Yowie Group — Regrouping and reprioritising, or a new path?

Yowie has met with a number of challenges in the past 24 months: several management restructurings, an unexpected change in distributors at its largest customer (which created some volatility in order timing/size versus plan), supply chain upgrades, formalizing internal financial and operational controls and processes, two hurricanes and a prolonged legal battle with its original contract manufacturer. These challenges have taken their toll on shareholder patience and Yowie’s share price.

In our September update note, we cautioned that Yowie’s largely Australian retail shareholder base might be overly sensitive to its short-term sales trajectory, because those investors have been waiting for the Yowie brand to have the same impact in the US as it did in Australia in the 1990s. However, we also believed that the US$1.25/ADR in net cash would more than support the US$1.68/ADR price at the time. However, since September, the ADR price has dropped an additional 57% and now trades at a c 30% discount to net cash.

Following the December results, Yowie’s chairman, Louis Carroll, cut sales guidance for FY18, announced a cost-cutting program targeting Yowie’s marketing and administrative spend, and the promotion of global COO, Mark Schuessler, to the position of CEO. The former CEO and two long-time board members resigned shortly thereafter. The company has yet to articulate whether it will change strategy with less aggressive sales growth and lower marketing spend beyond FY18, leaving some uncertainty on the outlook for the Yowie franchise in terms of geographic and product line growth.

Yowie’s quarterly performance issues are not particularly unusual for an emerging confectionary brand, although it is unusual for a food company with such modest (c US$20m) product sales to be publicly traded. More traditionally, start-up food companies are privately held (with/without venture capital) before completing an initial public offering. As a result, Yowie’s investors are exposed to early-stage trading volatility.

We are reducing our FY18 revenue estimate to US$18.0m (-41%), including a US$1.95m downward previous period sales adjustment. Our reduction reflects disappointing sales in the December quarter stemming from a poorly executed end-cap promotion at Walmart and the slow uptake of Yowie’s lower-priced Discovery World product. December’s stumble aside, Yowie has improved internal controls, formalized planning and execution standards, as well as taking a more measured approach to communicating goals to the investor community. We believe these changes should begin to have a measurable impact on both results and investor perception over the next six to 12 months.

At its core, Yowie has many positive investment features. Sales rose from US$2.4m at the end of FY15 to nearly US$20m in two years, with no brand recognition and limited promotion in the US. The company has healthy gross margins of c 50%, administrative expenses that will benefit from increased economies of scale and current US$1.05 net cash/ADR exceeding its US$0.73/ADR price. However, as we have seen over the past two years, small setbacks in sales timing or expenses can have a large impact on reported results and investor sentiment. It will take consistent forecast delivery to regain investor trust and hence valuation upside. Our valuation assumes that Yowie uses the remainder of FY18 as a transition to reset expectations, before reaccelerating its brand investment and sales expansion. Using our new estimates for FY18-19, our target value of US$1.78/ADR is based on a 10% WACC, a four-year sales CAGR of 15% through FY20, tapering to 2%, and an undemanding EBIT margin of 8%.

Yowie’s net sales in the first half of FY18 fell 16% to US$8m over the prior year period. Net sales include a downward prior period sales adjustment of US$1.95m. The company attributes the delayed roll-out of Series 3, disappointing early adoption of its lower-priced Discovery World line, a decline in chocolate sales in the novelty confectionary statement and pressures from newly introduced competitive products. Product gross margins for the first half (excluding the sales adjustment) improved by 80bp to 54.7%, from 53.9% in FY17. This is 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 in both production and supplies (such as packaging). Including the prior period sales adjustment, product gross margins fell to 43.6%.

We estimate revenues of US$18.0m in FY18, climbing to US$30.6m by FY20, including US$0.6m of licensing revenues, a three-year compound average annual increase of 25%. We lowered our licensing forecast from US$2.1m to US$0.6m to reflect management’s focus on the core confectionary products and a more modest timeline for developing the characters so they are well positioned for licensing opportunities.

For FY18, our gross margin estimate (as reported) is 54.8%, compared with our previous estimate of 50.0% and based on the 50bp increase reported in H118, and reflects increased emphasis on sales outside Yowie’s key customer (where distribution expenses are absorbed by the customer in exchange for a slightly lower net price). We look for sales and distribution expenses to be largely unchanged in H218 compared with H118, totaling c US$3.8m for the full year.

The most significant change is marketing expense. Management is guiding to marketing expense in H218 to be 50% lower than in H118 – or approximately US$3.7m compared with our previous estimate of US$5.3m. We now forecast administrative expense for the year (as reported) of US$5.8m, down from our previous estimate of US$7.7m.

We forecast EBITDA margins to move from -16.9% in FY18 to 14.0% by FY20, primarily through savings in marketing spend and better economies in administrative expense. The company has had litigation and product development expenses (related to moving production from Whetstone to Madelaine in January 2016, and the creation and patent of the new capsule), which will continue into FY18 as Whetstone continues to challenge unfavorable decisions on its production contract with Yowie, along with professional expenses to set up transfer pricing/intercompany arrangements and ASX filing costs. As a start-up, Yowie is required to file quarterly financials, compared with semi-annually for established companies. Share-based expense was a credit of US$0.8m in the first half of FY18, compared with a debit of US$3.2m in the prior year period. The drop in share-based expense stems from unvested share-based compensation.

At this early stage, Yowie is not operating cash flow positive. The company used US$4.3m in operating and investing cash in the first half of FY18, compared with US$2.6m in the prior year period. The additional cash used in the first half of FY18 reflects the prior period sales adjustment plus investment in intangible assets.

Yowie remains debt free, with US$22.7m of cash on the balance sheet at 31 December 2017. Trade accounts payable and accruals increased to US$4.0m from US$2.7m in the prior year period, reflecting the prior period sales adjustment. The adjustment will be expensed over the upcoming 12 months.