Category Archives: Honworld

WEEKLY COMMENTARY JAN 9, 2017 – JAN. 15, 2017 (M. DIAS BRANCO)

WEEKLY COMMENTARY JAN 9, 2017 – JAN. 15, 2017 (M. DIAS BRANCO)

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

On January 6, 2017, Honworld received approval from the National Office of Leading Group for Administration of Hi-tech Enterprise Recognition to be a New and Advanced Technology Enterprise. A New and Advanced Technology Enterprise is entitled to certain tax benefits including a reduced enterprise income tax rate of 15% for three consecutive years commencing from 2016. The company’s New and Advanced Technology Enterprise status expired in 2016. From 2013 to 2015, Honworld paid an average effective tax rate of 15.6% since 2013. A decrease in the tax rate from the normal corporate tax rate of 25% to the lowered tax rate of 15% into perpetuity adds about 10% to the company’s intrinsic value.

 

Honworld seems to have multiple competitive advantages in the form of economies of scale related to R&D, and marketing within its key regions. The company’s products are frequently purchased, low priced and ingested creating customer captivity due to these habit forming characteristics. Aside from the customer captivity from habitual use, the low price also increases search costs as a 10% difference in price between Honworld’s products and a competitors will not induce customers to change meaning competitors need to undercut Honworld’s price significantly to increase the probability of acquiring Honworld’s customers. Honworld has a price premium and market share advantage pointing to a brand advantage. The company also has superior profitability relative to competitors making it difficult for those competitors to undercut Honworld’s pricing and stay profitable.

 

While the company business seems to be very high quality, management’s capital allocation decision of investing heavily in inventory is deteriorating returns and decreasing cash flows to the point where the company cannot finance growth from internal cash flows. Holding inventory allows Honworld to age its base wine allowing the company to sell more premium products. If the company was able to generate sufficient profitability from premium products to cover the cost of ageing inventory, it would not be a concern but the ageing of inventory is a drag on the company’s returns. In a previous post (link), there was a detailed calculation on this issue. The other side of the inventory debate is maintaining high levels of inventory allows the company to age that inventory to sell more premium products and be ready for any expansion. Selling more premium products provides a higher gross margin but the gross margin is not high enough to cover the cost of holding the inventory required for premium products. The argument of being ready for growth does not make sense, as the majority (57%) of the company’s sales is medium range product, which does not require base wine to be aged. The company has also been able to grow over the past few years without as much base wine inventory as the company has now. The true benefit of ageing inventory is it makes it difficult for competitors to replicate the aged inventory strengthening the company’s competitive position. The passion of the owner as illustrated by holding base wine inventory before he got into the business may actually be a detriment as his goal may not be running the business optimally but building as much base wine inventory as possible.

 

An additional concern arose in the company’s H1 2016 results. The company’s growth slowed and investment in inventory slowed, which should have led to positive free cash flow, as there is not a significant amount of fixed capital investment required for the business. Unfortunately, the company made significant pre-payment for fixed assets. These are very concerning accounts to see on a balance sheet.  We are selling trying to reach a 2% position size due to our concerns over capital allocation will permanently depress profitability not allowing the company to reach the intrinsic value, it would if it had proper capital allocation.

 

Miko International issued a profit warning. It did not cause a large drop in the company’s share price, which may be a signal that all the bad news is priced in. This may be the case but the weakness in the corporate governance overrides the company’s cheapness. We are in the process of selling our position.

 

We completed the sale of our Credit Analysis and Research position.

 

 

INTERESTING LINKS

 

A Chat with Daniel Kahneman (Collaboration Fund)

 

An article by Morgan Housel discussing his notes from a dinner he attended with Daniel Kahneman.  Kahneman along with Amos Taversky are pioneers in the behavior finance world. (link)

 

The Art of Looking Stupid (Eric Cinnamond)

 

A blog post discussing the investment management industry and how looking stupid is beneficial to returns. (link)

 

Normalized Earnings Yield (Eric Cinnamond)

 

A discussion of a simple valuation calculation that is a good approximation of the potential return of an investment (link)

 

Investing Narratives (csinvesting)

 

A blog post with a number of links discussing the topic du jour, narratives (link)

 

Ben Graham’s 1932 Forbes Articles (Old School Value)

 

Three articles written by Ben Graham for Forbes in 1932 (link)

 

Alibaba Offers To Buy Out Intime Retail For $2.5 Billion, At 42% Premium (Barron’s)

 

Alibaba is making a shift offline buying Intime Retail, an owner of 29 department stores and 17 shopping malls. The transaction provides a private market value for retailers. (link) The table below illustrates the valuation of Intime Retail based on Alibaba’s takeover bid.

 

We are not experts in real estate and tend not to look at businesses in the industry, but the following are some thoughts on the acquisition. Intime Retail purchases land, develops the site, and the either sells or rents the shopping mall or department store. Price to book is often used for real estate companies as the process of developing sites can take years making earnings lumpy. Private market value assumes the price paid is a reasonable one, but is 1.7 times book value reasonable for Intime Retail. For 1.7 times book value to be reasonable, at a 12.5% discount rate and no growth, we must assume that the company will be able to generate a return on equity (ROE) of roughly 21.0% into perpetuity. If we assume a 5% growth rate, it would need to generate a ROE of roughly 17.0% into perpetuity. Since 2007, the company generated an average return on equity of 13.54% so something would need to change to make the company generate higher revenue to justify the purchase price. Unfortunately, the industry does not have any barriers to entry so excess profitability would be very difficult to sustain. There are many real estate developers. There are no economies of scale, no customer captivity or no sustainable cost advantages. Given the lack of barriers to entry within the industry, Alibaba could have hired the expertise needed and completed the projects at a cheaper price assuming cost inflation within the industry does not lead the company to pay 1.7 times the construction costs of Intime Retail.

 

A Profitable Industry You’ve Likely Never Considered (Fortune Financial)

 

An interesting blog post discussing the outperformance of publicly listed airports (link)

 

Amazon Stock’s Exceptional Price History Meets Value Investing (The Conservative Income Investor)

 

There are a number of thoughts with agree with in this article discussing a potential investment in Amazon from the perspective of a value investor. (link)

 

A Fee Structure for Fund Managers Who Put Their Money Where Their Mouth Is (Jason Zweig)

 

An article written by Jason Zweig discussing the fee structure of fund managers. (link) The rise of ETFs are completely understandable when the vast majority of mutual funds charge a much higher fee than ETFs yet have a difficult time outperforming the ETF. The article discusses a much better fee structure.

 

 

M. DIAS BRANCO 

 

The following is a research report we nearly published on M. Dias Branco in late January, early February 2016. We liked the business but disliked management’s capital allocation decisions. Management is increasing vertical integration by moving back into raw materials, which are primarily commodities. These commodity business may not dilute returns now but they should be a drag on the more consumer oriented businesses. Additionally, rather than expanding its distribution channel at the margins, M. Dias Branco is making acquisitions where it does not have a size advantage or its own distribution leading to weaker returns. This is illustrated by the percentage of sales to smaller retail outlets where it is the sole supplier. The company is also under spending on R&D and advertising. The company should be spending heavily on theses fixed costs as well as its distribution network to make it more difficult for smaller players to compete. In areas where its distribution network eliminates competition, there is no need for advertising as there are not alternatives. In markets where the company does not have a distribution advantage, without advertising the only way to attract customers is pricing. This is not an effective method of competing when products are low cost meaning a small differential in pricing is not going to cause a customer to change. In addition, taste and texture are probably more important than a small differential in pricing.

 

Our decision to not to recommend M. Dias Branco was clearly wrong. The company’s share price was between BRL60-65 per share at the time of writing the research report. M. Dias Branco closed at BRL130 on Friday January 13, 2017 meaning we missed a 100% return opportunity in one year. We were far too greedy on price as the company had a history of growth in an industry with barriers to entry, yet, was trading on a no growth valuation. At the time of the report, our position sizing philosophy was aggressive and we only wanted to invest in a stock if it was able to be a large position >5%. Missing the investment opportunity in M. Dias Branco is one of the reasons of adding high quality stocks that may be slightly expensive and taking advantage of portfolio management skills to add to or reduce the position as the share price moves. We do not know if the change in position sizing philosophy would have changed our decision to pass on M. Dias Branco. If we had recommended the company, we most likely would have sold out due to valuation before realizing the full 100% return, as we were already skeptical of the company’s capital allocation strategy. The change in the position sizing philosophy did provide opportunity for returns in Credit Research and Analysis and Anta Sports, two of our top three recommendations in 2016.

 

The valuation section of the report reflects the investment opportunity at the time rather than the current pricing. We left out the investment thesis, as we did not complete it at the time.

 

 

COMPANY DESCRIPTION

 

M. Dias Branco is a Brazilian manufacturer, marketer, and distributor of cookies and crackers, pasta, flour and wheat bran, margarines and vegetables fats, and cakes and snakes.

 

 

HISTORY

M. Dias Branco was founded by Manuel Dias Branco when he started baking and biscuit production in the 1940’s in the Brazilian state of Ceara. Mr. Dias Branco first established M. Dias Branco & Cia Ltda in 1951 before founding M. Dias Branco in 1961. In 1953, Mr. Francisco Ivens de Sá Dias Branco joined M. Dias Branco & Cia. Ltda. providing strategic direction with an emphasis on investments in industrial technology to produce and sell cookies, crackers, and pasta on large scale.

 

In the early 1960’s, the company started operating its current distribution model of focusing on supplying micro, small, and medium retailers. The company’s distribution model along with its large-scale production allowed expansion initially in Ceara then in neighboring states. The company created its Fortaleza brand created in the 1950’s and its Richester brand created in 1978.

 

During 1990’s, Brazilian government deregulated wheat market. M. Dias Branco took advantage of the deregulation by opening its first wheat mill plant in the state of Ceara in 1992. The new plant allowed the company to backward integrate into its supplying its main raw material, wheat. In 2000, the company expanded its raw material production capacity with a second wheat mill plant in the state of Rio Grande do Norte. The plant increased the integration of the production process as it also has pasta production capabilities.

 

To vertically integrate its production process, in 2002, M. Dias Branco opened its first shortening and margarine plant. The plant produced shortening needs for the production cookies and crackers.

 

In 2003, the company opened a third wheat mill and acquired Adria, a traditional cookies, crackers, and pasta manufacturer. Adria was a leader in both South and Southeast regions giving M. Dias Branco national coverage and making it the leader in the Brazilian market. Adria had a turnover of R$400mil in 2002, up 29.45% on 2001. The acquisition increased M. Dias Branco’s market share by 14% in the cookies segment and 20% in the pasta segment. The company also acquired Adria’s brands Adria, Basilar, Isabella, and Zabet as well as three industrial plants in the state of Sao Paulo and one plant in Rio Grande do Sul. These plants include three pasta factories and two cookies and crackers factories.

 

In 2005, the company started its fourth cookies and crackers facility and its sixth pasta facility, both are integrated with the wheat mill opened in 2003. It is also integrated to a private port so the company can import wheat grain at a lower cost relative to public ports. The Bahia factory adopted a model that eliminated the cost of wheat flour transportation to the cookies, crackers, and pasta factories. It also created a platform for expansion into the South and Southeast regions. In the same year, in the state of Paraíba, the company opened its fourth wheat mill and its seventh pasta factory adopting the same vertical integration model to eliminate the costs of wheat flour transportation.

 

With the expansion of its production in the South and Southeast regions, M. Dias Branco also expanded its distribution network with a focused on the micro, small and medium retailers in the regions.

 

In October 2006, the Company made its IPO listing in the Novo Mercado with the ticker MDIA3.

 

In April 2008, M. Dias Branco acquired Vitarella, a cookies, crackers, and pasta company located in the state of Pernambuco. Vitarella has a strong position in the Northeast region, particularly in states where the M. Dias Branco does not have leadership. The acquisition expanded the company’s national and Northeast region leadership in sales volume of cookies, crackers, and pasta. M Dias Branco paid BRL595.5 million for the Vitarella’s plant and brands Vitarella and Treloso. According to AC Nielsen, at the end of February 2008, Vitarella held 5.5% of the cookies market and 2.9% of the pasta market in Brazil in terms of volume. In 2007, Vitarella had net revenue of BRL323.2 million.

 

In April 2011, M. Dias Branco acquired NPAP Alimentos S.A, a manufacturer of cookies, crackers, and pasta with the brand Pilar, located in the state of Pernambuco. NPAP recorded net revenue of BRL107.5 million in 2010 with 56% from cookies and crackers and 44% from pasta. With The acquisition, M. Dias Branco increased its share of the national cookie and cracker market by 1.2% from 22.2% to 23.4%, and by 2.3% in the pasta market from 22.4% to 24.7%. M. Dias Branco paid roughly BRL70 million for NPAP.

 

In December 2011, M. Dias Branco acquired Pelágio and J.Brandão (both known as Fábrica Estrela) a manufacturer of cookies, crackers, pasta, and snacks with a focus on the country’s North and Northeast regions under the brands Estrela, Pelaggio, and Salsito. In 2010, the company generated BRL190.6 million in net revenue from two industrial units located in the state of Ceará. The acquisition increased M. Dias Branco’s market share in Brazil grew by 1.2% from 24.1% to 25.3% in the cookies and crackers segment and by 0.7% from 24.5% to 25.2% in the pasta segment. The company paid BRL240 million for Fábrica Estrela.

 

In May 2012, M. Dias Branco acquired Moinho Santa Lúcia Ltda., a company located in the state of Ceará that produces wheat flour, cookies, crackers, and pasta under the brands Predilleto and Bonsabor. In 2011, Moinho Santa Lucia had net revenue of BRL88.1 million. M. Dias Branco paid BRL90 million for Moinho Santa Lucia.

 

In 2014, M. Dias Branco increased investments in production line expansion of cookies, crackers and pasta as well as introducing new products (cake mix and toast). It also started the construction of three new wheat mills in the state of Ceará, Pernambuco, and Rio Grande do Sul allowing the company to fully integrate the production process with wheat flour, the company’s main raw material. In a public auction, the company also acquired a new wheat mill factory in the state of Paraná to accelerate the vertical integration of its facilities in the Southeast region.

 

 

CORPORATE STRUCTURE

 

Tergran was founded on September 22, 1996 and is scheduled to shut down on September 2026. It was established to carry on port operations related to the import, export, and trading of grain. Tergran’s other shareholders are J. Macêdo S.A. and Grande Moinho Cearense S.A., both are competitors. Each shareholder holds an equal equity stake in Tergran. M. Dias Branco operates Tergran with the goal of increasing the efficiency of the import and export of wheat at the Fortaleza Port. Tegran sells its products to shareholders.

M. Dias Branco Argentina S.A. is a wholly owned subsidiary that purchases, imports, and exports wheat grain, wheat flour, and its derivatives. The company has not yet started its activities.

M. Dias Branco International Trading LLC is a wholly owned subsidiary that purchases raw materials (principally wheat and vegetable oil)

M. Dias Branco International Trading Uruguay S.A. is its wholly owned subsidiary that purchases raw materials, particularly wheat.

 

 

SHAREHOLDER STRUCTURE

 

DIBRA Fundo de Investimentos em Participações (DIBRA) is 99.82% owned by Francisco Ivens de Sá Dias Branco. DIBRA and managers sold shares in 2010 to increase free float to the required 25%.

 

 

REVENUE

 

Over the trailing twelve months, cookies and crackers accounted for 52% of revenue, pasta accounted for 23% of revenue, wheat flour and brand accounted for 19% of sales, margarine and vegetable shortening accounted for 5% of revenue, and new products like cakes, snack, and packaged toast accounted for the remainder of revenues.

 

Over the past five years, the company grew its revenue by 14.3% per annum. The 14.3% compound annual growth rate represents a total increase in revenues of BRL2,232 million with BRL278.1 million or 12.5% of incremental revenue acquired from the Pilar and Fabrica Estrela acquisitions and the remainder from organic growth.

 

Over the past twelve months, M. Dias Branco has produced 1,692 tonnes of product at an average price of BRL2.71/kg. Since 2009, the company volume sold increased by 8.0% per annum or 550 tonnes. Over the same period, M. Dias Branco has increased prices by 5.7% per annum. The increases in weight sold and average selling price were even across products.

 

In 2014, revenue from the Northeast Brazil accounted for 72.2% of sales up from 63.4% of sales in 2004 growing at 14.7% per year over the period. The increased proportion of sales from Northeast Brazil came at the expense of Southeast Brazil. Revenue in the company’s second largest region increased by 8.9% per annum over the last ten years leading to a decrease from 22.3% of sales in 2004 to 15.0% of sales in 2014.

 

 

BRANDS

 

 

The company has a large portfolio of brands with 23 brands across four product lines.

M. Dias Branco’s largest brand is Vitarella, a cookie and cracker and pasta brand accounting for an estimated 17.4% of 2014 revenue. The company acquired the brand along with Treloso in April 2008. Until 2014, the company disclosed the Vitarella and Treloso brands separately but combined revenues in 2014. Assuming the Treloso brand had BRL225 million in 2014, the Vitarella brand would have recorded revenues of BRL798 million representing a 14% compound annual growth rate since 2009. Vitarella is the cookie and cracker brand leader in Northeast Brazil.

 

The company’s second largest brand is Fortaleza, the company’s oldest brand. Fortaleza is a cookies and cracker and pasta brand created in the 1950’s that accounted for 12.3% of 2014 revenues. Over the past five year, the Fortaleza brand’s revenues have grown at 13.8% per annum.

M. Dias Branco’s third largest brand is the Richester brand, which has the perception of modern, young, and fun brand. It is the company’s second oldest brand with products in cookies and crackers and pasta segments. The brand accounts for 11.0% of the company’s 2014 revenue and has grown by 11.7% per year over the past five years.

 

Meldaha de Oro is the company’s largest wheat flour and margarine brand. The brands focus is bakery customers in wheat flour and food service customers in the margarine and shortening segment. It accounted for 10.5% of the company’s revenues in 2014 and grew by 15.4% per year over the past five years.

 

All other brands account for less than 10% of the company’s sales. Other notable brands include the company’s other wheat flour brand Finna serving retail customers with a focus on economic class A to E.

Based on household gross monthly income, class A household gross monthly income is above BRL 10,200, class B is above BRL 5,100, class C is above BRL 2,040, class D is above BRL 1,020, and class E is below BRL 1,020. Finna accounted for 5.4% of revenue in 2014. The company’s margarine product Amorela targets economic classes A and B, while shortening brands Puro Sabor and Adorita target economic classes B, C, and D.

 

In the cakes and snacks market, the company has a specific product range for the children’s segment marketed under the Pelagio and Richester brands, and a family product range marketed under the Pelaggio brand. The company has a licensing agreement with Disney for the use of Disney’s characters on some of Pelagio’s packaging.

 

The company has a diverse portfolio of brand but do the brands add any value. Indicators can be used to determine the strength of a company’s brands including market share, pricing power, relative pricing, advertising, frequency of customer purchase, and cost of an item.

 

Since 2008, through organic growth and acquisitions, M. Dias Branco has increased its cookies and crackers volume share from 19.8% in 2008 to 28.1% in 2014 and its pasta volume share increased from 21.9% to 28.9%. The company is the leader in both the cookies and crackers market and pasta market.

 

In 2014, M. Dias Branco had a 20.8% market share in Brazil almost twice as large as the company’s closest competitor Nestle and second largest competitor Marilan. The company is three times the size of its third and fourth largest competitors Mondelez and Pepsico. Within its home region of Northeast Brazil, the company has even larger market share advantage with 55.6% of the market. In the Southeast, the company is the fourth largest competitor behind Marilan, Nestle, Pepsico, and Arcor.

 

In 2014, M. Dias Branco had a 25.8% of the Brazilian pasta market. Similar to the cookies and cracker market, the company has roughly twice the market share of its largest competitor. Also similar to the cookies and cracker market, the company has a significant advantage in Northeast Brazil at almost five times the size of its closest competitor. In the southeast region, the company is the second largest company right behind the market share leader

 

On a global scale, M. Dias Branco is the seventh largest cookie maker in the world with a 1.7% market share in 2012. The company was also the sixth largest pasta maker in the world with a 1.7%.

 

 

PRODUCTION

 

M. Dias Branco has 14 manufacturing units and several commercial units distributed in major Brazilian cities.

 

The company just took control of the wheat mill in Rolandia, Parana in the second half of 2015 after recently winning the wheat mill at an auction.

M. Dias Branco’s capacity and production by product is listed above. Since 2005, cookies and crackers capacity has grown by 12.8% per annum, pasta capacity by 6.0% per annum; wheat flour and brand by 9.9%, and margarines & fats have grown by 9.7% per annum.

 

At the end of 2014, Wheat flour and bran accounted for the largest portion of production capacity at 50.5% followed by cookies and crackers at 26.5%, pasta at 16.9%, margarines and fats at 5.8%, and cakes at 0.3%.

 

The cost of building a new ton of capacity at existing facilities based on management estimates in both US dollars and Brazilian reals is illustrated above. The cost of reproducing capacity is lowest for wheat mill at USD120 per tonne increasing to USD300 per tonne for pasta and USD350-400 per tonne for cookies and crackers. Management did not have an exact figure for margarine and shortening but stated it was between the cost of wheat mill and pasta.

 

M. Dias Branco has a strategy of vertical integration by increasing its reliance in production of raw materials of wheat and vegetable shortening with a goal of reaching 100% vertical integration.

 

In the trailing twelve months, the company consumed 6.1 percentage points more internally produced wheat than in 2008 at 56.1% in the trailing twelve months compared to 50.0% in 2008. It increased reliance on internally produced wheat has also increased by 6.9 percentage points up from 72.2% in 2008 to 79.1% in the trailing twelve months.

 

Vegetable shortening production consumed internally has increased by 19.4 percentage points from 35.7% in 2008 to 54.1% in the last twelve months. Of the company’s total vegetable shortening consumption, 88.5% in internally produced up from 48.9% in 2008.

 

 

DISTRIBUTION

 

 

M. Dias Branco has 28 distribution centers in 16 states throughout Brazil with a concentration of distribution centers in Northeast Brazil. The company distribution system had been built over 60 years. The distribution systems caters to all customers but is focused on micro, small, and medium retailers through door to door sales and weekly customer visits leading to strong customer relationships.

 

In the early 1960’s, the company started to operate its current distribution model of focusing on supplying micro, small, and medium retailers. Company representatives make at least one visit per week to every client creating very strong relationships with clients and a constant feedback loop allowing the company to adjust its positioning and strategies as needed. Two marketing systems are used to meet the direct channels: the immediate delivery to the traditional retail (small and medium traders) and the pre-sale for serving large networks and average retail supermarkets.

 

The company’s distribution is primarily through road transport via the company’s fleet of 554 vehicles and an average of 2,662 outsourced vehicles per month. The company also uses 122 motorcycles used by pre-sale vendors.

 

Outside of larger cities infrastructure is poor so the company’s distribution channel gives it an advantage over competitors. The company estimates 40% of direct sales are to smaller mom and pop outlets that no other competitor can reach and there is very little competition. This reach and lack of competition allows the company’s brand to be the standard in their respective product category that all future products are compared. Given the company’s market share, its distribution network is extremely difficult to replicate particularly in the Northeast where the company has a 55.6% market share in cookies and crackers and a 61.6% market share in pasta. In regions where the company has lower market share such as the Southeast, the company relies on distributors as the fixed costs associated with distribution is too much of a burden. Additionally, margin on products sold through direct sales are higher than sales through indirect distribution.

 

The company’s extensive network of direct sales and close relationship with indirect channels ensures strong presence throughout the country and close contact with its customers creating customer loyalty and an increased customer base. More importantly, it is very difficult to replicate as it is a fixed cost and scale is needed to cover those fixed costs. For example in the Southeast region, M. Dias Branco has a 10.8% cookies and cracker market share and a 16.8% pasta market share yet the fixed costs associated with creating a distribution network to cover the region is too expensive.

 

The company’s sales from direct distribution decreased from 52.4% in 2005 to 40.7% in 2014. At last disclosure, the company had over 70,000 active clients and 110 distribution partners. Since 2005, direct sales grew at 12.6% per year compared to an 18.6% compound annual growth rate at intermediaries. The company’s direct sales network does not even cover half of the Northeast region so the company has plenty of room to build out its distribution network.

 

In 2014, 40.7% of sales were to smaller retail chains, wholesale distribution accounted for 44.2% of sales, large retail chains accounted for 12.5% of sales, and industrial customers accounted for 2.0% of sales. The company’s top 100 clients only account for 41.6% of sales, while the remaining clients accounted for 58.4% of sales.

 

The company stated it can economically ship basic crackers and pasta 1,000 kilometers before logistic costs puts the company at a disadvantage and higher value added products can be shipped 1,500-2,000 kilometers

 

 

INNOVATION

 

Since 2006, M. Dias Branco spent BRL25.5 million on new products with an average new product R&D spend is 0.1% of sales. Over that period, the company’s R&D spend translated to 373 total new products generating new product sales of BRL254 million or 1.0% of sales over the period.

 

R&D includes new products as well as slight modification such as new product shapes, new packaging, and improving product recipes. Some of the new products launched by the company include new flavors in pasta and cookies. The company’s goal for any innovation is to reach a minimum of 5% market share in the first year. The company believes it has a 60% success rate.

 

Tastes and cultures within Brazil are very regional making large international competitors’ international R&D not as useful in Brazil therefore much of their R&D has to be recreated for the country decreasing the potential competitive advantage from being global players.

 

Relative to international food and beverage companies, M. Dias Branco spends significantly less as a percentage of sales.

 

All large international food and beverage companies spend at least 1.0% of sales or ten times the amount that M. Dias Branco spends on R&D pointing to significant under spending by the company.

 

R&D is very important for two reasons. First, it is a fixed cost allowing the company to exploit its size advantage over competitors in Brazil creating a virtuous feedback loop. If the company is under spending it is negating the company’s size advantage allowing smaller competitors to compete on R&D and remaining profitable. Second, the company’s large distribution network comes with fixed costs that are better utilized if the company can push as many products through that distribution channel making creating new products very important.

 

 

COST OF GOODS SOLD

 

 

Total raw materials costs have increased from 28.3% of sales in 2005 to 46.8% of sales in 2014, accounting for the vast majority of the increase in the company’s cost of goods sold as a percentage of sales. M. Dias Branco lack of segment disclosure by product line or region leads to less information on segment gross margin but the increased importance of lower margin products in the form of wheat flour and margarine and shortening as well as the increased reliance on external distribution has lead to weaker margins. Wheat flour and margarine and shortening gross margins are probably higher than Bunge and ADM’s gross margins of 5% but well below the gross margin for cookies and crackers. The use of external distribution decreases gross margin on products through competition. Direct distribution comes with much less competition as the company has built an infrastructure than cannot be matched by competitors leading to less competition in small mom & pop retail outlets where infrastructure is poor.

 

 

OPERATING COSTS

 

 

The company fastest growing expense, and only expense to grow faster than revenue, is freight expense growing at 21.0% CAGR over the past five years as the company has increased the percentage of sales through indirect distribution channels. The largest expense is employee benefits, which grew at 11.2% over the past five years. Overall, operating expenses have grown at 11.1% since 2009 below the pace of revenue growth over the same period pointing to operating leverage. Unfortunately, cost of goods sold has increased at 16.1% per annum over the past five years lead to gross margin and operating margin compression.

 

 

PROFITABILITY

 

 

 

With the exception of 2007, M. Dias Branco has consistently generated a return on invested capital above 10% and since 2009, the company has consistently generated a return on invested capital above 15%.

 

On a per unit basis (tonne), since 2006, M. Dias Branco has increased volumes by 8.5% per annum, average selling price (ASP) by 7.5% per annum, and gross profit by 6.7% per annum as cost of goods sold has outpaced ASP. Operating income has increased at 12.8% per year as sales expense has grown below ASP increases, while administrative and tax expenses have decrease since 2006.

 

Working capital has increased at 12.8% per year driven primarily by a 12.0% per year increase in accounts receivable. PP&E has only increased by 3.4% per year. Given the company’s recent acquisitions, intangibles increased by 22.2% per year.

 

 

To determine marginal unit economics, all income statement and balance sheet accounts that move with sales as measured by a very low coefficient of variation are deemed to be variable. Variable accounts are cost of goods sold, sales expenses, working capital, and property, plant and equipment. Since 2006, the company’s contribution margin averaged 20.1% with a standard deviation of 2.2%. The company’s variable ROIC averaged 44.1% with a standard deviation of 7.8%.

 

 

 TAX INCENTIVES

 

M. Dias Branco receives state and federal subsidies when the company makes investments falling under public programs that encourage development.

State tax incentives come in the form of a deduction against ICMS (value added sales tax). These incentives are accounted for in the company’s cost of goods sold on the income statement. The state income tax incentives are illustrated above.

 

The company also receives federal tax subsidies as a result of investments in the Northeast of Brazil, through the installation, modernization, extension or diversification of industrial units located in the Superintendency for the Development of the Northeast (SUDENE) operates. Tax incentives are granted for a period of ten years and a 75% deduction is received.

 

 

Since 2009, the company has paid 13.0% of gross sales in sales tax while receiving state tax incentives equal to 3.3% of gross sales. The company receives tax incentives equivalent to 25.6% of the company’s value added tax. The company also reports a tax expense of 0.5% of gross sales in operating expenses. Income tax and social contribution as a percentage of operating income has averaged 9.4% since 2009.

 

 

STRATEGY

M. Dias Branco’s strategy includes increasing market share through diversifying its customer base through geographical expansion via acquisitions and organic growth. The company plans on increasing sales to non-residential food service and processing markets including restaurants, hotels, bars, hospitals, clubs, pastry shops, and bakeries. It also plans to expand its distribution network to increasing the fragmentation of its client base and sell new products.

 

The company also plans to improve operational efficiency and costs controls by optimizing its infrastructure, increasing the flexibility of the production chain, maintain full up to date production facilities with high-end technology and state of the art operations. The company also plans to increase vertical integration in order to meet 100% of its wheat flour and shortening needs.

 

M. Dias Branco will continue to focus on higher value-added products, such as new product lines or complementary product targeting markets in which it already operates.

 

The company also intends to grow organically through the expansion of production capacity. It also plans to acquire businesses with strong brands, a solid customer base, and an extensive distribution network.

 

 

INDUSTRY

 

Brazilian Wheat and Wheat Milling Industry

 

Currently, the Brazilian government intervenes into the wheat production sector through loans and minimum price guarantees. Brazilian wheat production is well below international standards due to unfavorable weather conditions for the winter crop in most parts of the country and poor soil conditions leading to poor quality of wheat and higher production costs. Consumers are often able to import higher quality wheat from Argentina and the United States at better prices than sourcing wheat from Brazil. In addition, domestic production is insufficient to meet domestic consumption needs making Brazil dependent on Argentinean imports. Currently, imports account for about half of domestic consumption. Given import requirements, Brazilian wheat mills have a strong vulnerability to price fluctuations of international commodity.

