Yowie Group — Growing pains, but manageable

On 18 April, Yowie Group released interim financials for the third quarter of FY17, ended 31 March. Results showed that the company has largely recovered from production implementation issues that prevented it from fulfilling several orders in its December quarter. However, the second quarter issues led the company to take a more conservative approach to both its new market rollout and product line extensions in order to avoid customer fulfillment issues in the future.

The company lowered its FY17 revenue growth goal to 70%, from its previous guidance of 85-90% issued in early March. In our update note dated 24 January, we lowered our revenue growth and profitability expectations based on December quarter results; our FY17 revenue estimate of US$22.1m is in line with management’s lowered revenue outlook and we are maintaining our revenue estimate for FY17-19 (see Exhibit 1).

On 24 February, Yowie Group released full financials for the first half of FY17, ended 31 December. The report showed strong gross margins (54% vs 52% in H116) and sales, distribution and marketing expenses well within our estimates; however, administrative expenses nearly doubled to US$6.4m from US$3.4m in the year-earlier period, with the bulk of the increase coming from stock compensation expenses to directors, executives and staff. We have adjusted our FY17 admin expense estimate to more closely reflect the US$3.2m stock compensation expense in the first half of FY17. As a result, we now expect to see profitability at both EBITDA and net profit levels in FY18 instead of FY17. We are also increasing our administrative expenses for FY18-19e to include higher stock compensation expenses.

We were surprised by Wayne Loxton’s resignation from the position of executive chairman, announced on 27 February. We met with Yowie management on 7 February in New York City and Loxton discussed general plans to pull back from an active operating role in the next year; however, we believed that the timing was an FY18 announcement at the earliest. We have no reason to believe that the timing reflects the board’s opinion of Loxton’s performance as executive chairman. His departure is likely to reduce administrative overhead while leaving operations in the hands of a strong team of confectionary industry veterans.

Our primary valuation metric for Yowie is reverse DCF, since the full value of the current opportunity is likely to become apparent over a number of years rather than in near-term results. We believe that if the brand continues to prove itself, the WACC and relative risks to the story will more closely reflect a consumer goods story, albeit one with very high growth. The biggest sensitivity we see with the Yowie story is how customer demand evolves as the product is rolled out broadly to stores in the US and across the globe. While sales have increased nearly tenfold from US$2.4m in FY15 to an estimated US$22.1m in FY17, the trajectory has been somewhat choppy, consistent with the growth trajectory of many start-up companies.

So far, Yowie has proven success at the checkout stands at Walmart, but it is still early in the game. We see Yowie continuing to increase its sales in Walmart by moving to the main candy aisle and expanding into other retail outlets in both the US and other markets.

We expect the US to contribute more than 80% of revenues through FY19; however, there is further opportunity as Yowie renews its existing brand franchise in Australia, New Zealand and Asia, and extends into Europe and the Middle East. Management announced that sales began in Australia on 10 April. We expect sales in Canada to start during first quarter of FY18, slightly behind the company’s original goal of expanding into two new markets in FY17.

We believe that the real margin opportunity will be as Yowie moves beyond confectionery into entertainment (books, gaming, media and out-licensing). Merchandise and other licensing agreements would likely be structured as royalty revenues to the company, with some level of guarantee.

Licensing revenue would likely be highly profitable and drop almost entirely to the operating line, after some level of administrative costs. However, we have not built this into our earnings model for 2017-18 and we have made only a modest assumption of US$2.1m for FY19.

As Yowie is still an emerging growth story, we use a reverse DCF model to gauge long-term EBIT margins based on the current share price and our revenue growth expectations. Our 10-year reverse DCF model builds to sales of approximately US$117m by FY26. As noted above, we believe that there is a real opportunity for investors should Yowie move significantly beyond confectionery into other products and out-licensing – in essence becoming a diversified brand as opposed to a pure confectionary play. Evidence of success here would lead us to adjust our forecasts to more accurately reflect the impact of the increased license income.

We assume a terminal growth rate of 2% and use a WACC of 10.0% (reflecting 10% gearing), an equity risk premium of 5.4% and a beta of 1.2. We selected these to reflect what we view as conservative earnings forecasts, a once strong and proven children’s franchise and a business model that is not capital intensive. On this basis, our reverse DCF requires a terminal EBIT margin of 15%, a level that we regard as achievable given our forecast of a modest increase in out-licensing income over the next 10 years, to c 9% of total revenue, albeit still significantly short of management’s aspirations in this area.

Additionally, using our base case forecasts, we have explored alternative scenarios with a range of WACCs of 7-13% and terminal EBIT margins from 7-23%. This indicates the sensitivity to the terminal EBIT margin, which likely corresponds to the rate of development of licensing income over the period. At the same time, overachievement on revenue growth milestones would be associated with a decrease in perceived execution risk and hence in the WACC.

The opportunity for Yowie is significant; however, we are still at the very early stages of what management sees as a global brand across multiple product classes. In addition, apart from Walmart sales performance, we have relatively limited sales data. In our view, there remains a fair amount of uncertainty as to how revenues will trend beyond FY19, especially as confectionary sales to Walmart mature and the company becomes dependent on growth from multiple smaller retailers, new products and new geographies.

Yowie’s net sales rose 50% y-o-y to US$5.9m in its March quarter. On a sequential basis, net sales rose US$1.5m from US$4.4m in the December quarter. Sales in the US continue to outpace its Nielsen data category growth, rising 0.1 point sequentially to 1.0% in the xAOC (eXtended All Outlet Combined) market. The company shipped US$1.2m worth of product to Australia during the quarter and on its 18 April conference call indicated that a similar size order was set to ship.

Gross margins in the March quarter expanded to 56%, from 54% in the December quarter. This is somewhat above the company’s long-term target of c 50% in the confectionary business and primarily reflects improved commodity costs (the company does not hedge its commodity purchases but does buy forward) and economies of scale both in production and supplies (such as packaging).

Our model calls for revenues of US$22.1m in FY17, climbing to US$51.0m by FY19, including US$2.1m of licensing revenues, a compound average annual increase of 52%. We forecast EBITDA margins to move from -16.0% in FY17 to 20.6% by FY19. Our margin forecasts could be conservative should the company not plan to accelerate its marketing spend to 19% of product sales, from 16.8% in FY16, a level that is in line with the large confectionery companies. In addition, should the company generate licensing revenues beyond the US$2.1m we have in FY19, margins could expand further as we would expect licensing revenue to largely fall directly to the operating profit line.

At this early stage, Yowie is not operating cash flow positive. The company generated approximately US$3.3m in total operating and investing cash flows in FY16, down from US$6.9m in FY15. Our forecast calls for operating and investing cash use to decrease to approximately US$5.9m in FY17.

Yowie remains debt free, with US$29.2m of cash on the balance sheet at 31 March 2017. In FY16, Yowie raised US$23m through a private placement of 35.6m shares in addition to US$4.2m from the exercise of options. These proceeds are being used to fund working capital, the continued rollout in the US and newer ventures in publishing and entertainment. We forecast net cash of US$25.8m at 30 June 2017.