Paradise Inc, $PARF, Operates In A Consistently Profitable, Extremely Small Niche That It Has Dominated For Years

In Part 1 of this series I told you that I was starting a series of posts where I would be taking a look at a few nano caps, compare them to each other, and at the end decide which one, if any, would be the best buy right now.  The first article in this series was on BAB Systems Inc (BABB) which looked like a potentially good investment.  The second article in this series is going to be on Paradise Inc (PARF).

Introduction, History, Management Discussion, and Overview of Operations

Paradise began as a subsidiary of a different diversified corporation soon after World War 2, but very soon afterward candied fruit became the focus of its business.  Current ownership purchased the company in 1961 and the name Paradise Fruit Company was adopted in 1965.  It later changed its name to Paradise Inc after diversifying its operations a bit in the 90s.  Paradise Inc. is the leading producer of glace (candied) fruit which is a primary ingredient of fruit cakes sold to manufacturing bakers, institutional users and supermarkets for sale during the holiday seasons of Thanksgiving and Christmas. Paradise, Inc. consists of two business segments, fruit and molded plastics.  As of the most recent quarter the glace fruit segment makes up about 61% of all company sales with the plastics segment making up the remaining 39% of sales.

Candied Fruit Segment Description-Production of candied fruit which is a basic fruitcake ingredient and is sold to manufacturing bakers, institutional users, and retailers for use in home baking. Also, based on market conditions, the processing of frozen strawberry products for sale to commercial and institutional users such as preservers, dairies drink manufacturers, etc.  When PARF does sell these frozen strawberry products it is generally not a big part of its operations.  While there is no industry-wide data available, management estimates that the Company sold approximately 80% of all candied fruits and peels consumed in the U.S. during 2011. The Company knows of two major competitors; however, it estimates that neither of these has as large a share of the market as PARF’s.

Being the dominant company in your industry for years on end, owning an estimated 80% market share of the industry, and being in a niche business that makes it likely that you will not see many, if any new competitors in its market is an absolutely exceptional thing to find in any business.  This combination of characteristics is something I have been looking for in a company since I have started investing seriously and had not found it in any single company until now.

The demand for fruit cake materials is highly seasonal, with over 85% of sales in the glace fruits taking place in the months of September, October, and November.  In order to meet delivery requirements during this relatively short period, PARF must acquire the fruit and process it into candied fruit and peels for an estimated 10 months before this time period just to meet demand. This means that PARF has a massive build up in inventory in the quarter before the holiday months every year, and depletes its cash hoard to pay for the inventory that is needed to make sales in the last quarter of its fiscal year.  These very seasonal circumstances in the fruitcake industry makes the full year results of the company, generally which come out in March of every year, the only financial report of its fiscal year that shows how truly profitable PARF has been for the preceding trailing twelve month period.

Molded Plastic Segment Description-PARF produces plastic containers for its products and other molded plastics for sale to unaffiliated customers.  The molded plastics industry is very large and diverse, and PARF’s management has no estimate of its total size. Many products produced by PARF are materials for its own use in the packaging of candied fruits for sale at the retail level. Outside sales represent approximately 85% of PARF’s total plastics production at cost, and, in terms of the overall market, are insignificant.  In the plastics molding segment of business, sales to unaffiliated customers continue to strengthen. This trend began several years ago when management shifted its focus from the sale of high volume, low profit “generics” to higher technology value added custom applications.

PARF has only recently started to sell these types of packaged fruits as well which could become a bigger part of operations going forward.

Costs of goods sold have ranged between 71-75% of sales every year since 2003 and this year’s trailing twelve month COGS is coming in at 71.98%.  Despite an increase in the cost of raw materials within the fruit segment and increasing cost of resins within the Plastics segment, PARF has successfully maintained control over its production labor costs during the past year.  Management says that this can be traced directly to its previously disclosed decision and action to eliminate 15 full time positions, reduce executive and salary wages by 15% and 10%, respectively, and rescission of a 4% merit increase awarded to hourly workers. These actions remained in place throughout 2011 and have help reign in the cost of sales during this timeframe.