 

The Brazilian wheat mill industry is very fragmented with a large number of small mills and a large amount of idle capacity. According to ABITRIGO, at the end of 2012, there were 229 mills with 77.3% of wheat mills in the Southern region, 10.0% of wheat mills in the Southeast region, 6.1% in the Northern region, 5.2% in the Midwest region, and 1.3% in the North region. The South has a 44.0% market share of wheat milled, the Southeast has a 24.8% market share, the North and the Northeast have a 27.5% market share, and the Midwest has a 3.6% market share. Domestic wheat mills account for 93% of flour consumption.

 

The bakery sector is the largest consumer of the Brazilian Wheat mill industry consuming 55.3% of flour produced. According to ABIP – Association Brazilian of Bakery and Confectionery Industry, the bakery sector is among the largest industries of Brazil and consisting of more than 63,000 bakeries with an average 41.5 million daily customers in 2014.

 

According to the ABIP – Brazilian Association of Bakery and Confectionery Industry, Per capita bread consumption in Brazil is on average 33 kg per year half of the consumption recommended by the WTO. It is also lower than the bread consumption in Argentina at 70 kg per capita and Chile at 90 kg per capita. Purchasing power of the population is one of the most factors that contribute to the low per capita consumption.

 

 

The Pasta Industry in Brazil

 

According to ABIMA, there are over 80 small, medium, and large companies and more than 100 micro enterprises operating about 140 factories in the Brazilian pasta industry. The installed capacity of the pasta industry in Brazil is around 1.3 million tons behind only Italy’s installed capacity of 3.3 million tonnes and the US’ installed capacity of 2.0 millions of tons.

 

The pasta production process allows producers to manufacture any type of pasta with minor adjustments. Pasta is also a low added value product making shipping costs a significant portion final price making pasta markets regional. The company believes basic crackers and pasta can be shipped 1,000 kilometers before logistic costs affect the product’s competitiveness.

 

Brazil is the third largest pasta consumer behind Italy and the United States. On a per capita basis, Brazil is behind many more industrialized countries at 6.2 kg per year.

 

Brazilian consumes much more rice (26.5 kg per year) than pasta (6.2 kg per year). As illustrated below, as Brazilian’s monthly income increases pasta and cookie consumption increases.

 

Many companies in the sector have integrated process to wheat mill with a broad portfolio of other wheat products such as flour, cake mixes, cookies, and cake mix.

 

According to AC Nielsen, in 2014, the Southeast region is largest pasta region by volume sold accounting for 43.4% of total pasta volume sold in Brazil, down from 49.7% in 2006. The Northeast is the second largest region accounting for 28.8% of volume sold in 2014 up from 25.9% in 2006. The South is the third largest region at 19.4% of volume sold up from 18.1% in 2006. The Midwest accounted for 6.9% of pasta volume sold in 2014 up from 6.3% in 2006. The North accounted for 1.4% of the pasta volume sold in Brazil. AC Nielsen just started accounting for the North region of Brazil in its survey of the pasta market.

 

The table above illustrates 2014 volume share and market share by region along with market share change over the past five years of the six largest pasta companies in Brazil. In 2014, M. Dias Branco was the largest pasta maker, on both volume and market share terms, in Brazil. The company’s share lead is driven by its market share dominance in the Northeast where it holds a 61.6% market share almost five times its closest competitor J. Macedo. The Northeast is where the company started and where it has its own distribution network. In the Southeast, the largest region in Brazil, is much more competitive with the five players holding over 10.0% market share. M. Dias is tied for second place with 15.2% behind Santa Amalia the market share leader with 15.8% of the market.

 

Since 2009, M. Dias Branco has increased its market share by 2.5% in all of Brazil driven by a 19.7% increase in market share in the Northeast. In the Southeast, the company lost 4.7% of market share. This increase in market share in the Northeast was primarily organic as since 2009 the company only acquired 3.0% market share.

 

The five firm concentration ratio is points to medium to high concentration across all pasta markets in Brazil. The Herfindahl index points to high concentration in the Northeast and very little concentration in Brazil and the Southeast.

 

 

The Cookies and Crackers Industry in Brazil

 

The cookies and crackers industry in Brazil has 593 companies. According to ABIMAPI and Euromonitor, in 2014, Brazilian companies sold 1,227 million tons of cookies and crackers meaning Brazilian cookies and crackers sold the 4th largest amount in the world. About 60% of companies are concentrated in the Southeast region the largest and highest per capita income region in the country.

 

In 2014, the Southeast accounts for 45.0% of the cookies and crackers market down from 47.3% in 2006. The Northeast was the second largest region in Brazil accounting for 30.2% similar to its share for 30.2% in 2006. The South is the third largest region accounting for 15.1% in 2014 down from 16.2% in 2006. The Midwest was the fourth largest region accounting for 7.7% in 2014 up from 6.3% in 2006 and the North accounted for 2.0% in 2014.

 

Logistic costs play a part in localizing the market. In lower value added products like basic crackers, products can be shipped 1,000 kilometers before logistic costs affect competitiveness. In higher value added products like cookies, products can be shipped 1,500 kilometers before logistic costs affect competitiveness.

 

Brazilian per capita cookie consumption is below developed markets and its neighbor Argentina.

 

 

Monthly household income is a large driver of demand for cookies and crackers as well as pasta. In both cookies and crackers and pasta, consumption starts increasing rapidly when monthly income reaches BRL2,490 to BRL4,150.

 

In 2014, M. Dias Branco is also the cookies and crackers market leader, both in volume and market share terms, in Brazil. The company market share is almost twice as large as its closest competitor in Brazil. Similar to pasta, M. Dias Branco’s market share lead is driven by its dominance in the Northeast where its market share is nine times its closest competitor. In the Southeast, the company is the fifth largest competitor with a 7.7% market share.

 

Since 2009, M. Dias Branco market share in Brazil increased by 3.0% driven by 12.3% market share gain in the Northeast and a 0.2% market share increase in the Southeast.

 

Similar to the pasta industry, the cookies and crackers industry shows moderate concentration with the Northeast being highly concentrated.

 

 

Barriers to Entry

 

Barriers to entry for food and beverage producers usually come in the form of brand and/or economies of scale with the fixed costs of advertising, distribution, and research and development. Evidence is analyzed to determine if M. Dias Branco’s brands create a barrier to entry. Signs are then evaluated to determine if economies of scale create a barrier to entry. Consistent returns on invested capital above are the best piece of evidence of potential barriers to entry. It does not always point to the existence of barriers to entry as growing markets often ease competitive pressures allowing demand to outpace supply leading to elevated profitability in the short term.

 

With the exception of 2007, M. Dias Branco has consistently generated double digit ROIC with an average ROIC since 2009 of 19.4%. The market has been growing at a healthy pace alleviating competitive pressures but additional evidence points to the company to sustainably resist competition.

 

In food and beverage products, market share leadership is usually a sign of a strong brand as many consumers choose a particular product in these markets based on a characteristic other than price. In the case of M. Dias Branco’s products, the customer’s decision is probably based more on the taste of the product or lack of alternatives rather than price. The customer focus on product characteristics such as taste increases the importance of a brand as customers identify the taste of the product with the brand.

 

Brand is particularly important as the company sells low cost products that are purchased frequently. The low cost of the product makes the small difference in price between brands less important leading the consumer to continually purchase its preferred brand. Products purchased more frequently are more likely to have brand loyalty as customers create a habit of purchasing the product particularly when taste is important product characteristic. Also in developing countries, customers are less likely to switch from a tried and true product to something new due to a lack of discretionary income. In AC Nielsen’s November 2013 Global Report of Loyalty Sentiment, Julie Currie of AC Nielsen stated “In developing economies, we see evidence of highly price-sensitive consumers choosing brands that are not always the lowest-price alternative. Making a switch from a tried-and-true product to something new can represent a tradeoff that consumers with little discretionary income are not willing to make. On the flip side, the cachet of new brands can be appealing for consumers with rising upward mobility status.” According to Strativity, frequency of interaction builds loyalty and advocacy with 87% of customers delighted with daily interaction, 64% with weekly interaction, 49% with monthly interaction, and 33% with a few times per year interaction. Also according to Strativity, 30% of less frequent customers wouldn’t miss a company or brand if they were gone or would leave for a better offer. M. Dias Branco’s high market share within Brazil points to valuable brands with pricing power.

 

The table above illustrates the relative prices of different companies within the pasta and cookie and crackers segments. M. Dias Branco is indexed to 100 and competitors prices are relative to M. Dias Branco. Competitors in red compete with M. Dias Branco in the pasta market while competitors in green compete in the cookies and crackers market. While this is an aggregation of all the brands of each company, it should be representative of M. Dias Branco brand position given the diversity of its brand portfolio. As illustrated, the company has the lowest price offering in both pasta and cookies and crackers. The pricing differential is particularly wide in the cookies and crackers market where the company’s price is 25% below the closest competitor in 2014. The low price of the company’s products points to a no brand value and a market share advantage based on lower cost. A strong brand should command a premium price as customers are willing to pay more for a strong brand. A combination of premium pricing and a leading market share is a sign of a very strong brand.

 

Another sign of a strong brand in consumer products is pricing power as customers are willing to accept price increases as there are not alternatives with the product characteristics that customers covet. To determine the extent of M. Dias Branco’s pricing power, the stability of the company’s cash gross margin. All tax effects are also removed. Cash gross margin is used to eliminate any potential manipulation of accounting assumptions. The company’s cash gross margin has deteriorated from 53.2% in 2005 to 31.5% in 2014, while raw materials expense as a percentage of sales has increased from 28.3% in 2005 to 46.8% in 2014. It seems the company has not been able to pass on raw materials expenses.

 

The company has been pursuing a strategy of increased vertical integration by producing more raw materials internally. Gross margins on wheat flour and margarine should be much lower given the commodity nature of the products. Revenues from non-cookies and crackers and pasta products have decreased from 26.7% in 2005 to 25.2% over the trailing twelve months so sale of lower margin products is not the reason for the lower gross margins. The proportion of wheat consumed from internal production has decreased from 89.6% in 2006 to 79.1% over the trailing twelve months. The proportion of shortening consumed from internal production has increased from 66.8% in 2006 to 79.1% over the trailing twelve months. Management states increased vertical integration will increase gross margins as the company can produce raw materials at a 15-20% discount to the price it can buy them on the market meaning the decreased internal wheat production may have affected over gross margins. Assuming a 10% increase in internal production at a 10% discount to purchasing external, M. Dias Branco’s gross margin would increase by 1% so the decrease in gross margin is primarily due to a lack of pricing power indicating weak brand strength.

 

 

A brand needs to be built and supported with advertising and promotion. M. Dias Branco currently spends 2% of sales on advertising with a target of increasing the expense in the future. The company’s current marketing spend of 2% of sales is well below the spending of other food and beverage companies. Most of the company’s 2% advertising expense is promotion at the point of sale rather than advertising. Without advertising, it is difficult to build a brand and the lack of marketing spending by M. Dias Branco points to a weak brand.

 

According to AC Nielsen, the lowest levels of loyalty on a global scale (respondents said they were not loyal and likely to switch) were found with the food and beverage categories. 43% of customers are not loyal to alcoholic beverage brands, 39% of customers are not loyal to snack brands, 38% are not loyal to carbonated beverages, and 37% are not loyal to cereal brands.

 

The company believes brand plays a much bigger role in the cookies and crackers market then in the pasta market. This makes sense as product characteristics other than price play a much more important role in the cookies and crackers market. In the pasta market, the difference in taste between different pasta brands is negligible. Pasta is also usually not the main taste in a particular meal. It is usually mixed with something like a pasta sauce or vegetables to provide flavor. Other product characteristics such as durability during cooking plays a role but it may not be central to the customer’s purchasing decision. With cookies and crackers, taste is different between products and is the main reason for eating the product making it that much more important during the purchasing decision. Additionally, price plays a much more important role with lower economic classes.

 

Although the company’s brands may create a small barrier to entry in cookies and crackers, the lack of pricing power, low relative price compared to peers, and low advertising to support the brand all point to no barrier to entry related to the company’s brands.

 

Economies of scale gives an incumbent a competitive advantage over peers due to is sized allowing it to spread fixed costs over many more units decrease the total cost per unit.

M. Dias Branco has a clear size advantage over peers as it is the largest cookies and crackers producer and the largest pasta producer. The company’s size advantage is even larger in the Northeast, where M. Dias Branco is almost five times it closest competitor in pasta and almost nine times larger than its closest competitor in cookies and crackers. In the Southeast, M. Dias Branco has no advantage in pasta and is the fifth largest player in cookies and crackers so the company is at a size disadvantage.

 

The relevant fixed costs are distribution, advertising, and research and development. In parts of the Northeast, M. Dias Branco owns its own distribution network, which would be very difficult for any competitor to replicate given the fixed costs associated with owning the distribution network. The company’s own distribution channel allows the company to reach retail outlets that competitors cannot decreasing competition and increasing profitability. 40% of sales through the company’s distribution channel are to smaller outlets where very few competitors can reach leading to a maximum of two to three competing brands. The company’s distribution network allows strong customer relationships ensuring customers’ needs are met and the company’s always has shelf space. It also allows the company to take advantage of the operating leverage associated with owning a distribution network through pushing multiple products through its distribution channel. The company’s distribution channel could possibly be expanded as direct sales for 65% of cookie, crackers, and pasta sales in the Northeast region in 2014.

 

Advertising is another fixed cost that allows the company to take advantage of its size. Spending more on advertising allows the company to educate and recruit more customers than peers through building and supporting its brands leading to pricing power from brand strength. Within Brazil, tastes and cultures are still very regional leading to market share within specific regions being the key determinant of economies of scale in advertising. Unfortunately, M. Dias Branco under spends on advertising and could increase this strategic cost as a percentage of sales to take advantage of its size advantage. The company plans on increasing advertising as a percentage of sales.

 

Research and development is another fixed cost allowing M. Dias Branco to take advantage of its size and outspend peers. Research and development in the food and beverage industry includes new products, flavors, recipes, packaging, nutritional benefits, and much more. Similar to advertising, the company under spends relative to food and beverage peers.

 

Barriers to entry exist in the industry in the form of brands and economies of scale with fixed costs in distribution, advertising, and research and development. The evidence points to M. Dias Branco lacking any brand advantage. The company clearly has a size advantage and is taking advantage of it through owning its own distribution channel in parts of the Northeast but is failing to take full advantage of its size with under spending on advertising and research and development. It would take decades for another competitor to replicate the company’s size and position in the Northeast. Outside of the Northeast, the company lacks any size advantage.

 

 

Other Four Forces

M. Dias Branco’s suppliers have no bargaining power. The company’s raw materials are commodity products that are not unique and are available from many different suppliers with no switching costs. It is also the largest producer of both cookies and crackers and pasta within Brazil giving it purchasing power. This purchasing power is magnified by the ability of the company to store up to five months raw materials.

 

M. Dias Branco’s customers seem to be very fragmented eliminating their bargaining power. The company has over 70,000 active clients with 40.7% of revenue coming from direct distribution.

 

Sales through indirect distribution account for 59.3% of sales. Indirect distribution sales are to larger customers and carry lower margins. The company’s cookie and crackers products are unique due to taste. Pasta, wheat flour, margarine, and shortening are all commoditized products that do not differ that much between competitors.

