value and opportunity

After the first post on Cranswick Plc, as promised some more thoughts about the business model and valuation.

Business model – peer company Frosta

As mentioned, Cranswick operates mostly in the private label market. Frosta AG a company I owned when I started the blog is a relatively similar company. They are also food producers (however frozen food and fish instead of “chilled” food and poork) and most of their sales are private label products for supermarkets.

Let’s look at a quick comparison table focusing on net margin, ROE and debt/assets for both companies:

	Cranswick	Cranswick	Cranswick	Frosta	Frosta	Frosta
	NI Margin	ROE	Debt/Assets	NI Margin	ROE	Debt/Assets
31.12.2002	5.3%	22.0%	6.2%	0.8%	5.9%	31.9%
31.12.2003	4.7%	19.3%	12.6%	-2.9%	-23.4%	36.3%
31.12.2004	5.1%	20.1%	39.2%	2.9%	18.7%	26.1%
30.12.2005	5.2%	22.2%	35.7%	3.1%	14.3%	30.8%
29.12.2006	4.4%	18.2%	30.4%	3.4%	15.6%	30.9%
31.12.2007	4.6%	17.6%	31.6%	3.5%	16.2%	35.0%
31.12.2008	3.1%	11.8%	27.1%	3.1%	14.4%	37.6%
31.12.2009	4.4%	18.1%	17.7%	2.9%	13.2%	36.1%
31.12.2010	4.7%	17.0%	15.2%	2.5%	10.0%	30.1%
30.12.2011	4.6%	16.1%	11.0%	2.3%	8.4%	27.2%
Avg	4.6%	18.2%	22.7%	2.2%	9.3%	32.2%

One can easily see that Cranswick earns twice the margins and ROEs of Frosta. Additionally they are employing on average a lot less financial debt than Frosta.

So what are the reasons for this discrepancy ?

One thing which distiguishes many good companies from mediocre companies is capital management. The less capital a company needs, the better is not only the return on capital (and equity) but also the net margin.

So let’s have a quick look at how those to companies compare with regard to Asset (and capital usage)

First Frosta AG:

	Frosta
	2010	2009	2008	2007
Sales	392.6	411.3	391.8	348.7
NI	9.8	12	12.1	12.2
NI in %	2.50%	2.92%	3.09%	3.50%
Inventory	56.5	61	70.9	57.7
Receivables	68.2	67	68.9	62.9
Trade liabil-	-40.6	-27.7	-44	-34.3
Net WC	84.1	100.3	95.8	86.3
In % of sales	21.42%	24.39%	24.45%	24.75%
PPE	77.9	78.9	84.5	71.8
in % of sales	19.84%	19.18%	21.57%	20.59%
Goodwill	1.2	1.1	2.2	1
Net WC+ PPE in % of sales	41.26%	43.57%	46.02%	45.34%
Net WC +PPE+GW in % of sales	41.57%	43.84%	46.58%	45.63%

I have concentrated on Working capital and fixed assets only. Frosta needs ~24% of sales in net working capital. Besides inventory, receivables are always much higher than payables which means that Frosta basically finances the supermarkets as they are not able to mirror their payment terms with their suppliers.

Fixed assets account for another 20% of sales on average, Frosta does not show any Goodwill as they haven’t made any acquisitions in the past.

So how does Cranswick look compared to this ?

	Cranswick
	2010/2011	2009/2010	2009	2008
Sales	758.3	740.3	606	559
NI	35.3	32.5	19.9	25.7
NI in %	4.66%	4.39%	3.28%	4.60%
Inventory	35.7	36	28.5	30.6
Receivables	78.7	84.1	73.7	77.3
Trade liabil-	-84.9	-86.7	-75.2	-73
Net WC	29.5	33.4	27	34.9
In % of sales	3.89%	4.51%	4.46%	6.24%
PPE	123.3	106.1	91.7	92.7
in % of sales	16.26%	14.33%	15.13%	16.58%
Goodwill	127.8	128.7	117.8	117.8
Net WC+ PPE in % of sales	20.15%	18.84%	19.59%	22.83%
Net WC +PPE+GW in % of sales	37.00%	36.23%	39.03%	43.90%

The short answer is: Much much better !!!

Especially working capital management seems to be extremely efficient. They can basically finance their receivables out of payables and inventory is on average only 5% of sales compared to 15% at Frosta.

Also fixed assets are around 5% less compared to sales than at Frosta, however Goodwill adds to assets which have to be financed.

The interesting fact about this asset usage is also the impact on the P&L. More fixed assets mean higher depreciations charges and maintenance capex. Goodwill on the other hand doesn’t require depreciation nor a lot of maintenance capex.

When we compare the two companies, Cranswick showed around 1.8% of sales in depreciation over the last 4 years against 3.0% at Frosta. If we assume equal tax rate, this alone explains the difference in net income margins over the last 4 years !!!!

