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How I Made 60% and Lost 50% in Fundamentally Sound Companies

Ser Jing is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Mary Buffett’s Buffettology series of books have been a wonderful gift for students of Warren Buffett’s school of investing and in them, an often repeated theme would be a consistent trend of growing earnings as an important criteria in seeking winning investments. In the Motley Fool community, I have been exposed to many different investing styles from various posts by different members, but I have always had an appreciation for businesses that can consistently grow their sales and earnings throughout the years as potential investment targets.

I was looking through some of my own investments and noticed an interesting nugget of information regarding investments I made in 2 different companies with consistent growth in both sales and earnings prior to my purchase. The important financial numbers that I looked at as part of my decision making process is given in the table below.

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>Company 1</strong></p> </td> <td> <p><strong>Company 2</strong></p> </td> </tr> <tr> <td> <p>Purchase Date</p> </td> <td> <p>Aug-11</p> </td> <td> <p>Oct-10</p> </td> </tr> <tr> <td> <p>Trailing Twelve Months (TTM) Net Income at Purchase Date</p> </td> <td> <p>$128 million</p> </td> <td> <p>$283 million</p> </td> </tr> <tr> <td> <p>TTM Net Income 5 years ago**</p> </td> <td> <p>$57 million</p> </td> <td> <p>$53 million</p> </td> </tr> <tr> <td> <p><strong>Compounded Annual Growth Rate (CAGR) in Net Income</strong></p> </td> <td> <p><strong>17.60%</strong></p> </td> <td> <p><strong>39.80%</strong></p> </td> </tr> <tr> <td> <p>TTM Revenue at Purchase Date</p> </td> <td> <p>$1673 million</p> </td> <td> <p>$922 million</p> </td> </tr> <tr> <td> <p>TTM Revenue 5 years ago**</p> </td> <td> <p>$713 million</p> </td> <td> <p>$328 million</p> </td> </tr> <tr> <td> <p><strong>CAGR in Revenue</strong></p> </td> <td> <p><strong>18.60%</strong></p> </td> <td> <p><strong>23%</strong></p> </td> </tr> <tr> <td> <p>Total Cash on Balance Sheet at Purchase Date</p> </td> <td> <p>$230 million</p> </td> <td> <p>$941 million</p> </td> </tr> <tr> <td> <p>Total Debt on Balance Sheet at Purchase Date</p> </td> <td> <p>$24.3 million</p> </td> <td> <p>$7.45 million</p> </td> </tr> <tr> <td> <p><strong>PE at Time of Purchase</strong></p> </td> <td> <p><strong>24</strong></p> </td> <td> <p><strong>25.4</strong></p> </td> </tr> <tr> <td> <p><strong>PS at Time of Purchase</strong></p> </td> <td> <p><strong>1.8</strong></p> </td> <td> <p><strong>7.8</strong></p> </td> </tr> <tr> <td colspan="3"> <p>** Example: At time of purchase of Company 1, the latest reported financial results was for Q2 FY2011. The TTM figures for 5 years ago would thus start from Q2 FY2006.</p> </td> </tr> </tbody> </table>

Both look great don’t they? Revenue and Net Income both had CAGRs of at least 17% for both companies and were consistently on the rise. They also had extremely clean balance sheets with minimal debt. My investments were also made at very reasonable Price Earnings Ratios when compared to the CAGR of their respective Net Incomes. However, one of them has given me a 63% return so far while the other has given me a negative 53% return. Based on the numbers alone, can you tell which would be a winning investment at the date I made my purchase (no peeking below!)?

The answer should become obvious once I reveal the companies. Company 1 is Panera Bread (NASDAQ: PNRA) and it has given me a positive return of 63% in less than one and a half years. Company 2 is Dolby Laboratories (NYSE: DLB) and it has given me a negative 53% return after more than two years. Graphs of Panera and Dolby's revenue and earnings growth in the 5 years prior to my investment are shown below (Note that I have fact-checked the TTM Net Income figures with Panera and Dolby's 10-Qs and 10-Ks. There is a discrepancy between the starting figures for TTM Net Income for both companies in the graphs from Y-Charts. Disregard the numbers, but note the trends, which was my intention for using the graphs).

