WeeValue (45.31)

Rummaging Around the Trash Bin

May 17, 2008 – Comments (0) | RELATED TICKERS: JBSS , NLS

Like many investors, I strive to buy high quality businesses, with strong competitive positions and great “moats”.  Every once in a while (like the recent market madness), these businesses get served up cheap – then we pounce.  That’s great, but what to do the rest of the time… The Buffet and Munger super duo are known to say “We’d rather purchase a great business at a good price, than an average business at a great price.”    In my admittedly limited experience, the truly great businesses are richly valued and have a tendency to stay that way, and stay that way… and stay that way…  Plus, gasp, I think I may not be as good as Buffet/Munger at identifying and mentally modeling which businesses are truly great.  Wonderful self disclosure, so what to do while we wait for that juicy fat pitch?  Well, there are many different strategies for investing; I personally think that one of the keys to success is to adapt your investment style to your personality and temperament. For me, that means finding profitable opportunities in the meantime.  I just don’t have the patience to sit on my hands - for what may be years - to wait to buy great businesses at good prices.  So I spend a fair amount of time looking at good (or even not so good) businesses for great prices.  A couple of things that I find advantageous:

1)      There are more of them.  Truly great businesses are rare, finding one at a value price is even more rare.  And who knows, one of the businesses that starts as less-than-great may end up as great.

2)      You get to practice more.  Valuation and evaluating business strategy can be difficult and somewhat mind bending, the more you practice, the better you get.

3)      Similar to above, you learn more.  If you’ve spent time analyzing a company, even if you pass on investing in the business, you’re much more likely to follow that company; hence learning if your reasoning was sound.

4)      It can be very profitable.

Joe Ponzio has a great blog entry at F Wall Street that summarizes this approach quite nicely: http://www.fwallstreet.com/blog/131.htm

One of the keys to this method is to monitor a business performance over time – often I screen for stocks that have had major drops.  Usually, I find the story to be a little too heinous initially, sometimes down right scary.  But occasionally over time, you will see things stabilize a little, and then sometimes, it doesn’t take a huge mental leap to see how things can improve for the company going forward.

By way of case study, let’s see what’s in the Trash Bin!  I have two opportunities: Nautilus (NLS), and John B San Filippo & Son (JBSS).  What do a maker of fitness equipment and purveyor of nuts (that’s right, nuts) have in common?  How do negative earnings, declining cash flow and wilting stock price sound?  If it sounds good, then you are reading the right blog.

Let’s start with JBSS, it,s probably the darker picture – for the uninitiated, that’s what how we refer to a company when the latest 10Q has the first heading “Note 1 — Management’s Plans to Continue as a Going Concern” I’m not going to do a detailed financial analysis here, the intent is more just to illustrate how one might evaluate a company such as JBSS.  A little history:

In 2005, the company undertook a consolidation program to move the majority of its nut processing business to Elgin, IL from previous sites primarily in Chicago.

Over the course of 2005-2008, the company invested over $163 million in land and equipment for this improved facility.  Since the words “on time and under budget” rarely come up in relation to large scale facility migrations, it is not surprising that the start up has caused huge unanticipated expenses.

In 2006, declining prices in almonds damaged the value of the pre-purchasing arrangements they have with growers, decreasing profitability. And in general recent increases in basic nut prices have squeezed margins and profitability.

Essentially, JBSS suffered from the one-two punch of declining profitability and cash flow, right when they were incurring significant debt to consolidate operations in their new facility.  As a result, they violated their debt covenants.  JBSS has been operating close to the edge for about a year now, selling properties outright as they consolidate, or selling properties and leasing back the operations in order to free up cash.

So why invest?  I see three potentially powerful catalysts:

1)      Their debt has been restructured into mortgages and a revolving credit facility - which is not quite maxed out ($87m v. $117 capacity).  These are secured against virtually all of the company’s assets.  But this should give them some breathing room to get operations stabilized.

2)      The new facility should be complete mid-year.  Increases in efficiency should help drive profitability.

3)      Seasonal demand – sales peak in the fall and holiday months.  Given the new facility operating more efficiently, this is the best chance that the company will turn profitable.

Some other considerations:

This is essentially a family run business with the founding family controlling a majority of the voting stock.  This can be good or bad based on the shareholder orientation of the controlling family, and I have no opinion or data on that.  But before you would make a final investment decision, this is certainly something you should evaluate.  Do they have significant related party transactions?  Are they effectively deploying capital?  “One time” charges should slow down.  I’m always worried of One Time Charges, that happen every quarter.  In this case, the hypothesis is that these have been most related to the facility moves and associated re-financing.  Not that the move is done, they should stop.They have taken steps to reduce the number of products they support, eliminating the lowest margin items.  Although this will potentially reduce the top line somewhat, the items left should be more profitable.Due to the large capital outlay for the new facility, depreciation charges will be relatively high – lowering earnings, but not affecting cash flow.

Valuation: 

This is a little tricky given the fact the company is currently not profitable.  However, we’ll take a stab two ways:

Earnings: comparing to competitors in a similar space, a reasonable operating margin is 3-5%.  The industry average is 4.5%.  Since JBSS clearly is not at the top of the heap, let’s assume its sustainable operating margin is 3%. Given revenue around $500m, that leave earnings of $15m or $1.50/sh.  This corresponds nicely to the $1.30-2.60/share they earned in the last period of profitability.  Given an 10X-15X multiple and this corresponds to a $15-22.50 share price.

Cash Flow:  Using DCF is tricky as well.  But cash is really the question with this company – will they generate enough cash to cover the interest on their new loans.  Assuming they can return to a reasonable profitable operation, they should be positioned to deliver $20-$40 million in free cash flow.  This assumes very limited capital expenditures now that the new facility is done.  This translates into $2-4 per share of FCF.  Given a multiple of 10X and you have a stock price in the $20-40 range.

So what is the verdict:  Well, you’ll have to judge for yourself.  But I figure the future depends on just a few (easy to monitor) metrics:

1)      Raw Profitability: will the commodity nut pricing allow them to achieve baseline profitability.

2)      Operations at the new facility stabilizing.

3)      Cash flow from operations covering capital requirements with hopefully some left over to reward share holders.

For me, I’m not sure the reward justifies the risk.  At this point, let’s assume the odds of JBSS continuing as a going concern are 50/50.  Based on my rough valuation, we probably have upside of 100-150% on the current $10 stock price. So, 50% we lose it all, 50% we double or more our money.  It’s not a bet I’m willing to take.  For these odds, I’d want an upside of 3-5X to justify the substantial risk of losing everything.

At the end of the day, it’s the uncontrollable commodity price of nuts that throws me over the edge.  Maybe if I had more expertise in the pricing of nuts (not my circle of competence), then I would have a better comfort factor, or knowledge that would change my probability assignments.

So there you have it, wasn’t that fun?  I certainly think that was a more interesting exercise than being the 10,0000,0000,000th voice in the Google debate!

So, next time, we’ll look at our second candidate: Nautilus!