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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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.

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.

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.

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.

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.

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.

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.

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.

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.

Wendy’s: Great Fast Food, Bad Investment

About a month and a half ago I wrote an article stating that I believe Jack In The Box to be overvalued despite the recent positive hype around the company.  Lately I have been researching Wendy’s $WEN because it has had JACK’s opposite problem; very negative recent press and wanted to see if this might turn out to be a potential contrarian value play or a value trap.

I will be referencing and comparing Wendy’s to Jack In The Box and the other fast food companies I wrote about in my $JACK article so if you would like to see how Wendy’s compares to other fast food companies please reference my JACK article that I link to above.

Wendy’s Overview

Wendy’s is an owner, operator, and franchiser of 6,543 fast food restaurants, 1,447 of the restaurants are owned directly by Wendy’s with the remaining amount owned by franchisees.  Wendy’s offers hamburgers, chicken sandwiches, salads, wraps, fries, and the rest of the typical fast food restaurant offerings but at a higher quality profile than most of its other fast food competitors.  Higher quality also leads to higher prices for its individual product offerings and meals which greatly affected the company during the recession with customers generally looking for cheaper food.  In the past several years to combat the low cost offerings of its competitors, Wendy’s has brought out its own value and extra value menus with prices generally under $2 per item.

Since the recession Wendy’s has streamlined operations by selling off its Arby’s subsidiary, enacting cost cutting measures,  updating its menu to offer new products including breakfast at some locations, and has started reimaging some of its restaurants by starting its Image Activation Program.  The program has been put into place to update its restaurants making them look more modern, offering more amenities to get customers to stay longer at its restaurants, and making the food ordering and cooking process more efficient so customers can get their food faster.

Unlike JACK who has recently finished up its reimaging of its restaurants and who should see at least small margin growth due to lower capital expenditures, Wendy’s has only just started this process with only a few dozen restaurants having been updated thus far.  Wendy’s hopes that by 2015 about half of its company owned restaurants will be reimaged so this process is going to take a while.  As we saw with Jack In The Box that will lead to generally higher cap ex for the foreseeable future, most likely lower or stagnant margins, possibly more debt, and potential loss of sales due to having some of its restaurants closed for construction periods of as long as eight weeks currently.

Valuations

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

All numbers are in millions of US dollars, except per share information, unless otherwise noted. The following valuations were done using its 2011 10K, 3Q 2012 10Q, and its 3Q 2012 investor presentation slides.

Asset Reproduction Valuation

Assets:	Book Value:	Reproduction Value:
Current Assets
Cash And Cash Equivalents	454	454
Accounts Receivable (Net)	65	55
Inventories	12	8
Prepaid Expenses & Other Current Assets	32	16
Deferred Income Tax Benefit	95	48
Advertising Funds Restricted Assets	75	50
Total Current Assets	734	631
Properties	1241	745
Goodwill	877	439
Other Intangible Assets	1315	658
Investments	118	89
Deferred Costs & Other Assets	57	29
Total Assets	4340	2591

Number of shares are 390

Reproduction Value:

With goodwill and intangible assets:

• 2591/390=$6.64 per share.

Without goodwill and intangible assets:

• 1494/390=$3.83 per share.

EBIT and Net Cash Valuation

Cash and cash equivalents are 454

Short term investments are 0

Total current liabilities are 344

Number of shares are 390

Cash and cash equivalents + short-term investments – total current liabilities=454-344=110.

• 110/390=$0.28 in net cash per share.

WEN has a trailing twelve month EBIT of 120.

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

• 5X120=600+454=1054/390=$2.70 per share.
• 8X120=960+454=1414/390=$3.63 per share.
• 11X120=1320+454=1774/390=$4.55 per share.
• 14X120=1680+454=2134/390=$5.47 per share.

TEV/EBIT and EV/EBIT Valuation

Total enterprise value is market cap+all debt equivalents (including the capitalized value of operating leases, unfunded pension liability, etc) -cash-long term investments-net deferred tax assets.

• TEV/EBIT=3310/120=27.58
• TEV/EBIT without accumulated deficit counted=2833/120=23.61
• Regular EV/EBIT=2946/120=24.55

The average EV/EBIT in the fast food industry that I found when analyzing JACK was 15.68 and the only company to have a higher EV/EBIT than Wendy’s is Chipotle Mexican Grill $CMG which had an EV/EBIT of 26.53.

I usually like to buy companies that have an EV/EBIT multiple under 8 so the fast food industry as a whole appears to be massively overvalued to me.  Not only that but Wendy’s current EV/EBIT multiple is comparable to Chipotle’s which generally has very high margins, which is exactly the opposite of Wendy’s.  As we will see later Wendy’s margins do not even come close to Chipotle’s and are generally much worse than even the rest of the fast food companies margins, so its extraordinarily high EV/EBIT multiple is astounding and I will explain later why it is so high.

I also did my normal other valuations but they did not work because after you take out the company’s debt and or goodwill and intangibles from the other valuations you get negative estimates of intrinsic value for Wendy’s equity.

Margin comparison

Please reference my JACK article above to see my thoughts on each of the other company’s margins as I will only be commenting in this article about Wendy’s margins.  The below chart has been updated to include Wendy’s margins for comparison to the other fast food companies.  The industry averages are still only including the previous five companies I talked about.

All numbers in the table were put together using either Morningstar or Yahoo Finance.

