I’m still doing some work trying to understand the railcar and coal industries, motivated largely by my feeling that RAIL represents a great opportunity. With 80% North American market share in the coal car manufacturing and with the substantial majority of the company’s business tied up in delivering to this market’s participants, it’s clearly an important item of research.

The industry is in a bit of a bubble, some say, that will burst within the next few months/years. Nonetheless, I think this may be a good time to by RAIL, since the bearishness on the industry going forward in the short-term has left the stock under-appreciated and poised to break out over the next few years, as coal has become a more long-term viable and growing business.

Things I like about the company:

- Great market share

- Working to diversify its revenue stream by offering cars catered to the needs of other buyers (not just coal transporters)

- Great returns on capital and respectable margins

- Growing institutional interest given Buffett’s recent railroad purchase and the cheapness of the stock

- Transparency of a good chunk of the next year to two year’s revenue given the nature of contracts with customers and order backlog records.

Things I don’t like:

- Cyclical business

- Product with long life-cycle, dependent upon spotty orders and infrequent repeat business for replacements

- My own uncertainty of the coal industry

Shares of PetMeds Express (PETS) plummeted today on news of a quarterly earnings shortfall. Sales were a better-than-anticipated $31.4 million, with a shift toward greater online sales (63% of revenue vs. 57% last year).

[So I don’t reinvent the wheel from here, feel free to check out my initial post on PetMeds.]

From a business perspective, I find the increase in online sales to be both good news and bad news. The bad news is simple: the market for online pet pharmaceuticals is fragmented and competitive, making targeted keywords increasingly more expensive and search engine rankings more difficult to build.

As more pet pharmacy retail operations try to steal market share, online customer acquisition costs will increase and price competition could further erode margins.

The good news is a bit counterintuitive. Allow me to explain.

What is somewhat striking about the online increase is that the company’s website traffic is down significantly from a year ago. The company has seen website traffic decline noticeably year-over-year, which is disappointing given the more than 50% increase in advertising expenses. My guess is that they are doing one or both of the following things to accomplish a sales increase in light of lower traffic:

1) Targeting their advertising better, leading to higher conversion rates from visitors.

2) Getting visitors to spend more money at the site, whether through upselling, cross-selling, a broader product offering, etc.

3) Getting customers who initially purchased via telephone to place orders on the web instead

All of these are good things (#1 and #2 for obvious reasons, and #3 due to the lower administrative expense to complete an order on the web vis-à-vis on the phone with a representative). Unfortunately, the aforementioned bad news may largely offset these benefits, and presents some looming challenges in building the PetMeds brand success. But more on that later.

Looking further into the numbers, PetMeds traffic was around 7.4 million visitors for the quarter, based on the Alexa.com statistics. With 130,000 new orders (presumably around 63%*130,000=81,900 from the web), 1.1% of the visitors were new customers. This conversion rate alone is higher than the standard retail website and probably industry averages, and given that a large chunk of traffic probably represents returning customers that need not be “acquired,” the conversion for new visitors was likely substantially higher.

So even while online acquisition costs are increasing, it appears the advertising money is being well spent.

Furthermore, investors shouldn’t lose sight of the PetMeds television marketing campaign. I believe the company is the only of its kind to do this (and maybe the only able to actually afford a national campaign), which gives it an added leg up. So while online marketing costs are increasing and competition stiffens, PetMeds has an extra edge through this media while all must suffer equally under the online sphere.

With greater financial resources, a stronger brand recognition, and successful television ads (including the new Betty White campaign), I still believe that PetMeds will come to dominate the industry and be the trusted, go-to source for pet owners. And now, with the shares having suffered what I would consider a correction, the stock may be at bargain levels (refer to my last post for more info).

This is what Joel Greenblatt would call a “Magic Formula Stock” (from his popular The Little Book that Beats the Market), which is currently in the top 30 ranks in terms of high EBIT/EV (return on capital), coupled with high EBIT/Price (earnings yield). With a PE around 6, a nil chance of bankruptcy, and solid growth over the past few years, there is no doubt the company’s numbers look attractive and a possible buying opportunity exists.