 

With the exception of the Northeast of Brazil, M. Dias Branco’s markets are highly competitive with low levels of concentration. With the exception of cookies and crackers, the company’s product markets are primarily driven by price competition. The wheat flour market is characterized by a large amount of unutilized production capacity. Cookies and crackers and pasta have the potential for high fixed costs to drive out smaller players but this advantage is not being fully utilized allowing smaller players to survive increasing competitive rivalry. All signs point to a medium to high competitive rivalry within the company’s product markets.

 

With the exception of wheat flour, M. Dias Branco’s products have many readily available substitutes. With many of the company’s products price is the main driver of the purchasing decision leading to a greater threat of substitution.

 

 

MANAGEMENT TEAM

 

Members of management are owner operators. The largest shareholder (63.1%) is Francisco Ivens de Sá Dias Branco, the Chairman of the Board. Managers own another 11.4%. The Board of Directors and the Board of Executive Officers are primarily family members of Francisco Ivens de Sá Dias Branco including Francisco Ivens de Sá Dias Branco Junior, the CEO. Seven of the eleven Board members and Executive Officers are part of the Dias Branco family.

 

Francisco Ivens de Sa Dias Branco, the current Chairman of the Board helped build the company his father joining in 1953. He led the modernization and expansion of the company and was CEO until 2014 when his son Francisco Ivens de Sa Dias Branco Junior took over the role. Being a family oriented business has pros and cons. Holding almost 75% of the shares, the family can take a very long-term wealth maximizing view and disregarding short-term advice of financial markets. Given the large shareholding, a large portion of the family’s wealth is tied to the company’s performance therefore the family’s incentives are aligned with minority shareholders. Members of management are not agents trying to further their career but family members trying to increase the family wealth through company performance. The potential cons are the company was built by the current Chairman over the past 60 years. He is the patriarch of the family and the largest shareholder. He may be unwilling to listen to dissenting views. The company is full of family members that may not have strategic expertise or diversity of views to see the necessary perspectives and strategic logic to maximize shareholder value. The family may look at the company as their asset rather than an asset that is part owned by minority shareholders allowing them to take advantage of their position in the company. This is partially evident by the company leasing airplanes from a related party.

 

Corporate Culture

 

The company has created a strong corporate culture and scores highly in employee reviews. On Indeed.com, the company scored 3.5 to 4.0 stars on work/life balance, salary/benefits, security/advancement, management, and corporate culture.

 

Strategy

 

M. Dias Branco’s strategy includes increasing market share through diversifying its customer base through geographical expansion via acquisitions and organic growth. The company plans to acquire businesses with strong brands, a solid customer base, and an extensive distribution network. The company also intends to grow organically through the expansion of production capacity. The company will increase sales to non-residential food service and processing markets including restaurants, hotels, bars, hospitals, clubs, pastry shops, and bakeries. Given the potential economies of scale in the industry, increasing market share is one of the key drivers of excess returns within the industry therefore the priority of the company. The other key driver of excess returns is spending as much as possible on fixed costs to take advantage of the potential size advantage and put competitors at a disadvantage.

 

M. Dias Branco plans to expand its distribution network to increasing the fragmentation of its client base and sell new products. The company’s distribution network is a significant competitive advantage for the company and should be expanded at the margins of the current distribution network in the Northeast as cheaply as possible. The company will have difficulty recreating its distribution network in other regions given its insufficient size to cover the fixed costs and remain profitable. Outside of the Northeast, the company would be wise to select small regions with a very strong competitive position and build out its distribution network there before expanding at the margins. Another option would be acquiring existing distribution networks.

 

The company plans to improve operational efficiency and costs controls by optimizing its infrastructure, increasing the flexibility of the production chain, maintain full up to date production facilities with high-end technology and state of the art operations. In areas where there is no potential for a competitive advantage, operational efficiency is vital for survival. It should be the priority in not competitive advantaged activities.

 

M. Dias Branco will continue to focus on higher value-added products, such as new product lines or complementary product targeting markets in which it already operates allowing for higher margin products and greater ability to differentiate the company’s products.

 

The company plans to increase vertical integration in order to meet 100% of its wheat flour and shortening needs. This is the one strategic initiative that does not make much sense. Wheat flour and shortening are commodity products with little potential for sustainable excess returns. Similar to oil refining, a plant (wheat mill) is build. In that plant, a commodity is refined into another commodity and a margin in earned based on supply and demand. A manufacturer is a price taker with no differentiation. The only way to generate excess returns is through low cost operations.

 

The company states it is able to produce wheat flour at a 15-20% discount to what it can purchase it at on the market due to technological advantages in its equipment. Currently, there are over 100 small wheat mills with old production technology and a lot of unused capacity in the industry. Eventually the sector will consolidate and modernize when it does M. Dias Branco will no longer have a cost advantage. The company will also have to make additional investments to stay cost competitive and not destroy value as its current advantage is due to having latest technology and most productive equipment, which will no longer be an advantage when the rest of the sector modernizes. The company states it is able to generate double digit EBITDA from wheat flour in Brazil.

 

The company can store up to five months raw material inventory. Along with its size, this storage capability allows for bulk purchasing giving the company bargaining power over its suppliers decreasing profitability of a vertical integration strategy. The company states the vertical integration strategy allows for better planning but the ability to keep five months of raw material should be sufficient to improve planning.

 

Looking at M. Dias Branco’s peers in each business segment provides insight into the quality of each line of business. Food producers such as Bunge and Archer Daniels Midland (ADM) are the company’s competitors in raw materials that the company is integrating. Bunge is a competitor in Brazil and ADM participates in similar activities of buying, processing, and selling agricultural commodities. In cookie and crackers, the company competes with global food companies such as Nestle, Mondelez, and PepsiCo. In addition, other food and beverage companies are listed as key success factors of economies of scale in advertising, research and development, and distribution are similar.

As illustrated above, the food and beverage companies generate much higher gross margins and operating margins with similar if not higher invested capital turnover leading to ROIC much higher than simple commodity processing companies, Bunge and ADM. The food and beverage companies share prices also reflect the strong operating performance while Bunge and ADM’s share prices have lagged significantly over both five and ten years.

 

The vertical integration strategy does not make much sense. You are processing commodity products into another commodity product. Bunge and ADM are two of the largest and most efficient companies in the commodity processing business and both have very small operating margins. It would be very difficult for M. Dias Branco to have sustainable operating margins much higher than Bunge and ADM. The company can process the commodity at a 15-20% discount to what the company can purchase from potential suppliers but the company is one of the largest, if not the largest, wheat consumers in the country giving it tremendous bargaining power a fragmented supply base. Given the company’s ability to store up to five months raw materials, this drastically increases the company’s purchasing power and ability to control it raw material requirements. The 15-20% discount is not sustainable as it is merely a technological advantage that any competitor with capital can catch up to. It seems very unlikely that M. Dias Branco can generate sustainable excess returns in commodity processing business.

 

Capital Allocation

M. Dias Branco is in a very strong financial position with a net debt to equity of 0.10 times and net debt to EBIT of 0.57 times.

 

The company has remained conservative with its financing with net debt to EBIT never breaching 3.1 times.

 

The company reinvests the majority of the company’s earnings with an average dividend payout just over 22% since 2009. The company shares outstanding have remained stable at 113.45 million shares outstanding since 2009. Given the stock exchange requires 25% free float and the company maintaining a free float just above it meaningful share buybacks are unlikely. The company maintains a very healthy financial position but is wise enough not have too much cash on the balance sheet.

 

 

Since the end of 2006, M. Dias Branco has generated operating income before research and development and advertising of BRL3,941 million. The largest outlay during the period was acquisitions, which accounted for BRL1,068 million or 27% of operating income. The next largest outlay was dividends of BRL586 million or 15% of operating income. Followed by growth capex and advertising both just above BRL500 million or 13% of operating income.

 

There have been some issues with capital allocation. As mentioned before, the company should be spending much more on strategic fixed costs of research and development, advertising, and distribution to take advantage of its size and create a virtuous cycle that competitors cannot replicate. The company sales through its own distribution should be continuing to grow rather than receding for sales outside its own distribution network where the company faces more competition and weaker profitability. The company should be spending much more on advertising as the company is competing on price at the moment with pasta price at an average discount of 10% and cookies and crackers prices at an average discount of 35%. Advertising should be focused on cookies and crackers where there is more potential to build brand loyalty and pricing power. The company should also be spending much more on research and development.

 

Given economies of scale and size are so important in the industry, the company could be more acquisitive. The company has mentioned that deals are available but not at a price that interested them pointing to a disciplined approach to acquisitions. The company targets a payback period of five years or 15% IRR for all investment decisions.

 

Since the beginning of 2008, M. Dias Branco has disclosed information on five acquisitions. The company spent BRL1,068 million or 27% of operating income on these five acquisition making acquisition the largest outlay since 2007.

 

The company’s first acquisition was Vitarella in April 2008. Vitarella had two brands Vitarella and Treloso was the leader in the states of Paraíba, Pernambuco, and Alagoas in the Northeast of Brazil. In 2007, Vitarella generated revenue of BRL323.2 million, gross profit of BRL100.7 million, EBITDA of BRL57.5 million, and net income of BRL45.5 million. According to AC Nielsen, in 2007, Vitarella had 5.5% cookies and crackers market share in Brazil and 2.9% pasta market share in Brazil. M. Dias Branco paid BRL595.5 million equal to 1.8 times sales, 10.4 times EBITDA, or 8.1 times reproduction value. Vitarella was a very profitable company at the time of acquisition with a gross margin of 31.2%, an EBITDA margin of 17.8%, a net margin of 14.1%, and an estimated return on reproduction value of 62.0%. Assuming no organic growth or operational synergies, Vitarella had average net income of BRL53.4 million in the two calendar years prior to the acquisition leading to an earning yield of 9.0%.

 

In the two years prior to the acquisition, Vitarella had net revenue of BRL293 million in 2006 and BRL323 million in 2007 and EBITDA of BRL74 million in 2006 and BRL58 million in 2007. In 2014, Vitarella’s net revenue reached BRL1,023.2 representing a 216.6% increase or 17.9% CAGR, estimated EBITDA increased by 205.0% to BRL175.4 million or 17.3% CAGR, and estimate net income increased by 194.2% or 16.7% per annum.

 

84% of the increase in revenue, 89% of the increase in EBITDA, and 94% of the increase in net income is associated with an increase in capacity with the remaining increase related to operational improvements. M. Dias Branco increased cookie and cracker capacity at the Vitarella’s plant by 198,200 tons and pasta capacity increased by 29,300 tons for a total increase in capacity of 227,500 tons.

 

Using estimated reproduction cost per ton at existing facilities of USD375 per ton for cookies and crackers and USD300 per ton for pasta and the average exchange rate from the beginning of 2008 to the end of 2014, the estimated investment costs for the increased capacity is BRL164 million. Since 2009, the company’s average working per capital to sales is 16.2% multiplying this figure by the increase in sales leads to an additional investment in working capital of BRL113.2 million. Assuming Vitarella’s net margin converged with M. Dias Branco’s average net margin, which is below Vitarella’s net margin at the time of acquisition, the average net income of Vitarella brands averaged BRL127.1 million in 2013 and 2014 representing a BRL73.7 million increase from the average net income of Vitarella in the last two years as an independent company leading to a return on investment in capacity and working capital of 26.6%. Overall, the total return on the acquisition and additional investment in Vitarella is 11.9%. Vitarella’s initial acquisition was at a fair to cheap price with additional investment providing a very good return to shareholders.

 

In April 2011, M. Dias Branco purchased NPAP Alimentos (NPAP) for BRL69.922 million. NPAP’s main brand was Pilar. In 2010, the company had 71,000 tons of total capacity with 30,000 tons of cookie and cracker capacity and 41,000 tons of pasta capacity. The company’s main activities are in the Northeast of Brazil.

 

In 2010, NPAP generated revenue of BRL107.5 million, gross profit of BRL29.8 million, EBITDA of BRL7.6 million, operating income of BRL3.5 million, and a net loss of BRL3.6 million. The company had a 1.2% Brazilian cookies and crackers market share and a 2.4% Brazilian pasta market share. The acquisition price of BRL69.922 million equates to 0.7 times sales, 9.2 times EBITDA, and 1.9 times reproduction value.

 

Since acquisition, NPAP’s main brand Pilar’s revenues have increased from BRL107.5 million in 2010 to BRL141.9 million in 2014 representing a 7.2% CAGR. The company’s capacity has decreased from 71,000 tons in 2010 to 27,300 tons in 2014 so there were no additional investments in capacity. The increased revenues came with an estimated working capital investment of BRL5.6 million leading to a total investment of BRL75.5 million to reach BRL141.9 million in revenues.

 

NPAP’s margins are well below M. Dias Branco’s margins. Assuming NPAP’s margins have converged to M. Dias Branco’s margins, the company’s net income in 2014 was BRL18.6 million leading to an earnings yield of 24.6% on estimated total investment in NPAP. The 24.6% earnings yield is driven primarily by synergies and improvements in operations. Assuming NPAP’s margins only converged half way with M. Dias Branco’s margins and 5% organic growth is achievable, the earnings yield would be 12.3% and total IRR would be 17.3%, a good return for shareholders.

 

In December 2011, M. Dias Branco acquired all the shares of J. Brandão Comércio e Indústria Ltda. and of Pelágio Participações S.A.(Fabrica Estrela) owner of the brands Estrela, Pelaggio, and Salsito for BRL240 million. At the time of acquisition, Fabrica had 87,600 tons of cookies and crackers capacity, 51,600 tons of pasta capacity, and 7,000 tons of snacks and cakes capacity in Northeast and North of Brazil. In 2010, Fabrica Estrela generated BRL190.6 million in sales, BRL11.6 million in EBITDA, BRL8.9 million in operating income, BRL4.8 million in net income leading to acquisition multiples equivalent to 1.3 times sales, 20.7 times EBITDA, and 2.6 times reproduction value. In 2010, Fabrica Estrela had a 1.2% market share of the Brazilian cookies and crackers market and a 0.7% market share in the Brazilian pasta market.

 

Since the acquisition, revenues from Fabrica Estrela’s brand increased from BRL190.6 million in 2010 to BRL281.5 million in 2014 representing a 10.2% CAGR. Since acquisition, total capacity increased marginally with cookie and cracker capacity increased by 500 tons, pasta capacity increased by 100 tons, and snacks and cakes capacity increased by 2,100 tons leading to an estimated investment in capacity of BRL2.0 million. With an estimated working capital investment of BRL12.1 million, the estimated total investment in Fabrica Estrela is BRL104.1 million.

 

Similar to NPAP, prior to the acquisition, Fabrica Estrela’s margins were well below M. Dias Branco’s. Assuming a full convergence to M. Dias Branco’s margins Fabrica Estrela would have provided a 35.4% earnings yield before accounting for any growth. Assuming a half convergence, Fabrica Estrela’s earnings yield would be 17.7%. The key driver of the return is the improvement in operations after integration as the company was acquired at a no growth estimated return of 5.1%.

 

In May 2012, M. Dias Branco acquired Moinho Santa Lúcia Ltda, owner of brands Predilleto and Bonsabor. At the time of the acquisition, Moinho had 21,600 tons of cookies and cracker capacity, 30,000 tons of pasta capacity, and 30,000 tons of wheat flour and bran capacity. In 2011, Moinho generated BRL88.1 million in revenue, BRL14.0 million in EBITDA, and BRL7.3 million in net losses. Predilleto and Bonsabor had 0.2% market share in the cookies and crackers market and 0.5% pasta market share in the Northeast region. Predilleto and Bonsabor are not large enough for M. Dias Branco to report revenues separately. In 2014, the smallest brand reported was Amoreal, which recorded BRL8.66 million in revenues. Given the lack of size of Moinho’s brands, it seems the purchase was more about Moinho’s capacity meaning price to reproduction value is a better measure of value. The company purchased Moinho’s capacity at a price to estimated reproduction value of 2.1 times, which seems expensive.

