Moats

What's Amazon's Plan for Whole Foods?

INTRODUCTION

It’s clear that Amazon’s $13.7b acquisition of Whole Foods will result in lower prices at the notoriously expensive grocer. What’s less clear is how Amazon will accomplish this. Most expect them to bring-to-bear their formidable supply chain and delivery know-how, driving prices lower by revolutionizing how groceries are shipped and distributed. While these are surely some of Amazon’s long-term goals, this presupposes that Amazon has already solved the unique challenges of storing and shipping groceries. The reality is Amazon does not yet have the core competencies required to operate a grocery supply chain. These they will learn from Whole Foods. 

But if improvements to the supply chain or logistics are still a ways off, then the question remains: how will Amazon reduce prices? We posit that by automating in-store operations via technology (e.g., self-checkout) and pushing more private label products, Amazon will drive down expenses by billions of dollars. They will then pass these savings right back to the customer in the form of lower prices and better value for Prime members. 

THE GROCERY CHALLENGE

Grocery is the holy grail of retail—nearly every individual must buy groceries on a regular basis, and what does get purchased is often the same from week to week (e.g., meat, eggs, milk, bread). At $650b, annual US grocery sales are 6x Amazon’s revenue, yet only 2% of those sales are done online. So grocery presents a massive opportunity for Amazon, but despite the company’s operational efficiency and extensive distribution network, they have not been successful in this space. Why? 

Look no further than the unique challenges of selling groceries. Amazon may have mastered shipping uniform, non-perishable, and scannable items like books and electronics, but shipping goods that spoil, have inconsistent availability and fluctuating costs, require refrigeration, and varying quality of individual units, is a significantly more difficult challenge. Had Amazon already solved this, they wouldn't have needed Whole Foods in the first place. 

WHAT IS AMAZON’S STRATEGY?

As Amazon experiments with logistics and distribution, their near-term strategy is likely to focus on three areas: improve in-store operations via technology and automation; introduce more private label goods like AmazonBasics and 365; and increase the value of Prime. 

1) In-store Operations 

In January, Amazon revealed AmazonGo, which is a suite of technologies (e.g., cameras and sensors) that enable customers to walk into a store, grab what they want, and walk out—all without needing to wait in line or see a cashier. By automatically detecting what a customer took off the shelf, Amazon can bill their account, monitor in-store inventory levels, and reduce “shrink” (i.e., theft). We expect AmazonGo technology to be pushed out across Whole Foods’s 465 stores. 

If we assume half of Whole Foods’s 100k employees are cashiers—and that their total hourly cost to the company (including wages, benefits, perks, etc.) is $25/hour—then Whole Foods likely spends around $2.5b/yr on this expense—13% of total sales. 

2) Private Label Goods 

No longer seen as cheap, low-quality knockoffs, private label goods are now sought after by savvy customers because of their attractive value proposition: same quality, lower price. Brands like Kirkland, Trader Joe’s, 365, and AmazonBasics, are going toe-to-toe with expensive name brand alternatives; and in many cases they’re winning. And it’s not just customers who benefit. By selling private label goods, companies earn higher margins, gain product exclusivity, and have greater control over packaging and distribution. Since Amazon and Whole Foods have been independently selling more low-priced, high-margin private label goods, we expect the acquisition to accelerate this trend. 

By improving in-store operations and selling more private label goods, Amazon stands to increase the profitability at Whole Foods. But rather than keep the profit, Amazon has other plans…

3) More Value for Prime Users

We expect Amazon to “give back” any profits to customers through lower prices and increased value for Prime members. To understand why, look no further than the company that serves as Prime’s inspiration: Costco.

Costco sells products “at cost”, meaning if it costs them $1 to supply customers 1lb of turkey, then that’s the same price they charge those customers. While this virtually guarantees Costco can offer the lowest prices, it also seemingly guarantees they’ll never make money. But there’s a catch—to get Costco’s low prices, customers must pay $60/year to be a “member”. It’s a unique but brilliant business model; customers win because they receive more than $60 worth of savings each year, and Costco also wins because there’s no incremental cost to provide a membership, so all membership fees fall directly to their bottom line.

