Tag Archives: Weekly Commentary

Weekly Update December 10 2017

Weekly Update December 10 2017

Over the past year, I have been busy with various projects and a move back to the US from India. Starting in the new year, I will have more time to produce weekly updates on a consistent basis. Hopefully, the weekly updates add a bit of value. Feel free to let me know your thoughts.

 

Johannesburg Stock Exchange Pass

 

The Johannesburg Stock Exchange (JSE) was reviewed as a potential recommendation but it was a pass. I was attracted to JSE due to potential network effects combined with a business with all fixed costs leading to potential economies of scale and significant operating leverage. The company is currently trading on a FCF yield of 8.0%. A company with a very strong moat in the form of network effects and economies of scale along with top line growth at GDP and profit growth at a higher rate due to operating leverage should be trading at a higher valuation. If the concerns were solely macroeconomic, I would have recommended the company.

 

In 2017, ZAR X and A2X were awarded licenses to operate equity exchanges. In 2016, equity markets accounted for at least 60% of the company’s revenue. Operating financial exchanges are a technology business. The biggest risk is new entrants can replicate JSE’s technology at a much lower cost, as JSE technology platform has been slowly built over years and therefore is a patchwork legacy system. The ability to operate a technology platform at a much lower cost allows new entrants to undercut JSE’s pricing. In other markets new entrants have been able to gain share in what was once thought to be an almost rock solid competitive position. The BATS platform has achieved a 19% market share in US equities since entering the market in 2005 and 20% market share in European equities since entering the market in 2008. New entrants in South Africa should at the very least force JSE to cut prices and/or to upgrade its technology platform.  Given the fixed nature of the company’s expenses, any loss of revenue will flow directly to a decrease in the company’s operating profit.

 

Looking at valuation, assuming market share gains by competitors and/or price cuts in the equity division, revenues related to equity markets would decrease by 20% leading to a free cash flow yield and expected return close to 5.0%. Assuming competition has some effect and cancels out any growth, the company’s free cash flow yield and expected return is roughly 8.0%. Assuming competition is unable to enter to gain a foothold in the market and the company is able to continue to grow at 5.0%, the expected return is 13.0% per annum (free cash flow yield + growth).  The potential ranges for expected return are only estimates as it is difficult to forecast with any accuracy. Assuming, the highest return scenario has a 60% probability and the other two scenarios each have a 20% probability then the expected return per year is 10.4%. KfW is a German government owned development has a rand denominated bond expiring in October 2022 with a AAA rating, which offers a 8.272% yield. Given the potential risk a 2.0% additional annual return over a AAA rated bond is probably not sufficient to warrant an investment in JSE.

 

Links

 

Given my focus on high quality companies, I often read Morningstar’s research and insights. Morningstar put out an article discussing company profitability and changing nature of moats (link)

 

Alpha Vulture, another value investing blog posted an investment thesis on Stalexport Autostrady, a company I wrote about earlier this year. My post on Stalexport Autostrady can be read here while Alpha Vulture’s post can be read here.

 

Francis Richon of Giverny Capital talked at Google. The talk is well worth the hour (link).  Giverny Capital’s letters can be view here. HT Value Investing World

 

Giverny Capital process is summarized below.

 

Financial Strength

  • ROE > 15%
  • EPS growth > 10%
  • Debt/profit > 4x

 

Business Model

  • Market leader
  • Competitive advantages
  • Low cyclicality

 

Management Team

  • High level of ownership
  • Constructive acquisitions
  • Good capital allocation

 

Valuation

  • 5 year valuation model
  • Try to purchase at half of the estimated valuation in 5 years = IRR of 15%

 

 

The Council of Institutional Investors discusses variable interest entities (VIE) used by Chinese companies when listing in the US. (link) Chinese companies also use VIEs when listing in Hong Kong. Below is one of the most interest aspects of VIEs.

 

“The VIE structure could be deemed to contravene Chinese laws that restrict foreign investment in strategically sensitive industries. VIEs operate using contractual arrangements rather than direct ownership, leaving foreign investors without the rights to residual profits or control over the company’s management that they would otherwise enjoy through equity ownership. While VIEs have established themselves as common practice among U.S.-listed Chinese companies and have won some validation from market actors, the structure puts public shareholders in a perilous position. VIEs depend heavily on executives who are Chinese nationals and own the underlying business licenses to operate in China, introducing unusually significant “key person” succession risk. Aside from dual-class structures with limited shareholder rights in the Cayman Islands and other jurisdictions in which these companies are often incorporated, the VIE structures themselves create significant management conflicts of interest, complicating, if not foreclosing, the ability of outside shareholders to challenge executives for poor decision making, weak management, or equity-eroding actions. VIEs lead foreign investors to believe that they can meaningfully participate in China’s emerging companies, but such participation is precarious and may ultimately prove illusory.”