Before saying anything else on this company (and to avoid saying what’s already been said just as well if not better), I’ve found it instructive to check out Hans Wagner’s recent post, upon which I hope to build.

Leaving aside all the numbers (important though they are), this seems like an interesting opportunity for several reasons. With an estimated 87% market share for its main product and significant barriers to entry for competitors (including high customer switching costs, economies of scale, and ongoing industry consolidation), the company is not likely to go out of business anytime soon. Furthermore, the company used the proceeds from its IPO a while back to pay off substantially all of its debt, giving it a capital structure far more enticing and significantly less risky than its major competitors (of which, I add, there are only about 3 or 4). Not to mention the fact that FreightCar America’s margins are slightly more intriguing.

So what’s the problem? For me it’s simply a “too hard to understand” proposition. Not so much because I don’t understand the business per se, but because I don’t fully understand the industry and where it’s headed (at least not yet). The number of railcars delivered in any given period of year fluctuates wildly, and the company’s results will logically suffer the same fate. Due to the erratic nature of industry and, by extension, company earnings, I don’t think I can place a reasonable valuation on the business. The company’s fortunes are also highly dependent on the coal industry’s fortunes, and I am far from an expert on the coal industry.

Nonetheless, a cursory glance at the company reveals that it may relatively undervalued when stacked up against its peers. Given its solid competitive position, strong capital structure, and ability to have weathered recent cyclical downturns, it makes little sense that the company should trade at a PE less than half that of its more poorly positioned peers (including TRN, ARII, and GBX).

My conjecture is that the biggest variables affecting this discrepancy are 1) the differences among most recently reported backlogs (RAIL’s competitors have all seen backlog increase in their latest 10-Qs, while RAIL has seen a significant decrease in its backlog), and 2) concern over a cyclical downturn in the coal market, to which RAIL’s profits (but not necessarily its competitors’ profits) are inextricably linked.

The key questions for any investment or nifty long-short trade (i.e. buying RAIL and shorting an appropriate basket of its competitors) is logically 1) whether this represents an overreaction by the market and 2) what does the coal market look like going foward. Given that the company is qualitatively strong vis-a-vis its competitors, an investor who can answer these questions correctly may stand to profit handsomely.

Unfortunately, it’s not within my circle of competence to answer those questions correctly. I’d love to hear from you, though, if you can.

Land and Pineapple Co.? HUH?

That’s what I said, too, when I stumbled across the company a few months ago. Who would want to own this thing? A pineapple company? I hate pineapples.

Then I dug some more. Not surprisingly, the company’s pineapple business is mediocre at best. The company also operates another subsidiary, Kapalua Land Company, which manages the company’s scenic Kapalua Resort community. As per consolidated results, the company is generally profitable (although erratic in its earnings) and boasts AOL founder Steve Case as a large shareholder. But that’s not why I’m writing this.

It turns out the company currently owns around 27,500 acres (or 1.2 BILLION sq ft.) on the Hawaiian island of Maui. That’s alot of land. And here’s the best part: all of that land is recorded at cost between — you’ll never believe it — 1911 and 1930 (!)

Just to remind you: Hawaii wasn’t even close to being a state around that time.

So what does that mean? How much is the land worth today? Well, it doesn’t take a genius to realize that land values in Hawaii have gone up at least a little bit in the past century. Unfortunately, the vast majority (around 22,500 acres) of the land is either mountainous, preserved, or used for agriculture, so it’s not [necessarily] easily salable or, for that matter, developable (if this use of “developable” is not a word, credit me for coining it).

Nonetheless, I’d quite precisely estimate the value of the land somewhere between a little and a whole lot (how’s that for perfection?), but still far more than its cost. Investors can also take solace in the fact that the company still owns an additional 9 miles of beachfront (read: prime) real estate, several PGA toured golf courses, a happening resort community, and who knows what else.

A very good post on the company and some valuation metrics can be found here if you scroll down, so I’ll save you from the technical discussion. The author, Clyde Milton, does as good a job as any in describing the company, and I highly recommend the reading (and the whole blog, for that matter).