	Jack in the Box (JACK)	Sonic Corp (SONC)	McDonald’s (MCD)	Yum Brands (YUM)	Chipolte Mexican Grill (CMG)	Company Averages	Wendy’s (WEN)
Gross Margin 5 Year Average	16.28%	34.30%	37.94%	26.20%	24.28%	27.80%	25.70%
Gross Margin 10 Year Average	17.08%	43.38%	40.42%	35.59%	11.73%	29.04%	39.86%
Op Margin 5 Year Average	7.46%	16.24%	27.42%	14.22%	12.76%	15.62%	-1.70%
Op Margin 10 Year Average	7.07%	18.05%	22.62%	13.50%	6.64%	13.57%	0.21%
ROE 5 Year Average	20.16%	66.33%	30.26%	131.56%	18.55%	53.37%	-6%
ROE 10 Year Average	18.77%	43.71%	23.19%	105.85%	10.27%	40.36%	-4.68%
ROIC 5 Year Average	11.17%	3.38%	17.38%	24.97%	18.49%	15.08%	-3.77%
ROIC 10 Year Average	10.91%	8.97%	13.37%	23.54%	10.22%	13.40%	-2.45%
FCF/Sales 5 Year Average	-0.26%	6.48%	15.90%	7.70%	6.92%	7.35%	1.07%
FCF/Sales 10 Year Average	0.80%	7.10%	12.86%	6.70%	2.26%	5.94%	-3.74%
Cash Conversion Cycle 5 Year Average	0.78	1.23	0.91	-36.35	-5.24	-7.92	-4.18
Cash Conversion Cycle 10 Year Average	0.27	1.14	-1.22	-49.02	-5.21	-10.81	-4.53
P/B Current	2.9	12.4	6.7	14.3	8.2	8.9	0.9
Insider Ownership Current	0.38%	6.12%	0.07%	0.50%	1.64%	1.74%	6.83%
EV/EBIT Current	14.25	9.65	12.16	15.81	26.53	15.68	24.55
Debt Comparisons:
Total Debt as a % of Balance Sheet 5 year Average	30.78%	80.91%	35.28%	45.24%	0	38.44%	34.03%
Total debt as a % of Balance Sheet 10 year Average	26.84%	50.77%	35.22%	40.72%	0.14%	30.74%	38.58%
Current Assets to Current Liabilities	1.02	1.38	1.24	0.97	4.13	1.75	2.13
Total Debt to Equity	1.03	9.69	0.97	1.6	0	2.66	0.81
Total Debt to Total Assets	30.50%	71.20%	41%	37.21%	0	35.98%	36.87%
Total Contractual Obligations and Commitments, Including Debt	$2.6 Billion	$1 Billion	$27.20 Billion	$11.42 Billion	$2.20 Billion	$8.88 Billion	$1.9 Billion
Total Obligations and Debt/EBIT	21.67	8.85	3.15	5.4	5.82	8.98	13.33

As you can see from the above margin comparison, Wendy’s margins are almost all quite a bit worse or at best about even with industry averages in comparison to its fast food competitors.  Even if we were to exclude Wendy’s absolutely horrible 2008 from its numbers, its margins are still quite a bit lower than its competitors.

Especially of note are the horrible in comparison to its competitor’s margins: ROIC, ROE, FCF/Sales, EV/EBIT, and Total obligations and debt/EBIT ratios, which are all a lot worse than its competitor’s ratios.  Wendy’s EV/EBIT is especially inflated due to its high amount of debt in comparison to its profitability which is why it has a comparable EV/EBIT to the much higher margin Chipotle.  My calculations of ROIC are a bit different than Morningstar’s numbers and help out Wendy’s a bit, but even at 5.4% without goodwill and 3.85% with goodwill those numbers are still generally quite inferior to its competitors.

About the only thing that Wendy’s has in favor for itself out of the entire above table is that its P/B ratio of 0.9 is a lot lower than its competitors.  A P/B ratio that low generally means that the company could be undervalued. That P/B ratio in this case is a bit of a farce because goodwill and other intangible assets make up the vast majority of current book value as just those two combine for an estimated $2.2 billion in value.  After subtracting goodwill and intangible assets tangible book value is actually negative.  The $2.2 billion is actually more than the current market cap so I think that it is fair to say that those values are probably massively overstated and may soon have to be restated or written down to a more reasonable level, thus eliminating some further perceived value and bringing the P/B value up closer to its competitors.

I also think that Wendy’s debt levels and costs are too high in comparison to its profitability as 83% of operating profit (EBIT) goes to interest expenses.  Costs and other expenses, not including interest expense and loss on extinguishment of debt, take up 95% of total sales.  Other expenses include general and administrative, depreciation and amortization, etc.  If you include interest expenses and loss on extinguishment of debt that takes total costs and expenses over 100% of sales, which is why Wendy’s recent earnings have been negative.

Pros

• Pays a dividend and recently upped it 100%.
• After a lot of the stores are reimaged margins should improve due to lower cap ex and higher same store sales.  Of the stores that have thus far been reimaged Wendy’s says they have seen 25% increases in sales.
• Has positive net cash.
• Has a good amount of cash on hand.
• Same store sales have risen for 6 straight quarters and a total of 2.3% in the past 9 months.
• Wendy’s has recently paid off some of its 10% coupon debt by taking out lower interest debt, which should lead to lower interest expenses going forward.
• Wendy’s recently overtook Burger King as the second biggest fast food burger chain.
• Owns a lot of its restaurants and the property underneath the buildings so Wendy’s does hold some valuable assets in case it has some problems.
• Just fewer than 80% of its restaurants are owned by franchisees that pay a 4% royalty to Wendy’s.  Collecting franchise royalty fees is a very high margin business.
• The company produces positive FCF excluding cap ex.

Cons

• Wendy’s is overvalued by every one of my valuations, sometimes in extreme cases, except when including the massive amount of goodwill and intangible assets.
• Wendy’s margins overall are generally a lot worse than its fast food competitors.
• Book value is only positive because of goodwill and other intangible assets.
• The company has had recent negative earnings.
• 83% of operating profit went to interest expense.
• The company’s equity has negative value after subtracting goodwill and intangible assets on various valuations.
• The company has been buying back a lot of stock at what I think are overvalued prices.
• The company’s debt levels and costs are too high in my opinion in comparison to its profitability levels.
• Wendy’s will have higher cap ex for the foreseeable future due to the reimagining of its stores.
• The reimaging of Wendy’s stores could be going on for at least a decade if not more as it hopes to have around 750 stores reimaged by 2015 leaving around 5,750 stores to be reimaged after that, not including new stores that are opened by Wendy’s itself or its franchisees.
• Cap ex this year has been around $225 million and will likely stay close to that elevated level for many years due to the reimagining of its stores and which should either lead to lowering or stagnating margins for the foreseeable future.
• The company has negative FCF when including cap ex.
• This year the company spent $126 million in cash on cap ex with the remaining $99 million coming from other sources.  To me that means Wendy’s will have to either increase its margins and FCF to pay the remaining cap ex costs, or more likely it will continue to have to issue debt to fund the reimaging of its stores.
• While sales have been rising within Wendy’s, costs have also been rising at about the same amount which is why margins have not been increasing much as sales have improved.
• The company has quite a few, what seem to me questionable related party transactions within the company, including with Mr. Peltz (former Wendy’s executive and current chairman) and Trian Partners the investment fund Mr. Peltz has formed with a couple Wendy’s other board members.
• Just one example of the questionable transactions is that Wendy’s paid just under $640,000 in security costs for Mr. Peltz who is a billionaire and could easily pay these costs himself.
• Trian Partners currently owns just under 25% of Wendy’s and has three members on Wendy’s board of directors so Trian could exert a lot of pressure on Wendy’s if it saw fit to do so.
• Due to some of the what seem to me to be questionable transactions; I do not trust management to do what is right for shareholders and to increase shareholder value.

