages and controls a big chuck of the space.

The only area where Intel has been struggling recently has been in the tablet and smart phone arenas, with Intel having to play catch up to Arm Holdings (ARMH) who was first and best in those areas.  Intel appears to be catching up to ARMH in the tablet and smart phone business segments as it currently has its chips in three smart phones, it will also have its chips in the upcoming Motorola Razr I, the Razr I will launch in October in Europe and Latin America, and its first Intel Powered tablets are going to be coming out in November.

Intel’s huge competitive advantages, size, and balance sheet, have enabled it to catch up to ARMH and I think it will soon surpass Arm Holdings in the mobile processor arena and extend its dominance into new profitable business segments.

Knowing what I know about Intel, its huge competitive advantages, gigantic margins, etc, I have decided to use the 11X EBIT and cash valuation, $38.65 per share, as my estimate of intrinsic value, a 40% margin of safety as its current share price is $23.32 per share.

Even if I were to use the 8X EBIT and cash valuation as my estimate of intrinsic value just to be safe, $28.82, that gets us to a 19% margin of safety.  I think the 8X estimate of value is too conservative with Intel’s massive competitive advantages however.

My current cost basis in Intel is $19.90 per share.  Again a bit fortunate to be up anything since I did not do any type of valuations before I originally bought into them.  With all of the above stated I am going to continue to hold Intel for the long term and have my investment compound hopefully years and decades into the future.

I will also look for opportunities when the stock price is at a healthy margin of safety to continue to add shares to my portfolio and for the portfolios that I manage, now looks like it would be a good entry point, and I will update when and if I buy any more stock in INTC.

Philip Morris Brief Thoughts and Valuations

Philip Morris International’s (PM) premium positioning of its strong brands, global scale, and addictive products give the firm a wide economic moat, in our opinion. While some of the company’s more mature markets are experiencing lower cigarette demand, we expect that the company’s Asian operations will continue to be an engine for the firm’s future growth.

Philip Morris International is the world’s second-largest tobacco company, behind only China National Tobacco, and holds 28% of the non-U.S./non-China global market. The firm owns seven of the leading 15 international brands. Marlboro, the company’s flagship brand, accounted for about one third of total volume in 2011. Other key brands include: L&M, Philip Morris, Bond Street, Chesterfield, Parliament, and Lark.

Both of the above descriptions were taken from Morningstar.

Asset Valuation

  • With intangible assets and goodwill $11.73 per share.
  • Without intangible assets and goodwill $8.34 per share.

EBIT and Net Cash Valuation

  • Philip Morris currently has -$7.59 in net cash per share.
  • 5X is $42.07 per share.
  • 8X is $65.97 per share.
  • 11X is $89.86 per share.
  • 14X is $113.76 per share.

Revenue and EBIT Valuation

  • Low estimate is $27.09 per share.
  • Base estimate is $49.29 per share.
  • High estimate is $71.50 per share.

Operating Cash Flow and Free Cash Flow Valuation

  • Low estimate is $76.24 per share.
  • Base estimate is $111.43 per share.
  • High estimate is $146.62 per share.

Debt Ratios

  • Current assets to current liabilities=0.92
  • Total debt to equity is not applicable because PM has negative equity.
  • Total debt to total assets=58%.

As with Vodafone, Philip Morris’ valuations are all over the place.

Philip Morris was spun off from Altria so that it could get away from the massive amount of litigation that is involved in the United States tobacco industry. Foreign countries are increasingly bringing litigation and sanctions upon tobacco companies that operate in their  respective countries such as Australia and Norway, but at this point it does not look to be a massive problem for PM.  It is something to watch for continuing into the future however as the proposed plain packaging could really hurt PM’s results as it would deemphasize the Marlboro brand and packaging.

Knowing what I know about its massive competitive advantages, which are generally the same as those I outlined in my Altria article, its risks, which are also generally the same as Altria’s, I would use the 11X EBIT and cash valuations, $89.86 per share, as my estimate of Philip Morris’ intrinsic value.  Philip Morris is currently selling at $89.48 per share meaning that there is absolutely no margin of safety.  My current cost basis for PM is $69.38 per share, up 27% since I bought in June of 2011.

Again, PM is one of the companies I bought before doing any kind of valuation so I am very fortunate to be up anything at this point. Philip Morris has gigantic competitive advantages, huge margins, creates a lot of free cash flow, pays a very good dividend, and buys back its shares.  My main concerns with PM long term are the same as Altria, a lot of debt, pensions, etc.

With my cost basis being so low I plan to hold onto my PM shares for years and hopefully decades and hope to have my investment compound well into the future.

Valuations and Brief Thoughts About Vodafone

Recently I decided it was probably time for me to value and analyze each of the companies remaining in my portfolio from before I truly dedicated myself to learning and becoming a “true investor.”  I had never valued any of the companies I am going to be writing about in the next several days.  I have read at least one annual report and one quarterly report, along with a myriad of other articles about each of the companies in the time since I bought them, and I am going to offer my brief thoughts on each.

I am also going to decide if I should keep, buy, or sell any of the companies after determining if I think any of them are under or overvalued.

Vodafone Valuations and brief thoughts

Vodafone (VOD) valuations done on September 10th, 2012.  Valuations in millions of GBP, except per share information, unless otherwise noted.  Valuations done using 2012 10K.

