Yowie Group — Update 8 November 2015

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 rollout to 1,500 stores in early 2015, Yowies are currently available in over 3,700 Walmart stores and are expected to be in all 4,300 Walmart outlets in the US by late fall 2015.

Recent trends early but encouraging

According to the company’s press release, Yowie Group reported record sales in the September quarter. An estimated US$4.8 million of retail sales value was achieved, which is more than double the previous quarter. 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.

We believe that the difference between management’s retail sales estimate and cash receipts for the quarter likely reflects two factors: sales of units that were shipped to retailers prior to the September quarter; and any unreported increase in accounts receivable.

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 2016-17 and we have a modest licensing revenue assumption of US$1.4m for 2018.

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 at this stage.

In many ways, Yowie Group is a high-risk startup venture. It is still too 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 from the start of the 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.

Other sensitivities for Yowie Group include commodity prices, reliance on a single-source manufacturer 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. However, a comparison with the branded confectionery peers gives reassurance on the significant earnings multiples available in the sector.

Our projections see rapid US revenue growth peaking in FY18. A reverse DCF at the current price with a WACC of 10% implies compound average revenue growth from FY16 to FY18 of 70% fading to terminal growth of 2%, and a terminal EBIT margin of 23%. There is nothing in our forecasts for rollout to other geographies, which would present upside.

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 from the September quarter are encouraging.

Our 10-year reverse DCF model builds to sales of approximately US$120m by 2025. There is nothing in our forecast for rollout 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 23%, 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.

Historic results largely reflect startup investment and meaningful sales have only commenced recently. Following a A$10m capital raise in January 2015, Yowie Group is well capitalised to invest in the US rollout as well as any plant expansion. At the end of September, Yowie Group had US$8.3m on the balance sheet, up $0.3m from the June quarter and reflecting financing cash flows of US$1.2 from listed and unlisted option exercises, partially offset by net operating and investing cash use of US$0.9m.

Assuming substantial success of the US rollout, led by strong uptake in Walmart stores, we forecast revenue of US$15.5m in FY16 rising to US$33.5m in FY17, when we expect breakeven and a pre-tax profit of US$4.1m. We forecast EPADR of US$0.49 by FY18.

With the Walmart rollout largely complete, Yowie Group is working down its inventory, moving the company towards positive operating cash flow and freeing up cash for other uses. Inventory at the end of September was $5.0m, down from $6.9m at the end of June, prior to the start of the rollout. Working capital used for raw materials and manufacturing costs was $0.7m, down from $1.0m in the June quarter. Net operating cash flow in the quarter improved to ($0.7m) from ($1.2m) in June.

Based on the information in Yowie Group’s quarterly report to September and the early stage of the full rollout, we are maintaining our estimates, but believe that there may be upside to our numbers for fiscal 2016 for several reasons:

However, two factors prompt us to maintain our F2016 estimates for now: