By Harry Long - Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in VIFL over the next 72 hours.
Introduction
Years ago, a private equity firm client retained us to objectively and to quantitatively identify firms which enjoyed oligopoly competitive positions, which were below $100 million dollars in equity market capitalization in the United States. Like many investment firms, they were interested in recreating another Berkshire Hathaway (BRK.A) that enjoyed stable cash flows from outstanding businesses. They agreed with our approach to objectively identify such firms, which we termed (somewhat humbly!) Long's Law. Long's Law states that long-term free cash flow margins (FCF/revenue) in any industry over a multi-decade time frame tend towards the inverse of the number of competitors in that industry. For example, in an industry with three competitors, FCF margins will tend towards 33.33% or 1/3. However, Economics "Laws" should best be termed Economic "Tendencies." The rule roughly holds across a vast array of industries. Therefore, when the investment management industry from private equity to quantitative equity searches for a host of high performance metrics in potential investees, we can empirically demonstrate that the number of competitors in the industry usually determines sustained company outperformance (excluding growth statistics).
Identifying large firms in oligopolistic competitive positions is relatively straight forward if you know what to look for. Think VISA (V). However, finding small firms, which enjoy very little competition, is almost impossible without the right approach. Food Technology Service (VIFL) is such a company. Its only domestic competitors in gamma ray sterilization of medical devices, its cash cow, are Sterigenics and Steris Isomedix (STE). Therefore, it is in the rare position of being a small company with extremely stable and growing cash flows, with high margins and a high return on capital to boot.
And the major advantage of finding a tiny oligopoly business is that it actually is small enough to be acquired and controlled! Try making a bid for MasterCard (MA) or eBay (EBAY). It will not be easy! But the most immediate advantage of searching for tiny oligopolies is that they can be had for very low valuations, because they suffer from neglect, rather than fundamental weakness. You can imagine my surprise when I found that Food Technology Service was, and is, selling for less than the replacement cost of its physical assets plus cash and cash equivalents. It would be akin to finding a diamond needle in a football field sized haystack, without having to pay for the diamond! The stock is selling for a discount to its physical assets. And investors are getting an amazing oligopoly business, which the market is not recognizing should sell for a premium.
A True Oligopoly
But why is this such a high quality oligopoly business? If one thinks about the restaurant business, it is clear that hundreds upon hundreds of restaurants in any city compete with each other. But they all buy Coke or Pepsi for their customers. Similarly, there are myriad medical device companies in the United States competing with each other, but when they are sterilized using gamma irradiation, they purchase these services from only three companies--Sterigenics, Steris Isomedix, and Food Technology Service.
And gamma sterilization is extremely important to medical device companies. If it is not done correctly, it is disastrous for the safety of these devices, such as knee implants, to say nothing of liability issues. So medical device companies are willing to pay up a bit to make sure that this sterilization is done perfectly. And Food Technology Service has an amazing reputation in the industry for the superb quality of its operations. The Company is certified to ISO 13485:2003 standards for the provision of radiation sterilization services for medical devices. The medical devices are perfectly sterilized every time by being exposed to the proper dose of gamma irradiation from a Cobalt 60 source.
The other thing to remember intuitively, is that for extremely high margin medical devices, which may sell for tens of thousands of dollars, the cost of gamma sterilization is a very small part of the total cost of the product, but if it is not done correctly, it could lead to millions in liability for the medical device company. So these companies will pay a premium for gamma sterilization, which still ends up being enormously cost effective. It is akin to branded bubble gum, if one excuses the comparison. A pack of gum might only cost a few dollars, so even though the mark up is healthy, customers do not perceive it the way they do for an Hermes handbag. Similarly, gamma sterilization providers can earn a healthy profit margin, but the cost of gamma sterilization is so low in relation to both medical devices' cost and in relation to the huge potential liability if it is not done perfectly, that they can earn healthy margins while still providing enormous value to the medical device industry.