 

Due to the high frequency of financial statements being completely wrong, I no longer look at Chinese companies. Through the end of Sept 2017, our average recommendation is up 7.9% in relative terms on a USD basis. Taking China out of the picture, our average recommendation is up 30.8% in relative terms on a USD basis. The reliance on financial statements within my research process means it is best just to stay away when financial statements cannot be trusted. When the outcome is poor the result is clear but when the investment goes right, there can never be conviction so the benefit of a good outcome cannot be realized.  The combination means time is better spent elsewhere. If you are looking at China and concerned with fraud, GMT Research (www.gmtresearch.com) does a good job discussing Chinese companies and potential concerns. There is a wealth of free information on their site. One particular video Faking Cash Flows and How to Spot It is a must watch. A key point from the video is outside of China only 1% of companies above USD500 million meet GMT’s four indicators for cash flow fraud while in China and Hong Kong that rises above 6%. Another blog discusses the risks of investing in Chinese companies (link).

 

Peters MacGregor discusses its investment in Fairfax India (link). Peters MacGregor is an Australian investment firm that invests in undervalued portfolio of world-class businesses with dominant market shares and good growth prospects. It looks very interesting at first glance.

 

Kellogg Insights interviews Lou Simpson (link)

 

An interesting tweet by @ValueStockGeek illustrating the number of position in a value portfolio and standard deviation of monthly returns (link). As the number of position in a value portfolio passes 10 the benefits of diversification decreases. Joel Greenblatt did a similar study in his book You Can be a Stock Market Genius. Validea discussed his finding here.

 

Fundsmith Equity Fund published an Owner’s Manual, which is well worth a read (link). HT @ToddWenning

 

This following link is to Amazon’s Shareholder Letters from 1997 to 2016. Amazon Shareholder Letters Jeff Bezos 1997-2016

 

Clear Eye Investing put together a list of 15 questions to ask management (link). HT @HurriCap

 

 

WEEKLY COMMENTARY 3/6/17- 3/12/17

WEEKLY COMMENTARY               3/6/17- 3/12/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

A Soriano Corp (Anscor) reported 2016 results. We recently initiated on Anscor with the key points to our thesis being:

 

  • The company has a healthy balance sheet
  • The company was in a number of highly competitive businesses, but
  • The company consistently generated a return on equity (ROE) around 10% our discount rate for all companies.
  • Despite the company’s healthy balance sheet and the consistency of the company’s ROE, Anscor trades well below its book value currently at 0.55 times its tangible book value and at 5.5 times cyclically adjusted earnings.

 

In 2016, the company maintained a healthy balance sheet with total liabilities twice the company’s cash position but less than half the amount of the company’s total securities. While the company’s businesses continue to be competitive, it was able to generate a return on tangible equity of 9.9%.

 

The company’s income before tax increased by 26% driven by strong results in all subsidiaries. Anscor’s largest subsidiary, PDPI grew its revenue by 8.3% due to a strong macroeconomic environment boosting construction activity. It was able to increase its net income by 30.7% in 2016. PDPI generated a ROE of 32%, the second year in a row over 30%. The company’s resort operations increased revenue and gross operating profit by 5.7% and 8.3%, respectively, generating a ROE of 34.0%. Anscor’s US nurse staffing business, Cirrus, grew revenue by 39% and net income by 70%. It generated a ROE of 35.9%.

 

Overall, the results reinforce our investment thesis of a company with a healthy balance sheet consistently generating a ROE close to its discount rate yet trades at a substantial discount to book.

 

 

INTERESTING LINKS

 

 

Explaining a Paradox: Why Good (Bad) Companies can be Bad (Good) Investments! (Musing on Markets)

 

In an environment where finding high quality ideas with any margin of safety is difficult value investors often stray to the idea that any high quality company is worthy of an investment regardless of the company’s valuation as holding cash due to a lack of ideas is more painful than investing in high quality companies that are overvalued. Contrary to what is often heard, Professor Damodaran describes how high quality companies can be bad investments while low quality investments can be good investments. (link)

 

 

Rethinking Conventional Wisdom: Why NOT a Value Bias? (Research Affiliates)

 

This Research Affiliates article is from August 2016 but it reinforces what pretty much any research on value states that it is a investment strategy that consistently outperforms with less volatility.  (link)

 

 

The Emerging Markets Hat Trick: Time to Throw Your Hat In? (Research Affliates)

 

While we are bottom up investors, there are a few top down investors enjoy reading with Research Affiliates being one of them. December 2016 article discusses the attractiveness of Emerging Markets equities. (link)

 

Additionally, we look at Research Affiliates expected returns for different asset classes on occasion. (link) Expected returns are not used in our investment process but we find them interesting nonetheless. We have thought about using the index expected returns as a discount rate. We view the discount rate as an opportunity cost rather than a specific cost of capital for a company. In our view, the marginal cost of capital is for a company does not relate to our acceptable level of return. There are other problems with using the marginal cost of capital as the discount rate including potential estimation errors and biases in the calculation as the marginal cost of capital changes from company to company. Rather than focusing on the marginal cost of capital of a company, we care about generating a sufficient return in each investment idea. Our current thinking is that the return on any investment in the long term equals the return on invested capital as any valuation discount or premium to the intrinsic value is insignificant over longer periods making the average return on invested capital (ROIC) a good starting point for the discount rate. According to McKinsey, from 1963-2004, the average ROIC excluding goodwill was 10%. (link) Triangulating the view that ROIC roughly matches the performance of a business over the long run is the returns of the S&P 500 geometric average from 1928-2016 is 9.53% and 1967 to 2016 is 10.09%, roughly equal to the average ROIC excluding goodwill. (link)

 

The thought of using expected returns of Emerging Markets as the discount rate makes sense as any recommendation or actively managed portfolio should outperform its index in the long run otherwise you are destroying value as an investor can just buy a low cost index of the asset class. The big problem is the expected return is very difficult to forecast accurately. Also, using expected returns leads to intrinsic values moving with the market direction rather than being the ultimate anchor for a value investor. We are using 10% as a discount rate for all investments.