This is the same model that Amazon Prime means to replicate. Since the company doesn’t need to make money directly off the goods it sells, it can keep prices lower than its competitors. The low prices drive more memberships, which increases sales, which in turn gives the company more leverage to get even lower prices from its suppliers. Rather than keep that margin, the company gives it right back to the members through lower prices, thus driving more memberships and restarting the virtuous cycle.

Because of the acquisition, Amazon will have a number of new opportunities to increase Prime’s value, such as: free grocery delivery, member-only sales/pricing, exclusive brands, online ordering/pickup, and easy re-ordering. And by increasing Prime’s value, Amazon attracts more Prime members, which increases sales, which in turn gives the company more leverage with suppliers, which drives prices lower, which….well you get the point. 

CONCLUSION

While predictions of drone-delivered swiss chard may make for good headlines, the future success of Whole Foods does not depend upon it—nor any other single technology for that matter. What it will depend on is whether or not Amazon can create value for customers through low prices, great selection, and convenience. Over the next few years, we think it is far more likely for Amazon to achieve these goals through slightly less exciting—though no less impactful—methods like self checkout technology and selling more private label goods. Both changes will substantially reduce costs in the near-term, which Amazon will use to accelerate the virtuous cycle of AmazonPrime. 

Berkshire Hathaway (BRKB)

INTRODUCTION

Berkshire Hathaway is a conservatively-run, well-capitalized business, managed by one of the greatest CEOs of all time. It uses minimal leverage, operates across many recession-resilient industries, and has grown earnings 20% per year since 1999. Businesses like this rarely trade for less than 20x earnings. Berkshire Hathaway trades for 7x.

While the company is best known for being a collection of “Warren Buffett’s stock picks”, it now derives a significant—and growing—portion of its value from another source: earnings from the company’s wholly-owned subsidiaries. We argue that this latter group—whose earnings exceed those of Amazon, Google, Netflix, Tesla, Twitter, and Uber; combined—is being under-appreciated by the market.

BUSINESS HISTORY

In 1964, Warren Buffett took control of a struggling New England textile manufacturer, named Berkshire Hathaway. Its net worth was $22m at the time. Fifty years and $411b later, Berkshire Hathaway is now the fourth largest company in the US, with a reach so wide it makes money nearly every time:

  • a plane is flown
  • a car is sold
  • a house is built 
  • goods are transported to/from the West Coast
  • an iPhone is purchased
  • a lightbulb goes on in Nevada
  • someone drinks a Coke
  • a french fry is dipped in ketchup
  • and the guy at DQ does this

So how did Buffett grow a modest textile company into a sprawling conglomerate—one that now owns dozens of operating companies and a stock portfolio worth $150b?  

In the decades after taking control of Berkshire, Buffett steered the company through three major—and lucrative—shifts. He began in the late 1960s by acquiring insurance companies. Then he started using the insurance premiums generated by their operations to buy shares of publicly traded companies. Finally, in the 1990s, he began buying large businesses outright. 

Phase I: Buying Insurance Companies to Generate Float

The first step took place in 1967, when Berkshire purchased a small Nebraskan insurance company called National Indemnity for $8.6m. Buffett was drawn to characteristics unique to the insurance business: cash—in the form of premiums—is collected years before claims are paid out. In the meantime, the insurance company is free to invest it. This money is commonly referred to as “float”. Buffett explains further: 

“Float is money we hold but don't own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an ‘underwriting loss’, which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds.”

In other words: for most insurers, the combined cost of running their business and paying out claims usually exceeds the money they receive from premiums. Most insurers make up for these underwriting losses by profitably investing their float. If they just so happen to earn an underwriting profit—that is, if premiums ultimately exceed the cost of running the business plus the cost of claims—it’s simply a bonus. 

Unlike most insurers, Berkshire consistently earns an underwriting profit. So not only does Berkshire get to invest the float, but it’s effectively paid to do so! Buffett says, “That’s like your taking out a loan and having the bank pay you interest.” 

