1 potential multi-bagger and a Zebra
Sometimes, turnarounds are good for hunting.
Over the past months, I bought 1 stock.
As explained in our investment strategy, we believe there are 2 ways of using the market to our advantage:
Buying high-quality companies that for some reason are trading lower (this does not happen often). This is the light side of investing. These companies are there for everybody to see. The danger is a quality trap (multiple compression), so we need to buy these when there is some kind of downturn.
Buying mispriced small and underfollowed companies because nobody is looking (they exist, but are not easy to find). The dark side of investing. These are unknown, hiding in the dark recesses of the stock market. The danger is a lack of information and more fragility in the business.
You could call this the way of the Zebra, relating to their magnificent black and white striping, symbolizing balance, or harmony between opposing forces.
Short Intermezzo: What is the purpose of a Zebra’s stripes?
Evolution is a survival of the fittest game. An experiment was run in the UK. They outfitted horses with different colored coats. One horse had a grey coat, the other a brown one. Then they put on a checkered coat and finally one with stripes on the remaining horses.
The results: The horse with the striped coat attracted the least amount of flies.
Striped skin ➡ Fewer flies and mosquitoes ➡ Fewer diseases ➡Better adapted to survive in Africa
End Intermezzo
Both approaches mean we are not buying that often.
Finding a super high-quality company at a low PE, these opportunities do not appear often.
Discovering an unknown microcap that is mispriced because of friction in information flow, it’s digging for gems in a pile of rubble.
They all require patience.
The process
At the start of the year, I outlined our investment process in detail. One of the steps was to create a one-pager before diving deeper into the company.
I’ve modified the process a bit. The steps are now:
Get the idea
First, check for red flags
Second check and reading of statements
Full deep dive into the company’s long history
Write up a one-pager before entering a position
I wanted to focus on step 5. The one-pager is a summary of the investment thesis. It’s the document an analyst would look at right before doing a 2-minute pitch to his portfolio manager. It is the principal reason to buy the company, to become an owner.
The structure or template looks like this:
Information sources used? Show where you got the data
How does it make money? If I can’t figure this out in a reasonable amount of time, it goes into the TOO HARD bucket
Why own it? State at least the 3 most compelling reasons you would like to own this company (irrespective of price)
When to own it? It might be a great company, but maybe the price is too high. State a level at which you would be comfortable. Set a price alert.
What is the downside risk? Elaborate on what could go wrong. These are the metrics to track to verify if the business stays strong (or not)
What is the upside potential? Try to give an order of magnitude. Are we talking about a potential double, tripling, or more? The minimum should be a 100% upside over 5 years (15% CAGR)
Why does the opportunity exist? Try to understand why the market is offering this opportunity. Most of the time the market is efficient, so what is happening here?
Is it better than what I already have? The end goal is to make the overall portfolio stronger. If it looks like a great investment, but it's not better than what you already own, then do nothing and set a price alert at which it would become interesting.
This all has to fit on 1 piece of paper. So it cannot go beyond 2 pages or 1000 words max.
Well, I guess it's a two-pager then 😉
Would you add or change anything to this list of questions?
Below, you’ll find the summary I wrote before buying the company. This company is called Innovative Food Holdings (IVFH). Remember our article on Buffett’s hidden capital allocation skill: divesting?
That’s exactly what is happening at IVFH.
But before diving into the summary, here’s some data on revenue and profits over the last 2 years.
Yep, revenue is in decline. Operating income is almost non-existent but bear with me.
2-pager template for IVFH
Information sources used?
Annual reports
Q1 2024 information (Q2 will be discussed at the end of the article)
Treasure hunting substack
The write-up by treasure hunting is the best you’ll find.
How does it make money?
The company is selling its unprofitable e-commerce business and aims to grow its specialty food business. It allows vendors with unique products to access bigger distribution with the end consumer typically being restaurants.
Vendors -> IVFH platform -> US Foods platform -> Restaurants
This means if a restaurant buys an Alaskan black cod provided by a certain vendor.
US Foods gets a cut
IVFH gets a cut
Why own it?
IVFH is a company that in the end allows restaurants:
To get access to unique produce
Have frequent deliveries throughout the week
There are no minimum order amounts
It is a CAPEX-light business, as no inventory is held. New distributors (who already have the restaurants as customers) must be integrated into their platform. This requires time but increases the switching cost when it is done.
A typical big distributor has no incentives to develop this kind of niche capability.
