The next post I have written is on Where Food Comes From (OTCMKTS: WFCF). I have took a little bit of a different approach in writing this post. I have not completed my work on the company, but I think I have got to an important junction where it would be helpful for both myself and my readers to express my thoughts. The goal is to start an open dialogue. I have grown very sick of a lot of both sell side and hedge fund research that is totally one-sided (based on whatever position they are taking). My aim here is to provide balanced commentary that acknowledges opportunities and threats. It has always been my intention to be balanced, but something I will strive to do even more so in the future.
Why I started looking at WFCF?
The root of the idea came from listening to a podcast between Meb Faber and Dan Rasmussen found here. Rasmussen is an interesting speaker. His primary thesis is that ‘private equity’ only did well in the 80s and 90s because they bought assets very cheap and leveraged them up; private equity’s ability to provide operational expertise and increase business value is limited. Rasmussen believes assets being bid on by private equity are no longer cheap; there are too many bidders. Therefore, future private equity returns will not match what the asset class has done historically. His belief is that you can instead earn excess returns by instead buying publicly traded small cap companies that have attractive valuations and high leverage, as long as they use all of their excess cash flow to reduce leverage.
While the strategy makes some sense to me, my view is that the downside risk is much too high for me to be able to justify it at this point in the cycle. I do not have the appetite to buy heavily indebted stocks with low levels of liquidity. However, it did get me thinking… My thinking was along the lines of while I do not necessarily want to try to replicate a private equity strategy with publicly traded micro to small cap equities, are there any other types of strategies that could be worthwhile replicating? My thoughts turned to venture capital. Maybe there is a group of publicly traded micro to small cap companies that are aggressively growing the top-line, but have not yet reached profitability. Since they are likely underfollowed, they could trade at attractive valuations.
WFCF seemed to fit this bill quantitatively. The chart below shows WFCF’s history of sales, EBIT and free cash flow. While sales have grown strongly, WFCF appeared to be driving all of its profit back into further sales growth.
What does WFCF do?
WFCF provides third party verification and certification solutions for agriculture, livestock and food industry. Claims like gluten-free, non-GMO, non-hormone treated, humane handling require verification for credibility. WFCF provides this verification through onsite and “desk” audits to verify that claims being made are accurate.
In 2017, WFCF’s revenue mix was ~80% verification/certification, ~10% software (from acquisition of SureHarvest) and 10% product (mainly ear tags for cattle).
WFCF has 25 million shares outstanding and most recently traded at $2.15 per share, giving it a market capitalization of $53 million.
The opportunity that WFCF has is fairly clear. Consumers are increasingly demanding transparency in all facets of their life, food included. They want to know where their food came from and if suppliers along the value chain act in a sustainable manner. This has opened up lots of opportunities for WFCF to certify claims made by suppliers. Additionally, food has faced increasing regulatory burdens – an area where WFCF can again assist.
Another opportunity lays in the structure of the industry. According to Bureau Veritas, the testing, inspection and certification (TIC) markets related to agriculture and food are highly fragmented (see table below). Bureau Veritas also discloses a TIC market size for Food & Agriculture of 23 bn EUR. All this to say, WFCF operates in a market that is both large and highly fragmented. This could present an opportunity for WFCF to continue to use M&A to drive consolidation in the industry.
The last opportunity I will mention is that WFCF currently spends 40-45% of sales on SG&A. This is high. As WFCF increasingly becomes larger, it could be possible that its sales force becomes more productive. As WFCF grows, their presence and reputation also grow, meaning they could potentially begin seeing more inbound inquiries. This would likely result in higher productivity per sales person as more time could be spent on real prospects rather than cold calling. And as a result SG&A as a % of sales would decrease.
There are some large public companies that operate in the broader testing, inspection and certification industry (“TIC”) that can act as a comparable to WFCF. They are SGS, Bureau Veritas, and Intertek. Given the nature of the industry, the major expense for each company is its employees. In the case of WFCF, their service is for one of their employees to show up at a farm or call the farm (depending on the audit type) to verify that the requirements for a third party certification are being met. In this business model, the amount of sales/employee is critical. The more the better.