An insurer that consistently generates float and earns an underwriting profit is a great business. Still, Buffett saw more potential. Instead of investing the float in conservative and low-yielding bonds like a traditional insurance company does, Buffett took a new approach: he used the float to buy stock in other companies selling for reasonable prices.

Phase II: Using Float to Buy Partial Ownership of Other Companies (i.e., Stocks)

Throughout much of the 1970s and 1980s, Buffett used the proceeds from Berkshire’s insurance businesses to buy shares of a number of fantastic companies—such as Coca Cola, American Express, and The Washington Post—which were at the time selling for far less than their intrinsic values. By investing the borrowed money (i.e., float) that Berkshire was in effect being paid to hold, Buffett was able to lever his returns—earning Berkshire and its shareholders 20%+ per year. Even better, this leverage came from owned insurance operations rather than debt—which meant Berkshire reaped all the benefits of leverage without shouldering its traditional downside (such as interest expenses and an increase in risk).

Until the early 1990s, Berkshire Hathaway was in essence a lightly-leveraged, publicly-traded stock portfolio, managed by an unusually prudent investor. But as Berkshire grew in size, it became increasingly difficult to find opportunities in publicly traded companies that were large enough to move the needle. So Buffett changed track for the third time: he began acquiring operating businesses outright.

Phase III: Buying Full Ownership of Operating Businesses

Though Buffett did buy a few operating businesses in the 1970s and 1980s, it wasn't until the 1990s that he started doing so in earnest. Present-day Berkshire fully owns dozens of businesses, including: GEICO, Burlington Northern Santa Fe Railroad, Dairy Queen, Benjamin Moore Paints, Clayton Homes, and ACME Brick. At first, the collective net worth of these businesses was dwarfed by Berkshire’s investment portfolio. And to this day it is the investment portfolio which remains the focus for most investors. But as Buffett continued to acquire simple, stable businesses that possessed what he deemed favorable long-term competitive advantages, their total value swelled. Today, they make up half of Berkshire’s intrinsic value.

PRESENT-DAY BUSINESS OVERVIEW

I. What is the Value of Berkshire’s Investment Portfolio (and Cash & Bonds)?

Included in this half of Berkshire’s value are its cash, bonds, and 5%-15% partial ownership stakes in companies such as American Express, Kraft Heinz, Apple, Coca Cola, IBM, Bank of America, and many others. Valuing Berkshire’s investment portfolio is simple. Since “cash is cash”, and the market prices the stocks and bonds every day, one needs only to look up the price and the number of shares owned by Berkshire to get an approximation of their worth:

An investor can then apply a premium or a discount, based on whether current market prices are under or overvalued.  An argument could be made that Berkshire’s stock portfolio warrants a slight premium in light of Buffett’s investing prowess, but for simplicity’s sake we are assigning no premium, and assume the market is pricing each company correctly. 

After summing up available cash, stocks, bonds, and preferred shares—and subtracting out deferred taxes Berkshire may eventually have to pay—we get $262b worth of investments.

On a per share basis, this totals $105, or 64% of Berkshire's current $163/share price. 

II. What is the Value of Berkshire’s Operating Businesses?

The rest of Berkshire’s value comes from its operating businesses. After backing out the $105/share of investments from Berkshire’s current share price ($163), the remainder—or $58/share—is what the market believes the operating businesses are worth. 

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Since the true value of its investment portfolio is more or less determined by the market, the question of whether or not Berkshire is properly valued at $163/share comes down to this: is $58/share a fair price to pay for Berkshire’s operating businesses? Considering these companies earned $8.56/share (pre-tax) in 2016, we feel that paying $58/share for this group—or 7x earnings—is a bargain.

Let’s break this down. Berkshire’s group of wholly-owned operating businesses has grown20%/yr for nearly two decades, earning $21b ($8.56/share) in 2016. Broadly speaking, its businesses fall into one of five segments: insurance; Berkshire Hathaway Energy (BHE); Burlington Northern Santa Fe Railroad (BNSF); Manufacturing, Services, & Retailing (MSR); and Finance & Financial Products. 

