The Business (And Stock) Behind Where Food Comes From

China began importing US beef for the first time in almost 14 years on July 16. The catch? The beef has to be source verified i.e. traceable to the farm where it was raised. Enter Where Food Comes From (OTCMKTS: WFCF) which specializes in auditing and verifying beef, poultry and other meats for source verified, organic, non-GMO, and other labels. Travis Wiedower, founder of Wiedower Capital in Austin,  has had a position in WFCF since the beginning of the year, and sees future growth given the company's regulatory and auditor network moats.

Luke Schiefelbein, SumZero: What about Where Food Comes From initially caught your attention as a value investor?

Travis Wiedower: Where Food Comes From checks several of my favorite investment boxes: small, founder-led, high insider ownership, zero debt, profitable, and growing. I love industries that have long runways of growth ahead of them. Where Food Comes From benefits from several major trends in food—organic, non-GMO, gluten-free, animal welfare, and more generally, consumers demanding transparency in the food chain and wanting to know where the food they eat comes from. I like large industry tailwinds because it makes business much easier. In a fast growing market, competitors are less likely to engage in price wars or other detrimental practices. This is because most participants are growing revenue, even if they’re losing market share. Growth is harder to come by in mature markets so there’s more likely to be competitive practices that are harmful to all participants.

Schiefelbein: What is the market missing and why?

Wiedower: The most common pushback I get is on how scalable this business model is. A lot of bears think Where Food Comes From will not be able to expand operating margins (and thus net margins) as they grow. The argument is that net margins have been in the low single digits the past several years and because they have to keep adding auditors as they expand, revenue can’t grow much faster than expenses. My opinion is that this business will scale very well as it matures. One thing a lot of people miss (because it’s not mentioned in the SEC filings) is that most of their auditors are part-time employees whose per-audit payment goes into cost of goods sold. Therefore, operating expenses should scale better than a lot of people realize. So if that’s true, why haven’t net margins gone anywhere the past several years?

The biggest reason is they’ve made seven acquisitions since 2012 so the financials are muddied quite a bit. I generally don’t like acquisitive companies, but their acquisitions have a lot of cross-selling opportunities. They generally buy companies that work with different types of food producers who may want some of the other audits that Where Food Comes From offers (like non-GMO, organic, gluten-free, etc). Where Food Comes From also helps these new customers get distribution into places like Whole Foods. So the acquisitions will continue to hurt current financials, but the logic behind them makes sense.

Also, they’re adding infrastructure to handle significantly more business down the line. They just moved into a new office that can handle many more employees than they currently have, so that extra rent will hurt margins in the meantime. John Saunders, the CEO, has said their current business could handle 2-3x as much organic growth without adding significant infrastructure.

Looking at past and current financials doesn’t really determine if a company will benefit from scale in the future—that requires thinking about the business and how it may evolve in the future. I think a 10% free cash flow margin is reasonable for a company with a monopoly or near monopoly in the majority of its business. 10% won’t be reached for many years away though, once the industry is more mature and growth investments slow down.

Schiefelbein: Is Where Food Comes From still attractive to buy at today’s prices? What kind of future growth do current valuations imply?

Wiedower: I think so. They have the characteristics to potentially be a long-term compounder (passionate and capable founder who is still relatively young, strong competitive position, long runway for growth, fantastic balance sheet) so I don’t plan on selling for many years.

The stock is currently valued at over 100x earnings so the market is no doubt implying a lot of future growth, but surprisingly it’s still very possible to come up with scenarios where the market is undervaluing it. I believe the broad industry that they’re in (auditing food producers) will eventually be at least a several hundred million dollar industry and their strong competitive position will allow them to continue to capture a meaningful portion of that. They’ll do under $15 million in revenue this year, so if they get $100+ million of the eventual mature market at a 10% free cash flow margin, the business will be worth multiples of what it is now.

Schiefelbein: There is currently little or no scientific proof that GMOs are harmful to either consumers or the environment. Since much of WFCF's revenue comes from the Non-GMO Project, do you see a correction in the perception of GMOs as a risk?