Selling, general and administrative expenses have generally taken up between 18-20% of sales over the past decade but have started to come down a bit over the decade from a high of 20.33% in 2002 to the trailing twelve month period being only 18.14%.   This all leaves PARF’s trailing twelve month operating margin at 9.86% which is much improved and is its highest operating margin in the past decade.  Operating margin has actually been below 5% for most of the last decade so PARF has been able to double its operating margin in recent years.  It’s ROIC and ROE are a bit more volatile over the past decade but are both up over recent years and currently stand at 7.59% and 8.31% respectively over the trailing twelve month period.  My estimates of ROIC are 11.29% without goodwill and 11.09% with goodwill.  One thing of note and concern is that PARF’s cash conversion cycle has jumped dramatically as it stood at 160 days in its 2011 fiscal year and it now stands at 282 days in the trailing twelve month period.  This is most likely the buildup in inventory for the 2011 holiday season and may only be an aberration because of the seasonality of its business but it is something that definitely bears watching when PARF’s full annual report comes out.

PARF is pretty much a family owned and operated business as out of the top five executives four of them are related.  The only one who seems not to be related to anyone is the CFO and treasurer Jack M. Laskowitz.  Melvin S. Gordon who owns around 37% of PARF, and who is the current CEO, Chairman, and a director of the company, has been with PARF since the 1960s in various capacities.  His two sons, one daughter in law, and a cousin make up the remaining five member executive team.  The group of executives has done a pretty good job over the years of managing the company and expanding its operations into the plastic industry to become more diversified which has helped the company’s sales and profitability.  In total insiders own right around 41% total of PARF so outside of Mr. Melvin S. Gordon the other executives own very small percentages of the company.

As with BABB in my previous article, PARF also has excessive executive pay in my opinion.  Just the five executives in the company got paid including bonuses, in 2011 $1.551 million, or about 16% of PARF’s market cap, about 6% of revenues, and about 21% of gross profit.  While BABB’s executive pay is worse in relation to these benchmarks PARFs pay is still excessive in my opinion especially in relation to the company’s small size of around $10 million.

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 PARF’s 2011 10K and 2012 third quarter 10Q. All numbers are in thousands of US$, except per share information, unless otherwise noted.

Also remember that these valuations are not containing the full year’s number which generally come out in March of every year, and will show a much truer picture of how the company is operating.  The company’s operations are extremely seasonal and in the most recent quarter PARF had to use up nearly its entire cash hoard to buy inventory.  The cash should be at least partially replenished in the full year report and was standing near $7.8 million before they had to buy inventory.

Minimum Estimate of Value

EBIT Valuation

PARF has a trailing twelve month EBIT of 2,624.

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

• 5X2,624=13,120/520=$25.23 per share.
• 8X2,624=20,992/520=$40.47 per share.
• 11X2,624=28,864/520=$55.51 per share.
• 14X2,624=36,736/520=$70.65 per share.

I would use the 5X EBIT estimate of intrinsic value as my minimum estimate of value for PARF.

Base Estimate of Value

Assets:	Book Value:	Reproduction Value:
Accounts Receivable	8,088	6,875
Inventories	11,664	5,832
Deferred Income Tax Asset	235	118
Prepaid Expenses & Other Current Assets	481	241
Total Current Assets	20,468	13,060
PP&E Net	4,037	2,624
Goodwill	413	0
Customer Base & Non-compete Agreement	471	236
Other Assets	233	0
Total Assets	25,622	15,920

Number of shares are 520

Reproduction Value:

• 15,920/520=$30.62 per share.

High Estimate of Value

EBIT Valuation

PARF has a trailing twelve month EBIT of 2,624.

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

• 5X2,624=13,120/520=$25.23 per share.
• 8X2,624=20,992/520=$40.47 per share.
• 11X2,624=28,864/520=$55.51 per share.
• 14X2,624=36,736/520=$70.65 per share.

This time I would use the 8X EBIT value of $40.47 per share and it would be my high estimate of value for PARF.

Relative Valuations

• PARF’s P/E ratio is currently 6.9 with the industry average P/E standing at 16.7.  If PARF was selling at the industry average P/E it would be worth $48.40 per share.
• PARF’s P/B ratio is currently 0.5 with the industry average P/B standing at 1.8.  If PARF was selling at the industry average P/B it would be worth $72.00 per share.
• PARF’s TEV/EBIT is currently 5.02.
• PARF’s EV/EBIT is currently 4.95.