1. Insurance

  • 2016 earnings: $2.1b (10 % of total)
  • Companies: GEICO, General Re, National Indemnity, etc. 

Since the purchase of National Indemnity in 1967, Berkshire’s insurance operations have become the largest and most profitable in the world. They have delivered 14 consecutive years of underwriting profits—a feat unheard of in the industry. 

Aside from unusually consistent earnings, the insurance group provides Berkshire with an even greater benefit discussed earlier: float. At year end 2016, the company’s float—money that Berkshire holds but does not own—stood at over $100b. This free financing is available to Berkshire to acquire more businesses across a range of industries.

2. Finance and Financial Products

  • 2016 earnings: $2.1b (10% of total)
  • Companies: Clayton Homes, XTRA, Marmon, CORT

This is Berkshire’s smallest group, made up of companies that specialize in mobile home manufacturing/financing, furniture rentals, and equipment leasing. 

3. Berkshire Hathaway Energy (BHE)

  • 2016 earnings: $2.7b (13% of total)
  • Companies: NV Energy, MidAmerican Energy, PacifiCorp, etc. 

Berkshire Hathaway Energy is a group of regulated utilities, renewable power sources, and gas pipelines operating in Nevada, Utah, Iowa, Oregon, Canada, and the United Kingdom. Regulators allow these monopolies to exist, in exchange for a limit on how much they can earn. Even with these limits in place, this group of companies provides predictable and recession-proof earnings, with the important added benefit of allowing Berkshire to defer billions of dollars in taxes because of their large capital expenditure needs. 

Said more simply: owning utilities is not a way to get rich; it’s a way to stay rich. And Berkshire intends on staying rich.

4. Burlington Northern Sante Fe Railroad (BNSF)

  • 2016 earnings: $5.7b (27% of total)
  • Companies: Burlington Northern Santa Fe Railroad

Railroads play a vital role within the US economy; they ship goods from point A to point B more efficiently and cheaply than all other forms of transport. And because railroads require massive amounts of capital, land, equipment, and government cooperation, these companies are virtually impossible to duplicate—making disruption by a new competitor extremely unlikely. 

The railroad industry is made up of regional duopolies, with BNSF and Union Pacific controlling the western US. While their earnings are cyclical and highly dependent on the health of the national economy, their long-term returns will almost assuredly be above average. Since acquiring BNSF in 2010 for $30b, the company has already earned a total of $24b, and is now the second largest contributor to Berkshire’s operating profit. Like the BHE group, BNSF requires large amounts of capital investment every year to maintain the infrastructure. And just like BHE, these capital outlays can be used to defer taxes at the parent-level for decades to come. Being able to “pay today’s taxes tomorrow” is another nice little form of float; one that lets Berkshire profitably—and tax-efficiently—reinvest billions of dollars back into both segments. 

5. Manufacturing, Services, and Retailing

  • 2016 earnings: $8.5b (40% of total)
  • Companies: See’s Candy, Lubrizol, Dairy Queen, Marmon, The Pampered Chef, etc. 

This segment drives the lion’s share of Berkshire’s operating earnings. It is an eclectic collection of businesses, selling everything from Dilly Bars to partial ownership of private jets. As a whole, the group earns very respectable returns on capital—with almost no use of financial leverage. Furniture, ice cream, airplane parts, and underwear may not be the most trendy businesses in the world, but they’re safe, stable, and profitable, with many earning 15%-20%/year. 

Together, these five groups earned $21b last year for Berkshire, or $8.56/share.

Are Berkshire’s Operating Businesses Being Fairly Valued by the Market? 

Back to the question: Is $58/share a fair price to pay for Berkshire’s operating businesses? 

For $58/share, investors are getting $8.56 of earnings generated by a group of stable companies that: earn solid returns on capital; have been vetted by an investor widely recognized as the greatest of all time; have grown earnings at 20%/yr since 1999; are unlikely to be disrupted by technological advances; and have long-term competitive advantages. 