Potential Catalysts

• The reimaging of its stores will most likely eventually lead to margin and sales growth.
• If Wendy’s can get its costs under control, which it is trying to do now, it could achieve some margin growth.
• In my opinion Wendy’s has overstated its goodwill and other intangible assets and may have to restate or write down some of the value of each.  Wendy’s warns it may have to do this in its most recent annual report, which would lead to less perceived value in the company, and would probably drop the price of the stock further.

Conclusion

Wendy’s has recently overtaken the number two spot for hamburger fast food chains in the United States from Burger King.  Growth in this case appears to be bad for shareholders as its costs have been rising about in line with sales which are why margins have not seen much growth as Wendy’s sales have been growing.  Wendy’s margins are also generally quite a bit worse than its other fast food competitors, in my opinion its debt levels and costs are too high, and I do not trust its management to do what is right for shareholders.

Wendy’s appears to be destroying shareholder value with its high costs and debt levels, buying back its stock at overvalued prices, and continuing to grow its restaurant count and sales but not improving its margins.  Because Wendy’s margins have not improved as sales have been rising, it looks like Wendy’s is growing at less than its cost of capital which in my opinion has led to value destruction for shareholders.  The destruction of shareholder value will not reverse unless Wendy’s can cut its costs and debt levels and or improve profitability which probably will not happen for a while due to some of the reasons stated above.  Unless something drastic happens, in my opinion shareholders of Wendy’s stock can only look forward to further value destruction of their shares into the future.

Having stated all of the above I would estimate Wendy’s intrinsic value to be my 5X EBIT and cash valuation of $2.70 per share.  Due to all of what I stated in the above article I do not think that Wendy’s is even worth its reproduction value and I would not even be a buyer of the company at my $2.70 per share estimate of value.

Even if Wendy’s margins and sales do rise after reimaging of its stores, which should happen, that will not take place for many years as Wendy’s has only recently started to reimage its restaurants.

I hope I am wrong about Wendy’s because food wise it is by far my favorite fast food restaurant.  I hope it can fix its problems, and hope that it starts to thrive as a company.  However, as an investment I think Wendy’s is the proverbial value trap and I plan to keep my investment funds far away from the company.

Weekend Reading Links: Klarman, Munger, Buffett, Valuation, and Learning

The new company I was researhing turned out to be another bust after valuation.  I found the Australian company to be in a range from fairly valued at the high end of my intrinsic value estimate to overvalued by as much as 70% from my low estimates of value and have decided to not do any further research on it at this time, especially since its margins were not very good either.

For now I am going to be reading some books over the coming days and then its back to searching for more companies to research.

Seth Klarman On Leadership.  This video is from ValuePrax and contains some very valuable insights from the reclusive Klarman.

Charlie Munger Lecture at the Harvard-Westlake School.  This interview is from Santangel’s Review and contains Mungers thoughts on the recent financial crisis.

Alice Schroeder On How Buffett Values a Business and Invests.  This is yet another article from Greg Speicher that contain Ms. Schroeder’s thoughts on how Warren Buffett looks at business.

Valuation: Valuing Growth and the Petersburg Paradox.  This is from Csinvesting and the page also has some links to papers that talk about different things valuation related.

I Learned To Speak Four Languages In a Few Years: Here’s how.  This is a write up from LifeHacker about the techniques that helped the author learn four languages in a relatively short amount of time.  This is fascinating to me because I have always wanted to learn a new language and have recently started learning a bit of Spanish.

Core Molding Technologies Valuations and Analysis

This is the entire article I have been working on which has been posted this morning to Valuefolio.com for his 50 Stocks in 100 Days Valuation series. I hope you enjoy all the new things I have added to my analysis and the amount of research I have done for this company.  Due to what I found out about Core Molding Technologies while researching, valuing, and analyzing them, CMT has become only the third companies stock I have bought in the past year along with Vivendi and Dole.  Let me know what you think about the article.

This is a guest post by Jason Rivera, founder of Value Investing Journey, a value investing blog. The tone of honesty and humility at his blog is refreshing. His quest for great stocks and as a value investor results in unique, authentic, high-quality content. In this article he values Core Molding Technologies as part of our 50 Stocks in 100 Days series. Follow Jason on twitter @JMRiv1986. 

For those of you who have not viewed my site and other analysis articles, I hope you enjoy my analysis and valuations, if not let me know where I am going wrong and what I could do better.  For those of you who have visited my site and have seen my valuations, I hope you like some of the tweaks I have made in my analysis.  I am now doing even more thorough research than I have been doing and I have incorporated some new things into my write ups as well, I hope you enjoy.

Core Molding Technologies (CMT) is going to be the subject of this article.  Core Molding Technologies is a manufacturer of fiberglass reinforced plastic products.  They supply products to companies in the medium and heavy trucking, automotive, marine, and other commercial industries.  The plastics are used in automobile hoods, air deflectors, air fairings, splash panels, engine covers, fenders, and bulkheads. They have five production facilities in: Columbus, Ohio; Batavia, Ohio; Gaffney, South Carolina; Warsaw, Kentucky; and Matamoros, Mexico.

Core Molding Technologies has about 90% of its current business coming from the medium and heavy trucking industry.  Sales to Paccar and Navistar make up about 75% of current sales as of the most recent quarter.  CMT has been slowly trying to increase sales to other companies, which I think is a good thing in the long term because if its relationship deteriorates with either of the above two companies CMT could be devastated.  CMT states that its current relationship with both Paccar and Navistar are good and that they work closely with both companies to solve any issue, work on research and development, and pricing.

