Yowie Group — Update 12 December 2016

Yowie is a confectionary/toy combination, similar to a Kinder Surprise egg. Yowies are based on animal characters linked to the natural world and were the basis of a successful children’s brand of confectionary and other products in Australasia from 1997-2005. With very limited competition in the US (where Kinder Surprise cannot be legally sold), the Yowie product takes confectionary branding to the next step with online opportunities for learning, collecting and games through the Yowie website. The company is in the early stages of moving the Yowie brand into publishing and entertainment with the ultimate goal of building Yowie into a global consumer brand.

It remains early to discern long-term trends but management has delivered consistent growth to date. In FY16, Yowie raised US$23m through a private placement and US$4.2m from option exercise. Higher investment spending in new ventures and increased shares have led us to trim our near-term expectations. We now forecast revenue of US$25.2m in FY17, against our previous US$33.5m, with pre-tax profit of US$3.2m and EPADR of US$0.15. By FY18 we look for EPADR of US$0.43.

The shares have fallen 53% since our initiation in September 2015. We attribute this to the impact of increased investment spend and additional shares. We value the ADR primarily using DCF techniques. Our projections see rapid top-line growth peaking in FY19 and slowing thereafter. A reverse DCF at the current price of US$4.4 with a WACC of 10% implies compound average revenue growth of 50% from FY17-19, fading to a terminal 2%, and requires a 21% terminal EBIT margin. Our forecasts are based purely on the US roll-out with modest licensing (c 9% of terminal DCF sales). We estimate each incremental US dollar of licensing revenue may add c US$0.04/ADR in after-tax profit. Therefore, we believe there is an incremental opportunity as Yowie demonstrates it can move beyond confectionary into licensing, and expanding the brand outside the US.

Yowie is still an early-stage venture whose growth trajectory entails risk, and it is still too early to know the eventual scale of the brand, both in the US and globally. However, the company has executed according to plan and is consistently exploring opportunities. We see the main sensitivities as:

Yowie Group (Yowie) is an emerging growth, brand development and marketing company. In 2015 it began the large-scale roll-out of a unique and patented chocolate/toy novelty to 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.

Without any real sales track record in the US, Walmart came on as a beachhead customer in 2014, based on what its buyers see as strong potential for Yowie’s chocolate encapsulated/toy product in its stores. Following a successful trial in 50 stores in fall 2014, followed by a preliminary roll-out to 1,500 stores in early 2015, Yowies have been available in all 4,500 US Walmart stores since late 2015. The brand has continued to perform well at Walmart and is expanding the number of points of sale for Yowies within Walmart stores. In particular, Walmart is seeking to add Yowies into the main candy aisles in multi-packs to supplement the single unit sales at the checkout stand and in other displays throughout Walmart stores.

Management’s strategy is to continue to develop its penetration of the North American market while expanding into new markets beyond the US, and growing revenues through licensing opportunities in confectionary and also entertainment and media.

Yowies were introduced in Australia in the late 1990s and became a successful children’s brand, encompassing chocolate/toy novelties, books, stuffed animals, apparel and other products. Yowies are fantasy characters based on indigenous Australian animals that act as ‘guardians of the natural world’ and teach children about endangered species, conservation and the environment.

In 1997, Yowie’s creator, Geoffrey Pike, worked with confectionery company Cadbury to design and launch a chocolate/toy novelty based on the Yowie characters. The collaboration became one of Cadbury’s strongest product launches globally, selling approximately 65 million units in Australia in its first 12 months.

Over time, Cadbury began selling Yowies across Asia and in the UK.

In 2005, Cadbury discontinued the Yowie product line after it was unable to secure the right to sell Yowie’s products in more countries. In 2010, Cadbury was acquired by Kraft Foods and then spun-off with other brands into Kraft’s new entity, Mondelez.

Under the Mondelez umbrella, the Yowie line continued to lie dormant. As Mondelez rationalized its portfolio, it opened up the opportunity for the Yowie brand to be revitalized under new ownership.

