Friday, October 16, 2009

Smart Balance, Inc. (Nasdaq: SMBL): A Saturated Valuation

I do not know Mr. Kabourek over at The Crusty Credit Analyst but what we have in common is that we both like boring stocks. He offers good, no-nonsense analysis of individual stocks: nothing about unit growth in China, market shares in India, FDA approvals, Stage 2 trials, and the like events that spell l-i-f-t-o-f-f for a stock.

He recently wrote a positive piece about SMBL (basically, good business, buy and hold) and I do not disagree with the argument as presented: chances are SMBL will continue to grow fast and will get acquired by someone for a nice multiple (i.e. up to high teens, IMO) because of that growth. However, to me, personally, SMBL appears fully valued.

Let's talk about the business itself first.

Everyone has seen their products in the supermarket. About 75% of the sales, for now, are in the spread category, where they compete with the likes of Unilever's I Can't Believe It's Not Butter. The other 25% are in various adjacent categories, such as oils and peanut butter, with more to come. Management has a good vision for where to go next: they are already testing extensively milk and sour cream, and have a few other closely related spaces in mind.

There is one important point about the main spread product, in my view: it is one of the very few substitutes with a patent-protected, legitimate benefit claim. While most patents in the food space are not essential in my view, SMBL's claim should make a difference: they do offer a unique product, and the people in their target market are likely to read/be more educated about the benefits of healthier eating, and how SMBL might fit there. The same can be said about the milk they offer: it is enhanced, again with patent protection.

Another unique thing about SMBL is that it is a true "virtual" company. They do not manufacture, distribute or broker the product: production is done via two contractors, and Acosta does the brokerage. They do not own the patents to their products either: the spreads are licensed from Brandeis and the milk is licensed from a smaller company. SMBL pays a commission based on product volume. This model has some obvious advantages: focus on its "core" competencies, superior scalability, easier to manage and others.

SMBL also has management with substantive executive experience at a number of food majors, and one can tell by both looking at the growth projections and the how they plan to get there. In addition, their marketing has been top-notch, an excellent combination of store facings, information and brand-building.

So these factors (quality management, virtual company, patents and growth) have turned SMBL into a true "story" stock, but unlike the "story" stocks we see IPOed today, SMBL is cash-flow positive.

Now on to the valuation part with some history.

SMBL burst on stage in 2007 when a SPAC (just like with APP) called Boulder Specialty Brands acquired GFA, which was the original Smart Balance. The acquisition introduced several tricky points in the valuation: first, the company took on substantial indebtedness to complete the acquisition. Then there were also the warrants, preferred stock, performance shares, founders' warrants, etc. that made the capital structure a bit more difficult to analyze. The dust has settled now, after conversions and private placements, and SMBL has only one class of stock outstanding, 1 mil founders' warrants (counted in the diluted count) and stock option awards. On the debt side, they have about $65 mm in two term loans.

SMBL has been growing phenomenally well for a company that operates mostly in the dull margarine space. Of course, you will never see the word "margarine" on their site. The company recently turned even earnings-positive, and it has been cash-flow positive for a while now: last 4 Qs and 6 of 9 Qs as a public co. have had positive CFO. Management has a long term goal of reaching $1 bn in sales (vs. $243 mm LTM), and expects to hit $500 mm in 2012. This implies growth rates of about 20-25% topline.

As revenues are increasing, we are seeing two positive tail winds. One, the company is lapping now serious commodity inflation, which should be good for the margins, and, two, there is the scale effect, which, again, should be good for the margins. We are already seeing that: looking at LTM EBIT and EBITDA vs. LTM a year ago, both metrics have reversed from negative to positive, and a part of that are lower SG&A costs. SMBL should also continue to benefit from the eat-at-home trend due to, you guessed it, "the economy."

I project for NTM and NTM a year from now 25% and 20% topline growth, and EBITDA margin improvement to 7.5% and 8% (lower-end for packaged food). LTM margin was 6.4%, and LTM year-ago was (2.0%). This works out to an estimated $26 mm in 2010 EBITDA. I apply a pretty wide range of multiples, from 10x to 15x, and get an implied discount from current of 10% to 45%. In other words, at the current $5.83 price, SMBL appears to be fairly valued.

A discussion of the proper value of the company would be remiss if we do not look at the outstanding options. The stock has been in a range of $6 to $8 this past year, and I think the number of options outstanding has something to do with it.

See, good management does not come free. SMBL's management is particularly dear: SMBL has to pay near par to the big guys, and if cash is tight, this means options. Lots of options. If you add in the SPAC "hertiage" to the mix, you get the picture.

Since companies are required now to expense options, we have good data on how much those cost based on the standard formula they use to calculate the value of the grants. For the LTM, the company has recorded $15.7 mm in options costs vs. EBITDA of $15 mm. This is substantial, to say the least. In aggregate, there are 12.2 mm options issued and outstanding (on 62.8 mm diluted shares, by diluted they mean that 1 mm warrants are counted; the regular options are not in the money for the most part). The weighted-average exercise price on those 12.2 mm is $9.43. For the current year, the shareholders voted an increase in the options available under the equity comp program, and this year, chances are that the exercise price will be lower. In other words, a move up in the stock price means potentially substantial dilution for the existing shareholders as the options move into the money. This might be keeping lid on the price, at least for now.

There are many positive sides to substantial management ownership: they have the same incentives as the other shareholders. Also, in SMBL's case, the management options vest immediately in a change-of-control situation. This clearly indicates that when someone knocks on the door with the checkbook, management will be dealing and will act in the best interest of themselves, which is aligned with that of the wider shareholder body.

To summarize, SMBL appears to be fairly valued at this point by my quick calculations here.

UPDATE: APRIL 2010 Dear readers, I keep getting hits from searches with search terms such as SMBL valuation, SMBL stock, and so on. Please note that the information presented was current at the time the article was published. There have been several interesting developments with the company since then which might be materially altering the potential value of the stock (i.e. the Best Life line and the national rollout of the milk). Please conduct your own research based on the updated information. While SMBL appeared overvalued to me at the time, the stock has run-up nicely since then along with the rest of the market, indicating that I was probably wrong.  

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