Where Food Comes From (NASDAQ:WFCF) is a food supply chain auditor that helps companies get quality certifications. Their main business is with cattle ranchers, but they are expanding into organic products, animal care, and food manufacturing facilities.

The business is in an interesting field with good unit economics, and I think they have a good plan for growth. Its sales and profits have been growing steadily, and it has no debt. It is run by its founders and biggest shareholders.

Even though the company has a lot of interesting traits, I think it trades at too high a multiple to earnings and FCF. For the company to be worth what it is now, it needs to grow a lot. The growth path for the company is not a straight line. It has a lot of competitors, some of which are much bigger than it is, while others don’t make any money.

Note: Unless otherwise stated, all of the information came from the SEC filings that WFCF made.

Business Description

Food supply chain auditor: WFCF helps its clients get their products certified so they can sell them. These certifications include where the cattle came from and how old they are, how the vegetables were grown (organic), the FDA’s quality standards for manufacturing facilities, and the retailers’ sources. WFCF helps its clients get almost 30 different kinds of certifications in total.

Experience with cattle: The company doesn’t say how much of its income comes from each industry, but I think a big chunk of it comes from cattle ranchers.

Before it changed its name, it was called IMI Global, which is now one of its subsidiaries. Most of what this branch does is give certifications to ranchers. It also shows more employees than the other subsidiaries on its website.

Also, the people who started the company have held important jobs in the meat industry. For example, between 2015 and 2016, the company’s President and COO were also the Chairman of the U.S. Meat Export Federation.

Lastly, on the FDA’s list of Process Verified Program service providers, which is a list of verification services for cattle ranchers, IMI Global’s services are listed on a separate page instead of in a table, because the company offers so many different services.

Great economics: The economics of certification is interesting. IMI Global says, for example, that certifying the age and source of a head of cattle can cost as little as $3.5, while the premiums paid on the market can reach $10 per head. Certification costs $4.5 per head for beef that has been proven to be natural, but premiums can reach $56 per head (of course, including higher production costs).

When a part (like a certification) is important to a business but only makes up a small part of total costs, the part’s provider is usually in a good position to negotiate. The rancher won’t haggle too much over the price of the certification if it’s only 10% of the total cost but is a key part of getting 100% of the extra money. Most of the time, certification is required to get into certain markets, especially when exporting food.

The process can also be mostly automated, and it needs a small building with good operating leverage. By FY21, WFCF had 80 full-time workers who helped 15,000 clients.

A plan for growth that works: The company’s sales and profits have grown steadily, and its margins have stayed healthy.

Two things have helped the company grow.

First, it has bought ten companies for small (but not necessarily low) prices, which has helped it grow into new markets and use its structure to its advantage. Even though these businesses don’t have many assets and should have recorded intangibles, the company’s goodwill and intangibles show that it did not pay too much for them.

Second, and this is just a guess since the company doesn’t say, I think it has a low entry price to get the client to sign up so it can get the most profitable repeat business. IMI Global, for example, doesn’t charge for facility audits but does charge a recurring fee per head certified. WFCFO, a subsidiary that works with organic food certifications, is another example. On its price list for Paleo Diet certification, the company has a small price of $1,250 for registering up to 5 products, but the cost of ongoing facility audits is up for a quote. For USDA Organic certifications, the same pricing system is used.

Strong balance sheet: WFCF doesn’t owe any money and has cash reserves of $6 million. In the last two years, the company has also bought back shares, which has cut the number of shares by 5%.

Owners and founders are managers: The most important management jobs are held by the Saunders family, who started the business. John Saunders is the CEO and Chairman of the Board, and Leann Saunders, his wife, is the COO and President. According to the company’s proxy statement for FY21, they own 28.4% of the stock, and two other members of the Board own 10% each. This means that insiders own more than 50% of the company. I think that a manager-owner is the best way to run a business.

Valuation Multiples: The stock price is the biggest problem with WFCF. The company is worth $82 million on the market right now. Still, it has a net income of less than $3 million and a little more in free cash flow (FCF). This is because it amortizes acquired intangibles but has no CAPEX expenses.

This means that the multiple for earnings and FCF is more than 30x. With such a high multiple to earnings, the investor has to be sure that the company will keep growing. Operating income has grown at a CAGR of 21% for the company since FY18, but can this keep up?

How much growth? We can’t compare growth to current yields with a simple formula, but we can use some numbers as examples.

The P/E ratio of Company A is 10x because it is worth $100 million and makes $10 million in net income. Company B is also worth $100 million, but it only makes $3.3 million in net income. This gives it the same 30x P/E ratio as WFCF. Also, we think that Company B will continue to grow faster than Company A for a while (growth differential period). After that period, both companies will sell for ten times what they were making at the time.

Compared to a P/E ratio of 10, how many years of growth at what rate are behind a P/E ratio of 30x? For both investments to give the same return, Company B has to grow 10 percentage points faster than Company A for 15 years, or 20 percentage points faster than Company A for 10 years.

So, for WFCF to get the same return as a company that is selling at a P/E of 10x right now, it would have to grow 20 percentage points faster for almost ten years. That’s a very hard thing to guess.

If WFCF stock had a P/E ratio of 20x, the assumptions for growth would be less strict. That is, it would be enough if it grew 20% faster in five years or 10% faster in ten years.

But not the only one: WFCF works in the same market segment as other companies. Some are much bigger, and a lot of them don’t make money. NSF International, for example, is a non-profit organization that will bring in $123 million in 2020. SCS Global Services, which is a business, makes $40 million in sales. Lastly, giant companies like SGS make billions of dollars.

These companies don’t just certify food, but they do compete in these other areas as well. Also, there are smaller, more local competitors. For example, the list of 16 providers for the USDA Process Verification Program for cattle shows that there are sixteen smaller, more local competitors.

Also, in the cattle market, packers can run their PVP programs without the cattle being pre-certified at the source by the ranchers.

I don’t see a moat. Since WFCF does not own the certifications they offer, I don’t see how they could create a moat in this market. They only check books.

Some certifications, like USDA PVP, do have compliance requirements that could make it hard for very small competitors to join the market. WFCF has a lot of services that its rivals don’t have, but they could also catch up.

Certification is a new trend, so I think WFCF’s market is growing. Still, it will eventually reach maturity because beef production and exports grow at a slower rate than the economy. When that happens, competition will cut into margins.

Conclusion

WFCF has a lot of things I like about it: it works in a growing market with interesting customer-power traits, it has grown while keeping its profitability, it is run by its owners, and it has a strong balance sheet.

Unfortunately, the stock price of WFCF is too demanding when it comes to future growth in profits, both in terms of rates and lengths of growth. I don’t think WFCF can keep growing at that rate for so long because it has bigger competitors, some of which are not-for-profit, and it doesn’t have a moat.

Because of this, I like to wait until entry prices are more attractive before I think about WFCF.

Featured Image: Unsplash @ Artur Rutkowski

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