A new company was formed to attempt to revitalize the Yowie. YOW and Kidcorp (owner of the worldwide Yowie franchise) acquired the confectionery rights back from Mondelez. Kidcorp became capital constrained, ultimately enabling Yowie to buy the global license.

Yowie’s management opted to focus the brand relaunch initially in the US. The US is one of the largest markets in terms of potential sales, and it is the only market where Yowie’s chocolate/toy novelty could have several years without direct competition because of a 1938 regulation, the Food, Drug, and Cosmetic Act, banning the sale, on safety grounds, of confections containing toys. This long-standing regulation has kept Ferrero’s Kinder Surprise, the world’s best-selling chocolate/toy combination, out of the US, thus creating an opportunity for a company that could find a way to work within the law.

Ferrero introduced its Kinder Surprise eggs in 1974. Kinder Surprise is an egg-shaped chocolate shell around a small toy that sells for US$1.50-1.75. Kinder Surprise has been the gold standard in novelty candy for many years, and Yowie management estimates that worldwide sales are c 2bn units annually. Despite its success, Kinder Surprise cannot be sold in the US as authorities have consistently ruled that the design presents a potential choking hazard.

Initially, Yowie Group paid for an exclusive license to use a patented chocolate/capsule design that is approved for sale in the US from Hank Whetstone of Atlantic Candy Company. Mr Whetstone’s patented capsule has a lip that shows through the chocolate and the chocolate halves fall away from the capsule when it is unwrapped. This differs from the Kinder Surprise design where the capsule is completely enclosed by the chocolate.

Yowie’s initial launch plans in 2012-13 were delayed by logistic and management issues. In March 2013, Wayne Loxton, a Yowie investor and former mining executive, took over the CEO role. He moved quickly to assemble a new team, renegotiate uneconomic contracts and push the process forward. By June 2014, the company had its first US order followed by its first large customer, Valero Corner Store, a 1,100-unit US chain in July.

In September 2014, Yowie began testing in 50 Walmart stores, and the company rolled into all 4,500 Walmart stores in late fall 2015. Yowies are now available in an estimated 60,000 accounts/ groupings in the US including Safeway grocery (1,300 stores), Walgreens (c 7,000 stores) and in smaller retailers through an agreement with Eby-Brown, the largest privately owned tobacco, candy and convenience distributor in the US, and in McLane’s virtual retail trade show offerings, which reaches an additional 20,000 convenience, military and travel stores. However, as many retailers order through distributors or are grouped into geographic divisions, store count is not a direct proxy for retail expansion progress.

While Yowie does not give explicit sales or volume goals, for FY17, the company is focused on expanding into the main candy aisle at Walmart (which it will do with new packaging containing three Yowies). Individually sold Yowies continue to sell for US$2.48 at Walmart with wholesale prices remaining steady at c US$1.60 (excluding discounts to McLane, Walmart’s distributor, to handle distribution and warehousing costs). It should be noted that as Yowie begins to sell multi-packs and moves into additional retail channels, a simple calculation of sales/volume will be less indicative of profitability than in the past.

One downside to using the Whetstone patent was that it was due to expire in April 2018 possibly opening up the company to competition. So in late 2015, Yowie quietly developed its own capsule design that would meet US guidelines. At the same time, Yowie began to search for a contract manufacturer it believed could scale more quickly than Atlantic Candy Company.

In January 2016, Yowie announced its new capsule design and its intent to move manufacturing from Atlantic Candy to Madelaine Chocolate Company, based in New York. Production at Madelaine began in April 2016 and base capacity is 100m units pa, nearly three times our forecast production of c 34m units for FY19.

The previous capsule was shaped like a Yowie character and helped the chocolate coating to maintain its character shape. The new capsule design is a simple shape and incorporates small plastic nubs that extend through the chocolate halves. However, the outside appearance of the candy has not changed as Yowie continues to use the same character-shaped molds for forming the chocolate.