Something of major note that is not included in any of the above valuations is that:

“The Company owns its plant facilities and other properties free and clear of any mortgage obligations.”

This means that PARF has some substantial hidden assets that are not fully on its books in the above valuations.  I found one set of links that showed PARF’s combined land, building, equipment, and properties were valued at a total of $6.6 million.

Being conservative I will use the link here where you can search for Paradise in the search bar, which shows a more conservative set of values for the property, land, equipment, and buildings valued at an estimated $5.41 million, or $10.40 per share.  This is probably a very low estimate and the combined value of the land, buildings, and equipments is most likely worth more than the $5.41 million.  Discounting this amount by 40% due to where the locations are at and for the overall sake of conservatism it still brings an extra $6.24 per share to the company’s valuations above.

This means the true valuations above should be: Minimum-$31.47 per share, Base-$36.86, and High-$46.71, making the company even more undervalued.

Valuation Thoughts

• By my absolute minimum estimate of value PARF is undervalued by 36%.  By my base estimate of value PARF is undervalued by 46%.  With my high estimate of value PARF is undervalued by 53% and is a potential double from today share price at $20 per share.  Again, these valuations are not including any cash which will be at least partially replenished when the full year results come out and make PARF even more undervalued.
• PARF is undervalued by every one of my estimates of intrinsic value and relative value.
• PARF’s TEV/EBIT and EV/EBIT are both under 8 which is generally the threshold I like to buy under.
• Again all of these valuations do not contain the full year’s results which are not out yet and will show a much truer picture of the company and its operations.

Customers Thoughts

PARF sells its products on its website, through Wal-Mart and Aqua Cal around the holiday seasons, smaller stores, some restaurants, and Amazon.  Wal-Mart and Aqua Cal both make up a substantial portion of all sales so if either decided not to reorder it would affect the company’s sales, profitability, and margins.

On Amazon, like everything else that is sold on the site, customers leave reviews and generally as you can see with this link, customers seem to think very highly of Paradise’s products.  After reading through all the reviews most people talked about the high quality of PARFs products, and how they couldn’t get glace fruit in their individual local stores even sometimes around the holidays, so they had to search online for them.  This could also be a potential opportunity for PARF because if there is more demand for their products that isn’t being fulfilled currently that could lead to higher sales if more people knew about them.

Some of the negative comments were about how the packaging of the product was poor and came partially crushed or even broken in some cases.  In a couple of extreme cases people said that their products came with ants, bug legs, and other bug parts inside of the products.

It is hard to tell whether this is PARF’s or Amazon’s fault but assuming at worst that it is PARF’s, this is a problem that they need to fix in the process of packaging the product and shipping it because as I talked about in my BABB article, customer reviews like this could lead to trouble in the future for the company if it were to continue to have these types of problems.

PARF has also made it to number 2 in the Top 20 Glace Fruit Sites.  Only one or two of the companies on this list look to be direct competitors with PARF as most of the other companies have operations in a lot of other areas and only do a small amount of business in the glace fruit area.

Catalysts

• PARF becoming more known to people who like making fruit cakes would heighten their sales.

Pros

• PARF is the leader in its industry by far, owning an estimated 80% of all sales in the glace food market.
• PARF is in a very niche industry which should keep away competitors and its dominance intact.
• PARF is substantially undervalued by all accounts.
• PARF’s management team has done a very good job running the company over the years.
• Customers generally seem to love the product.
• There could be potential for a lot more sales if more people knew about PARF’s products as a lot of the customer reviews on Amazon stated that they struggled to find any glace fruit products in their local markets, sometimes even during the holiday season, and had to resort to looking online.
• PARF has nearly $500K worth of non-compete agreements signed with people to keep them from competing with PARF.
• PARF’s margins are overall pretty good and I will talk about that in the conclusion article.
• PARF operates on some amount of float which I will also talk about in the finale article.
• To boost the company’s margins PARF cut costs and payroll in recent years which has helped strengthen its margins.

