EATING SARDINE: USANA Health Sciences (USNA)

Last close: $25.22

There is no reason for the Market’s current view on USNA’s valuation.

USNA sells nutritional and personal care products using multi-level marketing. Larger companies using similar business model are Amway and Herbalife (NYSE:HLF).

(Personal views on multi-level marketing may be polarized. This analysis ignores criticisms directed at the network marketing business model relying on this type of marketing’s long and successful operating record to assume that it is, at a minimum, lawful.)

Since 1995, USNA delivered annualized sales growth of 21%. In this period, it experienced sales decline in only two years (2000 and 2001) and maintained positive sales growth - albeit at a lower rate - through 2009 and 2010.

• USNA operates in North America and Asia, a region which now contributes 53% of sales
• Between 2006 and 2011, all of USNA’s sales growth came from Asia (18% CAGR over 5 years) - driven by China (32%) - while the North American business remained broadly flat

Cyclically adjusted profits and returns have remained strong throughout.

• 77% gross margin, on average since 1996 and 82% currently (2011)
• 15% average EBITDA margin and 15% currently
• 30% average return on assets and 28% currently
• 45% average return on capital and 39% currently
• 55% average return on equity and 41% currently

USNA’s cash generation (defined as cash flow from operations less capital expenditure) is very strong. In the last 10 years, USNA converted 63% of EBITDA in to free cash on average (77% in LTM to July 2011).

Founder and management’s aforementioned track record and 54% ownership provides comfort when placing reliance on USNA’s business continuity.

Yet, despite these positives and increased current year guidance, USNA’s share price has underperformed S&P 500 by c. 48% and Herbalife by c. 136% in the last year. The Market is clearly underwhelmed by USNA’s prospects both on an absolute and relative basis when it values USNA at:

• 4x LTM EBITDA and c. 8x LTM P/ E, which is both approaching its lowest valuation historically and a significant discount to Herbalife
• 9% free cash flow yield, based on (absolute) free cash generated on average in the last 10 years (19% LTM yield)

Such indifference by the Market for a company with no debt! (USNA had $27 m net cash position as of July 2011.)

It is difficult to objectively understand Mr. Market’s yardstick to value USNA. (Perhaps another customer for USNA’s vitamin and mineral supplements?)

EATING SARDINE: Time Warner Inc. (TWX)

Last close: $35.07

Time Warner is a media and entertainment company involved in networks (e.g. HBO and Cinemax), film entertainment (e.g. Warner Bros.) and publishing (e.g. Time magazine). The company generates revenue from subscriptions (e.g. for pay television), advertising and content production (e.g. Harry Potter films). On a fully diluted basis, Time Warner’s market capitalization is $40.2 Bn and its enterprise value is $53.1 Bn.

Time Warner is a strong and stable business.

• Content ownership provides a natural “moat” to the company
• It has a consistent track record of generating cash flow, despite cyclical advertising exposure
• $8.6 Bn in unlevered free cash flow on average since 2003 ($4.7-$13.0 Bn range);
• $8.8 Bn in annualized unlevered free cash flow on average since Q4 2005; and
• $9.3 Bn in average rolling LTM unlevered free cash flow since Q3 2006
• The bond market is pricing all of Time Warner’s outstanding publicly traded debt above par
• The company could pay off all outstanding debt as of 31 December 2010 within 1.5 years, using available cash and based on historical through cycle cash generation. Incidentally, the company could also pay off all liabilities - including all outstanding debt - as of 31 December 2010 within 4 years, on the same basis

Time Warner’s equity is attractively priced, despite a 21% rally since July 2010 (which was in line with the market).

• The company is trading on a cash flow yield of more than 17%, based on cash generation both through the cycle and in the latest twelve months. For reference, the cash flow yield is more than 9% based on cash generation in the worst twelve month period since 2005 (LTM ending December 2008, which is understandable since this was the quarter after Lehman Brothers went bust)
• Current valuation implies that Time Warner’s cash generation will decline c. 9% in perpetuity, which is undoubtedly a bold statement to accept
• Other valuation metrics also support the Time Warner’s relative undervaluation compared to the company’s own trading history and comparable companies
• Risk-reward is attractive as downside is acceptably protected and upside is consumer spend and advertising driven, which are GDP linked. So, one is betting on (primarily US) GDP recovering for outperformance
• Outperformance vs. estimates over the last 9 quarters perhaps provides some comfort that a recovery is indeed underway
• The 2.7% dividend yield is an added sweetener

That’s all folks!

EATING SARDINE: Daiwa Industries Limited (6459.T)

Last close: JPY 412 (or USD 5.00)

For the sake of simplicity, all metrics are quoted in USD. To convert to JPY, multiply the USD metric by 82.4.