A second smaller effect where capital management influences net margins is the cost of interest. Currently interest rates are low, but nevertheless, Frosta had 0.2% higher interest cost compared to sales over the last 4 year on average. Especially for instance in 2010, where Forsta’s NI margin was 2.5% against 4.6% for Cranswick, the difference in interest expense (-0.7. ) and the difference in depriciation charges (-1.5%) fully explain the difference in profitablity.

Why is Cranswick managing capital so much better than Frosta ?

As we all know (now), competitive advantages are almost always local. If we look at Cranswick’s business locations, one can clearly see the regional concentration:

Most of theiz facilities are concentrated in and around the Yorkshire area. Due to their overall size one can assume that Cranswick has a dominating position in this local area with the local suppliers. Their suppliers are most likely several hundreds or thousands of pig farmers. Another aspect of this is that for a British farmer it is much more difficult to export living pigs to Europe for instance. I highly doubt that the Eurostar transports live pigs so you have to involve ships in the transport route which makes it much harder to transport the pigs than for instance driving them form Poland to Germany. If you just want to export just the meat, you will have to go to a Cranswick facility first……

In terms of payyments, it is most likely easier to negotiate “back to back” pamant terms than for Frosta which has to buy its suplies from fish markets or b2b traders etc. So this leaves Cranswick with a significant amount of negotiation power with its suppliers.

Another advantage of the regional concentration is of course inventory management. The longest distance between any of their sites is 250 kilometers, a distance which could be covered back and forth most likely within a day. With such short supply routes it is much easier to run “just in time” production than if you get your supplies from thousands of miles away by ships.

This was for instance also the problem of another company I used to own but sold, Einhell AG. They are sourcing most of their supplies in Asia but have to pay before the merchandise even gets shipped from China. Due to the relatively long time of ship travel, they have to finance 6-9 months of supplies upfront and then they have to wait another few weeks to get their money from the DIY stores.

Cranswick, on the other hand seems to have a quite powerfull local position, being able to pass through the payment terms of the supermarkets to the pif farmers, leaving it only with a relatively small amount of “just in time” invesntory to finance.

I am not sure how easy this is to copy, but it protects them at least also to a certain amount against cheaper imports.

Valuation:

As mentioned in the first part, the value in Cranswick doesn’t is not in its asset base or any mean reversion phantasy. It lies in a consistent business developement with stable and high ROEs.

If Cranswick would manage to deliver 20% ROE going forward, my Boss modell would indicate a fair value of around 2.000 Pence per share or an upside of 160%. If we assume going forward 15% ROE, Cranswick would still be a double with an Intrinsic value of ~1.550 pence per share. I think this is definetely possible over a time period of 3-5 years without any P/E expansion.

Risks

Of course, as any company, the busienss of Cranswick is subject to a lot of risks.

As Tobias mentioned in the comments, among them are:

Hygienic risks

This can kill food companies. One of the most recent examples is Mueller Brot in Germany. However at least in Germany, this is usually a developement over years. Normally, the authorities give many warnings before they really take actions. Of course in the interent age, this can go much quicker. But this is not only an issue for Cranswick, but for all food and beverage companies incl. the “Star” companies like Coca Cola and Danone as well (anyone remembering the Perrier scandal ?).

Customer power

The custumors of Cranswick are of course extremely powerfull, with a few names dominating the client list. But again, this is an issue for many food producers and other consumer product producers have, as retail is consolidating more and more. The loss of one client can harm the business significantly.

On the other hand, I highly doubt that any of the supermarkets can come up from scratch with such an efficient organization like Cranswick. As we have seen, they do not calculate crazy margins into their products but they are really great capital managers.

Subsitution

Of course, Pork products can be substituted through different meats. As we have seen, in the downturn, Cranswick has profited from substitution, so chances are high that in an upturn they will suffer from the tendency to buy more expensive products. It will be interesting to see how successfull they are with their other ventures, such as dried ham, olives, meat pastries etc. This should lower the risk of substitution to a certain extent.

Imports

If for some reason, for instance the EUR would depreciate strongly against the GBP, EU imports would be a lot cheaper than locally produced pork. Although I assume there is “sticky” demand for British pork, this could impact Cranswick’s margins to a certain extent. On the other hand this might be a good hedge against Dart Group’s off setting EUR exposure !! Howver Cranswick has proved that it can maintain margins in the past and I do not see any reason why this should suddenly change.

Summary:

Although Cranswick is no “cheapie”, I do think that Cranswick has some local competitive advantages which allow them an extremely efficient capital management and corresponding high returns on equity. As they have proved to maintain this through out the cycle, I will add a half position (2.5% of the portfolio) of Cransdwick Plc Shares to my portfolio.

The current valuation looks attractive enough, any take-over or recap upside is basically “for free”.

After the 2011/2012 report in July I will then decide if I double up to a full stake.