As of this year’s proxy form, Navistar currently has a seat on CMT’s board of directors as it is owns 9.2% of CMT’s stock, so I do not see Navistar ending its relationship with CMT any time soon.  CMT insiders own around 16% of the company’s stock.  Mario Gabelli personally, and through his funds owns 14.1% of CMT’s stock.  Rutabaga Capital owns 9.5% of its stock.  Rutabaga is a private investment firm whose concentration is in “Undervalued, unloved companies.”

I always like to see high insider ownership, and I am happy that CMT is owned by a couple value oriented investment firms.  I was especially happy to see that Mario Gabelli is a big owner of CMT’s stock, especially since he has bought shares in the company with his own money.  I also really like the ownership by Navistar as that could lead to a potential buy out, or at the very least a continued partnership between the two companies.  I am going to be watching very closely to see if and when any of the above start selling CMT’s stock as that could be a sign that there are big problems ahead for the company.

Here are some quotes from two of CMT’s biggest buyers about the potential huge catalyst in CMT’s main area of operations, the trucking industry:

• From Paccar, “Over six million heavy duty trucks operate in North America and Europe, and the average age of North American vehicles is estimated to be seven years. The large vehicle parc and aging industry fleet create excellent demand for parts and service and moderate the cyclicality of truck sales.”
• From Navistar “For our Truck segment, we expect benefits from further improvements in our “traditional” volumes as the industry continues to increase from the historic lows experienced in 2009 and 2010. According to ACT Research, the average age of the truck fleet was 6.7 years at the beginning of 2011, which is the highest average age since 1979. We anticipate higher sales in 2012 for truck replacement as our customers refresh aging fleets. We also expect demand for trucks to increase as freight volumes and rates continue to improve as the economy recovers. In addition to increased demand, we expect to further benefit from improved revenues and margins associated with the exclusive use of our proprietary engines. We expect to realize benefits from plant optimization actions taken during the trough of the truck cycle. Finally, we anticipate positive contributions from business acquisitions and investments made during this period.”

The above is exceptional news and should serve as a catalyst for CMT.

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

All numbers are in millions of US dollars, except per share information, unless otherwise noted.  Valuations were done using 2011 10K and second quarter 2012 10Q.

Asset Reproduction Valuation

Assets:			Book Value:		Reproduction Value:
Current Assets
Cash & Cash Equivalents			0		0
Accounts Receivable (Net)			26.3		20
Inventories			12.6		6
Deferred Tax Asset			1.8		0
Other Current Assets			2.8		0
Total Current Assets			43.5		26
PP&E Net			51.9		25
Deferred Tax Asset			1.1		0
Goodwill			1.1		0
Total Assets			97.6		51

 

I am using the companies fully diluted share count of 7.4.

• 51/7.4=$6.89 per share.

EBIT and Net Cash Valuation

Cash and cash equivalents are 0

Short term investments are 0

Total current liabilities are 27

Cash and cash equivalents + short-term investments – total current liabilities=0+0-27=-27

• -27/7.4=-$3.65 in net cash per share.

CMT has a trailing twelve month unadjusted EBIT of 16.5.

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

• 5X16.5=82.5
• 8X16.5=132
• 11X16.5=181.5
• 14X16.5=231

• 5X=82.5/7.4=$11.15 per share.
• 8X=132/7.4=$17.84 per share.
• 11X=181.5/7.4=$24.53 per share.
• 14X=231/7.4=$31.22 per share.

Since CMT has had a record trailing twelve months in terms of EBIT, I have decided to normalize EBIT and taken the 10 year average of 8.2 to determine the more normalized intrinsic value of CMT in case it is not able to keep up the pace of the past year.

• 5X8.2=41
• 8X8.2=65.6
• 11X8.2=90.2
• 14X8.2=114.8

• 5X=41/7.4=$5.54 per share.
• 8X=65.6/7.4=$8.86 per share.
• 11X=90.2/7.4=$12.19 per share.
• 14X=114.8/7.4=$15.51 per share.

Revenue and EBIT valuation

I am again using trailing twelve month numbers.

				Numbers:
Revenue:				168
Multiplied By:
Average 10 year EBIT %:				6.69%
Equals:
Estimated EBIT of:				11.24
Multiplied By:
Assumed Fair Value Multiple of EBIT:				8X
Equals:
Estimated Fair Enterprise Value of CMT:				89.92
Plus:
Cash, Cash Equivalents, and Short Term Investments:				0
Minus:
Total Debt:				13
Equals:
Estimated Fair Value of Common Equity:				76.92
Divided By:
Number of Shares:				7.4
Equals:				$10.39 per share.

 

My low estimate of value using a 5X EBIT multiple was $5.84 per share.  My high estimate of value using an 11X EBIT multiple was $14.95 per share.

Price to Book and Tangible Book Valuation

				Numbers:
Book Value:				53.13
Minus:
Intangibles:				2.2
Equals:
Tangible Book Value:				50.93
Multiplied By:
Industry P/B:				2.2
Equals:
Industry Multiple Implied Fair Value:				112.05
Multiplied By:
Assumed Multiple as a Percentage of Industry Multiple:				95%
Equals:
Estimated Fair Value of Common Equity:				106.45
Divided By:
Number of Shares:				7.4
Equals:				$14.39 per share

 

My low estimate of value using 75% of industry multiple was $11.36 per share.  My high estimate using 125% of industry multiple was $18.93 per share.

