Yowie Group — Update 25 February 2016

Yowie Group is an emerging growth, brand development and marketing company. It is launching a unique and patented chocolate/toy novelty in the US market as the first step in reviving a highly successful Australian children’s brand that teaches environmental awareness and conservation through whimsical cartoon characters and stories.

In many ways, Yowie Group has achieved the Holy Grail for new consumer products. Without any real sales track record in the US, Walmart came on as a beachhead customer in 2014, based on what Walmart’s buyers see as strong potential for Yowie’s chocolate encapsulated/toy product in their stores. Due to a successful trial in 50 stores in fall 2014, followed by a preliminary roll-out to 1,500 stores in early 2015, Yowies are currently available in all 4,300 US Walmart stores.

According to the company’s press release, Yowie Group reported record sales in the December quarter. An estimated US$6.2m of retail sales value was achieved, up 29% sequentially. Consistent with ASX practices, Yowie Group does not file an income statement on a quarterly basis, so we have to infer unit sales from management’s comments and its 4C filing.

Unlike the September quarter, where there was a sizeable difference between management’s retail sales estimate and cash receipts, retail sales and cash receipts were very close in the December quarter, suggesting that the company is quickly converting orders into cash.

Management has set its sights high for the potential target market in the US, with a fairly aggressive peak sales target based on Yowie’s success in Australia in the late 1990s (where annual sales were an estimated 3.6 units per capita), as well as versus Kinder Surprise, which averages 1-2 units per capita each year in the EU. At a penetration of 2-3 units per head of population, the 320 million US market would represent a sales volume of some 750m units, around 30 times higher than our 2018 base case forecast volumes in Exhibit 1 below. Our forecast scenarios were discussed in detail in our 21 September 2015 initiation.

While management’s unit sales targets may be achievable over the long term, we believe that the real opportunity for investors will be as Yowie moves beyond confectionery into other products and 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 FY16-17 and we have a modest licensing revenue assumption of US$1m for 2018.

On 30 December, Yowie announced that it entered into a long-term manufacturing agreement for its product with Madelaine Chocolate Company in New York. In addition, it has begun to use its own FDA-approved and patent pending capsule for its Yowie confectionary. Yowie ended its manufacturing agreement with Atlantic Candy Company, along with its agreement to pay royalties to the owner of its earlier capsule design patent, Hank Whetstone.

While the announcement was unexpected, we appreciate the issues driving Yowie’s decision. The Company faced the loss of patent exclusivity on the Whetstone capsule design in 2018. In its press release, Yowie’s management notes, “Yowie has developed the new Company-owned capsule and new manufacturing agreement as part of a long term strategic plan designed to mitigate risk and optimize Yowie performance as a sustainable company and brand well equipped to compete successfully in a competitive global market”.

The Madelaine contract provides Yowie access to a fully automated plant, which is intended to provide immediately increased manufacturing capability improved efficiency and enhanced quality assurance. Management states that it expects to be able to produce c 100m units per annum, compared with an estimated 18m units that could be produced on a single line at Atlantic Candy.

Yowie manufacturing will commence from the Madelaine factory in early 2016. Yowie believes it has significant product inventory in excess of currently committed customer requirements, which the Company believes is sufficient to cover the production ramp-up at Madelaine plus contingency.

However, we believe that Yowie’s decision to prematurely end its contract with Atlantic Candy could expose it to some risk of legal action on two fronts: patent infringement on the new capsule design and contract breach. We understand that the Board is confident of its legal position and that its legal advice formed a significant part of its decision. Yowie worked with patent counsel in developing the new capsule design, and its counsel believes the new design does not infringe on Whetstone’s patent. However, according to Confectionery News Hank Whetstone has successfully defended his patent as recently as 2013, making it possible that Whetstone will consider whether he can bring suit against Yowie. On the potential breach of contract issue, Yowie’s 2015 annual report lists a minimum payment of $1.37m due to Atlantic Candy covering patent exclusivity from December 2016-2019; however, further details of the contract have not been made public.

On the flip side, its former manufacturer, Atlantic Candy, is now free to use its existing, patented capsule design for other candy manufacturers, which could create near-term competition for Yowie.

