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Middleby’s (NASDAQ:MIDD) third quarter earnings release was very similar to their second quarter. Organic growth was down significantly, but the company continues to maintain strong profits. In their third quarter, net earnings were $15.5 million, or $0.83 per share as compared to $16.3 million or $0.96 per share for the third quarter of 2008.

Net sales were down 7.5% in the third quarter, but excluding the impact of acquisitions, net sales were down 19.8%. Despite the decline in sales, operating margins improved from 18.6% in the third quarter of 2008 to 19.9% for the third quarter of 2009. These strong margins were used to pay down debt. Total debt declined from $321 million to $295 million during the quarter.

The company continues to produce strong cash flow despite declining sales. Debt has been reduced by $51 million over the past two quarters. Adding back depreciation and amortization of $3.1 million and backing out about $1.7 million in capital expenditures to quarterly earnings results in owner earnings of $16.9 million. Other operating cash flow came from improvements in working capital.

The expansion plans for many restaurants have been put on hold, so much of the revenue produced by Middleby has to come from equipment upgrades occurring with their customers. Through innovation, Middleby is able to drive much of this cycle, but I suspect true sales growth will not occur until their customers begin to expand once again. One of the benefits of this stalled growth is that you can truly see Middleby’s earnings in more of a steady state. Annualizing this quarter’s earnings would result in $62 million in net income annually. Middleby had shareholder equity of $223 million at the end of 2008. With modest debt levels, Middleby is producing returns on equity of 27.8%.

The next year will remain challenging for Middleby. In determining a valuation, I start with owner earnings of $68 million, then assume a 20% return on equity. This results in the following series of cash flows:


Year Cash Flow Growth Ending Equity
1 $67.2MM -1.2% $403.2MM
2 $80.6MM 20% $483.8MM
3 $96.8MM 20% $580.6MM
4 $116.1MM 20% $696.7MM
5 $139.3MM 20% $836.1MM


For a reversion, I assume a P/E of 15 and add it to year five cash flow. Discounting these cash flows back at 10% results in an intrinsic value of $1.6 billion or about $84 per share. Even discounting these cash flows at 15% results in a value of $66 per share. The returns on equity of 20% are conservative based on the returns they are achieving even in a weak third quarter. Given the track record of Middleby’s management and their integration of past acquisitions, it is not unreasonable to look for the company to continue to invest free cash flow at strong returns.

Disclosure: I currently hold shares of Middleby.

Source: Middleby’s Q3 Shows Earnings in Steady State