A Post-Mortem on Armanino Foods - AMNF
A blog reader e-mailed me this weekend, asking if I had ever reflected on why I never bought Armanino Foods of Distinction. This reader (who happens to have a quality blog himself) rightly noted Armanino's many attractive characteristics. The answer is yes. I have asked myself why I never bought any Armanino. I've missed out on a nice return on what should have been a slam dunk investment. I had reasons, some good, some less so, and hopefully examining them publicly will benefit me in my future efforts.
I originally wrote about Armanino way back in 2012. Honestly, I have a tough time making myself read through posts from that far back. I've come a long way as an investor in the interim! But even then, I pointed out some qualities that made Armanino shares uniquely attractive. Chiefly, the business was astonishingly profitable. The humble purveyor of frozen pesto was producing nearly one dollar of EBIT for every dollar of capital invested, a feat that vanishingly few companies can match. This excellent capital efficiency enabled the company to grow at a rapid clip without dedicating meaningful additional capital to operations. In fact, the company had paid out more than its net income in dividends for several years running, yet managed to grow its top line at a high single-digits rate. Operating income grew even more quickly as operating leverage kicked in. Companies with excellent returns on capital and good growth rates typically and justifiably trade at lofty multiples, but Armanino traded at just 7x operating income at the time of my writing.
So, what made me hold back? Anchoring bias is probably the number one factor. The first time I ever looked at Armanino, shares were trading at between 50 and 60 cents. They were just under a dollar when I wrote. But even though everything about the company screamed "buy!", something in my mind told me that since the stock had already nearly doubled, it was no longer cheap. Let that be a reminder to us all. A stock that has doubled is not necessarily expensive. Likewise, a stock that has been cut in half is not necessarily cheap.
A second reason was my concern over the company's competitive positioning. After all, Armanino was and is extremely tiny, and sells its products into an intensely competitive industry. Hundreds of companies are jockeying constantly for shelf space in supermarkets and bulk stores. Many of these companies have annual marketing budgets that exceed Armanino's revenues. If only one or two decided to compete in frozen Italian foods and/or pesto, Armanino could see its margins get crushed in short order. However, it appears I under-estimated the reputation and loyalty that Armanino commands with its customers. Combined with the fact that Armanino's products are relatively niche items, larger operators have decided not to attempt to compete in the space, and Armanino's sales and revenues have continued their upward trend.
Finally, I was concerned that Armanino's growth would eventually put a strain on its manufacturing capabilities. Both then and now, Armanino creates its products in a single leased factory in Hayward, California. If Armanino's growth pushed the limits of that factory's capacity, I feared the company would be forced to undertake significant capex for expansion or forego pursuing additional growth. The possibility of a large deferred capex liability seemed material for a company that had been distributing over 100% of its earnings to shareholders.
So there it is, one intellectual blind spot and two reasonable concerns that perhaps could have been overcome with some deeper research and better understanding. There's nothing I can do about the missed opportunity except strive to avoid the same bias going forward, and strengthen my analytical capabilities. That's what serious investors do, try to end each day a little smarter and wiser than we were that morning.
What about now? Does Armanino offer good value today? Armanino shares trade at 11.0x trailing operating income and roughly 16x earnings net of excess cash. Free cash flow has been compressed by increased capital expenditures (there's that long-awaited expansion spending!) and an increased working capital need. But revenue growth remains healthy, and operating margins are robust, hovering around 18%. By all indications, Armanino shares are somewhat cheap, assuming that 5-10% annual revenue growth continues. Not the bargain they were in 2012, but still likely to provide nice returns for long-term holders. The company is close to paying off the last of its debt, which will free up more cash flow for investment or for returning to shareholders. And yet, I still see a few issues that I would need to understand better before considering an investment in Armanino.
First, it appears that operating margins have plateaued. Since sitting 18% in 2013, Armanino's operating margins have meandered between 18% and 19%, this after a long stretch where operating margins increased nearly every year. Has Armanino finally reached the limits of its operating leverage? Many small firms achieve remarkable increases in operating margins as their scale increases, but maturity means that future growth in earnings depends on top-line growth and not on better economizing of fixed costs.
And second, some data suggest that Armanino is finding itself competing more on price than it once did. The company very helpfully discloses both gross sales and the net amount received by the company after discounts, slotting fees, and promotional costs. Between 2006 and 2011, the net amount of sales received by Armanino averaged 87.0% and never dipped below 86.4%. But this figure has been trending downward in recent years. For the trailing twelve months, Armanino received 84.3% of gross sales. This is not necessarily a sign of trouble, though it is worth watching. Armanino could be choosing to implement a different pricing strategy, listing its products at a higher sticker cost but more frequently offering discounts and promotions. Or it could be intentionally chasing market share.
I have yet to reach a final assessment of these factors. I don't feel comfortable buying Armanino without a better understanding of what is driving each data point. Armanino is no longer trading at a single-digit multiple of earnings or EBIT, so there is less room for error if either of these factors indicates a negative business trend forming. So for now I sit on the sidelines, hoping only to learn.
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