Bye not Buy

I have owned BUB since early 2019 with a basic thesis that it was a niche player who had a strong hold on the goat’s milk/formula market, enabling make good margins at scale offering a differentiated product in the milk powder and baby supplement market, attractive particularly in Asia where goats milk addresses dairy intolerance.

Last week’s expansion in range announcement tells me my thesis is broken and goats milk isn’t going to get them to a profitable business. So, I have done a valuation to see if the fundamentals support its value beyond this thesis, and it is way short on this front also at $0.17. I would need to double sales assumptions to justify the current price.

It’s had time to deliver (Covid taken into account), so it’s time to move on and take my 40% loss. My review of the business in face of my thesis breakdown and a valuation are below and attached.

Review of business:

·       Sales Growth: solid sales growth momentum pre-covid now seems to have returned according to the company with Q1 FY22 sales up 45% QoQ and double PcP, but not yet at the previous high of $19.7m in Q3 FY20, but this was pantry stocking and followed by sharp falls. Re-routed Daigou trade and Cross Boarder E-Commerce (CBEC) are said to be the basis of the return to growth, but it will be at least a few more quarters before we know if this is true or the sales growth is just pipe fill and restocking. 

·       Gross Margins: Awful and Unreliable is my conclusion on this and a key weakness in the business model. FY21 has -16.9% Gross Margins due to a $12.6m inventory write off, even ignoring this write off Gross Margin would have been an awful 13.6%, down on FY20 margin of 22.0% (ignoring 1.6m in write offs) and FY19 margin of 21.4% (ignoring 745k in write offs). High inventory levels (see below), range changes and fickle demand is only going to lead to further write offs – it’s part of their business, which would be fine if they had a decent gross margin to absorb it. I had hoped margins would improve, but investments in manufacturing and poor inventory management give me little hope they will improve enough to make the business viable.

·       EBITDA Margins: For the last 3 years operating costs have been around $25m, to break even at a 20% Gross profit margin sales need to be $125m. Operating leverage is working against them and they are a very long way from crossing the line into operating profit. Having already burnt $190m of shareholder funds I would expect them to be a lot closer (even considering Covid) than they are to showing an ability to be profitable. A few operating cash positive quarters is no indication when they are due to inventory run downs in the quarters.

·       Inventory: I have worked in FMCG businesses where inventory turns (COGS divided by Inventory) under 3 despite shipping goods from the US or China and over 4k SKUs were unacceptable. BUB’s has inventory turns of 1.7 for FY21 and 1.4 for FY20 but did have 2.4 for FY19 and FY18. The higher the turns, the less cash tied up in inventory and the more free cash flows you can generate, it also reduces stock obsolescence and spoilage, lowering inventory write offs/downs. Either they suck at inventory management or the business model needs a lot of inventory which lowers it’s ROI and ROA.

·       Working Capital (WC): Extending on Inventory it is usually better to look at WC (Inventory + Trade Receivables – Trade Payables) to assess the assets/cash needed to run the business. On this front the WC turn (Sales divided by WC) was around 2 for the last 3 years. Which means that the business need 50c of WC for every $1 of sales, so as sales grow so does the need to hold higher levels of WC and this reduces free cash flows. Now consider they only get around a 20% gross margin then your 50c of WC generates 20c of margin dollars – then you have to pay the operating costs of the business. WC efficiency is horrible!

·       Write Offs: $15m in inventory written off in the last 3 years (11% of sales on average), $93m in goodwill impairment FY18-FY21 ($157m in sales over the same period), $20.4m in corporate transaction costs expensed in FY19 (Chemist Warehouse deal). I get they are building a business for growth but the track record on astute capital allocation is very worrying. Throw enough money at something and it will probably work – but I prefer to see good use of the money to justify more being given over.

·       Conclusion: Rapid growth and scale may improve margins and WC efficiencies, Covid has messed them up, but I suspect they are going to need a S#*T tone more capital to get there and that capital would see better returns invested elsewhere.

Valuation – $0.17 (includes 4c of cash on hand)

Lets assume the business grows well from here, which is quite possible and margins improve modestly as does WC efficiency and operating costs are controlled and more shareholder capital doesn’t go down in flames in “bad luck” investments. I will give you $0.17 a share and expect a 10% return. I would need to double my sales assumption to see the current price of $0.55 is fair value.

The valuation detail is attached, here are the key assumptions:

·       Sales: Up 75% in FY22 then trailing down exponentially as scale drags on growth rate and the re-opening boost tappers, but reaching $200m by 2030. There is upside risk if Q1 FY22 is anything to go by but also downside risk that this may be misleading and issues with China create significant headwinds for growth.

·       Margins: I assume these are 20% in FY22 and grow by 1% to 28% in FY30, performance to date and the move into more commoditised products does NOT suggest significant margin improvement is possible, but supply chain and manufacturing efficiencies could present a margin improvement opportunity as scale improves economies.

·       Opex: Flat at 25m for the last 3 years I am allowing a 5% increase each year and ignoring possible write downs because these done have a cash or valuation impact, but have considered this below for share count dilution.

·       Capex & WC: Assuming historically low capex spends continue and WC efficiency improves from 2.0 to 2.4 by 2030. If it stayed at 2.0 the valuation would drop 8%.

·       Tax: One advantage of loosing so much money is that it’s going to be a decade before they need to pay tax… silver lining.

·       Discount & Terminal Value: Sticking with a long-term market discount rate of 10%. Terminal value based on EV/EBITDA multiple of 12 which is the same as a PE of 16 and a perpetual growth rate of 2%. Again, all ballpark market long term averages.

·       Share count: I expect more dilution, so have assumed 10% increases for the next 3 years before dropping to 1% growth assuming significant acquisitions are completed by then. Note that the sales growth and margin improvements assumed rely on this additional investment.

I am taking advantage of the current positive price momentum to exit based on the valuation and broken theses of a niche player what can generate good margins and sales growth. I am sure to miss out on higher prices and hope for those who hold on that the business does much better than I expect.

Disc: No longer a holder (RL or SM)