<img src="http://media.ycharts.com/charts/e91c30d80624a977303c6a47b6890c7d.png" />

PNRA Net Income TTM data by YCharts

<img src="http://media.ycharts.com/charts/978da5e43c8ca4a213b7ced6e1509fd2.png" />

PNRA Revenue TTM data by YCharts

I went back to my own notes at the time of my investments in them to try and see what I could improve upon in my investment process. Even though investment results do matter, I am a firm believer in the adage that it is the process that truly matters. A good investment process should produce good investment outcomes over time more often than not, after factoring in the unpredictability of life.

What I realized was that I was blinded by Dolby’s great financial numbers back then without consideration of its future prospects. In addition to the stellar Net Income and Revenue growth rates, as shown in the table above, that Dolby had posted, it also had up to 12% of its market capitalization in cold-hard cash at that point in time.

However, Dolby’s future prospects were murky – its growth hook was obscured from view. Dolby’s business mainly involves licensing the technology (in FY2010, Dolby’s licensing business made up 77% of revenues) behind the creation, distribution and playback of audio content to Original Equipment Manufacturers (OEMs) such as DVD-players and Personal Computer (PC) manufacturers. Beginning with Apple’s introduction of the iPhone in June 2007, consumption of multimedia content on mobile devices started to become more and more prevalent, replacing disc-players and PCs as the platform of choice.

The trend accelerated with the introduction of the iPad in April 2010, and now tablets are said to be able to replace PCs for casual users. Dolby was slow to push its audio technologies for inclusion in mobile devices and in their most recent earnings release, attach rates for Dolby’s technologies in smartphones stood at 15%. The trend in declining PC sales versus growing mobile device sales looks set to continue and that would mean that Dolby stands to lose out on a great source of existing revenue as PC makers start to decline – thus providing an obstacle to Dolby’s growth.

I have blogged previously (here and here) regarding my views on Dolby’s future growth plans and still think that there is a chance that Dolby can turn the situation around, but the situation bears careful monitoring and is the main reason why Dolby’s share price has dropped by 53% since I bought it in October 2010.

Panera, in contrast, had a much clearer growth hook in view. Panera had opened 1493 café-bakeries when I invested in them in August 2011 while management and analysts foresee up to 4000 restaurants domestically before Panera reaches saturation point. With Panera opening about 100-130 new café-bakeries a year, there are many more years of growth ahead for Panera, international expansion not-withstanding. History has shown Panera’s management to be adept at managing newly opened restaurants and improving current sales in existing restaurants and there is no real threat on the horizon as restaurants are not prone to paradigm shifts, unlike the technology arena where Dolby resides. One of my favorite lessons from a Motley Fool Analyst, Thomas Engle, was that “If a company, whether its retail or a restaurant, has grown in the U.S successfully for the first few years and are still in just a few states than it is easy to identify a growth hook. So, regional chains going national is one important growth hook I try to find” - his quote can be applied directly to Panera’s situation.

In conclusion, Dolby might yet turn-around, but its future is definitely murky when compared to Panera. The cleanest balance sheet coupled with the nicest historical trends in earnings and revenue would not mean a thing if the company’s growth path has been permanently snuffed out. After all, financial statements are backwards looking and even though past-performance of a company can often be reliable clues for future performance, it pays to also think hard about what the company can do to continue their success – that was the lesson I picked up from my own investing results.


serjing owns shares of Apple, Dolby Laboratories, and Panera Bread. The Motley Fool recommends Apple, Dolby Laboratories, and Panera Bread. The Motley Fool owns shares of Apple and Panera Bread. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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