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The Science of Hitting
The Science of Hitting
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The Importance of the 10-Q: A Practical Example

November 08, 2012 | About:

In theory, everybody reads 10-Qs and 10-Ks; in practice, I would be willing to bet that many skim one or two a year, at best. Here’s an example of why you must be vigilant as an investor if you hope to avoid being blindsided with bad news:

In December of last year, Leucadia (LUK) purchased a stake of approximately 79% in National Beef, one of the largest beef processing companies in the United States, for $868 million in cash. In the company’s 2011 letter to shareholders, they addressed the rationale for the investment (bold for emphasis):

National Beef holds a 14% share of the U.S.-fed beef market and processes more than 3.7 million head of cattle per year – that translates into 5 billion pounds of live cattle! In National Beef’s last fiscal year ended August 2011, it produced $6.8 billion of revenues and $273.4 million of operating cash flow.

“The other members of the partnership that owns National Beef are the previous owners – U.S. Premium Beef (“USPB”), NBPCo Holdings (“NBPCo”) and Tim Klein, National Beef’s CEO. USPB is an organization comprised of cattle producers and is a major supplier of high quality cattle (mostly Angus) to National Beef and retains a 15% interest. Steve Hunt, CEO of USPB, will remain on National Beef’s Board and we are grateful for his advice. NBPCo is both a customer and a supplier to National Beef and retains a 5% ownership. Tim also invested alongside Leucadia and owns about 1% of National Beef.

National Beef has five primary operating areas:

• Beef Processing - This segment consists of 3 facilities: Dodge City, Kansas, Liberal, Kansas and Brawley, California. The Dodge City and Liberal plants each have the capacity to process 6,000 head of cattle per day. They are situated in the heart of beef cattle country and are among the largest and most efficient plants in the industry. The plant in Brawley can process 2,000 head of cattle per day and is one of the newest plants in the country. It is well situated to serve the major population centers in the Southwestern U.S. and key export markets.

• Case Ready - The case ready segment further processes and packages primal cuts (think 70 lb. chunks of beef) into shelf ready products for large retail customers. Case ready products allow retailers to eliminate in-house butchers and decrease the likelihood of food-borne illness. Upon delivery case ready products are placed directly on the retailer’s shelf. National Beef operates two case ready facilities: one in Hummels Wharf, Pennsylvania and the other in Moultrie, Georgia. We believe we are at the beginning of an industry trend toward case ready and this is and will be a rare win-win-win – good for the consumers, the retailers and the owners of National Beef.

• Hide Tanning - The tannery is located in St. Joseph, Missouri and is in the process of becoming a state-of-the-art wet blue processing plant. The facility is halfway through a complete renovation and will soon have the ability to process 30,000 of our own hides per week. By the end of 2013, that production should double. The plant takes cattle hides and processes them to create high quality wet blue leather. Wet blue leather is then sold to finish leather tanneries that prepare the leather for use in products such as automotive interiors, handbags, shoes, furniture and accessories. We think this is a real growth opportunity.

• Kansas City Steak - National Beef owns 75% of the Kansas City Steak Company, with the founding family owning the other 25%. Kansas City Steak sells high quality portioned beef directly to consumers through QVC, online and via catalog sales. The company also sells directly to restaurant groups and through retail channels.

• Trucking - National Beef also owns a trucking business called National Carriers. National Carriers delivers refrigerated products for National Beef and a variety of other customers. It also transports live cattle from feed yards to National Beef processing plants. National Beef’s value-added products command premium prices and meet customer product specifications based on quality, trim, weight, size, breed and other factors. Value-added programs provide higher margins and improve customer acquisition and retention. National Beef’s unique cattle supply relationship with USPB provides a solid foundation for its value added programs.

As our faithful investors know well, we have long watched and commented on global commodity consumption patterns. We continue to believe that as citizens of historically poor countries get richer they will demand higher quality items – and more of them. We believe this thesis is applicable to global protein consumption. While protein production and consumption in the U.S. is a mature market and is not growing, global protein consumption is growing at an astounding rate. U.S. beef exports were up over 22% in 2011 vs. 2010. This is an impressive number, made even more so by the fact that the U.S. is not allowed to export beef directly to China – not yet, anyway. For a variety of reasons, the U.S. grows the highest-quality beef cattle in the world, especially of the Angus variety. People across the globe have an ever-growing desire to consume high quality U.S. beef and we will do all that we can to make that possible.

