Leading Brands, Inc. (LBIX) bottles, distributes, and sells beverage products in North America, (mainly Canada and the western United States) and Asia. The company is headquartered in Vancouver, British Columbia and has a market capitalization of $12.6 million. The company also develops and markets its own branded products which include the TrueBlue®, PureBlue®, LiteBlue® and TrueBlackTM fruitjuices. Additionally, it currently licenses Stewart's® Fountain Classics. Both the company's own products and "co-pack" customer's products are bottled in Edmonton, Alberta.
Historically, the company has also licensed brands such as Fiji Natural Artesian Water® and Hansen's® products, along with distributing and licensing a variety of snack and grocery food brands. In recent years, the company has scaled back the brands it licenses and the number of products distributed through its network. By focusing on western Canadian markets, Leading Brands is currently exploiting markets where it already has a strong presence and taking advantage of a growing region that is being fueled by expanding energy production.
Throughout the 2000s, LBIX focused on increasing the turns of both its own products and its co-pack partners' products. To grow sales, LBIX focused on selling its own branded products in not only its core markets of Canada and the northwestern United States, but also throughout the mid-west and southern United States. By selling outside its core markets, LBIX increased its distribution costs and spent limited marketing resources in multiple markets to compete against products with much stronger brands.
As the following condensed income statements show, the company was somewhat successful at growing revenues until 2007, but this was at the expense of profitability. Once the company refocused its efforts by selling only the most profitable products in the most promising markets, gross profit as a percentage of revenues increased substantially. Before 2010, the gross profit margin never surpassed 30 percent, but in the last three fiscal years it has consistently been above 34 percent and has approached 40 percent.
Over the last three years, Leading Brands has improved its capital allocation practice. It first worked diligently to fortify its balance sheet and then return cash to shareholders. The company is now attempting to develop a new brand of lithium water called HappyWaterTM. Many believe Lithia Waters provide therapeutic benefits and improve brain cell function. The company is focusing its marketing efforts on the Vancouver metropolitan area and management is determined to roll out the product in a manner that is measured and provides an adequate return on invested capital.
We believe this strategy will allow the company to effectively manage the fixed costs associated with brand development and distribution by limiting the target market to one geographic area and focusing the company's resources on the most promising consumers. If the concept of lithium water proves successful, LBIX will increase the resources dedicated to marketing, production, and distribution of the product and thus expand the target market for HappyWaterTM.
Product development is always tricky and not all products work out. LBIX's executive management has a successful record of rolling out the TrueBlue® line of fruit juice drinks and has learned many valuable lessons that should prove useful in developing the new water. To date, results from HappyWaterTM have been limited and management has not yet communicated financial measures. Many expenses associated with the rollout of HappyWaterTM flow through the income statement but in reality are really capital expenditures. Based on changes in the company's financial statements, we estimate LBIX has spent approximately eight hundred thousand on the project thus far. It is too early to judge whether the investment is earning the required return, but the project has had a noticeable negative impact on the company's bottom line in the last few quarters. Nonetheless, executive management has communicated its commitment to make sure the development only continues if there is strong evidence that demand for the product exists and the company can sell the water at profitable levels.
Bottling Plant: The bottling plant in Edmonton runs two lines capable of producing a combined 144 oz. equivalent case capacity of approximately 10,000,000 cases per year. Ralph McRae, LBIX's CEO, stated the plant is currently running at 75% capacity utilization, which is effectively its maximum capability due to seasonality. Moreover, only approximately 1/3 of the plant production is LBIX's own branded products - all of the company's branded juice products are produced in Edmonton (even that which is sold into the Chinese market). The remaining roughly 2/3's of production is for co-packed product. LBIX has expressed a desire to gradually reverse this mix. LBIX's plant is operated with nonunion workers and thus should continue to provide competitive cost advantages. Nevertheless, running a bottling plant is a low margin commodity business with no significant barriers to entry. Consequently, we do not anticipate this segment of the business will ever generate above average returns over long periods.