Cons

• PARF’s business is very seasonal and requires a lot of lead time so if demand drops for fruitcake during the holiday season the company’s results would be highly affected.
• PARF’s management and executive pay is a bit excessive in my mind.
• A few customers have had some nasty problems with PARF’s products being delivered to them broken or with bug parts being in the product.
• PARF is highly dependent on Wal-Mart and Aqua Cal (Sales to these two companies make up between 20 and 25% of sales in recent years) purchasing their products for sale around the holiday season so if either one didn’t reorder it would affect PARF’s results.
• So far in the trailing twelve month period there has been a 120 day jump in the cash conversion cycles which is alarming.  Hopefully this is just due to the lead up in having the buy inventory for sale during the holiday season and will not be a problem after full year results come out.

Conclusion

Paradise looks like a fantastic company to own right now.  It is undervalued substantially and owns a conservatively estimated $5.4 million with of property and land that partially protects the downside of buying into PARF.  It has dominated its market for years and continues to do so.  Being in a very niche market and industry that it is dominating, it is unlikely that someone would come in and try to compete with them.  PARF has generally good to very good margins and its operations are partially supported by float.  The continued dominance and good to very good margins lead me to believe that the company also has at least a small moat as well or at the very least being in this extreme niche market has helped it to gain moat like qualities due to lack of competition.  I will talk about margins and float in depth in the conclusion piece of this series of posts.  PARF’s customers seem to love its products and since a lot of them complain that they cannot find glace fruit products in their local markets PARF might be able to capitalize on this with  through more advertising and advertising to a wider audience that they sell their products online.

PARF does have some negatives as well with what is in my opinion excessive executive pay, heavy reliance on two customers, some previous problems with its packaging, and it’s very seasonal market but up to this point PARF looks like a very exceptional company to invest in as the positives far outweigh the negatives in my opinion.

Next up in this now shortened series is the conclusion.

Advertisement

How To Value Float, Book Recommendation, And An Update On What I Have Been Doing Including Info About The Potential Investment Firm I Plan To Open

More Float Info and a Book Recommendation

While I was beginning to write my UNAM article I realized that of all the learning I had done about float, I had not learned how to value it.  Below are some more sites that I learned from while I was putting my article together on how to evaluate and value a company’s float.  Some of the information and valuations made it into my UNAM article and a lot of the other stuff made it into my written notes.

• The Brooklyn Investor: So What Is Berkshire Really Worth (Part 1)
• The Brooklyn Investor: So What Is Berkshire Really Worth (Part 2)
• The Brooklyn Investor: So What Is Berkshire Really Worth (Part 3)
• The Brooklyn Investor: So What Is Berkshire Really Worth (Part 4)
• Shookrun.com: Buffett On Insurance.
• Losch Management: Insurance Float.
• Bronstein Report: Estimating Berkshire Hathaway’s Intrinsic Value.

Personally I would put these links on about on par with some of the other information on float I have learned about and posted on the blog from the Fundoo Professor and others, and I hope you learn something from them as well.

I cannot recommend The Davis Dynasty highly enough.  I wish I would have known about this book and read it when I had first started learning about investing and would put in on the same level as The Intelligent Investor, Security Analysis, Margin of Safety, and You Can Be a Stock Market Genius as some of my favorite investment books.

The Davis Dynasty is a book about the Davis family starting with the older Shelby Davis who started with $50,000 in investment funds almost at the age of 40 and turned it into approximately $900 million by the time he died.  His son and grandsons are now continuing his investment legacy and have continued to compound portions of that money still to this day, or at least when the book was published.  The book goes over the general family and investment philosophies and how they made so much money.  The older Shelby Davis made his money mostly with insurance stocks.  The younger Shelby Davis made most of his money with a mixture of financial, insurance, and other stocks.  The grandsons have continued the overall philosophy but have expanded out from the so called boring insurance stocks.

Again, I cannot recommend this book highly enough.

I have started to read The Farmer From Merna about how State Farm Insurance was started to continue gaining knowledge about the insurance industry.  After I finish this up I plan to look for another company to research.