Daiwa Industries Limited manufactures and services industrial machinery for heating and cooling, such as freezers, showcases and ice machines. Daiwa’s current market value is $257 m and in 2010 it generated $342 m in revenue and $71 m in EBITDA (21% margin).

Daiwa is listed on the Tokyo Stock Exchange and all official communication from the company (i.e. website, reports, etc.) is in Japanese. I do not read Japanese, so I have relied on public databases to evaluate Daiwa’s published information. Daiwa is not covered by any Wall Street analyst.

At $5, an investment in Daiwa has very limited downside, if any.

• At 31 December 2010, Daiwa had total cash and short-term investments of $365 m and the company has no debt. Total liabilities were $91 m, primarily comprising current liabilities and pension obligations. So, if Daiwa paid down all its liabilities it would still have $274 m left in cash.
• This means that the market is valuing Daiwa’s cash (net of all liabilities) at a 6% discount, and its operations and assets at 0.

I am relatively less familiar with Japanese companies, so it is difficult to place a value on Daiwa’s operations and assets. But, the probability that Daiwa’s operations and assets are worth more than 0 is very high.

• Over the last 6 years, the company’s operations and assets have generated $70 m in free cash flow on average, and its margins and returns on capital/ equity were not bad either.
• At 31 December 2010, Daiwa had $57 m in receivables and inventory.
• Daiwa should be a “going concern” since it is unlikely to be liquidated (Ozaki family owns c. 45% of it and the probability that they would want to keep this company operational vs. liquidate it is high).

Finally, the probability that Daiwa’s accounts are fraudulent is very small because (a) Deloitte (the company’s auditors) have repeatedly qualified its accounts, and (b) Japanese culture - particularly for prominent family companies - limits the likelihood of this scenario.

Bottom line: at a minimum Daiwa’s shares are undervalued by ~6%, and potentially significantly more.

The catch is that -

• Daiwa’s publicly traded shares have a small float and trade volumes are small. As such, one’s ability to bet very large amounts of money is perhaps limited; and
• The market can be irrational for longer than one can remain solvent.

Maybe truly patient investors will even welcome a sandwich for lunch if it is free?

TRADING SARDINE: Weatherford International (WFT)

Last close: $26.08

Weatherford operates in an attractive industry (oilfield services). Other than that, there is little that is attractive about this company.

Weatherford is positioned as a growth company, but it seems to be pursuing growth for growth’s sake without regard for capital efficiency. The company has grown as “a result of internal growth and innovation as well as the consolidation of more than 250 strategic acquisitions”.

• It is difficult to see how 250 acquisitions can be strategic.
• However, some serial acquirers are indeed valuable businesses because they utilize capital efficiently. Unfortunately, Weatherford’s management has a bad track record in deploying capital (~8.5% ROCE over the last 7 years) and financing capital needs (~10-11% ROE over the last 7 years).

Weatherford’s profitability is average for an industrial company (~30% gross margin), and its asset returns are poor (~5.5% over the last 7 years).

• This means that Weatherford is either incapable (i.e. its products are not uniquely attractive enough for customers to pay up, and its presence in Iraq etc. does not mean anything) or incompetent (i.e. management is unable to extract value for shareholders despite unique products).

Weatherford’s cash flow management is also very poor.

• Working capital cash cycle is ~158 revenue days. That means that it takes the company ~5 months to convert $1 of revenue into $1 of cash!
• The company has required financing to fund cash outflows in at least 15 of 20 most recent quarters, as capital expenditure has exceeded operating cash flow. Unsurprising then, that leverage has increased significantly.

Management’s incentives are not aligned with shareholders.

• Management owns less than 0.3% of the company (or ~1% after including all deferred compensation), and was paid ~$46 m in total in 2009 (Mr. Duroc-Danner, Chairman & CEO, made ~$16 m in that year).

Finally, the company reports that it is under investigation in the US for trade sanction law, Foreign Corrupt Practices Act and other federal statues violations.

Weatherford’s shares have increased 66% in the last 6 months, when there was alleged general selling pressure on oil & gas stocks due to BP’s Gulf of Mexico oil spill. Investors who bought at the time have already made good money; but since there was no margin of safety in the valuation 6 months ago, the stock must surely be overvalued now.

• Weatherford is trading at ~12.5x trailing EBITDA, ~2 x book value and has never paid a dividend.
• These valuation levels imply that the company will grow its cash flow generation at least 10% in perpetuity, which is obviously impossible.
• Finally, adjusting for the 2:1 split in May 2008, the stock is above its all time high.

29 of 30 Wall Street analysts rate this stock as a Buy or Hold. Management’s plans to grow further internationally will doubtless include more acquisitions.

Investors should be asking WTF?