Angry Birds was Yowie’s first licensed character deal, and the first products off the Madelaine line were Angry Bird Yowies to tie in with the summer 2016 animated movie. While representing Yowies on the outside, the capsules contained characters from the Angry Birds brand. In addition, Yowie Group signed confectionary licensing agreements with SpacePop, a new music and fashion-driven brand created to appeal to tween girls, and Japanese brand YO-KAI WATCHTM, an animated TV series, manga, comics, and video game property have sold more than US$2bn in licensed retail merchandise sales in 15 months. We expect management to continue to seek additional licensing opportunities to drive confectionary sales.

Yowie is currently selling two limited edition series, its “All American” and “My Protected Species” editions. The “All American” edition focuses on animals in the US including a very limited American Eagle bonus character. The “My Protected Species” focuses on household pets and encourages US consumers to submit a photograph and details of their pet for consideration as the model for a limited edition collectable.

The confectionery industry is highly competitive, with hundreds of new products seeking to establish a foothold in the market each year. The most successful new products tend to come from the large confectionery companies – Hershey, Mars, Nestle and Lindt – where established brand loyalty, strong shelf positioning and large marketing budgets provide a competitive edge.

However, smaller brands are taking share away from the larger brands. A June 2015 article in Confectionery News cites data from IRI Worldwide noting that in 2014, sales by the top four confectionery manufacturers grew 1.9%, while sales outside the top four grew 5.7%. We believe that while the large brands have a number of financial advantages over smaller manufacturers, potential new products have to hit a much higher hurdle rate to move into production – a disadvantage in terms of innovation and the ability to change with the market.

Rising prices caused a drop in unit sales for overall chocolate in 2015, according to a study by IRI Worldwide. The study noted that dollar sales of chocolate rose 3.9%, but overall unit sales fell 3.0%. However, Yowie has managed to buck this trend with product revenue growth of 530% in the year to June 2016.

That said, a new product has to have several characteristics to be successful and we believe that Yowies are well positioned to do so.

Management sees Yowie as more than a confectionery play. We believe that management’s primary goal is to re-establish Yowie as a brand and then grow revenues through licensing opportunities in confectionary (such as Angry Birds) but also in entertainment and media.

To size the potential confectionary market, management has pointed to sales of Ferrero’s Kinder Surprise and Yowie confectionery sales in the late 1990s. As mentioned above, an estimated 2bn Kinder Surprises are sold annually, of which 1.2bn are sold in Europe, or roughly 2.4 units per capita. In the first full year of operations, Cadbury sold 65 million units of Yowie chocolates in the Australian market, which equates to 3.6 units per head of population.

Using past sales as a target range, management believes that annual sales in the US market could potentially reach 700-800m units, approximately 2.1-2.5 units per capita, or somewhat greater than US$2bn.

Wayne Loxton, a former mining executive and investor, heads Yowie Group. In FY16, the company added a number of senior executives to its team including Bert Alfonso as global CEO and Mark Schuessler as global COO to focus on growing the Yowie brand outside the US. The senior team is made up of executives with deep experience in the confectionery business, including several former Cadbury executives. Please refer to page 13 for a more complete management listing.

Yowie is still an early-stage venture whose rapid growth trajectory entails significant risk. Whereas the initial take-up of its premium-priced, novelty candy offering has been strong, it is still too early to know whether it will be sustained over the long term, or what the eventual scale of the brand may be, both in the US and globally. However, so far it has executed according to plan and is consistently exploring opportunities. Management has made many smart decisions to mitigate downside risks. In addition, consistent growth in sales volumes, in-licensing agreements and new customer wins over the past year boost our confidence in the story. We see the main sensitivities as described below.

Continued success at Walmart is crucial to our sales forecasts. Walmart not only has 4,500 outlets in the US, but also tends to have more points of sale (PoS) in each store and higher sales per PoS than Yowie’s other outlets. In our sales model, Walmart accounts for approximately 20% of total retail outlets, but 75-80% of volume. A typical Walmart will have 10-13 PoS in each store selling seven to 10 units per week, while other retail outlets will have one to four PoS and one to three units per week.

