In Part 1 of this series I told you that I was starting a series of posts where I would be taking a look at a few nano caps, compare them to each other, and at the end decide which one, if any, would be the best buy right now. The first article in this series was on BAB Systems Inc (BABB) which looked like a potentially good investment. The second article in this series is going to be on Paradise Inc (PARF).

Introduction, History, Management Discussion, and Overview of Operations

Paradise began as a subsidiary of a different diversified corporation soon after World War 2, but very soon afterward candied fruit became the focus of its business. Current ownership purchased the company in 1961 and the name Paradise Fruit Company was adopted in 1965. It later changed its name to Paradise Inc after diversifying its operations a bit in the 90s. Paradise Inc. is the leading producer of glace (candied) fruit which is a primary ingredient of fruit cakes sold to manufacturing bakers, institutional users and supermarkets for sale during the holiday seasons of Thanksgiving and Christmas. Paradise, Inc. consists of two business segments, fruit and molded plastics. As of the most recent quarter the glace fruit segment makes up about 61% of all company sales with the plastics segment making up the remaining 39% of sales.

Candied Fruit Segment Description-Production of candied fruit which is a basic fruitcake ingredient and is sold to manufacturing bakers, institutional users, and retailers for use in home baking. Also, based on market conditions, the processing of frozen strawberry products for sale to commercial and institutional users such as preservers, dairies drink manufacturers, etc. When PARF does sell these frozen strawberry products it is generally not a big part of its operations. While there is no industry-wide data available, management estimates that the Company sold approximately 80% of all candied fruits and peels consumed in the U.S. during 2011. The Company knows of two major competitors; however, it estimates that neither of these has as large a share of the market as PARF’s.

Being the dominant company in your industry for years on end, owning an estimated 80% market share of the industry, and being in a niche business that makes it likely that you will not see many, if any new competitors in its market is an absolutely exceptional thing to find in any business. This combination of characteristics is something I have been looking for in a company since I have started investing seriously and had not found it in any single company until now.

The demand for fruit cake materials is highly seasonal, with over 85% of sales in the glace fruits taking place in the months of September, October, and November. In order to meet delivery requirements during this relatively short period, PARF must acquire the fruit and process it into candied fruit and peels for an estimated 10 months before this time period just to meet demand. This means that PARF has a massive build up in inventory in the quarter before the holiday months every year, and depletes its cash hoard to pay for the inventory that is needed to make sales in the last quarter of its fiscal year. These very seasonal circumstances in the fruitcake industry makes the full year results of the company, generally which come out in March of every year, the only financial report of its fiscal year that shows how truly profitable PARF has been for the preceding trailing twelve month period.

Molded Plastic Segment Description-PARF produces plastic containers for its products and other molded plastics for sale to unaffiliated customers. The molded plastics industry is very large and diverse, and PARF’s management has no estimate of its total size. Many products produced by PARF are materials for its own use in the packaging of candied fruits for sale at the retail level. Outside sales represent approximately 85% of PARF’s total plastics production at cost, and, in terms of the overall market, are insignificant. In the plastics molding segment of business, sales to unaffiliated customers continue to strengthen. This trend began several years ago when management shifted its focus from the sale of high volume, low profit “generics” to higher technology value added custom applications.

PARF has only recently started to sell these types of packaged fruits as well which could become a bigger part of operations going forward.

Costs of goods sold have ranged between 71-75% of sales every year since 2003 and this year’s trailing twelve month COGS is coming in at 71.98%. Despite an increase in the cost of raw materials within the fruit segment and increasing cost of resins within the Plastics segment, PARF has successfully maintained control over its production labor costs during the past year. Management says that this can be traced directly to its previously disclosed decision and action to eliminate 15 full time positions, reduce executive and salary wages by 15% and 10%, respectively, and rescission of a 4% merit increase awarded to hourly workers. These actions remained in place throughout 2011 and have help reign in the cost of sales during this timeframe.

Selling, general and administrative expenses have generally taken up between 18-20% of sales over the past decade but have started to come down a bit over the decade from a high of 20.33% in 2002 to the trailing twelve month period being only 18.14%. This all leaves PARF’s trailing twelve month operating margin at 9.86% which is much improved and is its highest operating margin in the past decade. Operating margin has actually been below 5% for most of the last decade so PARF has been able to double its operating margin in recent years. It’s ROIC and ROE are a bit more volatile over the past decade but are both up over recent years and currently stand at 7.59% and 8.31% respectively over the trailing twelve month period. My estimates of ROIC are 11.29% without goodwill and 11.09% with goodwill. One thing of note and concern is that PARF’s cash conversion cycle has jumped dramatically as it stood at 160 days in its 2011 fiscal year and it now stands at 282 days in the trailing twelve month period. This is most likely the buildup in inventory for the 2011 holiday season and may only be an aberration because of the seasonality of its business but it is something that definitely bears watching when PARF’s full annual report comes out.