 

In December 2014, M. Dias Branco won an auction to purchase the Rolandia wheat mill from a creditor of the former owner. The mill has 146,000 tons of wheat flour and bran capacity. Given the commodity nature of wheat mills, capacity should be value at roughly reproduction value. The company paid more than 1.6 times reproduction value for the wheat mill, which is expensive. The company acquired the wheat mill in an auction. Auctions are well known and you are competing against many informed bidders leading to a low probability of acquiring assets cheaply during an auction.

 

The company has done a great job acquiring cookies and crackers, and pasta brands at fair valuations and then improving the top line. It also seems that the company should be able to improve margins at these companies dramatically as the majority of acquisitions had margins well below the company’s. The company does not do as well when purchasing capacity, which has been well above reproduction value.

 

 

Capital Expenditures

 

The growth capex number is slightly different than the number reported on the company’s cash flow statement. The breakdown can be seen above. Since 2007, an estimated 55.7% of capex was spent on growth capex with the remainder on maintenance capex. 70% of capex was spent on machinery and equipment with the remainder spent on construction in progress.

 

Since 2007, cookies and crackers is the largest change in capacity followed closely by wheat flour and bran. M. Dias Branco does not breakdown investment costs by segment but the company did provide estimated replacement costs per tonne at existing facilities. This is the cheapest way to expand capacity therefore it is used as an estimate of the investment costs since 2007 and total reproduction cost of capacity. The company made the largest investment in cookies and cracker capacity with BRL779 million or 57.4% of total investment from 2007 to 2014 being spent on cookies and cracker capacity. Wheat flour and brand and pasta capacity received similar investment over the period roughly BRL243 million and BRL240 million, respectively.

 

Unfortunately, the company neither gives sufficient segment reporting by geography or product line to allow for proper evaluation but strategic logic can aid in assessing investments in various product lines and geographies. The investments in cookies and crackers and pasta, particularly in the Northeast where the company owns its own distribution channel and there is a huge size gap between the company and its competitors allowing it to outspend on fixed costs are very wise and probably generate a very high rate of return. As the company moves away from its base in the Northeast where the company is not as dominate, is competing with many similar size players, and does not own its distribution network, the rate of return most likely decreases drastically as the firm no longer has economies of scale advantages over competitor.

 

Investments in wheat mills and margarine and shortening seem to capital misallocated. The activity of milling wheat is nothing more than refining a commodity into another commodity, a task that will earn a margin determined by supply and demand. Over the course of a cycle, the industry as a whole will not earn excess return. In commodity businesses, some players within the industry may earn excess returns from having a lower cost position than peers. M. Dias Branco states it can produce wheat flour at 15-20% discount to the price it can buy it on the market due to technological advantage of having the latest production facilities and equipment. The company states it generates double digit EBITDA margins in wheat milling operations. The ability to generate excess returns will only continue as long as the wheat mill industry remains littered with smaller mills without resources to upgrade equipment. The Brazilian wheat mill industry is fragmented with many small mills and significant unutilized capacity. The fragmentation in a commodity industry points to no barriers to entry. The fragmentation along with significant unutilized capacity points to high competitive rivalry. Both point to an inability to generate sustainable excess returns. The returns at the largest commodity processors Bunge and ADM also point to an inability to generate excess returns.

 

The company can store up to five months raw material inventory. Along with its size, this storage capability allows for bulk purchasing giving the company bargaining power over its suppliers decreasing profitability of a vertical integration strategy. The company states the vertical integration strategy allows for better planning but the ability to keep five months of raw material should be sufficient to improve planning.

 

Looking at M. Dias Branco’s peers in each business segment provides insight into the quality of each line of business. Food producers such as Bunge and Archer Daniels Midland (ADM) are the company’s competitors in raw materials that the company is integrating. Bunge is a competitor in Brazil and ADM participates in similar activities of buying, processing, and selling agricultural commodities. In cookie and crackers, the company competes with global food companies such as Nestle, Mondelez, and PepsiCo. In addition, other food and beverage companies are listed as key success factors of economies of scale in advertising, research and development, and distribution are similar.

As illustrated above, the food and beverage companies generate much higher gross margins and operating margins with similar if not higher invested capital turnover leading to ROIC much higher than simple commodity processing companies, Bunge and ADM. The food and beverage companies share prices also reflect the strong operating performance while Bunge and ADM’s share prices have lagged significantly over both five and ten years.

 

The vertical integration strategy does not make much sense. You are processing commodity products into another commodity product. Bunge and ADM are two of the largest and most efficient companies in the commodity processing business and both have very small operating margins. It would be very difficult for M. Dias Branco to have sustainable operating margins much higher than Bunge and ADM. The company can process the commodity at a 15-20% discount to what the company can purchase from potential suppliers but the company is one of the largest, if not the largest, wheat consumers in the country giving it tremendous bargaining power a fragmented supply base. Given the company’s ability to store up to five months raw materials, this drastically increases the company’s purchasing power and ability to control it raw material requirements. The 15-20% discount is not sustainable as it is merely a technological advantage that any competitor with capital can catch up to. It seems very unlikely that M. Dias Branco can generate sustainable excess returns in commodity processing business.

 

Given the inability to earn excess returns in wheat milling, and margarine and shortening, investment in capacity in these sectors would be better spent on activities where the company can take advantage of its size to put competitors at a greater disadvantage. These activities include advertising, research and development, and expanding the company’s distribution network. The company does not report investments by segment, but at the end of 2014, the company had 1,556.6 thousand tonnes of wheat mill capacity and 180 tonnes of margarine and shortening capacity. Assuming replacement costs are BRL480 per tonne for each, the minimum misallocation of capital by management is BRL833.6 million. The money spent on vertical integration would be better spent on taking advantage of economies of scale present in the industry and building a strong brand that does not compete solely on price.

 

M. Dias Branco does a good job of acquiring companies at reasonable valuation then improving operations by using its infrastructure and relationships. The company does not provide details of profitability post acquisition but if the company is able to improve, profitability to a level similar to the company’s acquisitions would provide a really strong rate of return.

 

Corporate Governance

M. Dias Branco’s useful life estimates are in line with Brazilian food peers. It is very close to the average estimated life for some categories, above the average for others, and below the average for others, but there is nothing to cause concern.

M. Dias Branco’s management does not extract too much value only receiving 1.7% of operating income, above the peer group average but well below most of its smaller peers. Peers with operating income below BRL1 billion had average management remuneration to operating income of 9.1%. M. Dias Branco’s management does receive short term benefits or participate in any profit sharing program. Given the large ownership of the company, these are welcome signs.

M. Dias Branco’s consolidated related party transactions are not significant. The one concern is until 2014, the company leased an airplane from a related party called Rowena SA. The leasing expense was insignificant averaging BRL4.29 million from 2009 to 2013. Leasing a plane could be seen as a wasteful expense and something you would not see in a company focused on extreme operational efficiency.

M. Dias Branco’s common shares have 100% tag along rights and any buyout offer to the majority shareholder would need to be made to minority shareholders.

M. Dias Branco is relatively transparent and provides a wealth of useful information in its annual reference forms. Unfortunately, it does not provide sufficient information to analyze the company’s strategy. Segment disclosure related to different products and geographies would be extremely useful. At a minimum, revenues by product line and geography, gross profit by product line and geography, and assets by product line and geography should be reported to better allow analysis of the company’s vertical integration strategy and geographical expansion.

M. Dias Branco measures performance with EBITDA margin and payback period. In the 2015 reference form released in December 2015, the company stated EBITDA margin was the most appropriate measure for understanding its financial conditions and operating results. The company’s statement on EBITDA is translated form Portuguese.

 

EBITDA is a financial indicator used to evaluate the result of companies without the influence of its capital structure, tax effects and other impacts accounting without direct impact on your cash flow, such as depreciation. We believe that EBITDA is an important measure for understanding the financial capacity and cash generation capabilities required to understand operating performance. EBITDA is commonly used by investors and analysts. In the opinion of management, the importance of EBITDA comes from the fact that it is one of the non-accounting measures more appropriate to reveal the potential for cash generation as it excludes the operating results accounting items with no impact in the period of cash, such as depreciation and amortization.

 

EBITDA margin as a key metric is severely flawed and creates significant concern whenever a company uses this measure to assess performance. The biggest flaw of EBITDA margin is that it does not account for investment requirements. If BRL100 million in assets are required to generate BRL1 million in EBITDA and BRL5 million in revenues, it probably is not a good investment despite the BRL20 million EBITDA margin. The second problem with assessing investments with EBITDA margin is depreciation is not accounted for. While depreciation is not a cash expense, it is a real expense as assets wear down during use and eventually need to be replaced. EBITDA margin is a very poor measure to assess the quality of an investment and operations.

M. Dias Branco attempts to get five year payback period for any investment. Unfortunately, payback period is another poor metric for assessing investment quality as it does not take into account for cash flows past the payback period. For example, if an investment is made in an industry or geography where short term profitability is elevated due to lack of competition or an easily replicated advantage, cash flows in the short term will be elevated but will fall quickly once competition is entered. This type of investment may register a good payback period but a poor ROIC or IRR. The company should be using more sophisticated measures of profitability, such as ROIC, EVA, or IRR to assess investment opportunities.

 

 

 

Valuation

 

When valuing any company strategic questions must be asked first if the industry is viable. If the industry is not viable the company should be valued assuming a liquidation of the company. M. Dias Branco exists in viable industries with no threat of extinction therefore liquidation is not an important measure. To determine M. Dias Branco’s liquidation value, net working capital plus property plant and equipment is used, which is calculated be discounting accounts receivables on the balance sheet by 75%, inventory on the balance sheet by 50%, and PP&E on the balance sheet by 50% minus all liabilities at 100%.

 

The company’s liquidation value is BRL830 million or BRL7.32 per share representing 89% downside.

 

Given M. Dias Branco’s industry is viable, the next question is do barriers to entry exist? If barriers to entry do not exist, theoretically competition should compete away all excess profits and the value of the company should be equal to the cost to reproduce the company’s assets. On the asset side, cash, accounts receivables, inventory, other current assets (pre-paid expenses), and investments are valued at book value.

 

Property, plant, and equipment are valued at the cost to reproduce capacity.

 

The company’s capacity breakdown by product line is illustrated above.

 

The reproduction value per tonne is listed in US dollars as equipment is bought from international suppliers and is quoted in US dollars. Reproduction value per tonne is translated to Brazilian real with the depreciation of the Brazilian real verse the US dollar making it more costly for the competitors to reproduce the company’s assets.

 

The cost to reproduce the company’s production capacity has increased from BRL 675 million or BRL5.94 per share in 2007 to BRL2,737 million or BRL24.12 per share today driven by both capacity increases and depreciation of the Brazilian real.

 

Any investment in research and development, and distribution is amortized over five years to reflect the true economics of the expenses. Typically, advertising would also be capitalized and amortized over five years but M. Dias Branco’s advertising is primarily promotional activities, which is not building a brand but driving short term sales therefore expensing promotional activities is a better reflection of the economics of the expense. On the liabilities side of the balance sheet, non-interest bearing liabilities and deferred taxes are liabilities that spontaneously occur through the course of business therefore reduce the cost of reproducing assets. In addition, debt reduces the value of reproduced assets to shareholders therefore is subtracted. All liabilities are valued at book value and subtracted from assets to get to equity value.

 

Under the assumptions mentioned before, it would take BRL11.8 million or BRL0.10 per share to reproduce research and development and BRL2,461 million or BRL21.70 per share to reproduce its distribution assets.

 

The total estimated cost to reproduce M. Dias Branco’s assets is BRL6,740 million with debt or liabilities naturally occurring during business of BRL1,253 million. The reproduction cost per share is BRL51.99 representing 24% downside from M. Dias Branco’s current share price. Reproduction cost is the best method of valuation for companies that compete in industry where barriers to entry do not exist. The best time to buy companies valued with reproduction cost is at a 50% discount to reproduction cost.

 

Another form of measuring reproduction cost is looking at valuation multiples of recent acquisition. The assumption is companies making the acquisition completed a detailed build vs. buy analysis.

 

The table above shows M. Dias Branco’s acquisitions, a Brazilian food and beverage acquisitions, a rumored acquisition of M. Dias Branco, and a number of wheat mill acquisitions. At the end of 2007, Kraft was rumored to be in talks to acquire M. Dias Branco for 1.3 times sales and 13.1 times EBITDA. Using the 13.1 times EBITDA multiple, M. Dias Branco’s fair value is BRL78.20 per share representing 14.2% upside.

 

The median acquisition multiple for non-M. Dias Branco acquisitions was at an EV/Sales of 1.7 times, and an EV/EBITDA multiple of 11.8 times. Using this median multiple of 11.8 times, M. Dias Branco’s fair value is BRL70.44 per share representing 2.8% upside.

 

The median wheat mill acquisition was at USD233.3 per tonne of capacity. Replacing the USD120 per tonne with a more conservative figure of USD200 per tonne increases the value of M. Dias Branco’s wheat flour and bran capacity from BRL6.70 per share to BRL11.60 per share leading to an increase in total reproduction value from BRL51.99 per share to BRL56.46 per share.

 

 

The table illustrates acquisition multiples (EV/EBITDA) within the food and beverage industry from 2009 to 2014. M. Dias Branco falls under Baked/Snacked foods, a segment where the average EV/EBITDA multiple was 10.7 times with a high of 13.4 times in 2014 and a low or 8.9 times in 2009. Assuming the average acquisition multiple of 10.7 times EBITDA, M. Dias Branco’s fair value is BRL63.87 per share or 6.7% downside.

 

If the company has barriers to entry and can sustainably earn excess returns, the best valuation technology is to determine the company’s sustainable earnings power to determine a fair value. To derive a value from M. Dias Branco’s earnings power we use an Earnings Power Valuation, a DCF, and a Residual income valuation. The key static assumptions used in earnings power valuations are  a discount rate of 10%, an effective tax rate of 12.1%, working capital turnover of 5.6 times, and fixed capital turnover of 2.5 times.

 

A discount rate of 10% is used as the discount rate is viewed more as a hurdle rate or opportunity cost rather than a company specific cost of capital. The typical method of determining a company’s cost of capital is subject to estimation errors as a company’s beta may change by up to 0.5 in a matter of six months leading to significant swings in the company’s cost of equity rendering the calculation useless. Include potential estimation errors in determining the risk free rate and equity risk premium, the cost of capital calculation is subject to large swings and potential behavioral biases.

 

A 12.1% tax rate is consistent with historical averages and assumes the company will continue to receive tax incentives for investing in improving or expanding facilities.

 

Capital efficiency is assumed to remain similar to the past seven years with 2007, 2008, and 2015 representing cyclical downturns.

The table above is estimated fixed capital turnover based on the cost of reproducing capacity as the company does not report assets by segment. The concern is the decrease in capital efficiency is due to competition and a lack of barriers to entry rather than cyclicality.

 

The key variable assumptions are sales growth and operating margin. In the earnings power valuations, there are three stages, the first five years, a second four years, and terminal assumptions. The second four years represent a fade from the assumption over the first five years to the terminal assumptions.

 

At current prices, there are only three scenarios where M. Dias Branco meets the 15% annualized return requirement over the next five years. These scenarios assume 2.5% perpetuity growth and peak margins or 5% perpetuity growth and average or peak margins. Using conservative assumptions the company looks more attractive below BRL50 per share, which coincides with the estimated reproduction cost of the company.