Asset Reproduction Valuation

Assets: Book Value: Reproduction Value:
Current Assets
Cash and Cash Equivalents 7138 7138
Short Term Investments 1323 1323
Accounts Receivable (Net) 3885 3302
Inventories 486 243
Prepaid Expenses 3702 1851
Other Current Assets 3491 1746
Total Current Assets 20025 15603
PP&E Net 18655 9328
Equity and Other Investments 35899 17950
Goodwill 38350 15340
Intangible Assets 21164 8466
Deferred Income Taxes 1970 1000
Other Long Term Assets 3482 1741
Total Assets 139545 69427

Number of shares are 5096

Reproduction Value:

  • With intangible assets and goodwill: 69427/5096=13.62 GBP per share = $21.80 per share.
  • Without intangible assets and goodwill: 45621/5096=8.95 GBP per share = $14.33 per share.

EBIT and Net Cash Valuation

Cash and cash equivalents are 7,138

Short term investments are 5,096

Total current liabilities are 24,025

Cash and cash equivalents + short-term investments – total current liabilities=

  • 7,138+1,323-24,025=-15,564
  • -15,564/5,096=-3.05 GBP per share=-$4.78 in net cash per share.

Vodafone has an EBIT of 11,187.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:

  • 5X11,187=55,935+8,461=64,396
  • 8X11,187=89,496+8,461=97,957
  • 11X11,187=123,057+8,461=131,518
  • 14X11,187=156,618+8,461=165,079
  • 5X=64,396/5096=12.64 GBP per share=$19.79 per share.
  • 8X=97,957/5096=19.22 GBP per share=$30.09 per share.
  • 11X=131,518/5096=25.81 GBP per share=$40.41 per share.
  • 14X=165,079/5096=32.39 GBP per share=$50.71 per share.

Revenue and EBIT Valuation

Numbers:
Revenue: 46417
Multiplied By:
Average 6 year EBIT %: 15.87%
Equals:
Estimated EBIT of: 7366.4
Multiplied By:
Assumed Fair Value Multiple of EBIT: 5X
Equals:
Estimated Fair Enterprise Value of VOD: 36832
Plus:
Cash, Cash Equivalents, and Short Term Investments: 8461
Minus:
Total Debt: 34890
Equals:
Estimated Fair Value of Common Equity: 10336
Divided By:
Number of Shares: 5096
Equals: GBP 2.03 per share=$3.27 per share

The $3.27 per share is my low estimate of value.  My base estimate of value using an 8X multiple was $10.16 per share, and my high estimate of value using an 11X multiple was $17.25 per share.

Price to Book and Tangible Book Valuation

Numbers:
Book Value: 126431.8
Minus:
Intangibles: 23806
Equals:
Tangible Book Value: 102625.8
Multiplied By:
Industry P/B: 1.7
Equals:
Industry Multiple Implied Fair Value: 174463.8
Multiplied By:
Assumed Multiple as a Percentage of Industry Multiple: 65%
Equals:
Estimated Fair Value of Common Equity: 113401.5
Divided By:
Number of Shares: 5096
Equals: GBP 22.25 per share=$35.62 per share.

The $35.62 per share is my low estimate of value.  My base estimate of value using a 95% multiple was $52.05 per share and my high estimate using an 125% multiple was $68.49 per share.

FCF and Cash Flow Valuation

Numbers
Operating Cash Flow: 12755
Minus:
Capital Expenditures: 7852
Equals:
Free Cash Flow: 4903
Divided By:
Industry Median FCF Yield: 6.17%
Equals:
Industry FCF Yield Implied Fair Value: 79465
Multiplied By:
Assumed Required FCF Yield As A % of Industry FCF Yield: 65%
Equals:
Estimated Fair Value of Common Equity of VOD: 51652.25
Divided By:
Number of Shares: 5096
Equals: GBP 10.14 per share=$16.23 per share.

Vodafone’s FCF yield is 5.41%.  The companies I used as comparisons are Verizon, China Mobile, and AT&T.

The $16.23 per share is my low estimate of value.  My base estimate of value was $23.71 per share and my high estimate was $31.20 per share.

Vodafone’s debt ratios are as follows:

  • Current assets to current liabilities: 20025/24025=0.83
  • Total debt to equity: 34957/76935=45%
  • Total debt to total assets: 34957/139576=25%

Brief Thoughts and Conclusions

Vodafone’s valuations are all over the place from a low of $3.27 a share to a high of $68.49 per share.  My cost basis for VOD is $27.37 per share.

After looking at its margins, reading its annual report and all that I have read since buying into Vodafone, I would use either the 8X EBIT and cash valuation, $30.09 per share, or my low estimate of value in the price to book and tangible book valuation, $35.62 per share, as my estimate of intrinsic value.  I would probably lean towards the $30.09 estimate of intrinsic value just to be safe, meaning that I think Vodafone is about correctly priced.

Knowing what I know now, I would not have bought into Vodafone when I did, or at this time, as it does not meet my minimum 30% margin of safety.   Others reasons I would not buy into it at this time are:

  • The high debt levels.
  • Massive amounts of cap ex needed constantly.
  • The problems that it has had in India and other countries lately
    .

I do not think that Vodafone is a bad company by any stretch of the imagination, I just bought into them at too high of a price and for the wrong reasons; mainly its dividend.

I really like that it is a truly global company with some very good assets, including being a 45% owner of Verizon.

For now I am going to hold onto Vodafone until there is some kind of clarity from Verizon on its dividend payment strategy towards Vodafone, and/or until I find another company to buy as I think I will have a hard time making money at my currently too high cost basis in Vodafone, and I will possibly look to sell my stake in VOD when I find another attractive company.