Ratios

				Ratios
Current Assets to Current Liabilities:				1.59
Total Debt to Equity:				23.60%
Total Debt to Total Assets:				12.30%
ROIC 10 yr avg From Morningstar:				10.62%
Unadjusted ROIC TTM :				24.60%
Normalized ROIC:				12.23%
Cash Conversion Cycle TTM:				54.47
Unadjusted EV/EBIT:				3.93
Normalized EV/EBIT:				8
ROE 10 yr avg:				15.73%
ROETTM:				21.10%
ROA 10 yr avg:				6.56%
ROA TTM:				11.49%
COGS as a % of revenue 10 yr avg:				83.36%
COGS as a % of revenue 2011:				79.16%

 

My Interpretation of the Ratios:

• I do not see any current problems with CMT’s debt levels.
• CMT’s ROIC is incredible, even if they fall back to the more normalized levels of above 10%.  If CMT can keep up the level of the previous year this company is very undervalued.
• The cash conversion cycle is a measure of how fast a company can turn its inventories into cash.  In CMT’s case it takes them about 54.5 days to make the conversion.  The number is lower than the high of about 73 in 2009, but not back to pre recession levels which were around 42 on average.  I do not see a major problem here but would like to see the number creep down over time.
• If CMT can keep its current revenue and profit levels going then they appear to be massively undervalued on an EV/EBIT basis.  If they revert back to the 10 year average EBIT then they appear to be about fairly valued on that basis.
• ROE and ROA appear to be boosted recently in comparison to the 10 year average in part due to Cost of Goods Sold decreasing as a percentage of revenue.  Hopefully they can keep up that pace as well.

Competitors

The competitors that CMT lists in its annual and quarterly reports are as follows: Sigma Industries, Decoma Composites (an owned subsidiary of Magna International), Molded Fiber Glass Companies, and Continental Structural Plastics.  Here are my thoughts on each competitor after doing research on them.

• Sigma Industries has operations in various industries including the heavy trucking industry, where CMT gets most of its sales from currently.  Sigma’s operations are mainly in Canada currently so it appears not be too much competition for CMT at this time.
• Magna International (MGA) is one of the largest and most diversified auto parts suppliers in the world.  I was a bit worried about the competition from Magna towards CMT, but the company currently does not make sales in the medium and heavy trucking segment.  Magna’s main operations are in cars and light trucks at this time.  Magna does state in its 10K that they are always looking for opportunities in various arenas including the heavy trucking industry, Magna’s entry into the heavy trucking industry would be something to watch out for. I think that Magna buying out CMT would be a better option because currently CMT has a market cap of around $50 million and Magna’s is $10.4 billion, meaning it would be a very minimal monetary investment and would also save them time from having to learn the processes by themselves.
• Molded Fiber Glass Companies is a privately held company whose operations appear to be mostly in the automotive and wind energy arena.  The little Molded Fiber Glass does in the trucking industry does not appear to be in direct competition with CMT as its operations are in entirely different states and regions.
• Continental Structural Plastics is a privately held company who has operations in automotive, heavy truck, agricultural, HVAC, construction, and material sales.  The following is the best information I could find on Continental “Continental Structural Plastics, Inc. manufactures structural plastic components, bumper beam reinforcements, rocker covers, oil pans, stamped steel seat frames, and underbody shields. It also offers composite seat bases, engine oil sumps, and composite sunshade substrates; and moulders of glass-mat thermoplastic composites, as well as long-glass-fibre-reinforced thermoplastic and direct-LFT composites. The company was founded in 1982 and is based in Troy, Michigan with manufacturing plants in Petoskey, Michigan; and Sarepta, Louisiana.”  Again, CSP does not appear to be a direct competitor in to CMT as they appear to make different products.

After looking into CMT’s competitors it appears that it does not have a direct competitor at this time and that it has found a very profitable niche which also might come with some minor competitive advantages.

Pros

• Undervalued by almost every one of my estimates of intrinsic value.
• I have not found any major direct competitors in CMT’s main area of operations.
• The company has found a niche in its industry that has made them very profitable.
• The company’s margins have been consistently good to great over the last 10 years: ROIC 10% average over that time period for example.
• Even if CMT is not able to keep up the pace of the previous year in terms of revenue and margins and reverts back to its 10 year averages, the company has been profitable over that time, even during the recent recession.
• Navistar, who is CMT’s biggest customer, owns about 9% of the company.  CMT insiders, outside value investment firms including Mario Gabelli personally, and through his funds, own over 30% of the company.
• By my estimation, the company looks like a potential buy out candidate.
• The company has been becoming more efficient in its operations in recent years.

Cons

• The vast majority of CMT’s sales are to only two companies, and they would be devastated if its relationship with either of the two companies deteriorates.
• CMT is a very small company whose market cap is currently only around $50 million.
• CMT could be hurt if a bigger, better financed, company enters its industry.
• On a revenue and margins level, CMT has had a record past year which might not continue into the future.
• If the past holds true, CMT’s results will be hurt quite a bit by any kind of recession or down turn in the economy.
• CMT has very low average trading volume of around 15,000, so it could experience wild swings in price.

Potential Catalysts

• The trucking industry currently has the highest average age of trucks since 1979 which should lead to sustained sales and margin growth.  The high age of the current trucking fleet should at least partially protect CMT’s revenues and margins if there is some new recession, as you can only hold off buying a new truck for so many years and many companies held off buying trucks during the recent recession.
• In my opinion CMT would be a great buyout candidate for someone like Magna who would be interested in entering the medium and heavy trucking industry as that would be less of a money and time investment for any potential buyer.
• Navistar who already owns more than 9% of the company also could be a potential buyer.

Conclusion

With all of the above stated I will be using my trailing twelve month unadjusted 5X EBIT estimate of intrinsic value of $11.15 per share.  The reason I am using this estimate of value is that by my estimation CMT should be able to at least partially sustain the previous year’s record revenue and margin numbers.  The 5X EBIT estimate is also conservative enough that it leaves a margin of safety if CMT were to revert back to previous year’s revenue and margins.

I actually think that CMT should be valued at one of my higher estimates of value due to the steadiness of its margins over the past decade and some of the other factors listed above, but I chose this estimate of intrinsic value due to the company’s small size and some of the other risks listed above, just to be safe.

The current share price is $7.35 which gets me a margin of safety of about 35%, reaching my minimum threshold of 30%.

Due to the previous, and for the reasons I listed throughout my article, I have decided to buy into CMT, making it only the third company I have bought this year along with Vivendi and Dole.

If you liked this analysis please visit my value investing blog Value Investing Journey and follow me on Twitter @JMRiv1986.  As always your comments, critique, and criticism are welcome.  Let me know what you think I could do better, where I might have gone wrong, and what you liked about the analysis.

Last minute update as I am getting ready to publish.  Navistar’s CEO of 30+ years has stepped down effective immediately.  This situation is something I am going to watch very closely, but with the information that is currently available I still have decided to buy into CMT at this time.  Hopefully this situation will not affect Navistar’s relationship with CMT.