Some Other Things I Have Been Up To

• I am still learning Mandarin and at this point I have learned probably somewhere north of 2000 words or close to that.  Still amazing and I think this will definitely help me at some point down the road.
• Nate (Oddball Stocks) and I were having a conversation a while back about how he read French value investing blogs to help him learn French faster so I decided to try to find some investing blogs that are in Mandarin to help me learn faster.  However, up to this point I have had only minimal luck so I have instead turned my latest article on UNAM into completely Mandarin text and thought I would try this out to see how this works.
• I got some pretty good news from my lawyer friend about opening up the potential investment firm that I mentioned almost a month ago.  So far no concrete updates and I still have some more calls to make and digging to do, but at this point it looks like nothing should prohibit me from opening up a small investment firm.
• I have started some work on an investor’s presentation so that when I do figure out things for sure I am ready to start contacting friends, family, and local wealthy people to see if they would like to invest.
• I have been trying to get myself out there more still in the hopes of getting some kind of job offer, even if it is just someone who wants to pay me for my investment ideas until I open up the investment firm, so I have reapplied to the Value Investors Club.  Last time I applied I had to wait a few weeks to see my rejection letter.  Applied to SumZero and have already gotten an email back from them saying that because I do not have hedge fund/investment firm experience that I cannot join their site.  Started putting my articles on Guru Focus and my Brazil Fast Food article, the first article I have posted to GF, was named an Editor’s Pick.  So far nothing in the way of job offers but people generally say that they like my work a lot and that I do a really good job of laying out my analysis. I have a couple ideas that I may share in the coming weeks about some other ideas I have in this area as well.

Right now I am going to be finishing up The Farmer From Merna, then find another company to research, and keep doing the stuff above.  I will also probably post some more links here shortly.

Floats, Moats, My Plans For This Year, Starting An Investment Partnership, And Looking For Partners

More About Floats And Moats

I am going to be taking another week or so away from researching companies to concentrate on learning more about floats and moats, and then start applying some of the lessons I have learned, especially about float, to the companies I have already written articles about.  Directly below is some of the material I have been learning from.

25iq.com-Charlie Munger On Circle of Competence, the Second Essential Filter.

25iq.com-Charlie Munger On Management With Talent And Integrity, The Third Essential Filter.

25iq.com-Charlie Munger On Margin Of Safety, The Fourth Essential Filter.

Read the book Repeatability and here is the accompanying site.  Would highly recommend the book as well as the site.  I also plan to read the authors other books as well.

NPR-Warren Buffett Explains The Genius Of Float.

Fool.com-Warren Buffett Plays The Float With Blue Chip Stamps And Private Jets….And Wins.

Seeking Alpha-Berkshire Hathaway Worth Its SALT 2012 Update, about float.

Seeking Alpha-Buffett On Insurance And Investing: Its About The Float.

Corner Of Berkshire And Fairfax-Munger On Deferred Tax Liabilities and Intrinsic Value.

These things along with the information on floats and moats that I have previously posted from the Fundoo Professor, are the types of things I have been learning from recently.  Now I am going to go back over all the companies I have written articles on to determine if they had any float and will report back to you sometime in the next week about my findings and then it is on to finding more companies to research.

I also found two fantastic blogs that I highly recommend going back and reading all of their blog postings.

Monte Sol Capital

Sahara Investing

Also Sahara Investing has recently published an article on Strattec, which is a company I own, and he came to a differing conclusion than I did and I wanted to share his fantastic article with you.

Plans For This Year

I am a very simple guy with simple wants and needs so I only have two plans and one goal for this year.

• Continue to learn something new and improve in every aspect of life every single day.
• To get completely healthy.

My one goal for this year is that by this time next year I want to have started my own investment partnership/hedge fund.

If any fellow value investors would like to collaborate on something like this please let me know as I have already started the process of looking into what I legally need to do to start an investment firm, I have already talked to my buddy who is a lawyer who said he will look into what exactly I need to do, and would be very interested to listen to any potential opportunities you may have thought of.

More Holiday Reading Links: Moats, Floats, Company Analysis, and Others

Gannon and Hoang On Investing-Unrepeatable Moats.

Csinvesting-A Reader’s Question On Niche Vs Moat and Greenwald Class Notes.  Make sure to read all the way to the comments as there is a very good discussion going on about moats there.

Fundoo Professor-Presentation on Moats and Floats.  Decided to post this again because it is so important.  Also read the comments section.

Fundoo Professor-All About Floats: Parts 1, 2, and 3.  Make sure to read the comments section as the discussion there goes quite deep into the inner workings of float.

Gannon and Hoang On Investing-Capital Allocation Discount.

ValueInvestingBlog.net-Audika Group: Can You Hear The Call Of Value.

Whopper Investments-$LAKE Update, The Bottom Has Fallen Out.