Branded Products: In 2006, Leading Brands introduced TrueBlue®blueberry juice. Initially, LBIX had great success with the brand and by 2008 sales had reached roughly $10 million. Once the economic downturn began, however, U.S. retailers began to demand higher rebates in order to continue carrying TrueBlue®. LBIX was unwilling to pay up and decided to reduce its U.S. sales to a select few health food retailers on the west coast and refocus its efforts on the Canadian market where there was stronger recognition and loyalty for its products. With the success of TrueBlue®, LBIX began to expand its product line. It now has the following juices under the TrueBlue®brand; Wild Blueberry, Wild Blueberry and Pomegranate, Wild Blueberry and Acai, Wild Blueberry and Cranberry, Wild Blueberry and Blackberry, Wild Blueberry and Raspberry, and Wild Lite Blueberry.
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Leading Brands has also introduced TrueBlackTM (a black currant drink), PureBlue® (an UnWine), PureBlack®, PureRed®, PureWhite® (Pure brands are based on super fruits and are marketed as part of a healthy lifestyle and diet), BabyBlue®, and TrueBlue® 100% Juice. TrueBlue® is typically only 25% juice, whereas PureBlue®100 is 100% juice. LBIX is building lasting brands that are introduced to the consumer early in life (hopefully by his or her mother), thus it uses less filler juices (apple and pear) than competitors who may choose to lower their average cost by using a variety of fillers.
We estimate the overall consumer juice market in Canada to be roughly CAN$1 billion and that blueberry juices account for approximately CAN$20-$40 million, with LBIX having around 25+ percent market share. By focusing on growing its brands in select markets where consumers show loyalty towards the True and Pure brands, Leading Brands has improved its overall profitability.
Leadership and Shareholders
Leading Brands' board of directors is made up of five individuals, three of whom are independent. Ralph McRae is the President and CEO of the company and thus not qualified as an independent director. R. Thomas Gaglardi owns in excess of 10 percent of the company's common shares and thus also does not qualify as an independent director. Mr. McRae currently owns 5.5 percent of the company's common shares in addition to another 8 percent from unexercised stock options that are currently in the money. In 2010, LBIX granted Mr. McRae 245,000 stock options at an exercise price of $2.45. The company's board stated that these options were granted to align management's interest with shareholders and to help retain workers, since most of the prior options became nearly worthless. Although we believe it is important for management to be properly incentivized and think like owners, we were uncomfortable with the board's decision with respect to this issuance of options. The board has communicated that unless there is a new hire the company will not issue more options.
By focusing on controlling costs and identifying core markets for the company's products, management has been able to improve operating results. Since 2008, this strategy has led to a steep decline in revenues. Note, however, that this approach has led to improved profitability and by 2010 the company was back in the black. Not only have the company's net income figures improved, but so have the company's return on shareholders' equity and return on assets. Adjusting net income for a large one-time non-cash compensation expense of CAN$1.7 million in fiscal year 2011, the company's return on equity has been above 11 percent for the last three fiscal years.
Likewise, LBIX's return on assets has remained above 6.5 percent over the last three fiscal years and reached 10.1 percent during the latest fiscal year. While non-cash compensation is a real expense, the adjusted number is more indicative of the company's true earnings power since the company has communicated that future options issuance is unlikely. Due to the increase in gross profit and decrease in operating expenses, the company has generated substantial retained earnings that have been used to create value for shareholders.
LBIX focused on using capital it generated from earnings to first repair its balance sheet and then return cash to shareholders via stock repurchases. An encouraging result of the change in strategy to focusing on only the most profitable sales was a deleveraging of the balance sheet. Since 2008, there has been a large reduction in both total assets and total liabilities - inventories and deferred costs on the asset side and debt and accounts payable on the liabilities side. After 2009, LBIX's liquidity and solvency began to show strong signs of improvement. The net cash balance (total cash & short-term investments minus short and long-term debt) improved to CAN$0.8 million at the end of fiscal year 2012 from negative CAN$9.3 million at the end of fiscal year 2007.