Request from ValueFolio and Buying Into a New Company

Sorry for the lack of posts in the past few days. While I was researching the new company I just bought into, I got a request from Daniel of ValueFolio.com asking if I would write an article for his 50 Stocks In 100 Days Deliberate Practice series and of course I accepted.

The article will hopefully be published later today and I will share it with you at that time.

I hope you enjoy the analysis and valuation article as I think it is my best thus far.  I have added some new things, done far more research than I have been doing, and I think it has paid off in a much better analysis.

The analysis, and what I found out about the company while researching it, has led me to buy into the company, making it only the third company I have bought in the past year along with Vivendi and Dole.

I cannot wait to share it with you and I hope you enjoy it.

Aceto Corporation valuation and analysis

This valuation and analysis article is about Aceto Corporation (ACET.) Aceto markets and distributes industrial and pharmaceutical chemicals. The company has three divisions, which include health sciences, chemicals and colorants, and agrochemicals. The health sciences division is involved primarily with pharmaceutical companies in the production of generic drugs. The chemicals and colorants division is involved in developing flavor additives, fragrances, cosmetics, and colored inks. The agrochemical division produces insecticides, herbicides, and fungicides.  Description from Morningstar.

Here is a catalog of Aceto’s Human Health products.

Aceto has said that it will not be focusing on the agricultural segment in the future, and in my opinion ACET should completely eliminate the agricultural segment from its operations.  Not only will they not concentrate on it much in the future, it also produces the lowest margins of the three segments.  ACET also did not anticipate the amount of competition in this segment, and has thus far been ineffective in trying to compete.

If you are not going to invest fully in something why do it at all?

As of the most recent 10Q, Health Sciences contributed almost 60% of total revenues, Specialty Chemicals contributed about 34%, and Agricultural contributed about 6%.

I am going to value the company as a whole, talk about the three individual business, give my analysis and then conclusion.

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

All numbers are in millions of US dollars, except per share information, unless otherwise noted.  Valuations were done using 2011 10K and second quarter 2012 10Q.

Asset valuation

Assets:			Book Value:		Reproduction Value:
Current Assets
Cash & Cash Equivalents			27		27
Short Term Investments			2		2
Accounts Receivable (Net)			84		71.4
Inventories			83		60
Other Current Assets			6		0
Total Current Assets			202		160.4
PP&E Net			12		6
Goodwill			34		14
Intangible Assets			47		20
Other Assets			17		8
Total Assets			312		208.4

Total number of shares are 27

Reproduction Value:

• With intangible assets: 208.4/27=$7.72 per share.
• Without intangible assets 188.4/27=$6.98 per share.

EBIT and net cash valuation

Cash and cash equivalents are 27.

Short term investments are 2.

Total current liabilities are 79.

Cash and cash equivalents + short-term investments – total current liabilities=27+2-79=-50

• -50/27=-$1.85 in net cash per share.

ACET has a trailing twelve month EBIT of 25.

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

• 5X25=125+29=154
• 8X25=200+29=229
• 11X25=275+29=304
• 14X25=350+29=379

• 5X=154/27=$5.70 per share.
• 8X=229/27=$8.48 per share.
• 11X=304/27=$11.26 per share.
• 14X=379/27=$14.04 per share.

Revenue and EBIT valuation

Using trailing twelve month numbers.

				Numbers:
Revenue:				455
Multiplied By:
Average 6 year EBIT %:				4.42%
Equals:
Estimated EBIT of:				20.11
Multiplied By:
Assumed Fair Value Multiple of EBIT:				9X
Equals:
Estimated Fair Enterprise Value of ACET:				180.99
Plus:
Cash, Cash Equivalents, and Short Term Investments:				29
Minus:
Total Debt:				44
Equals:
Estimated Fair Value of Common Equity:				165.99
Divided By:
Number of Shares:				27
Equals:				$6.15 per share

The $6.15 per share is my base estimate of value.  My low estimate of value was $3.17 per share and my high estimate was $9.13 per share.

Price to book and tangible book valuation

				Numbers:
Book Value:				169.83
Minus:
Intangibles:				47
Equals:
Tangible Book Value:				122.83
Multiplied By:
Industry P/B:				2.5
Equals:
Industry Multiple Implied Fair Value:				307.08
Multiplied By:
Assumed Multiple as a Percentage of Industry Multiple:				95%
Equals:
Estimated Fair Value of Common Equity:				291.73
Divided By:
Number of Shares:				27
Equals:				$10.80 per share.

The $10.80 per share is my base estimate of value.  My low estimate was $8.53 per share and my high estimate was $14.22 per share.

Aceto’s current share price is $9.09 per share.  Lets now take a look at its margins, pros, and cons, to decide which valuation I will be using as my estimate of intrinsic value.

Consolidated Margins:

• Six year gross margin average is 17.1%
• Operating margin, or EBIT margin, has been between 3-6% every year for the last 10 years except 2010 when it was 2.7%.
• ROE has been between 5-10% every year since 2002.
• ROIC has been between 4-14% every year since 2002.

Not great margins by any means, but very stable which is something I like.

Pros:

• Insiders have been acquiring a lot of shares lately, some of which have been exercising of options.  Always a good sign to see insiders buying.
• Dividend payer with a low payout ratio, 32% in the trailing twelve months.
• Revenue has been growing: From $229 million in 2002 to $412 million in 2011.
• Very stable margins.
• Many big drugs have come off patent or are going to come off patent in the near future which should help grow revenue further: There are examples of some in this article.
• An aging population needing more pills, should also help continue to grow revenue as well.

Cons:

• ACET has debt as of the most recent 10Q at $44 million, which ACET says will lower its ability to make further acquisitions.
• Does not produce consistent positive free cash flow.
• Does not appear to have any kind of sustainable competitive advantage.
• Although the margins are stable, they are pretty low for a potential long-term buy and hold candidate.
• They are involved in some very fragmented and competitive industries, which could lead to excessive pricing competition and lower margins.
• While the margins being stable is a good thing, they are not growing at this time.
• Most of ACET’s suppliers are in China, which could leave them vulnerable if a recession, political or social crisis occur there.
• Days sales outstanding has risen by 22.6% since 2003.
• Payable period has risen almost 90% since 2003.
• Days inventory has risen by 21% since 2003.

