On Thursday, January 27, we were pleased to see 1-800-Flowers.com (FLWS) post better-than-expected results and regain at least some favor from Wall Street. For some time now, we've been highlighting the value inherent in the company's diversified portfolio of businesses and expecting Wall Street to again embrace the company.
In our "Just Like Clockwork" post early last month, we said:
Among the overlooked ideas we've highlighted here on CS$, one leading candidate is 1-800-Flowers.com (FLWS), where we see a strengthening "moat" for an increasingly diversified business. We can again relay that, by the time fundamentals turn positive and we see broker upgrades along with funds clamoring for a piece of the company, the stock will probably already be back at $3-4 on the way to $5-6.
Well, following the results, Goldman Sachs moved to a "Neutral" rating from a "Sell" rating, which is a step in the right direction. We've not seen the report, but presume the firm is happy that fundamentals are stabilizing and that the coast is seemingly more clear than previously.
Of course, we all remain aware of nagging economic concerns and that "Selfish" Discretionary Spending is outpacing "Gifting" Discretionary Activity. For these reasons, Goldman Sachs possibly held off moving all the way to "Buy" rating and may also want to see positive Y/Y growth for the company. Per our prior discussion, many analysts are afraid to stick their necks out until the coast is entirely clear.
However, let's revisit what Warren Buffett pointed out in his October 2008 NYTs Op-Ed, Buy American. I Am (emphasis added in last sentence):
Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.
We continue to believe this is true for 1-800-Flowers.com. By the time Wall Street fully embraces the company, the stock will already be meaningfully higher. Hence, the best time to acquire shares is when they are discarded in the waste bin.
Moreover, assuming a stable to better U.S. economy, we think 1-800-Flowers.com may begin to show positive Y/Y comparisons in the coming quarters. We can point to reasons from the company's earnings release:
The Company said the 1.3 percent [revenue] decline reflected reduced wholesale order volume in the mass marke t channel as well as the loss of approximately $1.4 million of high-margin revenues associated with a third-party marketing program which the Company ended in December of 2009.
Here's the good news: going forward, the company has now "lapped" both the third-party marketing program and particularly steep declines in its wholesale basket business. As a result, delivering Y/Y growth is now easier, especially as other, growing business segments such as chocolates and cookies become more significant contributors to the company's revenue mix.
This finally brings us to the main point of today's post: is 1-800-Flowers.com's chocolate business gaining market share from See's Candy? Last December, we shared 1-800-Flowers.com: Is "Moat" Shallow, Shrinking, or Nonexistent? In that post, we referenced our Nestlé Kit Kat series, which alluded to the strength of 1-800-Flowers.com's growing chocolate business, Fannie May. We also shared this January 27 AP article (Sweet success: Fannie May back after bankruptcy):
The Associated Press — CHICAGO — A half-dozen years ago iconic chocolatier Fannie May, loved by Chicago candy devotees who passed down their affections for mint meltaways, caramels and vanilla buttercreams from generation to generation, was all but finished.
A large part of our thesis is that the "Market" is ignoring hidden value in the company's portfolio of brands, particularly Fannie May Confections and Cheryl's Cookies. We see these higher margin, growing, branded businesses as durable, consumer packaged goods (CPG)-like operations. It's worth noting that the historical long-term stock performance of many CPG companies is very positive. For reference, please see Jeremy Siegel's books Stocks for the Long Run and The Future for Investors: Why the Tried and True Triumph Over the Bold and New.
Now, let's look briefly at Fannie May Confections (FM). The AP article included a number of interesting tidbits, particularly an updated annual sales figure for the business and production volume:
...a brand approaching $100 million in revenue annually...
..produces about 10 million pounds of chocolate a year.
We can take the sales figure and combine with our analysis:
- 1-800-Flowers.com purchased FM in April 2006. At that time, the company's trailing twelve month sales were approximately $75 million.
- Our understanding is that revenue was approximately $90 million two to three years ago.
- According to the article, revenue is now approaching $100 million, which implies a five-year CAGR of 7% per year versus a flat to down North American chocolate market.
- While the overall market probably grew along with the economy in 2010, here's backup data for the flat to down market from an LMC International presentation entitled the Outlook for Cocoa Demand (October 2010):
- The entire deck is worth reviewing. Above, we see North American consumption shrinking ~1.5% per year over the past five years (although maybe skewed downward by a weak 2009?). The deck is sourced from the World Cocoa Foundation's October 2010 Partnership Meeting and Roundtable Sessions.
- The overarching conclusion: if FM is growing revenue 7% per year, on average, in a flat to down market, FM is gaining market share!