The amount of sales that each WFCF employee produces relative to the three major comparable public companies is striking (WFCF at >$250K vs Big 3 at <$100K). One driver of the large difference is where the employee base is located. All of WFCF employees are in the United States versus a mix of developed and developing countries for the three comparables. Employees in developing countries earn much less so it makes sense that they can also produce less revenue on a per employee basis and still be profitable.
We can correct for this ‘location of employee’ bias by looking at recent acquisitions the Big 3 have made in developed countries.
- Intertek. Acquired FIT Italia in Dec 2015. 15 Employees and 2M EUR (USD $2.37M) of sales. Sales / Employee = $156,000.
- SGS. Acquired Vanguard Science in Jan 2018. Sales of US$11M and 95 employees. Sales / Employee = $115,789.
- Bureau Veritas. Acquired Maxxam in 2013. Sales of CAD240M and 2500 employees. Sales / Employee = C$96,000.
The magnitude is reduced, but WFCF still earns much higher sales/employee than the recent acquisitions of the Big 3. This could be a good thing. But in order for it to be a good thing, we must believe that WFCF is able to do something that the big 3 is not.
For example, it’s possible that WFCF operates much ‘leaner’ than the big 3 and has a very skinny overhead structure. This is likely true, although I find it difficult to believe that it could account for such a large magnitude. I’d note that in general businesses whose major expense is ‘service employees’ are much easier to run when they are smaller. The founder/owner mindset or culture is much easier to transmit to frontline employees when the company is very small and there are not many layers. I’d note WFCF has a husband/wife team that run the company as well as own a large chunk of the shares.
Another possibility is that WFCF has better IT and systems allowing its employees to be more productive. While this could also be true, I have a harder time believing it will be sustainable. Any advantage from WFCF likely stems from a first mover advantage. WFCF’s Big 3 competitors have a very large resource in terms of their capacity to spend on technology/software and I would expect them to catch up.
Another possibility is that WFCF is better at ‘bundling’ certifications and selling more than one certification per site visit or audit. This would result in sales per employee being higher. I also question sustainability here for the reason that the Big 3 competitors own all of their own testing labs. This means that WFCF services are limited to visual inspection or what the human eye can see. Their Big 3 competitors can go a layer deeper and offer services involving analysis beyond visual inspection (ie. DNA testing, identification of microbes, nutritional labeling, etc.). To me this would mean WFCF could be susceptible to being “out bundled” by their larger competitors who can offer both lab analysis and visual inspection/certification as part of the same package.
There is also a threat that could explain the large difference in revenue/employee. It could be that WFCF charges a too high a price for their services and will be forced to lower it in the future to retain its customers. My impression is that many retailers and suppliers have been scrambling to get their food certified as ‘organic’ or ‘hormone free’. In this scramble, they have prioritized speed over cost. Most retailers now have access to organic foods that were previously only offered in a specific vertical (ie. Whole Foods). Now that they have figured out the availability issue (ie. they have figured out how to get supply), they will likely start slowly turning the screws on price and suppliers including WFCF could get squeezed.
- Tailwind from consumers demanding transparency and greater regulations;
- Large, fragmented market provides consolidation opportunities;
- Sales force could become more productive once brand becomes better known;
- Operators are also owners;
- Labor intensive businesses are easier to operate/execute when small;
- First mover advantage leads to better IT/systems;
- Leveraged strength in beef verification to cross-sell other certifications.
- WFCF may have taken advantage of their customers with high prices while they were prioritizing speed to market over cost.
- Large competitors have resources to catch up and eliminate any first mover advantages (ie. there is not a feedback loop that improves WFCF product because they have more data).
- There is a risk that WFCF’s “bundle” is not large enough as they do not own laboratories. Big customers who own labs could offer a better “bundle”.
WFCF is currently trading at 3.5x revenue with limited profitability. This multiple may actually be a bargain if WFCF can turn into a software company that can show increasing returns as it scales up. However, this would be a big leap given 80% of sales are still coming from certification/verification which is a very labor intensive business. In the certification/verification business, WFCF cannot add sales without adding cost (ie. employees). This is not true in software where code is written once and has only very small costs to scale. For more on software and increasing returns to scale, here is a great podcast.
Author Ownership: NO OTCMKTS: WFCF
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