 

 

Return Expectations Going Forward (Ben Carlson)

 

Ben Carlson discusses his views on forward expected returns. (link)

 

 

On the Valuation of the Indian Stock Market (Latticework)

 

Samit Vartak provides his thoughts on the current valuations in the Indian equity market. (link)

 

 

Trusting Management and the Limitations of Research (MicroCapClub)

 

Mike Schellinger writes about the limitations of research and assessing management. (link)

 

 

Where companies with a long-term view outperform their peers (McKinsey)

 

McKinsey studies the performance of companies with a long-term view and find they outperform on many measures. (link) There is a link to the full report at the bottom of the article.

 

 

Between ROIC and a hard place: The puzzle of airline economics (McKinsey)

 

McKinsey analyze the economics of the airline business through a ROIC lense with thoughts on what attributes lead to outperformance. (link)

 

 

Salvation or misleading temptation—low-cost brands of legacy airlines (McKinsey)

 

McKinsey provides a strategy for low cost airline brands under the umbrella of a full service carrier. They also discuss the differences in cost structure between the two. (link)

 

 

The economics underlying airline competition (McKinsey)

 

A short discussion on the difficulties of low cost carriers moving into long haul flights. (link)

 

 

Shipbroking and bunkering (Bruce Packard)

 

Bruce Packard compares two shipbrokers, Clarkson and Braemar. It is an excellent comparative analysis that may be useful in any investor’s process. (link)

WEEKLY COMMENTARY 2/27/17 – 3/5/17

WEEKLY COMMENTARY               2/27/17 – 3/5/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

There was no company news this week.

 

 

INTERESTING LINKS

 

 

The Fervent Loyalty of a Costco Member (Scuttlebutt Investor)

 

The Scuttlebutt Investor does an excellent job writing about Costco. The company is not an Emerging Market company, but it is always interesting to see business models that work, particularly in the retail industry. The first quote by Peter Lynch is an excellent way to look at industries with no barriers to entry. (link)

 

 

Why Facts Don’t Change Our Mind (New Yorker)

 

The New Yorker discusses research and reasoning for flaws in our ability to change our minds or think critically about our own ideas. (link)

 

 

How Indian families took over the Antwerp diamond trade from orthodox Jews (Quatrz)

 

Quartz takes a look at how Indians took over the Antwerp diamond trade from Hasidic Jews. The success story sounds like many new entrants within a market by starting at the parts of the industry that are overlooked by competitors, typically due to lower margins. Added to the successful strategy were cheap labor in India, large families, and a strong work ethic. (link)

 

 

3G Purchases and Their Profit Margins (Economist)

 

The Economist writes a short article discussing 3G, their history, and operating model.  The most interesting takeaway is the improvement in profit margins post acquisition. (link)

 

 

Notes from Howard Marks’ Lecture: 48 Most Important Things I Learned on Investing (Safal Niveshak)

 

Vishal Khandelwal talks about the 48 most important take aways from Howard Marks lecture in Mumbai. (link)

 

 

How Signet Jewelers Puts Extra Sparkle on Its Balance Sheet (New York Times)

 

The New York Times provides some insight on Signet’s business model and use of in-house credit. (link)

 

 

Tools We Use to Forecast the Future Prospects of a Business (Latticework)

 

Michael Shearn, author of the great book The Investment Checklist, contributes to Latticework by discussing what he looks for in businesses to increase the odds of correctly forecasting the future. (link)

 

 

Can YouTube TV Get You to Cut the Cord for $35 a Month? (Bloomberg)

 

Bloomberg looks at Youtube’s new service of providing a cable television product for $35 per month. The internet continues to disrupt traditional media. (link)

 

 

India’s Battle With Booze Isn’t Stopping Johnnie Walker (Bloomberg)

 

Bloomberg wrote an good article looking at India’s Spirits Market and recent regulation. (link)

 

WEEKLY COMMENTARY 2/20/17 – 2/26/17

WEEKLY COMMENTARY               2/20/17 – 2/26/17

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

There was no company news.

 

 

INTERESTING LINKS

 

 

Founder-Led Companies Return Three Times S&P 500 Average (Mason Myer)

 

Mason Myer discusses how owner operators outperform the S&P 500. (link)

An HBR article from the Bain Consultant mentioned in the previous article. (link)

The original research paper by Purdue professors used in both articles. (link)

 

 

The $143bn flop: How Warren Buffett and 3G lost Unilever (CNBC)

 

FT looks at 3G’s failed bid of Unilever. (link) In the article, sources state Unilever thought the bid had no merit and thought a 3G takeover was the worst-case scenario as illustrated by following statement.