A standalone company with similar characteristics would probably trade above $170/share. Yet Berkshire’s operating business group trades for only $58. Perhaps if Berkshire renamed this part of their business Berkshire Hathaway AI Biotech Cloud Data Inc., it would it start trading at a more appropriate level. To put this in perspective, let’s imagine that certain popular tech companies started trading at a similar multiple to Berkshire’s operating businesses. Google’s share price would be $245 (versus actual $823); Netflix’s would be $4.50 (versus actual $142); and Amazon’s would be $64 (versus actual $884).

So how many times earnings should an investor be willing to pay for Berkshire’s operating businesses? Each of the five groups has different economic characteristics, so one could apply specific multiples to each (for example, 10x for insurance, 12x for BHE, 15x for BNSF, 15x for MSR, and 10x for Financial Products are probably appropriate). Doing so may yield a more precise (and probably higher) assessment of Berkshire's worth. But with either approach, the message is clear: the market is undervaluing Berkshire.  

We apply a simple—and rather conservative—10x multiple to Berkshire’s group of operating businesses, which yields $85/share in value. When combined with its $105/share of stocks, bonds, and cash, this puts Berkshire’s intrinsic value at somewhere around $190/share—a 15% premium to today’s price.

Conclusion

50 years ago, Berkshire Hathaway was a struggling New England textile manufacturer. The business—which required a lot of capital, was barely profitable, and had no long-term competitive advantages—was not a good one. But Warren Buffett decided to buy it anyway, thinking the company’s assets (e.g., machines, factories, accounts receivable, etc.) were worth more than the price he could could pay for the entire business. After assuming control, business steadily deteriorated, and it became apparent the market had been right—Berkshire was a dud. 

Half a century later, Berkshire Hathaway is far from a dud. In fact, it’s probably one of the best companies in the world. While the textile business is long gone, what remains is an investment portfolio worth $105/share, and a collection steadily growing, well managed, and very profitable businesses, that together earned $8.56/share in 2016. A company like that should trade for 20x earnings. Berkshire is available for 1/3rd that.

Douglas Dynamics (PLOW)

INTRODUCTION 

I believe that Wall Street is currently offering Douglas Dynamics (PLOW) at a 30% discount to intrinsic value. 

As North America’s premier manufacturer of snow plows, de-icing equipment, and vehicle attachments, Douglas Dynamics possesses two formidable moats stemming from their ability to produce high-quality products more cheaply than their competitors, and then selling those products through an extensive network of dealers.  

Further, the company has significant advantages in the shareholder-oriented management team, a high free cash flow conversion rate, low capital spending requirements, and a largely variable cost structure. These considerations make Douglas Dynamics a company that can weather most any storm (pun intended). 

An unseasonably warm winter in Douglas Dynamics’s core markets has driven the stock down to $18.50--offering investors the opportunity to buy a great company at only 10X earnings,  a 12.5% FCF yield, and a 19% operating earnings yield! Additionally, management is dedicated to paying a significant dividend (5% current yield) under all weather conditions, without sacrificing near- or long-term liquidity. 

WHY IS IT CHEAP?

The primary factor weighing on Douglas Dynamics’s stock is the psychological tendency to overweight near-term salient factors (what Munger calls the “availability-misweighing tendency"), which in this case is the impact the warm winter will have on the company's core markets. With temperatures pushing 70 degrees on Christmas in much of the Northeast and little indication of snow, it is easy to discount a business whose prosperity presupposes wintry conditions. 

Looking at a small sample size, snowfall amounts indeed appear to be highly varied and unpredictable. But by widening the sample to Douglas's 66 core cities, we get a consistent rolling ten-year average annual snowfall of 3,100 inches. The market appears to be over-focusing on the short-term catalyst of heavy snow fall (or lack thereof), and overlooking longer-term factors, such as the high quality of the business and management's record of prudent capital allocation. 

With an estimated 600K units in use, and an average 7 - 8 year replacement cycle (at $5K - $9K each for light-duty mounted plow), Douglas Dynamics can count on a continual demand for products---even if that demand may be uneven. Because snow poses a grave and immediate threat to public safety and productivity, there will always exist a critical need to quickly remove it from roads. In short, it is not a matter of if customers will buy Douglas Dynamics products, but when. 