Despite these risks, our initial read on this news is largely positive, as Yowie will potentially be reducing its production costs by eliminating both its exclusivity and per unit patent royalties previously paid to Whetstone. Management has not disclosed any anticipated savings from the move; however, we believe it is reasonable to expect a portion of any savings will be reinvested back into marketing and product development.

In many ways, Yowie Group is a high-risk startup venture. It is still early to know whether consumers will consistently flock to a premium-priced, novelty candy based on little-known characters.

Foreign exchange sensitivity for ADR investors has been mitigated as the company has switched its functional currency from Australian dollars to US dollars as of this current fiscal year (1 July 2015).

Success at Walmart is crucial to our sales forecasts. Walmart not only has 4,300 outlets in the US, but it also tends to have more points of sale (POS) in each store and higher sales per POS than Yowie’s other outlets. While management will not break out sales to Walmart specifically (citing confidentiality agreements), we believe that sales from Walmart could drive more than 80% of Yowie’s total sales in the next 12-18 months.

In the past, we considered Yowie’s reliance on a single manufacturer a sensitivity because of the potential risk for supply disruption. At the same time we saw the capsule design patent exclusivity as a competitive advantage. By creating its own FDA-approved and patent-pending capsule, Yowie has mitigated the single manufacturer risks but as we discussed in the previous section, the Company may have invited legal action from its previous supplier – although Yowie’s board and legal counsel are confident in the Company’s position.

Finally, with Atlantic Candy able to sell its capsule design to other manufacturers, Yowie may now face competition in the encapsulated toy/candy space if another manufacturer chooses to use Whetstone’s design (which is patented until 2018); however, it strikes us that given Yowie’s ability to quickly design an FDA-compliant capsule, Ferrero’s Kinder Surprise absence in the US market may involve more than capsule design.

Other sensitivities for Yowie Group include commodity pricing and typical regulatory and legal issues.

Our primary valuation metric for Yowie is DCF, since the full value of the current opportunity is likely to become apparent over a number of years rather than from near-term results.

In the short term, we see the Yowie story as somewhat binary – either US customers will love the brand or they will not. As a result, we believe that if the brand proves itself in the next year, the WACC and relative risks to the story will more closely reflect a consumer goods story – albeit one with very high growth. In this context, the retail sales data over the past six months are quite encouraging.

Our 10-year reverse DCF model builds to sales of approximately US$120m by 2025. There is nothing in our forecast for roll-out to other geographies, which thus represents pure upside. We also believe that there is a real opportunity for investors should Yowie move significantly beyond confectionery into other products and licensing. 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% market 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 14%, a level that we regard as achievable given our forecast of a modest increase in licensing income over the next ten years, to c 9% of total revenue, albeit still significantly short of management’s aspirations in this area.

Yowie reported $0.9m in operating cash flow in December, its first quarter of positive operating cash flow. The company began working down its inventory in the September quarter as it worked through the initial stocking for its Walmart roll-out. Net cash at December 2015 was US$11.6m, up $3.3m from September, reflecting financing cash flows from listed and unlisted option exercises in addition to the positive operating cash flow.

We expect Yowie to ramp up production and rebuild inventory once it has completed its factory transition, so it seems reasonable to expect that operating cash flow may return to negative territory this year as the company looks to expand distribution and begins to work with retailers that may have a longer accounts payable cycle.

Management indicates there will be lower input costs associated with the move to the new factory and the use of its own capsule design. We believe that most of these lower input costs will come from the discontinuation of royalties paid to Atlantic Candy: a flat annual exclusivity fee and a variable fee based on production volume. At this point, however, we are maintaining our cost estimates until we see (1) evidence of lower manufacturing costs; (2) costs associated with the new patent; (3) any unforeseen costs associated with the new contract or transition costs; and (4) any changes in corporate spending for marketing, product development and the like as a potential use of the lower input costs. However, we are adjusting our EPADR down slightly to reflect the net effect of discontinuing royalties and the increase in ADRs outstanding from 15.5m to 17.1m.