 

Another insider said: “When they put something on the table, Paul was just utterly categorical that there was no merit. He gave a number of reasons why there was no interest in such an offer.” The offer was rejected immediately.

 

Completely dismissing the bid without analyzing the proposal feels as if shareholders are irrelevant and an entrenched management team is worrying about their own positions. A FT article from 2010 echo’s this. (link)

 

Mr. Polman said: “I do not work for the shareholder, to be honest; I work for the consumer, the customer . . . I’m not driven and I don’t drive this business model by driving shareholder value.”

 

In 2016, FT published another interview with Mr. Polman. (link) If the link is behind a pay wall google “FT interview with Unilever.” The narrative is Mr. Polman is concerned about all stakeholders including shareholders. He has no concern for short-term oriented shareholders but long-term investors as his focus is the next 100 years.  There are a number of other interviews with Mr. Polman essentially saying the same thing. This is another interview with The Guardian where  he says shareholder value is not the most important focus. (link) Here is another recent interview with Fortune. (link) Unilever’s focus is the customer not the shareholder. The customer should be the focus when making products, but the company is owned by shareholders and management has a fiduciary duty to them.

 

Illustrated above is Unilever’s relative performance over the past five years. Unilever has the fourth lowest operating margin with the second highest capital efficiency leading to the third highest ROIC. Growth has slowed among all peers. Over the last five years, Unilever’s sales grew by 0.7%, its operating profit grew by 2.8%, and invested capital grew by 2.7%. The focus on the customers has not lead to drastic underperformance or outperformance.

 

Kraft Heinz bid $50 per share or €47.30 for all Unilever shares. The company has a strong competitive position with economies of scale being the biggest competitive driver along with customer captivity in the form of habit. ROIC also has very little dispersion making so it is a safe assumption that its average ROIC over the past five years will persist. The €47.30 bid placed Unilever’s market cap at €134.32 billion and an enterprise value at €146.26 billion. In 2016, the company generated €5.17 billion leading to a cash flow yield of 3.5%. Since 2012, the company grew its free cash flow at 3.8% per year creating a total return of 7.3%.  Using a residual income model, a ROIC of 127% with a growth of 2.5%, similar to operating profit growth and invested capital growth over the past four years, and a discount rate of 10% into perpetuity, Unilever’s fair value is 26% below the offer price. Using a lower discount rate of 7.5% and the same profitability and growth assumptions, Unilever’s fair value is 10% above the offer price.

 

Kraft Heinz’s bid did not undervalue Unilever given its recent growth. Rejecting Kraft Heinz’s bid without analysis along with numerous management statements points to a management team at Unilever that are more concerned with the benefits of their position over focusing on shareholder value.

 

 

Shareowner’s Rights Across the Markets (CFA Institute)

 

A 2013 CFA Institute report on shareowner’s rights across markets (link)

A. Soriano Corporation Shareholder Structure Correction 2/24/2017

A. Soriano Corporation Shareholder Structure Correction 2/24/2017

There was an error in the shareholder structure table in Anscor initiation.  The total outstanding shares was incorrect.  The corrected table is below.  We also corrected the table in the initial post.

WEEKLY COMMENTARY 2/13/17- 2/19/17

WEEKLY COMMENTARY               2/13/17- 2/19/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

PC Jeweller report Q3 FY17 results over the past week. Demonetization impacted the quarter’s results with the company estimating sales were affected for three to four weeks. Post-demonetization, sales started improving in December and returned to normal in January. Gross margin were stable but the decline is sales resulted in a decline in profitability. Year on year sales declined by 3.4%, the number of showrooms grew from 58 in FQ3 2016 to 68 FQ3 2017, or 17%, and total square feet increased by 8% year on year from 346,855 square feet to 374,481 square feet. Year on year, the company’s operating profit declined 13.7%. Assuming during the four weeks that demonetization affected sales there was a 50% decreased in sales, no impact from demonetization would have lead to an increase in sales by roughly 16% year on year.

 

It is tough to tell how good or bad the quarter was due to demonetization. The company continues to increase its showroom footprint and sales barely declined despite demonetization. The company estimates 75% of the jewelry industry is unorganized dampening competitive pressures.

 

PC Jeweller is one of the most profitable and fastest growing companies in the Indian jewelry industry illustrating the strength of the company’s management and focus on efficiency. Management is one of the most innovative in the industry with many initiatives not seen in the industry. The company is trying to double its showroom footprint over the next five years. Despite the company’s strengths, it trades on an EV/NOPAT of 14 times and an EV/IC of 2.6 times. We will maintain our current position size.

 

In the past week, Grendene reported Q4 2016 and full year results. For the full year 2016, net sales declined by 7.2% with domestic sales falling by 1.6% and export sales falling by 16.3%.

 

Overall volume declined by 9.3% with domestic volume declining by 8.0% and export volumes falling by 13.0%.

 

ASP increased by 4.1% with domestic ASP increasing by 7.2% and export ASP falling by 3.2%. Gross profit fell by 6.7% as cost of goods sold declined by 7.6%.