This is how I am understanding the days sales outstanding, payable period, and days inventory all rising:

• Those three are measures of efficiency, and to me it looks like ACET is becoming less efficient.
• ACET is taking longer to confirm payments, it is also taking longer to pay its bills, and it is holding its inventory longer.

All are bad things and could lead to inflated revenue numbers.   Please let me know if my conclusions about the DSO, PP, and DI are wrong as I am new at incorporating these metrics into my analysis.

Catalysts

• An aging population that will need more drugs.
• A lot of big drugs have already come off patent or are going to soon.

Conclusion

With all of the above stated I have decided to choose the revenue and EBIT base valuation as my estimate of intrinsic value, $6.15 per share, because of all the risks I see in ACET: I do not see any competitive advantages, it functions in very competitive low margin arenas, etc.  My estimate of intrinsic value makes ACET overvalued by almost 30% at this time, as the current share price is $9.07.

At this time I will not be buying any shares in ACET as I think the cons outweigh the pros.

As always your comments, critique, concerns, and thoughts are welcome.

Why I am holding my Altria shares for now, but would not buy at current price.

When I first started reading about Altria (MO) its dividend is what initially got me very intrigued.  Altria was the first company that I bought where I actually read an annual report so it was my starting point for the research I am doing now.  However, I was not doing any type of valuation or near the amount of research I am doing now so I got a bit lucky that my position is now up around 30%.  I started doing this write-up and research of Altria mainly to see how far I have come since I originally bought.

However, now that I have just read its most recent 10K and 10Q I have found many things that bother me about the company.

First I will give the reasons why I originally bought more than a year ago:

• Big dividend in a low yield environment, the dividend has been growing as well.
• Huge competitive advantages that I noticed even then: Addicted customers who were willing to keep paying higher and higher prices.  A government sponsored mini-monopoly since there aren’t likely to be any new entrants due to litigation and taxes.  Massive brand recognition and market share.
• They were producing about $3 billion in FCF per year, which I thought was enough to cover the dividend.

Risks I saw then:

• Massive debt load over $12 billion.
• Litigation expenses.

Those were literally the only two concerns I had, and the only major concern of the two was the debt.  Altria seems to win a lot of its lawsuits or if they do lose, they end up having the amount to be paid out cut substantially, so that did not worry me too much.

The above are literally the only things I looked at before deciding to buy MO last year.  Not very in-depth thinking, and definitely not enough to get me even close to a buy or sell decision today.

Analysis now

Altria comprises Philip Morris USA, U.S. Smokeless Tobacco Company, John Middleton, Ste. Michelle Wine Estates, and Philip Morris Capital Corporation. It also owns a 27.1% interest in SABMiller, the world’s second-largest brewer. Through its tobacco subsidiaries, Altria holds the leading position in cigarettes and smokeless tobacco in the United States and the number-two spot in cigars. The company’s Marlboro brand is the leading cigarette brand in the U.S.

Having sold its international segments and the bulk of its nontobacco assets, Altria now operates primarily in the challenging U.S. tobacco industry. U.S. cigarette volume is in secular decline, and the Food and Drug Administration, having assumed regulatory control, has been quick to assert its authority. The threats of regulation and taxation have now overtaken litigation as the most significant risks to an investment in tobacco, in our view. Despite these headwinds, tobacco manufacturing is still a lucrative business, and we think Altria is poised to generate steady medium-term earnings growth. The addictive nature of cigarettes and Altria’s dominance of the U.S. market is the key reasons behind our wide economic moat rating.

The two descriptions above are taken from Morningstar.com.  You can view Altria’s SEC filings here.

Valuations:

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

Valuations were done using 2011 10K and second quarter 10Q.  All numbers are in millions of US dollars, except per share information, unless otherwise noted. Valuations were done on July 27th 2012.

Net cash and EBIT valuation:

Altria has cash and cash equivalents of 1,528.

Its number of shares outstanding are 2,027.

Altria has total current liabilities of 6,081.

Cash and cash equivalents-total current liabilities=1528-6081=-4553.

• -4553/2027=-$2.25 of net cash per share.

Altria has a trailing twelve month EBIT of 3519+6068-1295-1539=6753.

5X, 8X, 11X, and 14X EBIT+cash and cash equivalents=

• 5X6753=33765+1528=35293
• 8X6753=54024+1528=55552
• 11X6753=74283+1528=75811
• 14X6753=94542+1528=96070

• 5X=35293/2027=$17.41 per share.
• 8X=55552/2027=$27.41 per share.
• 11X=75811/2027=$37.40 per share.
• 14X=96070/2027=$47.40 per share.

Current price is $35.63 per share.

Market cap is 72.44 billion.

Enterprise value is 84.44 billion.

• EV/EBIT=12.50

My average unit cost including dividends is currently $27.10 per share for the MO shares I currently own.

Only the 14X EBIT valuation would get me a reasonable margin of safety if I were to buy now.  If I were to buy MO shares now I would be using either the 11X or 14X EBIT valuations as my base case.

A couple things of note:  Altria has a negative net cash number which I generally do not like.  Altria’s EV/EBIT is higher than the companies I usually evaluate, which is another sign that it might be fairly or overvalued currently.

Revenue and EBIT valuation:

Using Trailing twelve month numbers:

Revenue: 16,670

Multiplied By:

Average 4 year EBIT percentage: 34.13%

Equals:

Estimated EBIT of: 5,689.47

Multiplied by:

Assumed fair value multiple of EBIT: 10X

Equals:

Estimated fair value Enterprise value of MO: 56,894.7

Plus:

Cash and Cash equivalents: 1,528

Minus:

Total Debt: 13,089

Equals:

Estimated fair value of common equity: 45,333.7

Divided by:

Number of shares: 2,027

Equals:

$22.36 per share.

Low estimate

My high estimate of value, which I would use as my base estimate of value in this case, was a 15X estimated EBIT multiple which came out to $36.40 per share, about evenly valued.

Free cash flow valuation:

Again using Trailing twelve month numbers.

Operating cash flow: 3,388

Minus:

Capital expenditures: 108

Equals:

Free cash flow (FCF): 3,280

Divided by:

Industry median FCF yield: 6%

Equals:

Industry FCF yield implied fair value: 54,666.67 ($26.97 per share.)