The most significant sensitivity change compared with our initiation note is Yowie’s increasing focus on investment and growth in non-confectionary businesses such as entertainment (books, animated films). Management will launch Yowie Publishing in FY17 and is currently in negotiations with scriptwriters to develop potential webisodes, animated series and a feature film based on the characters. Management’s goal is to optimize risk/reward in each of these investments by seeking partners or selling the rights to entertainment companies with the expertise and financing structures required to produce these potential projects. Such ventures have different risk/reward profiles from confectionary operations, which could affect the growth trajectory for the brand.

We estimate that raw materials including chocolate, foils, toys and capsules account for 85% of cost of goods sold. Of this amount, we believe that cocoa and sugar make up at least a third of total costs. Like many confectionery companies, Yowie does not make its own chocolate, buying it instead from one of several bulk chocolate wholesalers in the US. In this way, Yowie is somewhat insulated from short-term volatility in the cocoa and sugar markets; however, it does mean that the company could see rising costs if wholesalers are forced to pass on higher costs, as occurred in 2014.

Another concern is the potential of a toy recall. Yowie sources its capsules and toys from China and the products are safety tested once they arrive in the US. The manufacturing process is designed to make it relatively simple to remove any problematic toys before they are put into capsules and covered in chocolate, but there is a risk that if a problematic toy gets through this control process, it could not be found easily once the products have made it to market.

In the past, we considered Yowie’s reliance on a single manufacturer a sensitivity because of the potential risk for supply disruption. However, by creating its own FDA-approved and patent pending capsule, Yowie has mitigated the single manufacturer risk. As we discussed in our previous note, the new capsule and the change in contract manufacturers has invited legal action from its previous supplier; however, Yowie has prevailed in all rulings to date.

Foreign exchange sensitivity for ADR investors has been mitigated as the company has switched its functional currency from the Australian dollar to the US dollar as of the 2016 fiscal year (1 July 2015).

Finally, there are grassroots efforts to regulate and limit marketing of candy and other items directly to children. These efforts have been around for at least a decade and are particularly strong outside the US, but to date the impact on the candy industry has been limited.

Management has set its sights high, 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 Kinder Surprise, which average one to two units per capita each year. At a penetration of two units per head of population, the 320m US market would represent a sales volume of some 750m units, around 22 times higher than our 2019 forecast volumes in Exhibit 2 below.

While these targets may be achievable over the long term, we believe that the real opportunity 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 2016-17 and we have a modest assumption of US$2.1m for FY19.

There is a further opportunity as Yowie renews its existing brand franchise in Australia, New Zealand and Asia, and extends into Europe and the Middle East, none of which we have attempted to value in this note.

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 in near-term results.

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. To illustrate the effect of this, we have modelled three sales scenarios – our base case, a moderately higher-growth case and a moderately lower-growth scenario.

Our sales scenario models are currently store and units/store driven. However, as Yowie’s confectionary business continues to grow, store count will be a less meaningful proxy for sales progress and we encourage investors to focus ultimately on unit sales. Several factors drive our reasoning. First, as its retail availability expands, the store base will become less homogenous in terms of expected per store volumes and in terms of net sales prices. Second, many retailers order Yowies either through a distributor or in other indirect groupings (usually geographic), so it is difficult to accurately pinpoint the number of stores where the product is stocked at any particular time.

For our explicit forecast timeframe, our base case model relies primarily on the full roll-out to Walmart stores and moderate expansion in the grocery and drugstore markets as the key sales drivers. We believe that there is upside room for sales per store, however we believe that store expansion will be the primary driver of sales growth through 2019. In our base case we assume that Yowies will continue to be sold in its current base of 4,500 Walmart stores in FY19, and that PoS will grow from an estimated 10 PoS per store and weekly units per PoS of 4-5 to 13 PoS per store and the weekly number of units per PoS rising to 10 by July 2019. Management states that Yowies are available to some 60,000 accounts/groupings, but we have modeled for approximately 23,000 stores selling Yowies in FY18 (growing to just over 25k by FY19).