Moreover, Food Technology Service has an almost monopoly position on the peninsula of Florida. If a medical device is manufactured in Florida, it is not going to pass Food Technology's irradiation facility in Mulberry, get sterilized somewhere else, then go to its destination. Florida-based medical device companies will almost certainly use Food Technology Service if they need gamma sterilization. The strategic value of a monopoly on gamma sterilization in Florida is massive. Indeed, Florida is the second leading state in the U.S. for the manufacture of FDA registered medical devices
Quantitative and Objective Evidence of High Quality
Food Technology Service has extremely stable and growing cash flows. You could almost set your watch to its consistent cash flow from operations:
2010: $1.36 million
2011: $1.88 million
2012: $2.44 million
In addition, revenue grew 11.4% in the quarter just reported and net income rose 8.5%. And in each of the last three years, the cash flow from operations divided by revenue hovered around 50%. That is absolutely outstanding.
The Most Conservative Method of Valuation: Replacement Cost
Determining the replacement cost of physical assets is the ne plus ultra of all valuation work. Valuation experts can disagree on valid comparables, or the correct multiple of Enterprise Value to EBITDA that a business should sell at, but replacement cost is the bedrock of all valuation work. Determining replacement cost sets the most conservative floor on valuation upon which there can be little reasonable disagreement.
What is the nature of the company's physical assets plus cash and cash equivalents, minus all liabilities?
Assets Considered
The Company's irradiation facility and executive office are located on an approximately 2.17 acre site owned by the Company in Mulberry, Polk County, Florida. Its address is 502 Prairie Mine Road, Mulberry, FL 33860. The Company purchased the site because of its convenient access to State Road 60, a major transportation artery between Central Florida near the major interstate systems. The Company's irradiation facility and executive office comprise approximately 28,800 square feet, including a 22,600 square foot warehouse and loading and unloading area, a 3,200 square foot office area, and a 3,000 square foot irradiation chamber and Cobalt 60 storage cell. The Company's facility is designed to operate 24 hours per day, seven days per week. The facility is licensed for a maximum of 4,500,000 curies of Cobalt 60, which allows production to be increased significantly, if needed. The Company has an approximately 8,000 square foot warehouse on 2.17 acres of Company-owned land adjacent to the processing facility.
The replacement cost of the company's physical assets would be $10.0 million.
The company currently has 1.4 million curies of Cobalt according to the latest 10-K. At $3.00 per Curie, this comes to $4.20 million worth of Cobalt.
The company's cash, certificates of deposit, and receivables amount to$3.75 million.
Stunningly, the company only has liabilities of $0.23 million.
Therefore, in total, the company has a replacement value of $17.72 million.
$17.72 million in replacement value divided by 2,922,870 shares outstanding = $6.06 per share as a valuation floor.
The company is currently selling for $5.18 per share, or a 14% discount to the replacement cost of the company's physical assets. This is a clear market inefficiency. Moreover, this valuation floor does not take into account the company's intrinsic value as a going concern as calculated by a discounted cash flow model.
Intrinsic Value
The most conservative discounted free cash flow model places the company's intrinsic value at $23.1 million, or $7.90 per share. First, it is important to use a stable growth discounted free cash flow model to create a valuation for the company, as opposed to a multi-stage model. The reason for this is simple. With an aging population, it is clear that the growth in demand for medical devices will be consistent. It is not going to taper off or stop in any year in the imaginable future. In addition, for reasons we will explore shortly, it is highly unlikely that any rational competitor would construct a competing irradiation facility in Florida. So Food Technology Service will clearly be a beneficiary of the growth in demand for medical devices and will capture the economic benefit of growth in demand for medical device gamma sterilization.
