Comvita — Update 15 May 2016

The results for the 12 months to 31 March 2016 are unaudited because CVT is changing its year end from 31 March to 30 June to reduce the disparity in the half year performance. Audited accounts will be released in August 2016 for the 15 months ended 30 June 2016. Management advised that the results for the 15 months ending 30 June 2016 will be similar to the results for the 12-month period ended 31 March 2016 because the June quarter is the quietest one due to seasonal factors. CVT has released a select set of unaudited data, as detailed in Exhibit 1 below.

CVT reported unaudited NPAT for the 12 months ended 31 March 2016 of NZ$17.2m, which was 1.2% above the top of the November 2015 NPAT guidance range of NZ$15-17m. FY16 NPAT was up 68% on FY15. Revenue for the 12-month results to 31 March 2016 was 2.3% below our forecasts; EBITDA was 11.7% ahead of our forecasts. Highlights of the results included:

The half-yearly comparison table shows the impact of the strategy to reduce sales in New Zealand and sell through higher-margin channels. The rate of sales growth in H216 is the same as H215, but the EBITDA margin for FY16 of 18% is 300bp more than FY15.

CVT did not release details of operating cash flow for the year. However, as set out in the following table we calculate the operating cash flow (negative) for the year as around -NZ$4.4m. The negative cash flow is due in the main to the NZ$25.9m investment in inventory. (H116 gross operating cash flow was -NZ$22.9m.)

After a period of suboptimal returns in FY15, CVT achieved a ROCE of 12%, which was in excess of its cost of capital (we estimate WACC at 10.7%). In FY16 sales growth and improved margins saw ROCE reach 15.3%. Our forecasts show continued improvement in ROCE as CVT continues to achieve strong sales growth (we are forecasting CAGR in revenue from 2016 to 2026 of 12.6% pa) and improving EBITDA margins (~20%) with a low level of sustaining capital expenditure.

ROCE history and our forecasts for expected future ROCE are set in Exhibit 4 below.

Manuka honey is a product that is supply constrained, therefore securing inventory to fulfil demand is a key sales driver. Production of Manuka honey is constrained by the plantings of Leptospermum scoparium (also referred to as tea tree), which typically grows in the drier east coasts of the North Island and the South Island of New Zealand, and in Australia in Tasmania, Victoria and New South Wales. The tea trees that produce the highest-quality Manuka honey typically grow in the wild in low-nutrient soils where there is abundant water supply. Tea trees are relatively fast growing and take about five years to maturity. Investment in tea tree plantings in Australia and New Zealand is continuing, but at this stage the rate of development is lagging demand. Production of honey, as with most agricultural products is affected by weather conditions during the crucial Christmas flowering period. Raw material inventory at 31 March 2014 was NZ$14.7m compared with raw material inventory as at 31 March 2016 of NZ$53.6m.

CVT has put in place a number of initiatives to secure the supply of Manuka honey, which is a strategic imperative for the company:

CVT believes that one of its key competitive advantages is the investment it has made in the whole value chain, from owning and developing apiaries to product development and manufacture, to distribution through both wholesale chains and its own retail stores. CVT controls the value chain from hive to shelf. It sources raw material from its own and contracted apiaries in New Zealand and its olive tree plantations in Australia, as well as partnering with long-term trusted suppliers for the supply of raw materials.

CVT’s strategic review focused on five key platforms. Progress on the strategy to date is set out below:

In our view CVT is able to increase margins through:

We have used the limited unaudited data provided for the year ended 31 March 2016 to revise our forecasts for the 15-month period to 30 June 2016 and subsequent years. The company has indicated a flat three months to complete the 15-month period to June 2016, reflecting the customary quiet June quarter. However, the strong sales and margin improvement for the 12 months ended 31 March 2016 have resulted in the following key changes to our forecasts for FY17 and FY18:

Our assumptions relating to inventory show that inventory as a percentage of cost of goods sold reduces from 66% at 30 June 2016 to 60.7% in FY17 and 60.5% in FY18. The reduction in inventory levels of raw material and finished goods reflects the competition for raw materials. For the 12 months to 31 March 2016, we have assumed inventory levels as reported for raw material of NZ$53.7m plus an estimate for work in progress and finished goods inventory of NZ$14.7m. This equates to 71.8% of cost of goods sold compared with 49.4% in FY14 and 54.8% in FY15.

In the table below the decrease in dividend of 11.1% for the year to 31 March 2016 has been impacted by the change of year end. Management announced that a final dividend will be paid for the period to 30 June 2016. Details of our forecast changes are shown in Exhibit 5 below.

CVT holds 864,880 shares (3.3%) in Derma Sciences. The financial statements at 30 September 2015 show the value of this shareholding at NZ$8.152m. At 10 May 2016, DSCI’s share price was US$3.29 (NZ$4.88 using an exchange rate of US$/NZ$1.48), a total value of NZ$4.221m, or NZ$0.106 per CVT share. The net change in fair value of available-for-sale assets was NZ$4.3m in H116, and we estimate that there will be a further downward adjustment of NZ$4.3m in H216, calculated as shown in Exhibit 6 below.

Our DCF valuation of NZ$13.08 uses a WACC of 10.7% and a terminal growth rate of 2%. The terminal value accounts for 54% of the DCF valuation.

Our previous DCF valuation was NZ$9.20. The 42% increase in our DCF is due to increased EBITDA margins and an expectation of strong growth continuing past FY20 (CAGR to 2026 of 8%) when our forecasts assume that CVT will beat its five-year revenue goal of NZ$400m by 10%.

There are three companies in our peer group:

We have included the vitamin, minerals and supplements companies because they address the same markets with a comparable product range, albeit that the peers’ product range is more extensive than CVT’s, which is largely focused around products using Manuka honey, olive leaf and fish oil. We understand that CVT plans to add more clean, green, healthy products to its range. Both Blackmores and Vitaco see Asian markets as key growth drivers. CVT has been operating in Asia for 10 years and has built both brand and distribution capability in key Asian markets.

CVT’s recent re-rating by the market and BKL’s recent share price decline mean that CVT is now trading at a premium to its peers on all earnings-based measures. In our view, the premium is justified by CVT’s superior growth rate and the expected strong growth in ROCE. Our forecasts show CVT’s ROCE increasing from 15.3% in FY16 to 26.8% in FY18. In our view, compared with BKL and CZZ where ROCE is projected to be flat, CVT is at an earlier stage of its development and investors are therefore likely to be prepared to pay more for its superior growth prospects.

CVT is trading on a FY17 price-to-growth (PEG) ratio of 0.57 compared with the peer group’s FY17 PEG of 0.80. If we apply our DCF valuation to CVT plus the value of the Derma Sciences investment, the CVT PEG ratio for FY17 becomes 0.61.