Despite the ill effects that a mild winter will no doubt have on Douglas Dynamics, the market has likely overreacted in the short term---presenting patient investors an attractive opportunity to buy a high-quality business trading at a 30% discount to intrinsic value. 

WHAT DOES DOUGLAS DYNAMICS DO?

Douglas Dynamics designs, manufactures, and sells snowplows, sand and salt spreaders, and complementary accessories, which they sell through an extensive network of 2,200 dealers throughout the US/Canada and an additional 40 dealers internationally. 

The main costs for the company are raw materials (e.g. steel), employees, amortization oftheir dealer network, interest expense, and from time to time, acquisitions. The operations are astonishingly light, with the current operating earnings yield at 19%! As the company is funded by both debt and equity (1.13 debt to equity ratio), interest expense weighs on margins, but the ability to quickly turn income into cash provides Douglas Dynamics with enviable capital flexibility and hard cash at the end of the year.   

Through organic growth of core products and the timely acquisitions of Blizzard, SnowEx, and Henderson, revenue has grown at a 7.7% CAGR since 2008, while profit has increased 248% over the same period. 

While Douglas Dynamics has been slowly growing their marketshare of light-duty truck mounted plows (currently 50 - 60%), their $95m acquisition of Henderson Products in 2014 will add $83m in annual sales, and provide entry into the heavy-duty truck mounted equipment market. Gross and operating margins have stayed impressively stable at 34% and 17%, which are a product of Douglas Dynamics’s aggressive employment of lean manufacturing principles, though these will come down for FY 2015 due to the Henderson acquisition.

The straightforward nature of the company’s operations are reflected in the simplicity and candor with which their financial statements are presented. It is here we can see a few key characteristics of the business essentially jump off the page, requiring further analysis and exploration.  

ADVANTAGES

For any business to be worthy of investment, it must be able to maintain certain competitive advantages over competitors for long periods of time. These advantages, regularly referred to as “moats”, are often the difference between a failed or mediocre business, and a sensational one. Therefore, an investor’s aim should be to identify businesses fortified by a significant moat, and attempt to acquire it at a reasonable price. If that business happens to require little reinvestment and/or is tended to by capable and honest management—even better—but these cases are tremendously rare. 

“I don’t want a business that’s easy for competitors. I want a business with a moat around it. I want a very valuable castle in the middle. And then I want…the Duke who’s in charge of that castle to be honest and hard working and able. And then I want a big moat around the castle, and that moat can be various things.”

- Warren Buffett

If Douglas Dynamics’s strong management team is able to continue their focus on operational efficiency while strengthening the dealer network, all with very little capital, their moats will widen and the intrinsic value of the company will continue to grow.  

1. Operations are lean and nimble

For a vertically integrate manufacturing firm, Douglas Dynamics has a surprisingly variable cost structure (15% fixed vs. 85% variable) and low capital spending requirements. Their manufacturing operations are lean and exceptionally nimble, contributing to a consistent 34% average gross margin since 2008. And with 10% - 15% of their workforce being seasonal and demand-driven, they have the added benefit of further flexibility should the weather not play out in their favor. 

The company continually optimizes their manufacturing operations, resulting in the fastest lead times in the industry (3-5days, down from 2-4 weeks in 2004), and a 61% reduction in the total number of suppliers since 2007. This ability to operate efficiently and flexibly with little overhead and low fixed costs enables the company to maintain gross (and net) margins across all environments. Impressively, the lowest that gross margins have ever dropped (during 2012, which saw the lowest snowfall in company history) was to a still-healthy 31%. It appears unlikely that a few consecutive years of light snow will put the company at operational risk or make paying the dividend a challenge. 

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By vertically integrating the selling, designing, manufacturing, and sourcing of raw materials into finished goods, the company is able to deliver high-quality products to their customers cheaper than any of their competitors. 

“To the extent my costs get further lower than the other guy, I’ve thrown a couple of sharks into the moat.”