My most conservative estimate for Food Technology Service's Free Cash Flow this year is $1.1 million. In reality, the true Free Cash flow of the business is probably closer to $1.6 million, but I am being extremely conservative. In a stable growth discounted free cash flow model:
Present Value of the Firm = Free Cash Flow / (discount rate - growth rate)
So, we take $1.1 million / (discount rate of 10% [0.10] - perpetual growth rate of 5% [0.05]) = $23.1 million in present value of the firm, or again, $7.90 per share. At $5.18 per share, Food Technology Service sells at a 34% discount to conservatively calculated intrinsic value.
I really can't get more conservative than assuming a 10% discount rate and a 5% growth rate. The big present value of the company's oligopoly in a market with massively consistent and growing demand is that we actually can reasonably presume that the 5% growth will be perpetual. Remember, the way to get truly rich in any industry is to sell the picks and shovels to the miners. It works for Bloomberg with investment banks, it works for Coke and Pepsi with restaurants, and it works for Food Technology Service with medical device companies.
An Acquisition by Sterigenics or Steris Isomedix Would be a Massive Catalyst to Unlocking Shareholder Value
A strategic control premium would certainly be paid by Sterigenics, or Steris Isomedix, if they wanted to acquire a much smaller competitor, and further consolidate control of the market for gamma sterilization of medical devices. As we have seen, the oligopolistic nature of the medical irradiation industry makes the marginal benefit of acquiring even one competitor extremely high. Moreover, the low marginal costs of increasing production increases profit margins as capacity utilization increases. And Food Technology Service's license for a maximum of 4,500,000 curies of Cobalt 60 allows for much more capacity utilization.
But most importantly, the dynamics of an oligopolistic industry make the game-theoretic optimum strategy very clear. Sterigenics and Steris Isomedix clearly would benefit by acquiring the company's near monopoly on the peninsula of Florida, since the state is the second leading manufacturer in the nation of FDA-approved medical devices. But the really neat part, is that they would have to be insane to construct a new facility, rather than acquire Food Technology Service. Constructing a new facility would cost at least $15 million dollars. Any new facility would face the prospect of sustained losses of at least $3 million per year for 5 years, further increasing the total cost of bringing a new facility online with only the prospect of breakeven to $30 million.
Remember, Food Technology's market capitalization hovers below $15 million and it is hugely profitable already! Then, after absorbing $30 million in construction costs and losses just to have the prospect of breaking even, the developer of any new irradiation facility would have to massively discount prices to pull business away from Food Technology Service, which has the best reputation in the industry for high quality gamma sterilization with very quick turnaround times. And since Sterigenics and Steris Isomedix own dozens of other facilities around the country, they would have to discount prices at all of their other facilities due to the price war they would have created to gain business in Florida. That's why, in any oligopoly industry, the rational strategy is to never start a price war. Humans are great at first order reasoning problems. Under first order reasoning, you cut prices and gain market share. But under second and third order conditions, one cuts prices to gain market share, the competitor cuts prices to maintain market share. And no one's market share changes, but both firms now earn lower profits. In the last 20 years every major business school worth its salt has pounded this into the heads of MBA students. Getting a new facility to breakeven in Florida would require a price war, and that is why no rational competitor would ever try it. And that's also why new entrants have not been attracted to the industry, to say nothing of the difficulties of handling radioactive material, which requires top-notch technical talent. So, there is a very compelling argument that Sterigenics or Steris Isomedix might acquire Food Technology Service in an effort to growth their businesses. And they would actually be quite shrewd to pay a strategic control premium of many millions.
Conclusion
Food Technology Service is an outstanding oligopoly business that is totally undiscovered by the market. Amazingly, it is selling for less than the replacement value of its assets, simply because it is undiscovered. The company is well run, has zero competition in gamma sterilization on the peninsula of Florida, and will probably be acquired by Sterigenics or Steris Isomedix unless a brilliant private equity firm takes it over first. Investors are increasingly realizing that cheapness alone is no longer good enough. In an increasingly competitive world, investors realize that they need both cheap and extremely high quality companies. But such finds are rare, and require sophisticated statistical insights and technology to source efficiently. Food Technology Service is such a find.
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