Our moderately higher-growth scenario raises both the number of stores and units sold per store by 10%, for a ~30% increase in sales over the 2017-19 timeframe. Our moderately lower growth scenario reflects a 10% lower annual increase in both the number of stores and units sold per store off our base case, resulting in a 33% decrease compared with our base-case scenario.

In the short term, we see the Yowie story as somewhat binary – either US customers will love the brand or they will not. So far, Yowie has proven success in Walmart; we now project that Yowie continues to increase its sales in Walmart by moving to the main candy aisle and expands into other retail outlets. 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.

Our 10-year reverse DCF model builds to sales of approximately US$116m by 2026. 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 21%, a level that we regard as achievable given our forecast of a modest increase in 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 WACC of 7-13% and terminal EBIT margins from 13-29%. 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, over-achievement on revenue growth milestones would be associated with a decrease in perceived execution risk and hence in the WACC, while any negative impact from factors mentioned in our sensitivities section could correspond to a higher WACC in the eyes of investors.

In FY16 Yowie shifted from the Australian dollar to the US dollar as its functional currency. As a result, there is a slight difference in historical reported results for FY15 versus our previous numbers (which were based on our translation from the A$ financial statements). Exhibit 4 shows the change in FY15 numbers reported in US dollars as well as Yowie’s performance relative to our FY16 estimates and our existing and new estimates for FY17-FY19.

Yowie’s FY16 results reflect the successful roll-out of product across the Walmart store base as well as other retailers. Lower COGS were associated with the discontinuation of exclusivity and patent royalty payments to Atlantic Candy Company offset by new capsule design and product development costs, increased senior staffing costs, the cost to move and initiate production at Madelaine Chocolate and legal expenses.

The opportunity for Yowie is significant and the company’s performance delivery has been in line with strategy; however, we are still at the very early stages of what management sees as a global brand across multiple product classes. In addition, exclusive of 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 (we have not included new geographies in our models). In Q117 to September, volume sales increased 103% to 3.3m, ahead of our 3.0m volume estimate. Further quarterly updates (the next is due in January 2017) could be catalysts to the share price, although the stock failed to respond positively to September volume results.

Revenues for FY16 totaled US$13.1m, a more than fourfold increase from US$2.4m reported in FY15. This is below our estimate of US$15.5m, reflecting lower average net selling prices to McLane (Walmart’s distributor, which shoulders Yowie’s distribution and warehousing costs on those items in exchange for a lower wholesale price), slightly fewer units shipped relative to our base case (8.6m vs estimate of 9.5m) and weakening of A$/US$ exchange rate in 2016 versus our estimates. Product sales rose to US$12.9m from US$2.0m primarily from the nationwide roll-out to Walmart. Other revenues – which include royalties, freight and settlement costs – totaled US$0.2m versus US$0.3m in FY15 and our estimate of US$0.4m.

Yowie posted gross profit of US$6.8m in FY16, up 411% from US$1.3m in FY15 and well ahead of our US$5.8m estimate despite lower revenue results. Gross margins on product sales in FY16 rose to 51.5% from 49% in FY15 and our estimate of 37.3%. The gross margin improvement primarily reflects lower ingredient costs versus FY16 and improved manufacturing economies of scale.

Our new base case calls for revenues of US$25.2m in FY17e climbing to US$56.9m by FY19e, including US$2.1m of licensing revenues, a compound average annual increase of 50%.

We forecast EBITDA margins to move from 14% in FY17 to 27% 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 further expand 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 used approximately US$3.3m in operating and investing cash flows in FY16, down from US$6.9m in FY15. Our forecast calls for operating and investing cash flow losses to increase to approximately US$4.3m in FY17, before turning positive in FY18. However, should the company continue to maintain its very low level of accounts receivable, our estimates may prove conservative.

Yowie remains debt free, with US$30.5m of cash on the balance sheet at 30 September 2016. In FY16, Yowie Group raised US$23m through a private placement of 35.6m shares in addition to US$4.2m from the exercise of options. These funds are being used to fund working capital, the continued roll-out in the US and newer ventures in publishing and entertainment. The company maintains a low level of accounts receivable (A/R), however we would expect A/R to grow as the company expands its customer base.