 

Operating profit declined by in 7.5%. The company’s capital intensity did not change over the year with working capital at 47.9% of sales, fixed capital at 18.9% of sales, and invested capital at 66.8% of sales.

 

Grendene’s key value drivers are illustrated above. In 2016, gross margin reached a peak level of 48.7%. Selling expenses remain near its historical average relative to sales at 24.0%. General and administrative is at its peak at 4.8% of sales. EBIT margin remained at its historical peak of 20.0%. Working capital remains slightly elevated relative to historical averages. Fixed capital as a percentage is at its highest level over the past eleven years.

 

Grendene continues to struggle with economic weakness in Brazil and in export markets. The company operational efficiency allows the company to maintain its profitability during a period of declining revenue. In 2015, the company reiterated its growth targets of revenue growth of 8-12% and net income growth of 12-15%. The company continues to believe these targets are achievable but acknowledge risks of not achieving these results are increasing due to economic weakness in Brazil and in exports markets.

 

Given the new data, we update Grendene’s earnings valuation range. Grendene illustrated its ability to maintain profitability despite a period of declining revenues and increasing competitive pressures making earnings valuation the most appropriate valuation methodology.

 

Looking at Grendene’s earnings valuation, the company reaches our target return of 15% per year under the most optimistic scenarios. We would assume perpetuity growth only under scenarios when the company operates in an industry with barriers to entry and pricing power. Within the domestic market, there are clear barriers to entry with the company and its main competitor Alpargatas having economies of scale as they occupy over 50% of the market with large fixed costs in the form of distribution and advertising. Grendene also has unique capabilities in manufacturing plastic products as it modifies its own machines and can formulate plastics that are unavailable to other footwear producers. These barriers to entry do not transfer outside of Brazil. The company is a low cost producer with only China producing exports at a lower price.

 

The question is whether the barriers to entry within Brazil translate to pricing power. The barriers to entry within the segment means very few other players could sell products at the Grendene’s and Alpargatas’ price range meaning the company’s probably do have some pricing power in Brazil. Over the past ten years, the company average selling price increased by 3.8% per annum with the domestic selling price increasing by 2.6% and export selling pricing increasing by 3.9% in USD terms so there is a strong argument for potential pricing power. We assume 2.5% pricing power in our base case scenario. The company sales have grown at 6.8% over the past ten years with growth stagnating at 4.9% over the past five years. Assuming an inability to growth operating profit above sales growth a 5% growth rate seems appropriate for our five-year forecast period. Despite the company’s ability to maintain profitability during the recent industry weakness using peak margins seems aggressive therefore average margins are more appropriate. Our base case scenario is 5% forecast period growth, 2.5% terminal growth and average operating margins leading an upside to the 2021 fair value of 60% or 9.9% annualized return. Overall, the average return over the next five years under the earnings valuation is 59% or 9.7%.

 

 

INTERESTING LINKS

 

 

How much is growth worth? (Musing on Markets)

 

Professor Damodaran breakdowns how to value growth, the key drivers of growth, and the importance of ROIC in determing whether growth is valuable or not. (link)

 

 

Narrative and Numbers: How a number cruncher learned to tell stories! (Musing on Markets)

 

Another post by Professor Damodaran explaining how narratives can be worked into your valuation to provide a better picture of how the market is valuing a company. (link) Professor Damodaran recently published a book Narrative and Numbers, which I have not read but is next on my list.

 

 

Diversification..again.. (Oddball Stocks)

 

Nate Tobik of Oddball Stocks shares his thoughts on diversification. (link) Our current thoughts on diversification and position sizing can be viewed here. (link) We have a similar thought process on the limits of one’s knowledge as an outside investor with valuation being the biggest tool to offset the limits of our knowledge.

 

 

Humility and knowledge (Oddball Stocks)

 

Related to his post on diversification, Mr. Tobik discusses how investors sometimes make the mistake of believing they know too much. (link)  We touched on a similar topic in our diversification post linked above.

 

 

Graham & Doddsville (Columbia Business School)

 

Columbia Business School put out another edition of Graham & Doddsville, which always makes for interesting reading. (link)

 

 

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

 

Base Hit Investing’s John Huber talks about how Buffett categorizes business by their return on capital and capital requirements. (link)

 

 

What Does Nevada’s $35 Billion Fund Manager Do All Day? Nothing (Wall Street Journal)

 

The Wall Street Journal profiles the Steve Edmundson, the investment chief for the Nevada Public Employees’ Retirement. (link)

 

 

Howard Marks’ Letters Sorted by Topic (Anil Kumar Tulsiram)

 

Anil Kumar Tulsiram complied all Howard Marks’ letters by topic. He has compiled other documents in the past and can be followed on Twitter @Anil_Tulsiram. (link)

 

WEEKLY COMMENTARY 2/6/17-2/12/17

WEEKLY COMMENTARY               2/6/17-2/12/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

After the company’s recent share price appreciation, Grendene’s estimated five-year annualized return has fallen to roughly 10% base on scenario analysis.