-Warren Buffett

2) Extensive and entrenched dealer network

Perhaps the company’s greatest advantage is its extensive and entrenched dealer network, which has grown from 720 distributors in 2010 to over 1,100 today (plus an additional 570 and 125 for SnowEx and Henderson, respectively). For end-users, a major factor influencing purchase decisions is not only how easy it is to buy and install the snowplows, but how easy it is to service them. This makes the end-user’s relationship with the dealership critically important.

The ubiquity of Douglas Dynamics’s brands, coupled with the reinforcing nature of the dealership’s network effects, has historically driven stable pricing power of 2% above the inflation rate, and the reason is simple. With over 600K products in use---which are in constant need of upgrade, repair, and maintenance---dealers are incentivized to support this massive existing install base to avoid losing out on substantial revenue, providing Douglas Dynamics with compelling pricing power. If we assume a 7-year replacement cycle of Douglas Dynamics's existing install base at an average price of $6K per plow, each dealership stands to sell an additional $250,000+/yr---a substantial sum for the majority of small independent dealers! 

And to end-users, dealers are more than just point of sale locations; they also offer immediate access to post-sale service and support during mission-critical periods of snowfall. If a plow operator were to miss a storm due to a product needing service or waiting for a part, it would directly result in lost revenue for him. This results in dealers needing to keep Douglas Dynamics products in stock, strengthening the network effects, and further widening the company’s second substantial moat.

3) Low reinvestment requirements

Another advantage the company enjoys: for a design and manufacturing firm, their reinvestment requirement is surprisingly low (only 1.38% of net sales, and 26% of FCF). This enables their sustained profitability, and even more importantly, generates significant cash---to reinvest in the business, to make strategic acquisitions, and to compensate shareholders via a generous dividend. 

It is not uncommon to find a business, especially ones requiring the manufacture of heavy equipment (e.g., auto, airplane, machinery, etc.), that shows an accounting profit at the end of the year, while having very little leftover cash due to the reinvestment requirements of the business, just to maintain its current operating level.

“We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.”

- Charlie Munger

Douglas Dynamics faces no such dilemma. Since 2008, the company has generated $99.68MM in profit, and a remarkable $98.72MM in free cash flow---even accounting for acquisitions.

4) Management

With this surplus cash, management has elected to provide generous dividend payments to shareholders, reduce outstanding debt, and make strategic acquisitions. By remaining disciplined and forgoing expensive or distracting acquisitions made solely for the sake of growth, they’ve focused on maximizing shareholder return and only reinvesting in the business when value can be added. If a wise option doesn't exist, management is happy to cut a fatter dividend check to shareholders.

Management, led by CEO Jim Janik, has a history of acquiring good businesses, which fall within their circle of competence, at fair prices (e.g., Blizzard, SnowEx, & Henderson). Avoiding the common trappings of empire-building that often ensnare executives flush with cash, management has remained laser-focused on their stated goal to consistently produce high-quality products while driving shareholder value. 

Shareholders may be tempted to interpret Douglas Dynamics's high dividend payment as a sign of a lack of growth options, rather than a sign of prudent leadership that chooses only smart growth options. But taking a closer look at their record of acquisitions, it's clear that the latter is true.

OPPORTUNITIES

At first glance, the company’s growth opportunities seem limited. While an investor may expect to earn a mid-to-high-teens ROE while collecting a large dividend, there doesn’t appear to be much more the company can do other than to keep selling to their existing (and stagnant) customer base and return any excess earnings to shareholders. After all, total snowfall amounts haven't changed much in 50 years, large swaths of the population aren’t exactly rushing out to become professional snowplow operators, and despite the very real threats of global warming, snowfall patterns likely won’t change in the foreseeable future. 