 

At current share prices, an investment in M. Dias Branco only reaches the 15.0% target return if it can generate return on reinvestment of 25.0%. With the company investing heavily in vertical integration and regions outside of the reach of its distribution network, it will be very difficult for the company to reach a 20.0% return on reinvested earnings never mind a 25.0% return on reinvested earnings. 0% organic growth is assumed as it has been illustrated that the company does not have pricing power.

 

The ideal valuation method would take into account the barriers to entry in some of the company’s segments valuing those segments on the company’s earnings power, while valuing segments in more commodity businesses at reproduction value. Unfortunately, M. Dias Branco’s reporting is not transparent enough, therefore the company’s earnings power is the most appropriate valuation technique given the company’s consistent excess returns, economies of scale, and potential for a brand.

 

RISKS

 

Brazilian macroeconomics poses a large risk to any investment within the country. Brazil is a large exporter of commodities and the weakness in commodity prices lead to a downgrade of the country’s credit rating to junk. The macroeconomic concerns caused the Brazilian real from a low of 1.5252 in June 2011 to a high of 4.2411 in August of 2015. The weakness of the Brazilian real leads to increased cost of goods sold as raw materials are quoted in dollars.

 

The company’s raw materials are commodities with extremely volatile prices.

 

The company moving away from its traditional stronghold of the Northeast, where it has a huge market share advantage as well as an unrivalled distribution network. This move away from a region where it is competitively advantage brings with it competition and little if any advantage over peers leading to potentially weaker returns.

 

The company’s vertical integration strategy brings with it a potential decrease in returns. The company is backward integrating into pure commodity industries. The company can currently produce its integrated raw materials cheaper than buying them on the market due to having the most technologically advanced equipment. The industries of the company’s vertically integrated raw materials are characterized by many small players and significant unutilized production capacity. These smaller players do not have access to capital to modernize their facilities. As the market consolidates, competition will become more intense and these facilities will then acquire the latest production technologies and M. Dias Branco will have to invest to keep up with the newer competition or returns will lag competitors.

 

The company is facing increasing competition from Multinationals corporations with significant resources and expertise.

 

Increased concentration of retailers will bring increased bargaining power of customers. Increased concentration of the retail segment also brings increased risk of competition from private label. There was  a big private label push in 2002 and 2003 but was not able to gain a substantial piece of the market.

 

  1. Dias Branco is acquisitive with acquisition comes the risk of overpaying, integration risks, and antitrust risks. The company has shown to be a good integrator with most acquired brands showing strong improvement in revenues. The company has overpaid assuming no improvement to the acquired company earnings. In commodity markets, the company has paid well above estimated replacement cost.

 

The company profitability is tied to tax incentives. If the company loses tax incentives profitability will deteriorate.

 

  1. Dias Branco admits to under spending on advertising spending about 2% of revenue primarily on promotions. To build a brand, the company will need to increase advertising decreasing profitability. It runs the risk of advertising not leading to a stronger brand allowing for price increases and pricing power in the long run.

WEEKLY COMMENTARY 12/13/16 – 12/19/16

WEEKLY COMMENTARY 12/13/16 – 12/19/16

 

 

POSITIONING

 

 

 

 

COMPANY NEWS

 

Grendene changed its auditor from PWC to E&Y due its requirement to change its auditor every five years.

 

We were thinking about PC Jeweller and the potential evolution of the jewelry retail industry in India. When think about industry evolution in Emerging Markets, we often look to developed markets for roadmaps. Each market has idiosyncrasies but strategic logic should hold from industry to industry across geographies. For example, the retail market structure in India should eventually look like retail market structure in the US as the industry develops. Retailing is fiercely competitive in all markets with no barriers to entry therefore all industries should have many competitors with very few if any generating significant sustained excess profits.

 

Our main reference point for the following information on the US Jewelry market is Edahn Golan Diamond Research & Data’s 2015 US Jewelry State of the Market report. You can download the report here. According to the Jewelers Board of Trade, there were 21,463 specialty jewelry retailers accounting for 43% of the US jewelry and watch retail market. The vast majority of these specialty stores are independent with Signet Jewelers being the largest retailer accounting for 4.3% of overall jewelry sales in the US and 9.8% of specialty jewelry sales. Signet Jewelers had roughly 3,000 stores at the end of 2015.  Despite market development and industry maturation, the US jewelry market remains fragmented with thousands of players illustrating a lack of barriers to entry and continued competitive pressures.

 

The lack of barriers to entry puts a cap on Signet’s and Tiffany’s ability generate excess profits with their average ROIC over the last five years below 15%.

 

Looking at the United States jewelry retail industry as a roadmap leads one to believe that fragmentation will persist within the Indian jewelry retail industry.

 

Another use of the roadmap is the potential multiple the market gives a company during maturity.  Signet’s EV/IC has ranged from 1.69 in 2012 to 2.89 at the end of 2015, while Tiffany’s EV/IC ranged from 2.54 at the end of 2016 to 3.55 at the end of 2015.

 

Signet’s EV/EBIT ranged from 6.86 in 2012 to 18.94 in 2015. Tiffany’s EV/EBIT ranged from 11.84 in 2016 to 37.19 in 2014, with operating Income in 2014 was depressed. Accounting for the depressed operating income, EV/EBIT ranged from 11.84 to 14.49.

 

We have included similar analysis on Honworld (condiments) and Universal Health (pharmacies/pharmaceutical distribution) that we did in the past at the end of the weekly commentary.

 

 

INTERESTING LINKS

 

Deep Dive into China’s Apparel Market (Fung Business Intelligence)

Fung Business Intelligence freely provide a lot of good information on China. In this multi-part report, Fung Business Intelligence provides detail on China’s Apparel Market. (Part 1) (Part 2)

 

Asahi to Buy SABMiller’s Eastern European Beers in $7.8 Billion Deal (Bloomberg)

Acquisition news is always interesting as a knowledgeable player in the market puts a value on an assets based on a detailed analysis. The problem is we do not know the assumptions the acquirer is using, which are crucial, but it gives an idea of an appropriate valuation multiple in an industry. The paragraph below is from the Bloomberg article.

 

The offer values the SABMiller assets at about 15 times Ebitda of 493.8 million euros for the year ended March 2016, according to Bloomberg calculations. That compared with the median of about 11.5 times trailing twelve-month Ebitda for 9 brewery acquisitions announced worldwide in the past five years, according to data compiled by Bloomberg.

 

We extended the sample size of acquisitions back to 1999 and the median acquisition multiple was 11.7 times not far off the 11.5 times paid over the last twelve months.

 

 

 

The table below shows the upside to the 11.7 times multiple for various brewers in Emerging Markets.

 

 

 

Median Buyout EV/EBITDA Ratios Rising (PitchBook via ValueWalk)

 

The PitchBook examines the median buyout multiple for private value investors.  (link)  What we find interesting is the disconnect between what business owners are willing to pay and the valuations public market investors are willing to pay for companies.

 

 

The Undoing Project: A Friendship That Changed Our Minds (The Rational Walk)

 

The Rational Walk discusses Michael Lewis’ new book about pioneers in Behavioural Finance and how it relates to investing. (link)

 

 

The Story of How McDonald’s First Got Its Start (Smithsonian)
The story of the history of the McDonald brothers before McDonald’s became a multi-chain restaurant. (link)

 

 

What is Your Edge? (Base Hit Investing)

 

An article discussing three types of edges in investing. (link)  We view our biggest edge over other market participants is a time horizon edge as we are looking for stocks for the next three to five years.  This also brings an analytical edge as we are analyzing business from the view point of a business owner rather than trying to figure out if the company will beat next quarter’s expectations.

 

 

Buffett’s Three Categories of Returns on Capital (Base Hit Investing)

 

An older post discussing how Buffett categorizes businesses (link)

 

 

HONWORLD DEVELOPED MARKET ROADMAP

 

As mobility increases in China, cultures converge leading to a more homogenous tastes and markets.  This will take generations to play out but when it does it leads to a national market similar to many developed market like the US. The cultural convergence leads to the ability to apply fixed costs to a larger market increasing consolidation and dominance of larger players as smaller players cannot reach the minimum efficient scale required to compete.

 

The significant fixed costs in the form of advertising and distribution allows a brand to be built by larger competitors as more customers can be reached and educated. A brand is particularly important in an industry with a low priced product as the brand decreases search costs for customers leading to potential habit forming behavior. For example in the US, customers have acquired a taste for Heinz Ketchup.  When a customer goes to the store given Heinz may cost as little $2.50 a bottle and the Heinz brand represent a known and liked product that customer is not going to spend anytime even thinking about another brand given very little benefit.

In addition, retailers only have so much shelf space and are unlikely to place 15 to 20 different cooking wines on the shelf as a good number of the 15 or 20 cooking wines will not sell leading to waste shelf space.  The biggest players have a tremendous advantage as retailers now they will sell.

 

The table below shows the market structure of the five largest condiment markets in the US.

 

The US condiment industry is a great example of industry consolidation in a more developed market and a good roadmap for the Chinese Cooking Wine industry. The lowest concentration ratio among the largest five US condiment markets is the Hot Sauce market with a 52.2% four firm concentration ratio, while the highest is Ketchup with a 78.6% three firm concentration ratio. The four firm concentration ratio in the Chinese Cooking Wine segment is only 26.8% so there is potential for significant consolidation. The low four firm concentration ratio reiterates the fragmented regional nature of the market.

 

 

UNIVERSAL HEALTH DEVELOPED MARKET ROADMAP

 

Market Structure

 

The pharmaceutical retail segment in China is fragmented. According to the China Food and Drug Administration, in November 2013, there were 433,873 chain and individual drug stores in China, 10,150 more stores than 2012. There are 3,376 enterprises with multiple locations in China. Enterprises with multiple locations are more likely to manage the business for profitability and close down unprofitable stores. All though the market is fragmented, market consolidation is underway with Universal Health and Sinopharm leading the way. Retail competition comes in the form of target customer bases, business models, and product portfolios.

 

At the time of its IPO, Universal Health was the largest pharmaceutical retailer in Northeast China with 794 self operated outlets.  There is not sufficient information to get a sense of the efficiency of each store as competitors with higher revenue per store maybe a function of bigger stores, but it seems Universal Health’s may not be as efficient as competitors. This poor efficiency may be due to acquiring less efficient stores and improving operations. The pharmacy market in Northeast China has low level of concentration with a 2012 five firm concentration ratio of 44.2%.  This only tells part of the story as there could be a large number of smaller independent stores.  Universal Health has increased its estimated market share in Northeast China retail from 5.7% in 2012 to an estimated 8.8% in 2014.

 

The largest distributors in Northeast China at the time of the IPO are listed below. Universal Health is the largest private pharmaceutical distributor in Northeast China.

 

 

The largest retail pharmacy chains in China are listed below.  In 2012, the largest pharmacy operator had a 2.1% market share.  The 2012 five firm concentration ratio was 9.4%, while the ten firm concentration ratio was 16.0% indicating a very fragmented market. At the end of 2012, Universal Health’s China retail market share was 40bps.

 

The Chinese pharmaceutical distribution market is less fragmented than the retail market but still exhibits low concentration with the leading player accounting for 16.8% of the overall market.  The five firm concentration ratio is 36.5% and the ten firm concentration ratio is 44.9%. Universal Health garnered 16 bps of the total Chinese pharmaceutical distribution market.

 

While each individual country has its own idiosyncrasies leading to different development paths, the market structure of more developed markets may give a roadmap for developing countries.

 

The US pharmacy market shows moderate levels of concentration with a five firm concentration ratio of 64.4%.  There is some fragmentation but there are a significant number of small players still operating in the market.

 

According to Canada’s Office of Consumer Affairs, the Canadian pharmacy market has a 2012 four firm concentration ratio of 68.6%. The largest company is Shoppers Drug Mart with a 31.8% market share followed by Katz Group with a 16.7% market share, Jean Coutu with a 12.2% market share, and McKesson with a 7.9% market share.

 

According to the Pharmaceutical Journal, in the UK, there are 14,361 pharmacies with 4,201 independent owners, owning up to five pharmacies, operating 5,590 pharmacies and 174 multiple owners, owning six or more pharmacies, operating 8,771 pharmacies.  Large owners and supermarkets account for 52% of the overall market.

 

The US’s, Canada’s, and UK’s pharmacy market structures point to a much more consolidated market than the Chinese market but not the oligopolistic market structure you would expect if there was a significant benefit from economies of scales.  There seems to be economies of scale in purchasing but only to a point. Another reason for the fragmentation and large number of small independent operators may be that independent operators do the job for something other than profit maximization.  Just like optometrists or dentists, the ability to be your own boss and make a decent living trumps the desire to sell to a larger chain or exit when faced with a competitive disadvantage.

 

Pharmaceutical distribution markets are far more concentrated in developed countries than China with a three firm concentration ratio ranging from 43% to 85%.  Developed pharmaceutical distributors, economies of scale manifest themselves in high capital efficiency as operating margins often struggle to reach 2%.   The high fixed costs associated with upfront investments and low marginal cost for selling an additional unit leads to very high competitive rivalry among distributors and the need to utilize fixed costs as much as possible leading to greater profitability.

 

 

Peak Sport Products, PC Jeweller, and Honworld Position Sizes 10/30/2016

Peak Sport Products, PC Jeweller, and Honworld Position Sizes 10/30/2016

Peak Sport Products completed its privatization at HKD2.60 per share on Monday October 24, 2016, therefore we no longer have a position in Peak Sport.

 

We are decreasing our position in PC Jeweller to 2.0%. The company is now valued at 12.9 times EV/EBIT and 3.7 times EV/IC. The company and Titan are clearly the two most operationally efficient competitors within the India jewelry industry, but we must remember, the organized sector is very small portion of the total market and there are no barriers to entry in the jewelry retail industry. As the organized sector increases its share of the market, competitive pressures will be more intense. The lack of barriers to entry means PC Jeweller and other participants can do very little to shield themselves from competitive pressures.

 

To reach an annualized return of 15%, sales growth of 5% into perpetuity, stable operating margins, and stable capital efficiency must be assumed. Stated another way, PC Jeweller must have pricing power and defend against competitive pressures in an industry with no barriers to entry and over 500,000 participants, which seems high unlikely. Our conservative base case scenario assumes 10% growth over the next five years before fading to 0% growth in the terminal year and no margin deterioration leading to annualized return of 8.6% over the next five years.

 

We are decreasing the limit on our current sell price of Honworld to HKD4.00 per share. Our position size decrease to 2.0% is a risk measure because during a period of weak growth, when there is minimal investment in inventory the company is unable to generate free cash flow due to an increase in prepayments, which is extremely concerning. Capital allocation to inventory is a big concern as the company has sufficient inventory to last for years and the overinvestment is hurting profitability. The lack of free cash flow, the increase in soft asset account, and it being a Chinese company leads us to be concerned over the factual nature of financial statements. Our initial position size in Honworld, Miko International and Universal Health were far too aggressive. We were blinded to the risks of our aggressive position sizing due to the strong performance at PC Jeweller and Zensar Technologies and more importantly, our assumption that financial statements were accurate representations of the operating performance of theses Chinese small caps. The inability to trust the financial statements of Chinese companies should probably eliminate any future investments, as there never really can be high conviction. For these reasons, the position size in Chinese companies are typically going to be no larger than deep value stocks, if any positions are taken.

Honworld H1 2016 Report Review and Position Sizing October 9, 2016

Honworld H1 2016 Report Review and Position Sizing October 9, 2016

 

Honworld recently released its H1 2016 report.  In the first half of 2016, the company’s revenues increased by only 0.9% and its gross profit and operating profit contracted by 2.5% and 10.2% respectively.