 

There are barriers to entry within Grendene’s Brazilian business. Within Brazil, it is a low cost operator with scale advantage due to heavy investments in advertising, product development, automation, and process improvements. It produces a low priced experienced good with a strong brand allowing for pricing power. Grendene’s exports are at the low end of the cost curve ensuring the company stays competitive in export markets but growth in exports markets will come with lower profitability due to the weakened competitive position and excess returns.

 

Owner operators with strong operational skills, an understanding of its competitive position, and who treat all stakeholders with respect run the company. It also has consistently generated stable, excess profit even during periods of industry stress and has a net cash balance sheet.

 

Given the company’s expected return, the company’s competitive position, and the strength of management, we are decreasing our position size to 2.0%. Please review our initiation (link) for a more in-depth discussion on the company.

 

 

INTERESTING LINKS

 

 

My Interview with Jason Zweig (Safal Niveshak)

 

Vishal Khandelwal interviews Jason Zweig, who provides some very good ideas on improving your investment process. (link)

 

 

The Making of a Brand (Collaboration Fund)

 

In a wonderful article, Morgan Housel of the Collaboration Fund discusses the history of brands and what a brand is. (link)

 

 

Riding a retail roll out (Phil Oakley)

 

Phil Oakley discusses the difficulty in investing in retail rollouts. (link)

 

 

January 2017 Data Update 7: Profitability, Excess Returns and Governance (Musing on Markets)

 

Professor Damodaran provides some interesting statistics on ROIC across geographies and sectors. (link)

 

 

Investing Mastery Through Deliberate Practice (MicroCap Club)

 

Chip Maloney talks about the benefits of deliberate practice and how to use deliberate practice to make you a better investor. (link)

 

 

Out with the old (Investor Chronicle)

 

Todd Wenning provides insight on when to sell your investments (link)

 

 

2 Bitter Truths of Stock Valuation…and How You Can Avoid Them (Safal Niveshak)

 

Vishal Khandelwal highlights potential mistakes in valuing companies and how to avoid them. (link)

 

 

Revlon’s restructuring plan represents the future of legacy beauty (Glossy)

 

Glossy magazine writes about the beauty business. (link)

 

 

6 smart tips for micro-cap investors (Morningstar)

 

Ian Cassel gives readers 6 tips for micro-cap investors. These are useful for all investors. (link)

 

 

HAW PAR CORPORATION (HPAR:SP)

 

 

Company Description

 

Haw Par Corporation is a corporation with two operating businesses and strategic investments. The company’s two operating businesses are healthcare and leisure. The company’s healthcare business is the owner of the Tiger Balm, a well-known topical analgesic. The company’s leisure business own and operate two aquariums: Underwater World Singapore in Sentosa and Underwater World Pattaya in Thailand. The company also has investments in property and quoted securities.

 

 

Healthcare

 

Haw Par’s healthcare business manufactures and markets Tiger Balm and Kwan Loong. Tiger Balm is a renowned ointment used worldwide to invigorate the body as well as to relieve aches and pains. Its product extensions such as Tiger Balm Medicated Plaster, Tiger Balm Joint Rub, Tiger Balm Neck and Shoulder Rub, Tiger Balm Mosquito Repellent Patch and Tiger Balm ACTIVE range cater to the lifestyle needs of a new health-conscious generation..At first glance, the company’s healthcare business looks like a very attractive business. Tiger Balm is a trusted brand that has been around for over 100 years and generates very strong profitability.

 

Over the past four years, the healthcare business has increased sales by 18.4% per year while increasing its operating margin by 4.4 percentage points per annum and asset turnover by 0.14 per annum leading to an increase in its ROA from 27.7% in 2012 to 60.9% in 2015.

 

The majority of Haw Par’s health care business revenues are in Asia, but the company is growing fastest in America.

 

The company’s strategy for the healthcare business is to drive growth from further product penetration across existing markets to widen the brand franchise for Tiger Balm. The company has launched new products in several markets. Sales of Tiger Balm’s range of traditional and new products continued to grow in most of its key markets. The healthcare business’ margins improvement is due to lower commodity prices mitigating the pressures from rising staff costs amid tight labor markets.

 

 

Leisure

 

Haw Par’s leisure business owns two aquariums, Underwater World Singapore and Underwater World Pattaya.

 

In 2012, the company’s two aquariums attracted 1.48 million visitors at an average price of SGD20.50 leading to a SGD30.3 million in sales. The company generated operating profit of SGD11.80 million and a ROA of 45.8%. In 2015, the company attracted 0.76 million visitors to its two aquariums at an average price of SGD16.85 leading to SGD12.74 million in sales. The company had operating profit of SGD0.15 million, a segment profit of SGD-4.34 million and a ROA of 1.3%.  From 2012 to 2015, the number of visitors to the company’s two aquariums declined by 20% per year and the average price per visitor declined by 6.3% per year causing a sales to drop by 25.1% per year. The high level of fixed costs in the business saw operating profit fall by 76.8% per year.

 

The decline in the leisure business was caused by a decline in tourism and stiff competition from existing and new attractions, including direct competitors within the immediate vicinity of the two aquariums.

 

The leisure business is a great business as long as you are attracting a sufficient number of visitors to your property as the business is primarily fixed costs. Unfortunately, competition can easily enter the market in your vicinity decreasing the number of visitors at your property causing a decline in sales as you drop prices to attract people and an even greater decline in operating profit due to the operating leverage in the business.