The likeliest source of growth will not come from selling more plows to their existing users or praying for more than average snowfall, but from the 2014 acquisition of Henderson. The acquisition not only adds $83MM in annual sales, but will also open up new markets for the company, with growth potentially exceeding Henderson’s 11.7% 10year-CAGR due to Douglas Dynamics’s existing distribution network and continual grab for marketshare. While the demand for snowplows has a very fixed upper limit (pending drastic weather changes), Henderson’s position in the heavy-duty segment gives Douglas Dynamics access to significant new customers such as municipalities and the Department of Transportation. Though the market leader, the market is somewhat fragmented, and Henderson only has 25% marketshare, giving considerable room for expansion.  

Because government contracts are less dependent upon the total amount of snowfall than professional plow operators, the addition of Henderson will make Douglas Dynamics less reliant on snowfall amounts for overall profitability. From 2010-2014, Douglas Dynamics shipped 10% of their unit volume in Q1, 34% in Q2, 26% in Q3, and 30% in Q4. Henderson’s shipments on the other hand, are much more evenly distributed at 22%, 23%, 27%, and 29%, respectively. Even in 2012, which saw the lightest snowfall in 50 years, still saw Henderson’s revenues increase 13.5% from $59MM to $67MM (whereas revenue dropped 33% for Douglas Dynamics). 

The only thing not to like about the acquisition is that Henderson’s margins are below those of Douglas Dynamics. As a result, gross and net margins dropped from 36.9% to 33.9% and 13.2% to 10.3%, respectively, for the nine months ended September 30, 2014, compared to the nine months ended September 30, 2015. 

As Douglas Dynamics further integrates and refines Henderson’s operations, margins should improve, although it is likely they’ll remain slightly below their historical averages in the future. 

RISKS

As with any business, there are risks that prospective investors must be mindful of. A major factor in Douglas Dynamics’s cost of goods is the price of steel. Recently, steel has been very inexpensive, and accounted for around 13% of revenue each of the past two years. However, steel prices have begun to rise, and in the most recent 9 months have accounted for 18% of revenue. Further increases in steel prices will undoubtedly weigh on gross margins, and while the company has historically been able to pass along the increase in component costs to customers, there is no guarantee they will be able to do so in the future, especially if costs increase drastically. 

Additional risks are obviously weather related, even though the company has been able to effectively manage these for the past 50 years. However, if snowfall is significantly below average for longer periods of time than the company is used to (i.e. many consecutive years), both profitability and solvency could very well be tested. An acceleration of global warming could threaten the total level of snowfall across the globe—significantly impairing Douglas Dynamics’s business—however, the probability of a short or mid-term impact on results is remote.

Notwithstanding these risks, investors should feel comfortable investing in such a high-quality business given the comfortable margin of safety, which our valuation shows us we have.

VALUATION

  • Discount rate: 10%

  • Constant growth rate: 4%, (2% annual price increase + 2% annual organic growth)

  • Slight decrease in gross, operating, and net margins due to acquisition of Henderson

  • Pays out 75% of earnings as dividends (based on Douglas Dyanmics's “normalized dividends estimate” as stated in their Spring 2015 investor presentation)

The nearly identical net income and free cash flows makes valuing Douglas Dynamics a relatively straightforward exercise. There aren’t any strange accounting treatments or red flags to get tripped up on, and the fundamental principle that “the value of any business is determined by the cash inflows and outflows–discounted at an appropriate interest rate–that can be expected to occur during the remaining life of the asset” easily applies when using DCF, Dividend Discount Model, or Residual Income Models.

Using a Residual Income Model to account for the cost of equity with the above-mentioned assumptions, we get a value per share of $26.94—31% above the current price! 

This margin of safety, estimated using conservative assumptions about the future, provides investors significant protection should any seen or unforeseen risks appear. 

CONCLUSION 

Historically, demand has been driven by the level of the prior year’s snow (which result in wear and tear from heavy use), rather than the snowfall of the current year. Even if this winter does wind up resembling the winter of 2012 (lightest snowfall in 50 years), resulting in a worst-case 30% drop in revenue, Douglas Dynamics’s long-term intrinsic value will not be significantly impaired. 

Obviously snow will be the ultimate catalyst, but it’s anybody’s guess as to when it will fall and how much. All we can be certain of is that when it does fall, Douglas Dynamics, and their shareholders, will be rewarded handsomely.