The more vendors IVFH can attract, the bigger the offering. In some ways, it will act as a 2-sides marketplace but in a B2B offering. There is a network effect as if the offering for the restaurants grows, the vendor, if capable, will be able to offload more inventory.
It is a form of counter-positioning, towards the large commodity distributor with a large inventory.
Divestitures will raise cash to reduce the debt load. Once the debt is reduced, management will look at possible ‘small’ M&A.
Management has proven experience in the industry. They came from industry giants and saw the potential of IVFH to become a lot bigger than it is right now.
When to own it?
The market cap has risen fast over the last year. Its current enterprise value sits at 65M USD. The sale of the e-commerce business (booked at 5M) and part of the current cash position could be used to pay down their debt (8M). The company then has a forward entre price value of 60M. If next year's EBIT sits around 6M, we’re paying a 10% pre-tax earnings yield. That does not look super cheap at this time. One has to look at the future business prospects to see if the price is interesting.
Management has set a goal to reach 10M USD in EBITDA and 100M in revenue. From there on, the long-term goal is to become a Billion USD company. That might not be feasible. It’s too difficult to assess at this time.
What is the downside risk?
Liquidity and debt risk seem under control, especially if the sales of the e-commerce assets can conclude
Dilution risk: Shares outstanding have increased in the past, but I consider the risk as limited since assets sales and earnings power should fuel future growth
Customer concentration: Most of the revenue comes from US Foods. They are taking on more initiative and contracts with other distributors to reduce this concentration risk.
What is the upside potential?
Even though the price has rallied significantly, a double from here in 5 years is not unreasonable. At the moment, the overall numbers still look bad on a screen. Management aims for a 100M revenue and 10M EBIT in the short term. Their next step would be to aim for a billion-dollar company. But that’s wishful thinking at the moment.
Why does the opportunity exist?
This company does not screen well. It has had negative write-ups in the past. The good bones in the business were covered up by the fat around it. In 2016 and 2017, the business had a gross margin of 30%+ and net margins between 8 and 11%. The top line grew 17% from 2016 to 2017.
If the thesis holds, is it better than what I already own?
Yes, but since the price rise, the investment is no longer a no-brainer. Investment results will rely solely on how fast the food service business can grow. Q1 2024 was pretty flat compared to 2023. They did however increase GM a bit (1.4%). Once the e-commerce business is gone, all resources can be invested towards the growth of this drop-ship business.
As an investment, it is better than what I own.
Q2 earnings overview
Q2 was a weak quarter in revenue seeing a 10% decline:
· 52% decline in their e-commerce business due to the ramp-down (divesting and reallocating resources)
· 4% decline in their Specialty Foodservice
Headwinds in their legacy drop ship business
Growth in the Artisan Specialty Foods business
Growth in the Airlines business
In particular, management stresses that
Newly added customers: 1 is a top 5 US distributor. Launch on non-perishables and because of the strong start, will continue into the perishables assortment
Providing gourmet cheese offerings to retail
Reallocation of resources from e-commerce to other business lines which is driving growth
Since the new management has taken over, 6 of the 10 brands in e-commerce have been sold to focus on what makes this business unique.
2024 is part of the stabilization phase, before entering growth once more.
On 22/8, in a press release, IVFH stated that the pilot they were running for the gourmet chess offering to retail (10 stores) had positive results and will now be fully expanded to all the stores within the distributor’s reach (hundreds). This again, is a positive sign that they are looking for more and more opportunities to grow.
Summary
Munger always warned against betting on turnarounds.
But I believe there are 2 types of turnarounds:
Company A’s business is declining. The company continues to invest to create new products or markets to turn the business around
Company B’s overall business is declining. But underneath the cover, management is divesting the bad business and reinvesting the proceeds in the good business (which has continued to show good results in the prior years).
IVFH is company B. That to me is a turnaround I am willing to bet on.
As always,
May the markets be with you!
Kevin
When considering ‘Is it better than what you’ve already invested in’ must you not have a fact sheet of KPI’s which the potential new biz must equal or exceed?
Excellent article as usual Kevin. Never thought about the virtues of being a Zebra, but there you go. One suggestion for your quick analysis - think like a pilot - what are the three key gauges to monitor when testing the worthiness of the potential investment. For mine they are ROE or ROCE, Net debt/ equity and a squizz over the history of eps growth ( as a proxy to determine the quality of management). Interested in others thoughts on this.