25iq.com-Charlie Munger On Moats (First Of The Four Essential Filters). Extremely valuable read for people learning about moats as I am right now.  Also contains a bunch of links to other Munger and moat information.

Gopal Gantayat-Evolving Competitive Advantages.

Psychology Today-Why Too Much Data Disables Your Decision Making.

Oddball Stocks-Thinking Like A Bond Investor.

Market Folly-Charlie Munger On The Psychology of Human Misjudgement.

Zenpenny-Here Is To The Downfall Of Micro Managing Portfolio Positions.

SMB Training-What A Star Portfolio Manager Can Teach Us About Improvement.

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.

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.

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.

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.

Portfolio Update And Links From Old School Value, Charlie Munger, Greenbackd, and PsychCentral

Today I am going to value the company I have been researching to see if it warrants further research and a full article, I will update you about what I figure out.

I also sold out of my entire position in Vodafone (VOD).  My valuations and brief analysis can be found in this post from last month.

I bought Vodafone before doing valuations of any kind and only minor research and again I paid the price.  I bought at too high of a price in my estimate and it would have been very difficult to make money due to my high cost basis.  In the link above I also give some other reasons why I was thinking about selling, which are ultimately why I decided to sell my entire portion of the company.  I sold my stake in Vodafone up about 2% after commissions.

That brings the cash position in my portfolio up to 17% and for now I am going to hold onto it and will let you know when I redeploy some of the cash I have built up.

To the links.

Two links from Old School Value; the first one is How The Cash Conversion Cycle Can Help You Pick Winners and Losers.  The second gives you 52 Techniques to Spot Fraud.  Both contain extremely important lessons.

How Reading Lights Up Your Mind is from Psych Central about the effects reading has on your brain, very fascinating.

Charlie Munger on Google’s Moat-It’s Huge…Probably Widest He’s Ever Seen is another great post from Greg Speicher’s blog.

Greenbackd on Hunting Endangered Species.  The link contains his 15 page strategy paper on “Hunting Endangered Species: Investing in the Market for Corporate Control.”  The link also contains links to some of his other papers.

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.

Some Fantastic Links

Before I get back into research and finishing up my checklist I wanted to give you some links that I thought held some kind of insight or knowledge that we all could learn from.

Warren Buffett on his Investment in See’s. See’s is one of his favorite all time investments and I think his reasons for investing should be studied by every investor. Article is from Valuewalk, @Valuewalk on Twitter.

The Secret’s of See’s Candies is an extensive profile of the business, why Buffett bought it, why it is such a good business, its new expansion plans, and how Buffett and Munger almost blew the investment.

Visiting Warren Buffett are notes from someone who visited Berkshire Hathaway on a trip from Columbia Business School in 2006.  These notes are from an interview and speech that was given while on the trip where Buffett gives some very valuable lessons.  The most fascinating thing to me was that Buffett was the following quotes from the article: Emphasis mine.

Question 12: What would you pay for a solid company that is growing earnings at 8-10%/year?

Not many companies will do that. You see a lot of garbage about EBITDA. Depreciation is the worst kind of expense in that it is prepaid. He looks at EBIT/EV. He’ll generally pay 7x for a decent business. For insurance companies, he looks at float and the cost of float.

Looks like that could be a very good starting point for valuations.

Masters of Compounding: Walmart ($WMT) 1968-2012 is an exceptional article from Student of Value on the history of Walmart and what has made it such a fantastic company over time.  I would also recommend following @dgenchev on Twitter if you would like to see his future write ups as they have so far all been fantastic.

How an Average Business Can be a Great Investment by Oddball Stocks has some interesting thoughts about average businesses and their investment potential.  There is some great back and forth in the comments section as well.  I would also recommend reading his two write ups about Hanover Foods that he links to in the article as the analysis he presents is very detailed.

4 Mistakes When Valuing Companies With Large Cash Holdings, and How to Avoid Them is another fantastic write-up by Simple Value Investing.  I would also highly recommend following him on Twitter @SimpleValue as all of his write ups thus far have also been fantastic.  His write ups on Ibersol were very detailed and he laid out a very good investment case for them. Part 1 and Part 2.

I hope you enjoy the links over the next few days as I am now off to finish up my own investment checklist and to research some more companies.