Multiplied by:

Assumed required FCF yield as a percentage of industry FCF yield: 95%

Equals:

Estimated fair value of common equity of MO: 51,933.34

Divided by:

Number of shares: 2,027

Equals:

$25.62 per share.

Low estimate

My high estimate, where I changed the assumed yield from 95% to 125% came out to $33.71 per share.

I would estimate its intrinsic value to be the 11X EBIT multiple from the net cash and EBIT valuation, $37.40 per share.

Through these valuations I have found Altria to be either overvalued or about fairly valued at current prices.  Looks like I got a bit lucky when I was doing no valuations, or the amount of research I am doing now, when I bought MO around $27 per share.

I was mainly doing this exercise to see how far I have come since I originally bought MO, doing no valuations and minimal research.  My intention when I started this was not to do a complete analysis, but I found a few things that gave me some pause while reading its SEC filings that I wanted to highlight.

Concerns:

• All the litigation, which I will not detail here since it takes up at least 50 pages of the 10K.  If you would like further information please read Altria’s annual reports.
• Altria has been issuing debt and drawing on its short-term credit line to in part sustain its stock repurchasing and dividend.
• Debt of around $13 billion, around $11 billion of which came from its acquisition of US Tobacco in 2009.  Altria almost immediately charged about $5 billion of the transaction price to goodwill, meaning that that they paid almost double the price of the assets.  Quoting from the 10K “The excess of the purchase price paid by Altria Group, Inc. over the fair value of identifiable net assets acquired in the acquisition of UST primarily reflects the value of adding USSTC and its subsidiaries to Altria Group, Inc.’s family of tobacco operating companies (PM USA and Middleton), with leading brands in cigarettes, smokeless products and machine-made large cigars, and anticipated annual synergies of approximately $300 million resulting primarily
  from reduced selling, general and administrative, and corporate expenses. None of the goodwill or other intangible assets will be deductible for tax purposes.” To me paying almost double the price of the assets for supposed synergies does not make much sense and will also make it take longer for Altria to earn back its investment.
• Altria has projected pension and health obligations of around $6.5 billion.  The projected amount has been rising by around $500 million a year for the last few years as well.
• Altria has total off-balance sheet arrangements and aggregate contractual obligations of $33.7 billion, most of which are coming due after 2017, with around $4 billion a year needing to be paid over the next few years.  The total obligations include: Debt, Interest on borrowings, Operating leases, Purchase obligations, and other long-term liabilities.
• Altria’s fair value of total debt as of the most recent 10K is $17.7 billion.  A 1% increase in market interest rates would decrease the fair value of Altria Group, Inc’s total debt by approximately $1.1 billion.  A 1% decrease in market interest rates would increase the fair value of Altria Group Inc’s total debt by approximately $1.2 billion.  This risk is taken directly from its 10K on page 95 of the final section of the 10K.  Since interest rates cannot go any lower, and will not stay low forever, rising rates are going to crush the debt of Altria, unless it can refinance portions of the debt, which could also make it harder for them to issue debt in the future.
• The above are not even including the dropping rate of smoking in the US, and state and federal governments around the country regulating the tobacco industry so strictly that it has turned into a prohibition like industry.
• People have been piling into the stock recently for the high yield, which could be turning into a mini bubble around the stock and other high yield companies.
• Will not grow outside of the US.  That was the whole reason for the spin-off of Philip Morris (PM) so that Altria would have the US market, and PM would have the international markets.
• Insiders only own 0.08% of company stock.
• Since Altria does have a high debt load, it could preclude them from acquiring companies until it pays down some of the debt.

Pros:

• Altria has ownership of one of the most recognized brands in the world, Marlboro.
• Altria has 50% market share of the cigarette market in the US.
• Altria has 55% market share in the smokeless products in the US.
• Altria also has 30% market share in the cigar market in the US.
• Altria own a 27% interest in SABMiller, valued currently at about $19 billion.  Altria could sell this asset if they needed to pay down debt.
• Altria creates about $3 billion a year in FCF.
• Its margins are gigantic: Gross margin at 54%, EBIT margin at 37%, ROIC at 19%, and FCF/Sales margin at 20%.
• Addicted customers.
• Because governments regulate the tobacco industry a lot, Altria will not have to deal with any new entrants any time soon.
• Competitive advantages: Economies of scale, quasi government sanctioned monopoly.

How I think they could improve further:

Paying down the substantial debt would be a great step in the right direction.  In my opinion Altria should become a conglomerate, kind of a Berkshire Hathaway sin stock conglomerate.  Altria already owns a wine company subsidiary, and it owns part of one of the biggest beer producers in the world, and I think that MO could get further into that arena if they wanted to.  Altria could produce and sell marijuana when and if that ever becomes legalized since it would have the distribution lines already available.  Altria could also buy a company like Star Scientific (CIGX).  Here is Morningstars description of them, Star Scientific, along with its subsidiary, Star Tobacco, is a technology-oriented tobacco company seeking to develop, license, and implement technology to reduce the carcinogenic toxins in tobacco and tobacco smoke.

I remember reading a while ago that there was a rumor that either Altria or Philip Morris could buy CIGX to develop next generation cigarettes that did not have the carcinogens in them, thus alleviating the main concern with smoking.  I have not read any more rumors of that in a long time though.

One thing that is for certain, although smoking will never go away no matter how much governments regulate and tax the industry, Altria in my opinion, will eventually have to branch out at least a little bit due to declining rates of smoking in the US.

Conclusion:

Altria is one of the most dominant companies in the world.  It has a virtual monopoly in the United States in the cigarette and smokeless product segments, with at least 50% market share in both of those two industry segments.  The company has incredible competitive advantages that enable it to continue to have huge margins even with all the litigation, taxes, and regulation.

The company is not perfect as it has a myriad of issues that I outlined above.  If you were to buy Altria at the current prices, it appears that you would have no margin of safety and I would not recommend buying at this time.

However, I think the positives outweigh the negatives at the $27 price that I bought at, and I plan to hold onto my shares of Altria for hopefully decades, and hope to have my money compound well into the future.  If Altria can get its debt and pension obligations under control that should be no problem.

As always comments, concerns, and critique are welcome and would be appreciated.