 

Honworld stated the cause of the slowing in sales growth was a slowing of the Chinese condiment industry as well as a shift in its distribution channel strategy from supermarkets to more traditional channels and the catering market. Additionally, the company altered its product mix to better serve the new distribution channels leading higher sales of medium range products, which we estimate as having roughly 50% gross margin compared to gross margin of 65-75% for high end and premium products. The company did not provided a breakdown of sales by product category or gross margins of product categories both of which would be very useful for any analyst trying to understand the business and should be disclosed by the company.

 

The table below illustrates the growth in the H1 2016 of various condiment makers with Honworld performing at the bottom of the pile for growth illustrating company specific issue more than an industry slowdown was the reason for weaker growth.

h1-2016-chinese-condiment-producers-growth

 

Operating margin declined due to an increase in advertising, distribution and research and development expenses. These are all fixed cost that the company should spend significantly on to take advantage of its size advantage over peers making much more difficult for peers to compete.

 

The big concern has been capital allocation of the company. Honworld stated in its annual report that it had reached an optimal inventory level with inventory levels remaining stable in H1 2016 compared to H1 2015. Despite the stable inventory levels, Honworld did not generate strong operating cash flows as both short term and long term prepayments increased significantly. The increase in prepayments could be attributed to growth plans of the company or it could something else.  It is a bit concerning that in the company’s first period to prove its ability to generate cash flow due to minimal inventory investment it was unable due to an increase in a soft account.

 

Overall, it was a disappointing set of results with growth slowing and free cash flow not increasing despite minimal investment in inventory.

 

We are moving to a new approach for position sizing.  There are significant limits to any investor’s knowledge given you cannot now everything inside a company particularly in smaller companies where there is less outside evidence to collaborate one’s ideas. Most investors base much of their analysis on the financial statements provided by the company being researched. For example, the primary driver of the quality of a business is the ability of a company to generate high returns on invested capital. If the financial statements are not an accurate reflection then any investment analysis will be completely off base.  Inaccurate financial statements happen quite frequently with Chinese companies. The lack of trust creates a need for a less aggressive position size therefore all Chinese companies will start at a 2.0% position and increase with evidence that provides credibility of accurate financial statements. Outside investment in Honworld by Lunar Capital improve the credibility of Honworld’s financial statements; unfortunately, an inability to generate free cash flow is a sign of a bad business or bad management decisions. In the case of Honworld, the business seems great with a very strong marginal economics. Unfortunately, management is misallocating capital in a quest to build mammoth inventory levels decreasing returns on invested capital and increasing the need for outside funding if the company keeps growing. The need for outside funding decreases potential returns for investors due to dilutive nature of growth.

 

Additionally during a period of weak growth, when there is minimal investment in inventory the company is unable to generate free cash flow due to a increase in prepayments is concerning. We are decreasing our position size in Honworld to 2.0% and selling at HKD4.50 or above.

 

Deep value investments outside of Hong Kong and Chinese will be 2.0% positions as these are inherent weaker businesses. As you move up the quality spectrum, our maximum position size will increase with the maximum position at 10.0%. Good businesses that are undervalued will start at 2.0% increasing to potentially 6.0% as undervaluation increases. Good businesses generate strong cash flow and profitability and operate in a growing market but may not have competitive advantage. Current examples are PC Jeweller and Zensar Technologies.

 

High quality businesses with competitive advantages that are close to fairly valued will start at 2.0% and increase to potentially 10.0% based on the level of undervaluation.  Current examples are Credit Analysis and Research, ANTA, Turk Tuborg, Grendene.

 

The new position sizing comes with understanding of the limits to our knowledge and the reliance on financial statements published by companies in formulating investment strategies.   Our previous position sizing seems a bit too aggressive. Our goal is to get between 20-30 investment ideas offering sufficient diversity to buffer against any potential  bad investments while still offer enough concentration to take advantage of upside from good investments.

Miko International and Honworld Position Size July 30, 2016

Miko International and Honworld Position Size July 30, 2016

 

Miko International released its unqualified 2015 year end results after four months of delay. During the delay, the Hong Kong Stock Exchange halted trading on the company’s shares.  The company’s previous auditor KPMG resigned due to incomplete information provided by Miko International. KPMG’s statement from the resignation letter follows.

 

‘‘In respect of our audit of the Company’s financial statements for the year ended 31 December 2015, there are a number of unresolved issues relating to receipt of satisfactory evidence and information, which remain outstanding. We have been communicating since early February 2016 with management on outstanding matters. The outstanding matters have been communicated to the Company’s management, Board of Directors, and the Audit Committee, details of which are set out below.

 

As at the date of this letter, we await satisfactory information in respect of the following matters:

 

  1. We await receipt of the draft 2015 consolidated financial statements from management.
  2. We await access to original bank statements in respect of one of the group’s bank accounts to be provided directly to us by the bank, which had a year end balance of RMB400 million, together with supporting documents in respect of security given over some of the group’s bank accounts.
  3. In respect of the group’s distribution channels, information is awaited relating to how the acquisition price was determined in respect of the distribution channels acquired during 2015 at a cost of RMB107 million, the signed valuation report and supporting documents in relation thereto, as well as supporting agreements and information relating to amendments made during the year to certain other distribution arrangements.
  4. In respect of the prepayment of RMB13 million as at 31 December 2015 for the group’s enterprise resource management system supporting information is awaited relating to the determination of the purchase price.
  5. In respect of the acquisition of a property in Shanghai during 2015, information is awaited in respect of the determination of the acquisition price, signed year-end valuation report, explanations relating to the difference between the year-end valuation and the acquisition price, and other documents in respect of the acquisition.
  6. Site visit and interview with an OEM Supplier.’’

 

Miko International hired HLB Hodgson Impey Cheng Limited (HLB) to audit its financial statements. HLB seems to be an auditor of last resort for fraudulent companies.

 

HLB also stepped in and gave China Solar Energy’s financial statements a clean audit opinion when the previous auditor Deloitte resigned in February 2012. China Solar is now considered to be a fraud and the shares have not traded since 2013.

 

HLB again stepped in when Deloitte resign in July 2015 as auditor of Sound Global. Sound Global received a clean audit from HLB. The company later found RMB2 billion missing from its books.

 

Other concerning evidence includes the resignation of the CFO and three independent directors within a few month time span including an independent director that resigned a month after joining.

 

There is significant evidence that Miko International is a fraud and we will be selling all our shares at the resumption of trading.

 

What can be learned from the poor investment in Miko International? We have decreased our position sizes on all investments to reflect the limits to our knowledge.  Additionally, we are any peripheral evidence will receive more attention. We also must admit when an investment is bad a take a loss.  Our gut told us there was a problem but we ignored it due to inconsistency avoidance and loss aversion.

 

Chinese companies must also be given a discount and smaller position due to the prevalence of fraud within the country. Given this we are decreasing our position size in Honworld to 5.0% as there is significant evidence of a passion owner operator with competitive advantages and credible financial statements (recent investment by a private equity firm), but there is the China discount that needs to be used in the form of a less aggressive position size. We will only be selling Honworld shares above HKD4.75 per share.

 

 

Honworld 2015 Annual Report Review June 29, 2016

Honworld 2015 Annual Report Review June 29, 2016

Honworld Annual Report Review 2015 June 29 2016 RCR

The amount of capital allocated to inventory is the biggest concern with an investment in Honworld. There is some complexity to how inventory works its way through the company’s financial statements so we thought it would help us to relook at the production process and how inventory is accounted for.

 

To start the production process, Honworld purchases raw materials. In the company’s IPO prospectus, it stated “Our raw materials are generally available from numerous suppliers. We minimize our reliance on any single source of supply for our raw materials by maintaining alternative sources.” The breakdown of raw materials is listed below.

Honworld Raw Material costs

 

Raw materials with the exception of packaging are pure commodities where the purchasing decision is based on price readily available from many suppliers.

 

Base wine production is the next step in the production of inventory. Rice is soaked and steamed to increase moisture content. The rice is then fermented, which takes place in cool weather, generally from every October to next May each year. Sometimes, there is a second fermentation process. The fermented product is then filtered and sterilized. Depending on weather conditions, it typically takes 30 to 35 days to complete the above production steps. Following base wine production, base wine is aged, seasoned and blended, and packaged to create the final cooking wine product.

 

The final cooking wine product is a mixture of vintage base wine, mixer base wine, water, seasoning, and spices. Vintage base wine is aged to deliver the desirable aroma and taste, while mixer base wine is added to adjust the ABV, sweetness, and acidity. Mixer base wine is aged less than two years. The final cooking wine product comes in four grades classified by the amount of base wine used in the end product and the age of vintage base wine used.

Honworld product characteristics by product range

 

  • In 2013, premium cooking wine was 6% vintage base with an average age of 10 years and 87% mixer base wine with an alcohol by volume of 15%.
  • High-end cooking wine is 6% vintage base with an average age of 8 years and 81% mixer base wine with an alcohol by volume of 15%.
  • Medium-range cooking wine is 4% vintage base with an average age of 5-6 years, and 81% mixer base wine with an alcohol by volume of 10%.
  • Mass-market cooking wine is 4% vintage base with an average age of 5-6 years, and 64% mixer base wine with an alcohol by volume of 10%.

 

Honworld has not reported its volume sold or base wine used since its IPO prospectus. Volume sold for 2013, 2014, and 2015 is estimated, by assuming ASPs do not change over those periods, while, 2010 to 2012 are from the company’s prospectus.

ASP by product

 

Honworld’s volume sold and base wine used is shown in the table below.

Volume Sold

 

Base wine usage in 2013, 2014, and 2015 is assumed to remain the same as the first eight months of 2013. Base wine as a percentage of cooking wine volume sold increased from 35% to 86% as Honworld sold more premium products, which require more base wine, and the amount of mixer base wine per liter of cooking wine increased. Since base wine represented 86% of volume sold, the estimated base wine inventory of 180 million translates to 211 million liters of potential sales volume or 2.87 years of inventory based on 2015 estimated sales volume. Honworld’s target base wine inventory of 225 million liters, expected to be reached in June 2016, translates to 263 million liters of sales volume or 3.58 years of inventory based 2015 estimated sales volume.

 

Honworld did not report base wine inventory at the end of 2015 but at the end of 2014, the company had 158.4 million liters of base wine inventory. The company has repeatedly stated its target is to reach 225 million liters of base wine inventory. The question becomes does the company continue to build inventory past the 225 million liters level at a rate equivalent to sales, which will lead to a continued cash flow drain, or does the company remain at its target level of 225 million liters. At the end of 2016, we will know if the company continues to build inventory or if it continues to throw off cash flow. The company has been raising money by selling shares and bank loans leading us to believe it will continue to build inventory with revenue growth. If the company was going to stop building inventory, it would make sense to use debt to maintain ownership as the company is not too levered with net debt to EBIT at 1.54 times.

Key Inventory Statistics

 

The above table illustrates base wine inventory from 2010 to 2015. At the end of 2015, Honworld had 180 million liters of base wine and a total inventory cost of RMB945 million for an estimated cost of RMB5.24 per liter of base wine. The cost of goods sold per liter of volume sold equaled RMB3.26, while the cost of goods sold per liter of base wine used equaled RMB3.81. The ratio of cost of goods sold per liter of volume sold to the cost of goods sold per liter of base wine equaled the ratio of base wine used to volume sold.

 

The ratio of the cost of base wine used to balance sheet inventory on a per liter basis fluctuated between 227.5% in 2010 to 59.3% in 2013 with 2015 ratio of 72.6%. The company uses weighted average method so a shift in raw materials costs will not create a differential between inventory valuation on the balance sheet and inventory valuation on the income statement in cost of goods sold. The shift in cost of goods sold per liter of base wine to base wine inventory valuation per liter is related to an increase in vintage wine in inventory relative to the amount of vintage base wine used in volume sold as there are costs to storing and holding base wine during the aging process leading vintage base wine to have a higher valuation. Vintage base wine will continue to increase as a proportion of inventory held while vintage base wine as a percentage of cost of goods sold not increase drastically meaning cost of base wine sold per liter should decrease relative to the cost of base wine inventory per liter.

Base wine breakdown

 

 

Capital Allocation

 

Other than understanding how the company’s main product flows through the financial statements, the central question to the analysis of inventory is whether allocating significant amounts of capital to inventory is in the best interest of shareholders.

 

Management states it can guard against the increase of raw material price from holding a higher level of base wine. Raw materials are commodities in the truest sense of the word so as long as a certain quality threshold is reached price is the only consideration in the purchase decision. These commodities are available from many producers. Suppliers of raw materials have no bargaining power so there will be no price increases due to supplier strength. If raw material prices increase all competitors will be affected equally allowing raw material price increases to be passed on to customers. Furthermore, Honworld has a brand, illustrated by its leading market share with premium pricing, meaning any increase in commodity prices can be passed on to customers.

Inventory buffer for price increases

 

Assuming that the company is unable to increases in raw material prices, to analyze the effects of increased inventory and associated working capital, we assume that the company carries half as much base wine to eliminate the company’s inventory protecting against raw material prices. We assumed base wine inventory is halved from 180 million liters to 90 million liters, which translates to 105 million liters of end product or 1.43 years of 2015 estimated sales volume. Total inventory costs decrease from RMB945 million to roughly RMB475 million leading to an increase in inventory turnover from 0.84 to 1.69. In addition, fixed capital is tied to inventory as much of the company fixed costs are storage facilities to age base wine; therefore, fixed capital is assumed to decrease by 25%. Other working capital is assumed to have no connection to inventory levels and therefore remains the same leading to overall invested capital decrease from RMB1,782 million in 2015 to an estimated RMB1,145 million without inventory and necessary infrastructure to protect against raw material increases. Raw material price increases lead to increased cost of goods sold with every other income statement account remaining the same.

Raw material price increases vs current ROIC

 

As illustrated above, if Honworld halved its inventory as well as associated fixed costs,  raw material prices need to increase by 30% for return on invested capital (ROIC) to reach the level seen in 2015. Commodity prices are difficult to forecast but a 30% increase in a deflationary environment does not seem like a high probability event. Additionally, there is a high probability (80-85%) that Honworld would be able to pass on increases in raw material prices due to its brand, and/or competitors would see the same increase in commodity prices leading to an industry wide increase in prices. The statement that management is building inventory to protect against rising assume that two low probability events occur rising raw material prices in a deflationary world (<20-25%) and an inability to pass on price increases leading to a decrease in profitability (<15-20%).

 

Management’s other reason for building inventory is to support future growth. The company’s current inventory is sufficient cover 2.87 years of 2015 sales volume. In addition, the company believes it will reach 225 million liters of base wine inventory at the end of the first half of 2016. The company can also produce enough base wine to cover 2015 in one year’s sales as while increasing its base wine inventory it is still producing sufficient inventory to cover current period sales.

 

Mixer base wine and vintage base wine are two types of base wine used in the production of cooking wine. Mixer base wine is less than two years old, so does not need any ageing, while vintage base wine is over two years old, and therefore needs ageing. The table below illustrates the amount of base wine, vintage base wine, mixer base wine, the average age of vintage base wine, the percentage of 2015 cooking wine revenue of each category of base wine, and estimated gross margin for each category.

Base whine characteristics by product with potential scenarios

 

The table also illustrates the 2015 blended average and two scenarios assuming an increase in sales of higher-end and premium products.

 

Given mixer base wine can be produced without ageing, the inventory build is to allow the company to produce more vintage base wine to allow the company sell more premium products.