- Plus, the business has excess production capacity -- our understanding is that FM has current capacity in place to produce 15 million pounds of chocolate per year. Put another way, volume could increase by 50% without incremental capital investment in physical plant and production equipment.
- Also noteworthy is FM's stable, committed leadership: David Taiclet remains at 1-800-Flowers.com as head of FM. He was the head of Alpine Confections, which bought FM out of bankruptcy, successfully reincarnated the business, and later sold to 1-800-Flowers.com.
Sorry to disappoint: The honest answer is that we don't know since -- to our knowledge -- the last reported financial figures for See's Candy were in Berkshire Hathaway's 2007 Annual Report:
2007A revenue of $383 million with $82 million of pretax earnings (= 21% pre-tax margin).
To see whether or not See's is maintaining, gaining, or losing share, we need updated revenue figures. Admittedly, as a shareholder of both Berkshire Hathaway and 1-800-Flowers.com, we're rooting for both businesses. However, we do know this: a well-run chocolate company makes for one heck of a business AND there aren't too many of them around.
One this point, Mr. Buffett has long praised See's as "a dream business" and included wonderful discussion in Berkshire Hathaway's 2007 Annual Report* (please click to enlarge):
*We are taking liberty by lifting this directly from the AR without express permission, yet suspect this is okay given the life-long propensity of Messrs. Buffett and Munger to educate and share key investment principles.
We recommend reading the text, as well as the balance of the shareholder letter. In a nutshell, this particular section makes very clear the benefits of owning "asset-light" businesses that possess pricing power and generate lots of excess cash flow. Also, Mr. Buffett notes that there simply aren't many "dream" businesses since most companies require significant capital expenditures to expand operations over time.
While Fannie May Confections is not as well-known or profitable as See's Candy, the businesses both specialize in old-fashioned, premium quality, gourmet chocolates. Fannie May actually pre-dates See's by one year -- founded in 1920 and 1921, respectively -- and established a wide following in the greater Chicago area. We know that FM's products are also excellent and, in some cases, very different and incredibly tasty. For example, Pixies and Mint Meltaways:
Based on our own experience and feedback from others, we're confident that the quality of FM's products and service is very high. Some people we know in Chicago even claim FM's chocolate is better than See's. We recommend trying them both and highly recommend FM's Pixies.
For sure, See's management team made deft operating decisions through the decades that enabled the company to grow into a business with (1) approximately four times the revenue and (2) potentially eight to ten times the pre-tax income by (3) selling only three times the annual volume of chocolate (measured in pounds). HENCE, the management teams of 1-800-Flowers.com and Fannie May have their work cut out for them. HOWEVER, we can safely say that by growing 7% per year in a flat to down market environment, management is clearly making some favorable decisions. Leveraging the "Flowers.com" significant Web traffic is no doubt a large part of the company's success over the past five years.
Here's where things get really interesting: with estimated contribution margins in the low teens (not reported), the private market value of Fannie May Confections could reasonably represent a significant component of 1-800-Flowers.com's current $177 million market capitalization and $217 million enterprise value (MC + net debt).
Here's what we mean:
- Assuming $100 million in annual FM revenue with a 9% pre-tax margin (estimate) produces $9 million of pre-tax income.
- Assuming corporate taxes of 40% yields net income of $5.4 million (*if the company could somehow build an international business, taxes might be lower; chocolate consumption is growing rapidly in Latin America; however, such an expansion effort would involve capital investment, management time, and various risk factors).
- Applying a 20 times earnings multiple (5% yield) for a difficult-to-replicate, growing franchise brings us to a $108 million valuation for the business.
- Note: variable margin and multiple assumptions create wide valuation swings.
Add to this figure a reasonable private market value for the company's growing Cheryl & Co. cookie business, and the Market is awarding very limited value to the company's other businesses.
On this basis -- even amidst the weak discretionary environment -- we arrive at a meaningful margin of safety that should mitigate key risk factors such as competition, macroeconomic conditions, and a U.S.-centric revenue footprint. We believe shares could fairly trade at double current levels *today* and even higher assuming a stable to better economy that supports revenue growth and margin expansion.
Accordingly, we happily acquired shares on weakness in early 2010 and again late last summer into the fall as some investors threw in the towel. We believe those selling the stock, as well as those who remain on the sidelines today, are missing tangible hidden value inherent in the company's diversified, durable portfolio of businesses.
In particular, the notable success of Fannie May Confections through the downturn tells a very positive story and provides much on which to hang our hat. In this sense, the company's record of growth and share gains should enable the Market to see the forest through the trees.
But, alas, as Mr. Buffett writes, some prefer to "wait for the robins."