As a result of the company's prior operating losses, LBIX has CAN$4.4 million of operating loss carry forwards - only a portion of these appear on the balance sheet under Deferred Tax Assets due to valuation allowances. Net operating losses are tied to CAN$5.5 million in Canadian losses and a CAN$8.3 million in U.S. losses. Assuming the U.S. operating loss carry forwards are worthless and based on current levels of profitability, LBIX will not pay taxes on earnings for a little more than three years. This should increase the cash flow available to common shareholders during this time by nearly CAN$420,000 per year (normalized EBT times the reported tax rate or CAN$1.6 million times 26.25 percent).
Results of operating changes are best seen in the statement of cash flows. As already stated, the company first focused on repairing its balance sheet. It then repaid a net CAN$7.8 million in debt. It further repurchased a net CAN$2.4 million of common stock during fiscal years 2010 through 2012. Moreover, LBIX completed a Dutch auction tender offer in June of 2012 (fiscal year 2013) whereby it repurchased approximately 8 percent of its common shares outstanding. Thus far in fiscal year 2013, LBIX has spent CAN$1.4 million on stock repurchases, leaving its current share count at approximately 3.5 million diluted shares outstanding. This is down from approximately 4.0 million in 2009. With LBIX's current market capitalization at about $12.6 million, the dollar value of share repurchases during the last three and a half years have amounted to approximately one third of the company's current market capitalization!
An investor in Leading Brands faces several major risks. The company may lose its current large co-pack partner. Because the bottling business is a commodity like business, a competitor could open a plant in Edmonton and drive down returns for all participants. However, as previously stated, due to the company's cost advantage, we think this risk is manageable.
The greater risk is one in which the company allocates its excess cash generated by the bottling plant in a manner that destroys, not creates, shareholder value. The most likely scenario would be that new product development proves overly difficult and management fails to have risk control measures in place to discontinue the development at an early stage. As previously stated, we believe the company has spent roughly $800,000 on HappyWaterTM. If the product does not sell at a profitable level in the future, the money spent could have been used to buy in shares or pay dividends. As is always the case with outside shareholders, we must assess whether or not the company, under the supervision of the board, is acting with shareholder interests in mind and has the correct policy and procedures in place to manage the risks associated with the operations of the business.
We believe Leading Brands has proper risk controls in place. The two largest shareholders sit on the board and one is also the CEO. Moreover, as a result of past operating losses and communications with senior management, we believe LBIX has policies in place to ensure that excess capital is not committed to unwarranted projects. Even so, this will continue to be a significant risk - to be sure, product development is always a difficult undertaking.
Another serious risk is that the company's current brands lose market share to competitors. Given LBIX's loyal consumers and high quality products, we feel this risk is minimal presently.
Conclusion and Valuation
We believe there is a high probability that Leading Brands' bottling plant and branded juice sales will continue to generate excess cash flow well into the future. Over the past several years, LBIX has used its surplus cash wisely to increase the value of the company's equity for shareholders by reducing debt and purchasing a substantial percentage of its common shares outstanding. The company is now positioned to grow revenue through new product initiatives, while continuing to use excess cash flows to repurchase shares. With a positive net cash position, return on assets around 10 percent, and return on equity around 13 percent, LBIX's bottling operations and branded juice products should be worth more than net book value. Thus, given its current earnings power and prospective future earnings, a current market capitalization of $12.6 million seems to greatly undervalue the company.
Disclaimer: The security described in this article is owned by the contributor and clients of Milwaukee Private Wealth Management, Inc., an investment management firm owned by the contributor. Thus, the contributor has a financial interest in any future price increase of the security.