PARF is pretty much a family owned and operated business as out of the top five executives four of them are related. The only one who seems not to be related to anyone is the CFO and treasurer Jack M. Laskowitz. Melvin S. Gordon who owns around 37% of PARF, and who is the current CEO, Chairman, and a director of the company, has been with PARF since the 1960s in various capacities. His two sons, one daughter in law, and a cousin make up the remaining five member executive team. The group of executives has done a pretty good job over the years of managing the company and expanding its operations into the plastic industry to become more diversified which has helped the company’s sales and profitability. In total insiders own right around 41% total of PARF so outside of Mr. Melvin S. Gordon the other executives own very small percentages of the company.

As with BABB in my previous article, PARF also has excessive executive pay in my opinion. Just the five executives in the company got paid including bonuses, in 2011 $1.551 million, or about 16% of PARF’s market cap, about 6% of revenues, and about 21% of gross profit. While BABB’s executive pay is worse in relation to these benchmarks PARFs pay is still excessive in my opinion especially in relation to the company’s small size of around $10 million.

Valuations

These valuations were done by me, using my estimates and are not a recommendation to buy stock in any of the companies mentioned. Do your own homework.

Valuations were done using PARF’s 2011 10K and 2012 third quarter 10Q. All numbers are in thousands of US$, except per share information, unless otherwise noted.

Also remember that these valuations are not containing the full year’s number which generally come out in March of every year, and will show a much truer picture of how the company is operating. The company’s operations are extremely seasonal and in the most recent quarter PARF had to use up nearly its entire cash hoard to buy inventory. The cash should be at least partially replenished in the full year report and was standing near $7.8 million before they had to buy inventory.

Minimum Estimate of Value

EBIT Valuation

PARF has a trailing twelve month EBIT of 2,624.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:

5X2,624=13,120/520=$25.23 per share.

8X2,624=20,992/520=$40.47 per share.

11X2,624=28,864/520=$55.51 per share.

14X2,624=36,736/520=$70.65 per share.

I would use the 5X EBIT estimate of intrinsic value as my minimum estimate of value for PARF.

Base Estimate of Value

Assets: Book Value: Reproduction Value: Accounts Receivable 8,088 6,875 Inventories 11,664 5,832 Deferred Income Tax Asset 235 118 Prepaid Expenses & Other Current Assets 481 241 Total Current Assets 20,468 13,060 PP&E Net 4,037 2,624 Goodwill 413 0 Customer Base & Non-compete Agreement 471 236 Other Assets 233 0 Total Assets 25,622 15,920

Number of shares are 520

Reproduction Value:

15,920/520=$30.62 per share.

High Estimate of Value

EBIT Valuation

PARF has a trailing twelve month EBIT of 2,624.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:

5X2,624=13,120/520=$25.23 per share.

8X2,624=20,992/520=$40.47 per share.

11X2,624=28,864/520=$55.51 per share.

14X2,624=36,736/520=$70.65 per share.

This time I would use the 8X EBIT value of $40.47 per share and it would be my high estimate of value for PARF.

Relative Valuations

PARF’s P/E ratio is currently 6.9 with the industry average P/E standing at 16.7. If PARF was selling at the industry average P/E it would be worth $48.40 per share.

PARF’s P/B ratio is currently 0.5 with the industry average P/B standing at 1.8. If PARF was selling at the industry average P/B it would be worth $72.00 per share.

PARF’s TEV/EBIT is currently 5.02.

PARF’s EV/EBIT is currently 4.95.

Something of major note that is not included in any of the above valuations is that:

“The Company owns its plant facilities and other properties free and clear of any mortgage obligations.”

This means that PARF has some substantial hidden assets that are not fully on its books in the above valuations. I found one set of links that showed PARF’s combined land, building, equipment, and properties were valued at a total of $6.6 million.

Being conservative I will use the link here where you can search for Paradise in the search bar, which shows a more conservative set of values for the property, land, equipment, and buildings valued at an estimated $5.41 million, or $10.40 per share. This is probably a very low estimate and the combined value of the land, buildings, and equipments is most likely worth more than the $5.41 million. Discounting this amount by 40% due to where the locations are at and for the overall sake of conservatism it still brings an extra $6.24 per share to the company’s valuations above.

This means the true valuations above should be: Minimum-$31.47 per share, Base-$36.86, and High-$46.71, making the company even more undervalued.

