Yowie Group — Update 24 January 2017

Yowie Group continues to execute on its long-term strategy of building a global brand in confectionary, entertainment/media and select merchandise. Yowie has made solid progress establishing a strong sales footprint, but management is not resting on its laurels for the sake of maximizing short-term profitability.

Rather, management is making an aggressive push to establish the brand outside the US; at the same time it is building on its year-long track record with its beachhead customer, Walmart. While the expansion timetable is in our view more aggressive than that of many start-up companies, we believe Yowie’s commitment to investment spend is well-reasoned and its expansion tactics are time-tested and proven for an experienced management team.

Success for a start-up is rarely a straight line and Yowie’s December quarter results were a rare setback, with net sales down 10% against the September quarter. Net sales still rose 44% for the quarter against a very tough comparison with the previous year. Additionally, a two-day power outage, along with planned production downtime, affected Yowie’s ability to fulfil some sales orders in the quarter.

In our view, any market concerns that December results could indicate lasting issues would be misplaced and reflect incomplete thinking. A fuller view would allow for the impact of seasonality in confectionary sales, vagaries in data sets used to gauge performance and an expectation that unit sales growth would be affected by the comparison with Q216, which included roll-out into the entire Walmart chain, along with additional sales to fill Walmart’s inventory needs. The measures of a truly strong start-up are management’s ability to focus on strategy, execute on long-term value drivers, address disruptions as they occur and communicate challenges, along with their root cause, remedies and business impact to shareholders in a concise and well-informed manner. Yowie’s detailed disclosure and frank discussion of the December results meets a high standard of disclosure. The end result for us is more modest revenue and profitability expectations for FY17-19, but maintained confidence in the company’s long-term growth and profitability prospects.

Yowie is building on its early success in the US and plans to expand confectionary sales into two to three new markets before the end of FY17. While the company has not formally disclosed its first OUS markets in investor materials, Yowie's chairman, Wayne Loxton, indicated late last year on Today Tonight, an Australian chat show, that Yowies would be returning to store shelves in Australia “very soon”. Given its geographic proximity, we believe that expansion into Australia may also include New Zealand. The company previously announced its long-term goal to eventually expand sales to the UK and Europe, as well as to Asia and the Middle East.

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.

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. At its peak in the 1990s, the company sold 3.6 units per capita in Australia, or approximately 65m units. If Yowie were to replicate that level of success with the brand relaunch, based on a population of 21 million, we could see annual confectionary sales of 77m units, or c US$115m based on a US$1.50 average net effective unit price. Using the same peak sales price and per capita assumptions and a population of 4.6 million, New Zealand represents additional potential upside of US$25m.

Timing and scale for the launch/roll-out in Australia has yet to be disclosed; however, the product will initially be made at the Madelaine plant and shipped overseas. We expect an enthusiastic early response to sales in Australia, based on anecdotal examination of social media postings over the past few years. At the same time, it is too early to predict long-term sales levels and sustainability. Two key differences from the 1990s will be the chocolate formulation and the lack of a merchandising and marketing powerhouse partner such as Cadbury. Consumers purchase and collect Yowies for the novelty as much as for the taste of the chocolate, but it remains to be seen whether a non-Cadbury Dairy Milk-like formulation will disappoint some fans of the 1990s product.

Logically, a second target market may be Canada as it is geographically contiguous to Yowie’s existing business, has nearly 400 Walmart stores and similar demographics and consumer tastes (although lower per capita chocolate consumption – c 4kg pa compared with c 5.5kg pa) to 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:

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 averages one to two units per capita each year. At a penetration of two units per head of population, the 320 million US market would represent a sales volume of some 750m units, around 27 times higher than our FY19 forecast volumes in Exhibit 3 below.

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. For now, we have largely maintained our overall unit sales expectations for FY17-19, but have divided our model revenue stream into US and OUS sales (the company has not discussed the timing and scope of its new market roll-out plans in detail). As we noted earlier, evidence points to Australia (and possibly New Zealand) as new target markets for FY17 and would suggest Canada may be an additional target for FY17 given its geographic proximity, similar consumer demographics and the possibility for Yowie to build on its existing partnership with Walmart by selling into Walmart’s c 400 stores in Canada.