 

 

Property

 

Haw Par’s owns three properties in Singapore and one in Kuala Lumpur. Of the company’s four properties, three are office buildings and one is an industrial building.

 

At the end of 2015, the company has total letable area of 45,399 square meters with an occupancy rate of 64.6%.

 

In 2015, the property division generated sales of SGD14.33 million, operating profit of SGD8.56 and ROA of 4.0%.  The division’s occupancy rate has fallen by almost 30 percentage points from 2013 to 2015, this could be due to a weaker environment or a deterioration of the properties’ competitive position as newer properties become available. I am not a big fan of property investments, as they tend to have poor return on assets and require significant leverage to generate a return near our required rate of return of 15%. On top of the poor profitability in the business, Haw Par’s occupancy rates have been falling potentially pointing to a weaker competitive position of the company’s properties.

 

 

Investments

 

Since 2012, Haw Par’s investment business accounted for 76.7% of the assets on the company’s balance sheet. At the end of 2015, United Overseas Bank (UOB:SP) accounted for 66.4% of the company’s available for sale securities, UOL Group (UOL:SP) accounted for 13.0%, and United Industrial Corp (UIC:SP) accounted for 9.5%.  United Overseas Bank, UOL Group, and United Industrial are all related parties as Wee Cho Yaw is the Chairman of Haw Par and the three other corporations.

 

Profit before tax is dividend income. Since 2012, the investment business has generated an average dividend income of 3.2%.

 

Since 1987, United Overseas Bank’s average annualized return was 7.0%, UOL Group’s was 5.2%, and United Industrial’s was 1.2%, nowhere near an acceptable return.

 

 

Management

 

Members of management are owner operators with insiders owning roughly 60% of Haw Par.  Management is doing a great job operating Tiger Balm but the rest of the business is a capital allocation nightmare with poor investments in leisure and property along with significant cross holdings in other family businesses.

 

Management also extracts far too much value with the average remuneration to key management personnel over the past two years at 9.9% of operating income. Operating income is used rather than profit before tax as the investment income and property income are poor capital allocation decision and it would be best if that money were returned to shareholders.  Since the income generated below operating profit detracts value it is best if operating profit is used. There are related party transactions outside of key management compensation. The company has no related party transactions.

 

 

Valuation

 

The poor capital allocation and management value extraction makes the business nothing more than a deep value holding, which would require at least 50% upside using conservative assumptions to be investible. To value the company, we value the healthcare business based off a multiple of operating profit and value all other division based on liquidation value due to the poor trends see in those businesses.

 

Given the quality and growth in Haw Par’s healthcare business, we believe 15 times operating profit is a fair multiple for the business. The company’s leisure business is given no value as the number of visitors continues to decline due to newer attractions and the company’s operating leverage means the company was barely breaking even in 2015. Cash and net working capital is valued at 100% of balance sheet value. The company’s property is seeing declining occupancy rates. We conservatively assume this to be a sign of the property’s deteriorating competitive position. There are also fees associated with any liquidation therefore we value the property assets at 75% of current value. The company’s available for sale securities are assumed to be liquidated at 75% of current value, as the holdings are so large that they would have a market impact if Haw Par ever tried to sell its shares.

 

Overall, Haw Par would be interesting below SGD7.50 but only as a deep value holding given the poor capital allocation and high management salaries.

WEEKLY COMMENTARY 1/30/17-2/5/17

WEEKLY COMMENTARY               1/30/17-2/5/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

There was no company news over the past two weeks.

 

 

INTERESTING LINKS

 

 

Expectations Investing: Reading Stock Prices for Better Returns (Michael Mauboussin)

 

A 2006 report by Michael Mauboussin when he was at Legg Mason discussing what he calls Expectations Investing. The report also discusses the link between ROIC and PE. (link) Mr. Mauboussin discusses how investors often only look at a company’s fundamental when investors should be assessing company fundamentals then comparing them to market expectations. He argues that any returns will be driven by a change in the markets expectations. Given there are many types of value investing (quality, deep value), value investing itself is the act of ensuring the market’s expectations are well below the probable path of a company’s fundamentals.

 

In the article, Mr. Mauboussin discusses the theoretical link between ROIC and PE. We studied the relationship between ROIC and EV/EBIT and EV/IC. Growth is eliminated from our study, as it is the most difficult value driver to forecast. We feel EV/EBIT is a more appropriate measure of earnings than PE as it eliminates all non-operating items and it takes into account the whole capital structure something that ROIC takes into account. We studied a number of different Emerging Market companies in a number of different industries from 2011 to 2015. We used a company’s estimated ROIC for the year (operating profit/ (net working capital + PP&E)) and the company’s valuation at the end of the year. As illustrated below, our study found no correlation between ROIC and EV/EBIT, with the adjusted R squared at 0.01, and a strong correlation between ROIC and EV/IC, with an adjusted R squared of 0.65

 

The scatter plots graphs below visualize the correlation between ROIC and the two EV valuation multiples.

