At the 2003 Berkshire Hathaway's shareholders meeting one investor asked Mr. Buffett:
"What is the ideal business?"
And Mr. Buffett responded:
"The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine. So if you had your choice, if you could put a $100 million into a business that earns 20% ($20 million) on that capital, ideally it would be able to earn 20% on $120 million the following year and so on. You could keep redeploying capital at [those] same returns over time.
But there are very, very, very few businesses like that... we can move that money around from these businesses to buy more businesses."
The type of company Mr. Buffett describes is exactly the type of company Expeditors International of Washington (EXPD) is. Expeditors is a global provider of logistic services helping customers move their goods globally by air or sea. Its business can generally be divided into two parts. The first one is bundling customer shipments and forwarding them to the appropriate air or ocean carrier. The second part is helping customers to deal with customs worldwide and all the related laws and bureaucracy, making it easier for them to import goods from all around the world. Expeditors doesn't own any ships or airplanes.
The reason I was first attracted to this company is its excellent performance while it is focusing almost exclusively on organic growth. As a matter of fact, the company is so focused on managing its core business efficiently that management has put this rare statement on the business section of the company's 10-K:
Unlike many of its competitors, who have tended to grow by merger and acquisition, the Company operates the same accounting and transportation computer software, running on a common hardware platform, in all of its full-service locations. Small and middle-tier competitors, in general, do not have the resources available to develop these customized systems.
Historically, growth through aggressive acquisition has proven to be a challenge for many of the Company's competitors and typically involves the purchase of significant "goodwill." As a result, the Company has pursued a strategy emphasizing organic growth supplemented by certain strategic acquisitions.
Expeditors' annual return on equity for the past decade has been on average 21%. Annual return on assets (excluding cash) averaged 22% for the same period. Those two ratios are nearly identical because Expeditors had no debt over these years.
Furthermore , when we take into account its low capital expenditures (its a services company after all), it becomes clear that Expeditors is exactly what Mr. Buffett described as the ideal company. A cash generating machine that keeps compounding at a high rate for a very long period of time.
However none of this means anything for us at the present unless the future of the company is going to be as bright as its past. This depends on one critical factor, the company's ability to retain and expand its business.
The fact that Expeditors achieved these returns with organic growth and it intends to continue to do so, implies that the company besides being well-run it must have also some kind of edge against its competitors.
The company's competitive advantage is the huge global network that it has created between carriers and customers over the years. To better understand why this is true one must understand the motivation that drives customers and carriers in choosing an international logistics provider.
- Customers want two things. First they want the lowest possible rate for shipping their products. Second they want to deal as little as possible with the hurdles of international trade (multi-lingual communication, custom clearance, cargo insurance etc.).
- Carriers also have two similar goals. First, they want to keep their planes and ships occupied at the maximum of their capacity in order to operate profitably. Second they want to lower their costs by outsourcing the sales force that is needed to attract new customers in a timely and reliable way.
Expeditors International uses its network to service the needs of both of these groups. Having more customers than competitors allows Expeditors to extract better prices from carriers. On the other hand the more customers it serves the more carriers use Expeditors as a stable and reliable source of business.
In other words, the bigger the network it has, the better it is able to serve its customers and carriers. The better it serves them the more they come, thus increasing the network. It's a classic virtuous cycle that goes on and on for as long as Expeditors keeps offering reliable, timely, and attractively priced services.
The only risk investors have do deal with about Expeditors' future is that the company's fortunes are closely tied with international trade. This makes the company vulnerable in recessions and other world-impacting events like the world-wide spread of a disease or escalation of war etc. However, due to its stellar balance sheet (no debt and $6/share of cash), its strong network and the strong customer centered culture, Expeditors is more likely to make "permanent" market share during those times than suffer lasting damage to its business franchise.
So far we saw that Expeditors International of Washington is a well-run, highly profitable company with a strong moat around its business. However all these are irrelevant for potential investors unless the company is trading at an attractive valuation.
To value Expeditors I will also use a Buffett-like mindset calculating how much cash a private owner could extract from the company during the next decade. Expeditors' free cash flow has grown at an average 17% pace over the past decade. Given the company's little need for capital expenditures, its great moat and the vastness of the market it can address I believe that we can extrapolate that growth into the future.
Using as a base the $1.52 FCF/share the company generated during 2012 we can calculate that during next decade (with 2013 being the first year) the company will generate in aggregate about $40 per share of usable cash. Add in the $6 per share the company already has as cash and cash equivalents and its fair value would be around $46 per share.
This is 33% above its current $7.3 billion valuation making it attractive to the long-term investor. This is exactly what Mr. Buffett calls "buying a great company at a good price".