The upside potential to our estimates is significant just considering the opportunity in Australia/New Zealand and Canada. Using past peak Yowie sales of 3.6 units per capita in Australia results in c.80m units in one country, which is very substantially above our FY19 OUS forecast volume of 5.4m.

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

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 and across the globe. 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 previous US sales scenario models were 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 are now moving to a unit growth methodology. 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. Finally, as Yowie expands confectionary into new markets, the company will report all OUS sales as a single line item, making it difficult to discern progress in an individual country.

As Yowie’s sales in the December quarter were affected by production problems and as the company has yet to detail its OUS sales roll-out, we are cutting our unit sales estimate for FY17 from 15.5m to 14.9m, while maintaining unit sales in our FY18-19 model. Our base case model relies primarily on management’s goal of diversifying its confectionary sales base and reducing its dependence on sales to Walmart. In FY16, Walmart accounted for approximately 80% of sales. The company plans to reduce the percentage to 70% by FY17 and 20-30% by FY19. Using these figures, we estimate that Yowie sold c 7m units to Walmart in FY16 and we project unit sales of c 9m in FY19, average annual growth of around 12%.

Separately, we have lowered our average realized unit selling price from $1.60 to $1.40 by FY19 in the US to reflect two factors: (1) a large percentage of sales direct to distributors, where profitability on Yowie’s lower unit selling price is offset by low (or no) distribution expenses and higher order volumes; and (2) a greater emphasis on moving into the main candy aisle with multi-pack stock keeping units (SKUs). Our initial OUS pricing assumption is $1.50/unit.

In the past, we have seen the Yowie story as somewhat binary –customers will either embrace the brand or they will not. So far, Yowie has proven success at the checkout stands at Walmart (irrespective of the Q2 result described above). 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 now 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.

Our 10-year reverse DCF model builds to sales of approximately US$117m by FY26. As mentioned above, we have largely maintained our total unit sales expectation, as the company has not detailed the magnitude and timing of sales into new geographies, which thus represents significant upside in the near term. We also believe that there is a real opportunity for investors should Yowie move significantly beyond confectionery into other products and out-licensing. Evidence of success here would lead us to adjust our forecasts to more accurately reflect the impact of the increased licence 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 20%, 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 WACC of 7-13% and terminal EBIT margins from 12-24%.

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, while any negative impact from the factors mentioned in our sensitivities section could correspond to a higher WACC in the eyes of investors.

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 (which we have incorporated into our new unit sales-based revenue model).

Yowie’s net sales rose 44% to $4.4m in its December quarter against a very tough comparison with the previous year. On a sequential basis, however, net sales fell $0.5m from $4.9m. A two-day power outage, along with planned production downtime, affected Yowie’s ability to fulfil some sales orders in the quarter. When looking at the quarter, however, investors should consider several points:

As noted earlier in this report, a growing portion of Yowie’s sales are through distributors, where Yowie books lower unit prices to vendors that assume distribution costs. The net effect is downward pressure on reported gross margins, which are offset by lower related operating costs.

Although we have lowered our FY17 sales expectations to $22.1m, several factors should work favourably for the company: Easter was seasonally strong in FY16, with unit volumes rising c 30% on a sequential basis to 2.6m from 2.0m in Q216, a trend that should be repeated; Yowie will drive sales with advertising and marketing support; new packaging will enable Yowie to move to the main candy aisle (more points of sale at Walmart, and roll-out ramp-ups at new customers and those moving from test to full roll-out – Walgreens/CVS, etc. Finally, we may see early sales to Australia.

Our new base case calls for revenues of US$22.1m in FY17e climbing to US$51.0m by FY19e, including US$2.1m of licensing revenues, a compound average annual increase of 52%. We forecast EBITDA margins to move from 12.9% in FY17 to 23.5% 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 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 outflows to increase to approximately US$4.8m in FY17.

Yowie remains debt free, with US$28.9m of cash on the balance sheet at 31 December 2016. In FY16, it 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 roll-out in the US and newer ventures in publishing and entertainment. The company maintains a low level of accounts receivable (A/R), although we would expect A/R to grow as the company expands its customer base. We forecast net cash of £26.9m at June 30, 2017.