Dairy Queen Contest

This is my solution of the contest set up by WhopperInvestments blog (I published it last friday or saturday as a comment in WI blog):

Dairy Queen is a good business that apparently has some kind of competitive advantage given its profitability, margins (and the fact that WB bought it). DQ’s ROE is high but the impressing thing is that this ROE is achieved with a low quantity of debt. The proof is that ROA is around 14% and ROCE is higher tan 17%. Net margin is 8%, not bad but not outstanding. However profitability and margins are decreasing in the last 3 years and this is a data that should be looked at closely. DQ is not very cheap from some metrics like P/B and P/S: P/B (2,8) and P/S (1,16). However, a P/E of 13 for a company with a ROA of 14% and good margins seem cheap. For this kind of business I would put a P/E of 15-17.

My estimation of EV is 586 millions. I’ve tried not being influenced by WB and I would not pay anything for future growth. However, I assume that, given the quality of the firm and the close relationship between depreciation and capex, last year’s earnings are sustainable in the future and that a slow growth can compensate for a slow decrease in margins. In 1996 the firm began to run its own businesss and it wasn’t a good move for its margins. Maybe the franchise style of business is better or maybe this move can be good in the long term.

So here are my calculations. I assume that 34 millions in Net Income is sustainable and I would apply a 17 P/E multiple, given that it is a good business (and WB bought it J), That gives me a Market Cap of 585 millions. I then add 14 millions of financial debt, 6 millions of capitalized “net” operating leases and almost 1 million of minority interests. Last, I subtract 21 millions of cash (50% of cash and marketable securities). This gives me 586 millions of EV and a 26 of share price. Applying 30% of margin of safety I would buy at a price of 18 dollars. I know I am not right, because WB bought it at a higher price but I have tried not being influenced by the Oracle and maybe I am more Graham oriented, given that I do not consider myself very good in finding competitive advantages.

Maybe the business can be levered a little bit more and focused on franchising instead of own business running and this could improve margins and valuations but I prefer being more conservative.

Great exercise though. Looking forward for the next one.

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