Valuation Thoughts

By my absolute minimum estimate of value PARF is undervalued by 36%. By my base estimate of value PARF is undervalued by 46%. With my high estimate of value PARF is undervalued by 53% and is a potential double from today share price at $20 per share. Again, these valuations are not including any cash which will be at least partially replenished when the full year results come out and make PARF even more undervalued.

PARF is undervalued by every one of my estimates of intrinsic value and relative value.

PARF’s TEV/EBIT and EV/EBIT are both under 8 which is generally the threshold I like to buy under.

Again all of these valuations do not contain the full year’s results which are not out yet and will show a much truer picture of the company and its operations.

Customers Thoughts

PARF sells its products on its website, through Wal-Mart and Aqua Cal around the holiday seasons, smaller stores, some restaurants, and Amazon. Wal-Mart and Aqua Cal both make up a substantial portion of all sales so if either decided not to reorder it would affect the company’s sales, profitability, and margins.

On Amazon, like everything else that is sold on the site, customers leave reviews and generally as you can see with this link, customers seem to think very highly of Paradise’s products. After reading through all the reviews most people talked about the high quality of PARFs products, and how they couldn’t get glace fruit in their individual local stores even sometimes around the holidays, so they had to search online for them. This could also be a potential opportunity for PARF because if there is more demand for their products that isn’t being fulfilled currently that could lead to higher sales if more people knew about them.

Some of the negative comments were about how the packaging of the product was poor and came partially crushed or even broken in some cases. In a couple of extreme cases people said that their products came with ants, bug legs, and other bug parts inside of the products.

It is hard to tell whether this is PARF’s or Amazon’s fault but assuming at worst that it is PARF’s, this is a problem that they need to fix in the process of packaging the product and shipping it because as I talked about in my BABB article, customer reviews like this could lead to trouble in the future for the company if it were to continue to have these types of problems.

PARF has also made it to number 2 in the Top 20 Glace Fruit Sites. Only one or two of the companies on this list look to be direct competitors with PARF as most of the other companies have operations in a lot of other areas and only do a small amount of business in the glace fruit area.

Catalysts

PARF becoming more known to people who like making fruit cakes would heighten their sales.

Pros

PARF is the leader in its industry by far, owning an estimated 80% of all sales in the glace food market.

PARF is in a very niche industry which should keep away competitors and its dominance intact.

PARF is substantially undervalued by all accounts.

PARF’s management team has done a very good job running the company over the years.

Customers generally seem to love the product.

There could be potential for a lot more sales if more people knew about PARF’s products as a lot of the customer reviews on Amazon stated that they struggled to find any glace fruit products in their local markets, sometimes even during the holiday season, and had to resort to looking online.

PARF has nearly $500K worth of non-compete agreements signed with people to keep them from competing with PARF.

PARF’s margins are overall pretty good and I will talk about that in the conclusion article.

PARF operates on some amount of float which I will also talk about in the finale article.

To boost the company’s margins PARF cut costs and payroll in recent years which has helped strengthen its margins.

Cons

PARF’s business is very seasonal and requires a lot of lead time so if demand drops for fruitcake during the holiday season the company’s results would be highly affected.

PARF’s management and executive pay is a bit excessive in my mind.

A few customers have had some nasty problems with PARF’s products being delivered to them broken or with bug parts being in the product.

PARF is highly dependent on Wal-Mart and Aqua Cal (Sales to these two companies make up between 20 and 25% of sales in recent years) purchasing their products for sale around the holiday season so if either one didn’t reorder it would affect PARF’s results.

So far in the trailing twelve month period there has been a 120 day jump in the cash conversion cycles which is alarming. Hopefully this is just due to the lead up in having the buy inventory for sale during the holiday season and will not be a problem after full year results come out.

Conclusion

Paradise looks like a fantastic company to own right now. It is undervalued substantially and owns a conservatively estimated $5.4 million with of property and land that partially protects the downside of buying into PARF. It has dominated its market for years and continues to do so. Being in a very niche market and industry that it is dominating, it is unlikely that someone would come in and try to compete with them. PARF has generally good to very good margins and its operations are partially supported by float. The continued dominance and good to very good margins lead me to believe that the company also has at least a small moat as well or at the very least being in this extreme niche market has helped it to gain moat like qualities due to lack of competition. I will talk about margins and float in depth in the conclusion piece of this series of posts. PARF’s customers seem to love its products and since a lot of them complain that they cannot find glace fruit products in their local markets PARF might be able to capitalize on this with through more advertising and advertising to a wider audience that they sell their products online.

PARF does have some negatives as well with what is in my opinion excessive executive pay, heavy reliance on two customers, some previous problems with its packaging, and it’s very seasonal market but up to this point PARF looks like a very exceptional company to invest in as the positives far outweigh the negatives in my opinion.

Next up in this now shortened series is the conclusion.