Wiedower: It’s a valid bearish argument. When I first looked at Where Food Comes From that was a major concern of mine, but it’s not as much anymore. The main reason why is I don’t see any signs that the demand for non-GMO is slowing down. Look at how much growth there has been in the organic/non-GMO/healthy sections of grocery stores—in my local stores those sections have grown enormously over the past five years. In 2013, Whole Foods carried 3,300 non-GMO products in their stores. In 2016, that number had grown to 13,500 and by 2018 their goal is to have a label on every single product indicating whether it contains genetically modified organisms. Last year, Vermont became the first state to pass standards for GMO labeling on food products (this is still being phased in) and quite a few other states have GMO bills in various stages of legislature as well. Finally, even though non-GMO has been Where Food Comes From’s largest growth segment as of late, it’s still less than 10% of revenue. So non-GMO’s popularity declining isn’t a risk to the company’s survival or anything like that. And even if sentiment does change, it’ll be a slow process—Whole Foods can’t unlabel nearly every product they sell overnight. Of course I would prefer if there was a bunch of scientific evidence supporting the non-GMO movement, but from everything I’ve seen the movement doesn’t seem to care. 

Schiefelbein: Could the current administration’s interference in trade and anti-regulatory attitude have a negative impact on Where Food Comes From?

Wiedower: US regulation is meaningful to their business so it’s certainly possible, but I'd say consumer demand and even foreign government regulations (with their own import requirements) are even more important. The most notable US regulation currently underway is the USDA requiring more cattle tracking, which benefits Where Food Comes From immensely. That regulation, Animal Disease Traceability, is already several years into phase one so I doubt that’s going to reverse. Everyone in the industry I’ve talked to thinks Animal Disease Traceability will continue to expand for many years.

Surprisingly, the current administration has had a positive impact on Where Food Comes From so far, mainly with China negotiations. China is just now starting to import US beef for the first time since 2003. Chinese imports of non-US beef have exploded the past several years and the demand for US beef seems to be very large. As they ramp up US beef imports, it could add several million dollars to Where Food Comes From’s business. This is because exported beef (whether to Europe or China) requires certain inspections that Where Food Comes From does.

Schiefelbein: What key metrics should investors be paying attention to as your thesis matures?

Wiedower: Operating leverage (how well the business scales) is a big one, as we talked about, but I don’t expect that to really start kicking in for a few more years because they’re still acquiring companies to improve their competitive positioning.

Beyond that the biggest demand for their services is from consumers and the major players in the food industry. These large companies include producers (Tyson, Cargill, JBS-Swift), supermarket giants (Wal-Mart, Costco), and fast food hamburger joints (McDonald’s, Burger King, Wendy’s). When one of these companies demands something from the hundreds or thousands of farmers that supply them, those farmers listen. McDonald’s has already proven this when they did a beef sustainability pilot program requiring all of their Canadian beef suppliers to get verified by Where Food Comes From. Earlier this year, McDonald’s announced that a portion of their US beef will be from sustainable producers by 2020. Tyson, Cargill, Wendy’s, and many others have also discussed verification and sustainability projects—all because their customers are demanding it. A lot of future demand for Where Food Comes From’s services will come from these industry giants requiring it. Thus, it’s important to watch for meaningful announcements from those companies. Tracking the progress of Animal Disease Traceability is something else I’m always keeping an eye on.What were the biggest risks associated with the trade in your view?

I have a hard time killing this company. No technology is going to get rid of the need for their services. Even if there is a new way to audit and tag cattle, a third party physical person still has to go to the farm and perform that audit.