Base wine ageing

 

Base wine inventory in liters is estimated by assuming the cost of base wine remained the same in 2015 as the company reported base wine inventory in liters in 2014. Mixer base wine is assumed to be the change in inventory from the previous two years as mixer base wine is any base wine under two years. The remaining base wine is considered vintage base wine. Vintage base wine’s age is estimated by taking the vintage base wine not used in the year and adding mixer base wine added to inventory two years ago. All new mixer base wine is considered to be 2.5 years and vintage base wine from previous years is considered to age by a year. Vintage base wine inventory estimated age reached 4.0 years at the end of 2015. The vintage base wine inventory’s age continues to fall as the mixer base wine re-classified as vintage base wine increases as a proportion of vintage base wine inventory.

 

The company now has estimated base wine inventory of 180.3 million liters consisting of 87.7 million liters of base wine inventory and 92.7 million liters of vintage base wine inventory. In 2015, Honworld used an estimated RMB3.3 million liters of vintage base wine meaning the vintage base wine inventory of 68.4 million liters is sufficient for almost 21 years assuming sales remain at 2015 levels. Mixer base wine can be easily produced as it does not have to be aged creating a situation where vintage base wine will continue to grow.

 

Assuming similar sales volume to 2015 and product mix of 50% of sales volume is premium, 25% is high-end, and 25% is medium-range, base wine would be 88.0% of a liter of cooking wine with vintage base wine would need to be 5.5% of inventory sold or 4.4 million liters of vintage base wine. At current inventory levels, vintage base wine inventory would have just less than 17 years of vintage base wine inventory. It seems the company is over building its vintage base wine inventory, which may not be used for decades and is well above the amount required. Vintage base wine could probably be closer to 10-12 years as in the most aggressive scenario of selling 100% premium cooking wine base wine only needs to be ten years old. Additionally, the company can produce an estimated additional 100 million liters in mixer base wine per year with the vast majority going to current period sales. The company is building inventory and should be effectively spread over ages, unfortunately the company does not provide disclosure on the age of its inventory. The company could effectively half its vintage base wine inventory and still have 10 years of vintage base wine inventory, while mixer base wine inventory should no more than a year as the company produces about 150% of its current period mixer base wine needs. Overall, base wine inventory could be decreased by 50% and still have sufficient inventory for current period and growth meaning ROIC could increase from 16.6% in 2015 to 25.8%.

 

The analysis above was not created to verify my past views on Honworld’s inventory levels but to use a new angle to see if my existing view were inappropriate. Unfortunately, the outcome of the analysis points to the same view that inventory is bloated and holding down returns of the company with inventory at twice the size it needs to be.

 

After reviewing Honworld’s 2015 annual report, the company will not be able to realize its full value if it does not do a better job on disclosure. Analysts need more information to get a much more accurate picture of the company and fully understand how inventory flows through the company’s financial statements. Additionally, the company should give better disclosure on product mix and profitability of each product. Our desire is to see the following disclosed:

 

  • ASP
  • Volume by product
  • Gross margin by product
  • Base wine inventory in liters
  • Base wine inventory ageing
  • Inventory ageing by base wine and vintage base wine
  • Estimated inventory cost by age
  • Base wine production capacity
  • Base wine storage capacity
  • Bottling capacity
  • Sales by geography
  • Sales by distribution channel

 

Overall, Honworld is one of our top ideas. There is a high probability that the company is building a multi-faceted competitive advantage in the form of economies of scale and brand. Over the past three years, the company spent 7.0% of revenue in research and development and another 7.1% in selling and distribution expenses meaning fixed costs were 14.1% of revenue. In 2012, the last reported data, Honworld was the largest Chinese cooking wine producer with a 13.8% market share. The company is the only top four cooking wine producer using a naturally brewed, traditional production process allowing the company to garner premium pricing. This premium pricing amplifies the company’s size advantage over its top four competitors, as 95% of cost of goods sold is raw materials in the form of agricultural commodities. As illustrated below in 2012 (latest available data), Honworld’s sales are 2.16 times and its gross profit is 2.86 times its largest competitor. Sales are 3.21 times and gross profit is 4.21 times its second largest competitor.

Top 5 cooking wine producers in china

 

The 14.1% of revenue in fixed costs translates to 24.4% of gross profit. The company’s nearest competitor is the only competitor that can match the fixed costs and still be profitable as Honworld’s fixed costs equate to 70% of the largest competitor’s gross profit and 103% of the second largest competitor’s gross profit. Honworld expects to increase advertising expenses and continue to increase the penetration of its distribution channel to third and fourth tier cities within its key sales regions. The company also has brand advantage illustrated by market share advantage and premium pricing. Additionally, it sells the lower priced product where the customer is less likely to search for alternatives with a small price increase as the increase is not as noticeable and search costs are much higher.

 

The company is run by a passionate, owner-operator and recently there was an investment by a private equity company with significant resources to conduct due diligence giving credibility to the company’s financial service. The private equity company is an expert in Chinese consumer companies so it brings additional relevant expertise. The major concern with Honworld is the investment in inventory. As illustrated above, inventory is running at twice what it should and dragging on profitability leading to financing issues. The company is increasing its debt load and selling part of the company to finance its growth as it is growing at 20% per year. The company is targeting 225 million liters of base wine inventory at the end of the first half of 2016. Hopefully, the company slows down the aggressive inventory build and if it continues to build inventory it does so at a slower pace than revenue growth.

 

The company offers a 12.7% EBIT yield and 5.0% organic growth through pricing power for almost 18% expected annual return. Additionally, the company’s debt load is inflated due to its inventory build and if the company changes direction with inventory it can pay down that debt quickly or increase dividends.

Honworld Share Sale June 3, 2016

Honworld Share Sale June 3, 2016

 

After trading hours on June 1, 2016, Honworld sold 11.57% of the company’s existing share capital and 10.37% of the company’s expanded share capital for HKD6.00 per share.  New shares were issued with no existing shareholders selling.  HKD6.00 is a 27.66% premium to the June 1, 2016 closing price of HKD4.70 per share. The subscriber is a wholly owned subsidiary of Lunar Capital, a private equity fund focused on investing in the Chinese consumer businesses in the PRC. The subscriber’s guarantor’s principal activity is owning and operating companies or businesses focused in the condiments market in the PRC.

 

The aggregate net proceeds from the subscription are estimated to be approximately HKD356.1 million representing a net price of HKD5.935 per share. The company intends to utilize the net proceeds for general working capital of the Group.

 

The HKD6.00 price puts Honworld on an EV/2015 EBIT of 10.37 times and EV/2015 NOPAT of 12.29 times meaning shares were sold at cheap to fair value but not a no brainer sale price and not a ridiculously cheap price.

 

Lunar Capital has investments in a number of consumer goods companies in China.  Lunar Capital often takes a controlling interest from older founder who have succession challenges.  Lunar Capital is only buying 10.37% of Honworld so it is not taking control but it should bringing additional operational expertise given its numerous investments in consumer products.  Additionally, it should provide additional perspective on other important aspects such as capital allocation.

 

As mentioned in the initiation report and most subsequent updates, Honworld is going to need to continue to raise capital due to inventory needs associated with growth. The company’s inventory is raw materials, which can be purchased solely on price and ageing the product into premium products does not generate sufficient margin to make up for the ROIC drag associated with holding inventory for additional length of time.  This is the second consecutive fund raising that potentially involves selling shares leading to dilution of existing shareholders, which was not a particularly high price.  The recent sale/loan allowed the company to raise RMB133 million. This transaction allowed the company to raise net proceeds of HKD356.1 million or RMB420 million leading to RMB553 million raised over the past month.  Assuming working capital turnover remains at 0.71, the RMB553 million will allow the company to grow by an additional RMB393 million or 50% from current levels.  Assuming a 15% growth rate, the RMB553 million will be sufficient to finance growth until the end of 2018.

 

This development brings outside capital and credibility at a significant premium to the current market price and at a cheap/fair value.  Capital allocation continues to be an issue as illustrated by the continuous need for fundraising. As of Friday May 27, 2016, Honworld was an 8.5% position, which we were trying to sell down to 7.5% but given the share price dropped below HKD5.00 per share we stopped selling.  We will maintain the current position of 8.5% given the credibility, operational expertise, and perspective of the external buyer.  Additionally, the owner operator is passionate about the business and may see it as a family legacy. The business has a very strong competitive position and is growing rapidly while trading below and EV/EBIT of 10 times. This transaction also puts a private market value on Honworld well above the current share price.  If Lunar Capital is purchasing at HKD6.00, it must expect to get at least 15% IRR from the investment maybe more given the premium required for a Chinese investment.

Honworld May 6, 2015 Cheap Financing or Something Else?

Honworld May 6, 2015 Cheap Financing or Something Else?

 

On May 6, 2016, Honworld Group announced a RMB133 million investment in its wholly owned subsidiary Lao Heng He from CD Fund in exchange for an estimated 3.5% of Lao Heng He’s capital. The actual percentage that CD Fund receives will be determined by a valuation report that will be released over the next three months.   The funds will be used to construct a natural ecological brewing production base in Wuxing Area, Huzhou City, Zhejiang Province, PRC (the investment project).

 

The transaction is conditional upon the satisfaction of the following conditions:

 

  1. from the date of the Investment Agreement to the date of the Completion, there is no material adverse event that will adversely impact on the business prospects, assets, and financial condition of Lao Heng He;
  2. the articles of association of Lao Heng He has been amended according to the terms of the Investment Agreement;
  3. all internal approvals of Lao Heng He, Huzhou Chen Shi, Honworld, and Huzhou Nantaihu with respect to the entry of the Investment Agreement have been obtained;
  4. Lao Heng He has obtained the relevant undertaking documents from Huzhou City Wuxing Finance Bureau for the Investment Project;
  5. Lao Heng He has obtained the approval from the relevant local government authorities for the Investment Project; and
  6. CD Fund completing its due diligence on Lao Heng He. Use of Proceeds Lao Heng He shall ensure that all proceeds of the Capital Investment to be used in the implementation of the Investment Project.

 

Honworld’s wholly owned subsidiary, Huzhou Chen Shi agreed to repurchase the equity interest of Lao Heng He to be owed by CD Fund within 8 years after the payment of the Capital Investment.  CD Fund is according to the repurchase schedule under the Investment Agreement. Under the agreement, the CD Fund with receive minimum returns of a dividend at an annual rate of return amounted to 1.2% of the Capital Investment. No dividend payments need to be made by Lao Heng He until 20 March 2018. On 20 March 2018, the CD Fund shall be paid the total dividend accumulated then the CD Fund will be paid a yearly dividend on or before 20 September every year after 20 March 2018.

 

Lao Heng He is a wholly-owned subsidiary principally engaged in the manufacturing of cooking wine, soy sauce, vinegar, soybean sauce products and other condiments products. Lao Heng He’s unaudited key income statement accounts are below.

May 6 2016 Lao Heng He Results

 

In 2016, the company accounts for 97% of Honworld’s revenue, 97% of its net profit before tax, and 89% of its total assets.

 

CD Fund, a wholly-owned subsidiary of China Development Bank, was established on 25 August 2015 and is principally engaged in the investment of financial bonds.

 

The investment will be reported as a financial liability on the company’s balance sheet as there will be no gain or loss as the company can repurchase the equity interest.

 

Assuming it was a straight investment in the company, it values Lao Heng He at just over 14 times pre-tax profit. The deal seems like a very cheap way of funding the company’s investment assuming it can repurchase the investment at a cost in eight years.  It also avoids diluting the company’s existing shareholders through rights issues or issuing additional shares to raise capital needed.   The company provided no additional details about the investment project.

 

As highlighted before, the company’s focus on maintaining such a high inventory level is not allowing the company to self fund its growth.  The vast majority of the company’s inventory is work in progress and the gross margin generated on aged products does not cover the cost of ageing products leading to a lower ROIC for the company, as illustrated in our initiation report.

 

This event has little change on our view that Honworld has a strong brand and economies of scale giving it a very strong competitive advantage.  The company is growing very rapidly and is run by a passionate owner operator with the only downside being the allocation of capital to inventory. We are in the process of decreasing our position size but as stated we are not selling below HKD5.00 per share.

Honworld Annual Results Review April 7, 2016

Honworld Annual Results Review April 7, 2016

Honworld report 2015 results on March 31, 2016.  The company’s grew its revenue by 19.5%, gross profit by 16.7%, and operating profit by 11.6%.  The drag in gross profit was primarily due to the application of new brewery method in premium soy sauce products in order to improve the quality and flavor. Operating profit was due to increased selling expenses as administrative expenses were flat year on year. Selling expenses increased as Honworld conducted more extensive marketing and promotional activities to better penetrate its distribution network to third tier and fourth tier cities, restaurants, and e-commerce platforms.

The company maintained approximately the same absolute level of research and development at RMB46.77.  Over the past three years, research and development has average RMB46.08 million. Selling expenses and research and development are key to maintaining the company’s competitive position given its size advantage over peers.

Our biggest concern with Honworld is inventory levels. Management stated it has reached its desired level of inventory. At the end of 2015, Honworld’s inventory days stood at 432.5 days compared to 453.5 days at the end of 2014. As illustrated it is an extremely working capital intensive business and working capital turnover as settled at roughly 0.70 times with 0.71 in 2015 and 0.72 in 2014.

The company’s financial health deteriorated slightly as growth lead to higher inventory requirements and the inventory may putt constraints on the company’s ability to grow. At the end of 2015, net debt to operating income stood at 1.54 times up from 0.75 times with operating income to interest at 9.06 times.

Overall in 2015, Honworld generated a ROIC of 13.8% with inventory accounting for 53% of invested capital. It is a business with very good economics apart from the inventory the business carries.  The owner is extremely passionate about the business and sees it as a family asset.  The biggest shareholder’s holding company charged shares for a loan creating a bit of concern but given his passion for the business and family legacy associated with the business it seems highly unlikely he would put ownership of the business at risk. The company offers an estimated return of roughly a 14% at current prices assuming 2.5% organic growth and 15% sustainable ROIC.  Assuming 10% growth over the next five years and 2.5% terminal growth in year ten with 13% sustainable ROIC, the company’s 2020 fair value is HKD10.26 or 15% annualized return.  The current EV/EBIT is 8.4 times

 

Given our modified position sizing on the back of Company 9/8/15 and Miko International mistakes, we are decreasing our position size by roughly USD2.0 million bringing our cost base to roughly 7.5%. Sales will be made as long as Honworld’s share price is above HKD5.00 slightly above our initial cost base of HK4.64 per share.

 

Pros

  • Great business with good economics
  • Industry leader with economies of scale and a strong brand creating pricing power
  • Low priced product allowing for greater pricing power
  • Passionate owner operator whose family has significant history with the business
  • Cheap valuation IRR = 15%

 

Cons

  • Inventory levels are a big drag on profitability particularly when inventory is commodity raw materials and the gross margins from products made with older age base wine does not make up for the cost of holding inventory
  • Shareholder charged shares in a loan

Honworld Position Size February 1, 2016

Honworld Position Size February 1, 2016

We have decided to stop selling Honworld.  The share are now under HKD5.00 and are undervalued offering a 12% EBIT yield. There is still a risk with the shareholder charging shares to ensure a note of his holding company was subscribed to.  Given the evidence pointing to the founder’s passion for the business and his family legacy with the business, it seems highly unlikely the founder would put his ownership of the company at risk.  Capital allocation continues to be a concern, but the business economics, the passion of the owner operator, and the valuation trump the concerns.

 

We sold just under 7.98 million shares for total proceeds just over USD4.77 million.  Honworld is now just under a 10% position.