I first thought about looking into PetMeds when I realized my family has been loyal customers (thanks to our pooches) for years. I’ve liked PetMeds for some time now, and I owned shares from back in June of 2005 to around the same time in 2006, selling only when I thought the runup that year represented an overvaluation.

But before delving into the valuation, I’ll say a bit about what I believe to be a strong company. First and foremost, it has strong presence of mind amongst a large number of (good) pet owners. The company has marketed well to its base, continues to grow that base (e.g. they increased the number of customers by 20% over the last two fiscal years), and does a phenomenal job of retaining that base with superb customer service (helpful hint if you ever order from them: they WILL beat any competitor’s price).

Though competition seems fierce (emphasis on the “seems”) with tons of knockoffs (nextdaypets.com, medi-vet.com, petrx.com, and on and on), there is really no company nearly as successful as PetMeds in its business model. The company is actually competing mostly with veterinarians, who arguably have a built-in advantage as a face-to-face “trustworthy” source. But as more and more pet owners become acquainted with PetMeds, its customer service, and its great prices, they’re making the switch, and they’re sticking with it.

Now to the nitty-gritty. Most importantly, PetMeds is financed very conservatively (basically no debt) and earns tremendous returns on its equity base. It is not a capital intensive business by any stretch of the imagination, and for a retailing operation, its margins are above-average. Notably, its competitors have yet to diminish the returns that PetMeds is earning, and the company’s management has been successful in employing the incremental capital at these high returns. PETS has lots of free, and growing, cashflow.

Assuming a 12% cost of capital (probably conservative) and a 10 year growth rate of 13% followed by continuing returns of 5% (certainly feasible, and I argue likely), a quick DCF analysis gives a value for the company of $365 million. Currently trading at a market cap of $317 million, this doesn’t represent a huge margin of safety, but its a reasonable figure and gives us plenty of reason to put it on the watch list in case the stock falls a bit in price.

In the end, though, the margin of safety will probably be the strength of the company and its ability to construct Warren Buffett’s famous “moat” around its business. It has done well to that end to date, and if it continues, we have ourselves a bargain.

Note: The author does not currently hold a position in any stocks mentioned in this article.

I’ve been following some smaller cap, but brand name, footwear companies for the past several years. Two particularly come to mind as well-financed, well-managed, simple and understandable enterprises that have been earning significant returns on capital. Both Timberland (TBL) and K-Swiss (KSWS) have had spectacular performances over the past ten years, and at their current prices (and especially their 6-12 month prior prices) are (were) enticing purchases.

Timberland enjoys a recognizable brand name and a dominant franchise with its boot. It’s US sales have been slowing, but business abroad is steadily growing, as Timberland penetrates foreign markets. The company is run by the Schwartz family, which holds a huge stake in the company. To me, this is a positive sign, as their management of the company has been superb and they’ve been earning high returns on incremental capital. There has been a bit of pressure on margins, but the financial position and brand wherewithal of the company makes that a small concern.

Timberland is also a big buyer of its own shares, and steadily invests in itself so long-term shareholders benefit from their profitable growth. Furthermore, the company has been mulling a sale, which I believe would (read: should) command a pricetag of around $40-45 per share.

K-Swiss, while not as dominant a brand, is top-notch in its financial performance. Like Timberland, the company earns high returns on its capital and employs no debt, and benefits from the same high margin sales as many of its peers (unfortunately, the high margins do not seem to be unique to either TBL or KSWS).

Here’s a small table of these key financial metrics as compared to competition (which is not too shabby itself).

TBL:

5 yr. ROE: 30.2%
5 yr. NPM: 9.3%

KSWS:

5 yr. ROE: 29.5%
5 yr. NPM: 15.6%

Industry:

5 yr. ROE: 26.5%
5 yr. NPM: 10.8%

Neither company will likely benefit from any sort of tremendous growth, but their steady construction of what Warren Buffett would call an economic “moat” is becoming evident. While neither company trades at huge discounts to their intrinsic value, they appear undervalued by a conservative discounted cash flow analysis, even assuming low growth rates and an overly cautious discount rate.