The only potential major risk I see is lab grown (“cultured”) meat. In my mind, it seems plausible that growing meat in a lab via stem cells could someday replicate the real thing. The good news is that no one is close to having a cultured meat product ready for commercial sales. Memphis Meats is one of the leaders in this space and their goal is to have a commercial product by 2021, so this is just something to keep an eye on for now. It also makes me feel better that the demand for increased auditing of food producers is in the early innings. Where Food Comes From has a low single digit percent of their overall target market, so even if demand for cattle and chickens decreases, the investment can work out just fine. In my opinion, there’s no going back on a lot of these trends (revolving around increased transparency in the food chain) so as long as traditional food production remains, consumers will want third party verifiers.

It also makes me feel better that Where Food Comes From is expanding into tangential food production markets so by the time something like cultured meat is a possibility, they won’t be as dependent on the livestock market as they are now. Eggs, grains, produce, dairy, almonds, wineries, and beekeepers are a few of the other areas they’ve expanded into.

Schiefelbein: If the market for organic and source verified meat grows, what prevents larger companies from getting into the business and scooping up revenue? It seems like the Pfizers of the world, with large existing networks of reps and experience with obtaining regulatory approval could easily oust WFCF if the money is there.

Wiedower: I suspect the ultimate market will be big enough for multiple companies to succeed, but I do think Where Food Comes From is favored to be the market leader for a few main reasons (in addition to just being the first mover which I do think matters in this market).

At the very least there are soft barriers to entry that will delay a competitor from ramping up. John Saunders made a comment on one call that even if Bill Gates wanted to compete with them, it would take Gates two years to do his first audit because of the regulatory approval process. Next, if he wanted to do non-GMO verifications, he’d have to get approval from the Non-GMO Project which takes over two years to get (and they’ve only approved four auditors ever). So I do expect more competitors, but it’s not as easy as “Widget A is selling like hotcakes! Let’s manufacture Widget Very-Similar-To-A and have it on shelves in a few months.” Some of these verifications seem pretty easy to get involved with (the National Organic Program works with a lot of companies), but others are far more selective and can take years to get approval. Two of the biggest sources of revenue for Where Food Comes From are the Non-GMO Project and the Global Animal Partnership (which does animal welfare). The Non-GMO Project only works with four companies for their audits and the Global Animal Partnership only works with two. So it would take quite a few years and would be very difficult to truly compete with the scale of audits they can do. They can offer farmers a very wide range of services, some of which are very selective and require years to get approved for.

There’s also not much room for disruption. Even if there is a better way to track or tag cattle, like I said before, a person still has to physically go to the farm and audit those operations. So it’s not like some companies or industries that are more susceptible to new entrants coming in by disrupting the technology.

Finally, their services are relatively cheap, ranging from a couple hundred to a couple thousand dollars, call it a $1,000 average. Their service gross margins are 50%. If a new entrant into the market can somehow sustain half as much margin to undercut them, are farmers going to switch to save $250 a year on something that’s important to their business? Maybe if they’re a small farmer, but those with thousands of cattle aren’t going to be affected by a few hundred dollars.

Schiefelbein: In the source verification business, WFCF currently only tracks cattle from ranch to slaughterhouse, but no further. Do you think the company can effect industry adoption of systems to truly track every steak and hamburger back to the ranch that produced it?

Wiedower: They’ve been trying to break into this with their Where Food Comes From labeling program, but it’s been a slow process (still only 1% of revenue). The idea here is that when you pick up a package of beef at your local grocery store and it has a Where Food Comes From label on it, you find comfort knowing that beef has been source verified by a third party. You can also scan the label with your cell phone and see exactly what farm that beef came from. How labeling becomes more viable in the future is that Where Food Comes From will audit more and more cattle farmers as part of their core verification business. Eventually, it becomes much easier for grocery stores to add labeling because some (or all) of their beef suppliers will already be verified by Where Food Comes From. Right now it’s a two year process for a grocery store to add labeling because they have to force all their suppliers into getting audits.

They’re also thinking about this in terms of software. One of the main reasons they purchased SureHarvest last December was for their software. SureHarvest has SaaS solutions that help their clients track everything on the farm (track inputs, measure yield, manage payroll, etc). Saunders thinks this software could be useful to their more traditional beef and chicken business as well.