We would not have made this investment were it not for our belief that we have the best management team. Tim and his management team are widely regarded as the best operators in the industry and we have confidence that these seasoned beef executives will guide National Beef through the inevitable rough patches. In October the number of people on the globe reached 7 billion and is expanding exponentially. Humans need protein, we have it!”

When the company reported Q3 results on Wednesday, the figures for National Beef continued to look strong – year to date, the business has generated $5.6 billion in revenue and $71.3 million in pre-tax income, despite the fact that a key ratio for gauging National Beef’s profitability was the lowest in the first nine months of 2012 than it had been during any comparable period over the past ten years (USDA comprehensive boxed beef cutout to the USDA 5-area weekly average slaughter cattle price; measures the spread between the price they receive for their products and what they pay for fed cattle).

At this point, you might be interested in finishing up the segment analysis – after all, the company is simply processing beef, so there’s not too much beyond the headline financials that should be too shocking; if one were to skip the MD&A in this situation, here’s what they would have missed – two added paragraphs at the end of the segment discussion:

“National Beef has received notice from Wal-Mart (WMT) that it intends to discontinue using National Beef as a provider of its case-ready products in 2013. National Beef has two case-ready processing facilities, one of which is completely dedicated to Wal-Mart’s business and the other substantially so dedicated, with an aggregate book value of $46,562,000 at September 30, 2012. Total case-ready revenues were approximately 7% of National Beef consolidated revenues for the nine months ended September 30, 2012, but as a value-added product, case-ready products have historically constituted a higher percentage of National Beef’s gross margin. Since 2008, case-ready products have represented from 10% to 21% of National Beef’s total gross margin, and are at the higher end of that range in 2012 due, in part, to reduced gross margin from other National Beef products.

National Beef is currently pursuing replacement business for its case-ready facilities once Wal-Mart discontinues using National Beef; however, it may not be able to fully replace the operating cash flow generated by these facilities in the near future, if at all. The Company has evaluated National Beef’s tangible and intangible assets for impairment as of September 30, 2012 and has concluded that they are not impaired; its evaluation included an estimate of expected future cash flows to be generated by the case-ready facilities from prospective customers who have not, as yet, committed to purchase case-ready products from National Beef. If National Beef is unsuccessful in securing any new case-ready business, the Company does not believe it will need to record any impairment to its intangible assets or goodwill. However, if National Beef concludes its best course of action is to close one or both case-ready facilities, impairment charges may be recorded if the fair value of those facilities on a held for sale basis is less than the book value.”

I’ll be 100% honest: I’m not too sure what this means longer term. As the company noted in the annual letter, case ready is where the industry is trending, and one could have assumed from the wording that National Beef planned to piggy-back retailers (namely Wal-Mart) international expansion and be a key supplier of U.S. beef cattle to the world. Now, it appears that they growth opportunity (at least with WMT) is no longer available (although there are plenty of other ways to get product to retailers around the globe), and that the near term impact will be a mid-single digit hit to revenue and a double digit hit to gross margin. In addition, the company may need to close one – or both – of their case ready facilities, and need to take an impairment charge.

As I noted in the previous paragraph, it's not entirely clear what this means to National Beef’s operations over time; considering the praise for the management team (“We would not have made this investment were it not for our belief that we have the best management team”) and the fact that they continue to be members in the partnership that owns National Beef, there’s no knowing (from a reading of the filings and the annual letter) whether any of this was anticipated or considered likely in prior periods (local newspapers and trade publications are helpful on this: as noted in The Moultrie Observer, a daily newspaper out of Moultrie, Georgia – where one of the case ready facilities is located – a change was anticipated, the company is transitioning to other retailers, and there shouldn’t be any cutbacks or slowdowns - assuming new customers are acquired).

For the investor that simply skimmed the 10-Q (or didn’t bother to read it at all), this won’t become apparent in the financials for at least another six months; while it doesn’t appear that it will have a material impact in this particular situation, the point is this - if you are finding out about relevant business changes as they’re showing up in the quarterly financials (or even after the fact if you only take the time to study annual reports), it’s going to be quite difficult to hold an informational or analytical edge over other market participants.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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