 

As you may have noticed, EV/IC is not really mentioned in our reports as we use more in-depth valuation methods. We use EV/IC vs. ROIC as a shortcut when screening companies to determine whether there may be sufficient margin of safety to spend addition time analyzing the company. Using a 10% discount rate and no growth, you can easily determine the appropriate EV/IC given a company’s ROIC by multiplying the company’s ROIC by 10.

 

 

Thirty Years Reflections on the Ten Attributes of Great Investors (Michael Mauboussin)

 

A more recent report by Michael Mauboussin discussing the ten attributes of great investors. (link)

 

 

Ten Attributes of Great Fundamental Investors

 

The top ten attributes discussed in the paper are:

 

  1. Be numerate (and understand accounting)
  2. Understand value (the present value of free cash flow)
  3. Properly assess strategy (or how a business makes money)
  4. Compare effectively (expectations versus fundamentals)
  5. Think probabilistically (there are few sure things)
  6. Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected)
  7. Beware of behavioral biases (minimizing constraints to good thinking)
  8. Know the difference between information and influence
  9. Position sizing (maximizing the payoff from edge)
  10. Read (and keep an open mind)

 

 

7 Deadly Sins of Investing…..!!! (Tortoise Wisdom)

 

Given the previous link discussed the 10 attributes of great fundamental investors, it seems appropriate to include a link discussing what not to do in investing. Tortoise Wisdom discusses the seven deadly sins of investing. (link)

 

The seven deadly sins of investing are:

 

  1. Following the herd
  2. Overconfidence
  3. Trading too much
  4. Envy
  5. Keeping Unrealistic Expectations
  6. Uncontrolled Emotions
  7. Focusing on outcome, Not on Process

 

 

The truth about pricing power (and chocolate) (Intelligent Investor)
Graham Witcomb of the Intelligent Investor provides insight into pricing power. (link)

 

 

Video Library (Hedge Fund Conversations)

 

Hedge Fund Conversations created a library of videos of hedge fund investors. It may be a useful resource. (link)

 

 

Video Library (Ben Graham Centre for Value Investing)

 

While on the topic of video libraries, The Ben Graham Centre for Value Investing at Ivey Business School has a tremendous video library of presentation given to its students by practitioners. (link)

 

 

Understanding the Role of Emerging Markets in Your Portfolio (Fortune Financial)

 

Fortune Financial discusses Emerging Markets and their role in a complete portfolio. (link)

 

 

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

 

Fortune Financial write an article discussing Mexican airports as a potential investment. (link)

 

 

How YouTube could capitalize on its rivals’ mistakes, and conquer the future of TV (Business Insider)

 

Business Insider discusses Youtube’s potential to take ad spend from television. (link)

 

 

Rolex is suddenly battling one of the biggest threats in history (Business Insider)

 

Business Insider examines the threats to Rolex and the watch industry. (link)

 

 

Conversation with Irish Hotel Mogul Pat McCann (Independent)

 

The Independent talks with Pat McCann on the hotel industry. (link)

 

 

Curing the Addiction to Growth (Harvard Business Review)

 

Harvard Business Review discusses retailers and strategies for when growth. Interestingly, they find the key metric in determining the winners and losers is ROIC as management teams that follow ROIC do not try to grow just to grow. Their focus is only growing when it creates value. The researchers focus on two other key metrics revenue per store and estimated revenue added per new store. (link)

WEEKLY COMMENTARY January 16, 2017 – January 22, 2017

WEEKLY COMMENTARY               January 16, 2017 – January 22, 2017

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

There were no company announcements this week.

 

 

INTERESTING LINKS

 

 

Think savvy business owners make savvy public investors? Not necessarily (The Globe and Mail)

Larry Sarbit writes about the difference between private business owners and public market investors. (link)

 

Luxittoca acquisition of Essilor (Business Insider) and (Wall Street Journal)

Two articles on Luxittoca’s acquisition of Essilor (link) (link)

 

Mining revisited – from extremity to normality (Unconstrained Thinking- Alliance Global Investors)

Alliance Global Investors’ value team discusses the move from extreme conditions to normal conditions within the mining sector. (link)

 

Enemies of Value Add in Fund Management (Burgundy Asset Management)

Burgundy Asset Management highlights the enemies of creating value as a fund manager. (link)

 

Bershire Hathaway’s 1987 Letter Mr. Market (link)

 

Value – Market, Intrinsic and Private (Investment Masters Class)

A blog post about the differences between market value, intrinsic value and private value with many useful quotes (link)

 

28 Big Ideas on Investing, Business, Life, Behaviour, and Thinking (Safal Niveshak)

An ebook on Vishal Khandelwal’s 28 big ideas (link)

 

Avoid News Towards a Healthy News Diet (Rolf Dobelli)

Rolf Dobelli talks about why we should avoid the news and how it will lead to less disruption, more time, less anxiety, deeper thinking, more insights (link)

 

Mark Slater: finding growth at a reasonable price (MoneyWeek)

Merryn Somerset Webb interviews Mark Slater, a growth investor with some interesting thoughts on investing. (link)

 

How Does One Prepare For An Unknowable Future? (Euclidean Q4 2016 Letter)

Euclidean talks about their process for preparing for an unknowable future (link)

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.