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1837.HK - Natural Food Intl Holdings


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For those who are interested in a PepsiCo backed natural food company in China at roughly 1/3 the cost of Pepsi's investment, read on.

Natural food IH is one of the largest pure play natural health food companies in China (#2 as of 2017). Their crown jewel brand, Wugu Mofang, is an extremely popular natural powder/ grain/ cereal brand that is a consistent Top 5 product in their category across all e-commerce channels, driven by their 26 million strong (and growing) registered members. For more details, see their latest presentation below:

http://www.szwgmf.com/Upload/WGMF2020年度业绩PPTCE-13432235913.pdf

Natural powder/ grains are basically healthy meal replacements for those seeking a convenient and quick way to eat healthy. It's somewhat similar to the quick meals/ supplements that permeate across the Japanese and Korean office culture, albeit with a more "health-focused" angle vs. the traditional "energy-boost focused" angle. Historically, this niche has been somewhat subdued, because customers simply didn't like the taste and repeat purchases were not common. Wugu Mofang's entrance into the market changed that, which introduced both healthy and tasty products that appealed to the taste-buds of consumers and drove high repeat purchase rates. Riding on this popularity, the company has grown rapidly year after year since inception in 2007.

By 2019, they caught the attention of PepsiCo (the largest player in traditional grains/ oatmeals), who decided to buy a ~26% stake in the company at $1.80 per share. Shortly after, they installed a high level executive (SVP and GM of foods in Pepsi China) to the company's board. Since then, growth has declined, and especially so since the pandemic. What happened?

Unlike many other fast growing Chinese companies that tend to pursue a "growth at any cost" mantra, this company has been very deliberate with their growth strategy, balancing brand development with data-driven distribution channel analysis. With the injection of the PepsiCo board member in 2019 (who has strong China e-commerce experience), they took the axe to their least productive offline distribution channels (all of which are small format concession counters within supermarkets - see presentation above for pictures if you're not familiar), and doubled down on their focus in e-commerce channels and more productive concession counter locations. They went from almost 4k concession counters to roughly 3.2k today in the span of less than 2 years. Not many companies will purposefully eliminate a big chunk of their sales so aggressively in the pursuit of efficiency, let alone in a growing industry (which gives you cover to be lazy). 

The market, however, did not take their strategic growth reversal well, and shares have been punished severely. Today, you can buy shares at roughly 1/3 the cost of Pepsi's investment. For this, you are getting a very attractive CPG brand with roughly HK$600M of net cash (44% of market cap) and 1.6m square ft of owned land (for their factories) in Guangdong and Hubei, at a mid to high single digit normalized P/E. The company has 70% gross margins (!!!) and roughly 7% - 11% net margins (prior to pandemic), and has been a consistent grower before their purposeful sales channel rationalization. On top of that, because they've historically reinvested the majority of their capital into their concession counter model as a means to build their brand (via promotion and labor costs for their nutrition consultants - see IPO prospectus for breakdown), true earnings power at maturity is probably much higher. 

These kind of gross margins are almost certainly best of breed in the CPG space (whether China or elsewhere globally), and is likely to attract a lot of competition over time. But it's also a testament to the brand's strength and position among Chinese consumers' minds, and the attractive niche they operate within. Combined with a highly incentivized management (who still own 51%), Pepsi distribution expertise, industry tailwinds, and e-commerce sales funnel tailwinds (as Alibaba et al. bring down platform costs at the direction of the government), the opportunity looks quite attractive.                        

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Thank you for this interesting idea and the great write-up. 

In their 2020 earnings announcement the company talks about the shift to ecommorce. To be expected given Covid. However, if you look at the mix within online then you can see that Wechat has decreased by little over 30%; roughly the same rate as H1. Do you understand this? Thought it a bit odd, esp. as the company does not comment on it. One would think that given shift to online sales should be booming. 

The other thing I was wondering: do you know why the market is so fragmented? I mean one would expect that as it matures it gradually consolidates, but the top 5 players only have 7.6%? And the company has a #2 place with 1.7% share. I am sure the numbers are correct, but would mean that the market looks very different than in the US/ Europe. Would sort of imply that there is either a long tail of mom and pop shops or localized markets that just look funny if you aggregate into national numbers. Just wondering if you came across anything on this. 

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Thanks for your astute observations Cicero.

Regarding Wechat, I think they use that platform as a tool for general health education to enhance their broader image as a healthy brand, rather than as a primary sales funnel for their products. For example, they distribute third-party products there as well, which is briefly alluded to under their 'other income and gains' section. In 2019, they noted that Wechat made some adjustments to their platform policy, which limited the tools to access customers, so that is probably the culprit for the declining sales there. Their main sales channels online are Tmall and JD, which seem to be growing just fine.   

Regarding market share, I don't think the industry is mature by any means. Chinese consumer demand for healthy food is still in the very early innings, and the company occupies a niche (a very attractive one, if not the most attractive) within the broader natural health food ecosystem. So there is still a lot of share to grab, their success is by no means guaranteed, and they're likely not at a stage where they will be milking/ optimizing their business for peak profitability in the near future. 

What I like about the situation is that they've created for themselves a nice foothold to compete, and the Pepsi involvement is a good proof-point of credibility, as well as an opportunity to leverage the supply chain/ product marketing knowledge and know-how of a powerful multinational who has been doing this for over a century. I also like their incredibly high gross margins, which gives them quite a bit of room to reinvest into their brand/ strategic initiatives and pivot based on changing trends. Combine that with a management team that seems to be laser focused on utilizing their resources in as efficient a manner as possible (despite them having lots of leeway to waste), and I think you have a pretty attractive setup (although of course not guaranteed). 

Finally, their balance sheet is pristine, which curtails the downside somewhat should headwinds materialize. I think this gives investors today a rather asymmetric situation where if the company is able to successfully maneuver in this attractive (albeit competitive) niche, gains could be very substantial. 

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Thank you for the idea!

Any idea why their interest income nearly halved in 2020 even though cash is pretty much unchanged? From their financials, their assets are in RMB at PRC banks. Other companies with large cash holdings in the PRC that I follow got interest income around ~ 1.5% in 2020. They are at about a third of that if you add interest income and income from financial assets at FV. Different styles of treasury management would make sense but they also had a large drop off year over year and from what I understand PRC deposit rates haven't had a significant move. Since it is a PRC company, I'm more concerned with the cash being real than the 100bps of interest income. 

On the subject of cash, what are you subtracting to get to $600m HKD cash? I'm seeing 564m RMB in cash and 21m RMB in financial assets at FV (structured deposits) so roughly $700m HKD and current assets - cash/financial assets more than cover current liabilities so just wondering what adjustment you're making. 

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A big chunk of their cash (40% as of 30 June 2020) are in HKD, which basically earns nothing. And as far as I can tell, the majority of their RMB deposits are mostly on demand bank deposits (not wealth management products and very little time deposits), which is basically the lowest interest rates after checking accounts. The cash looks legit. A big chunk was raised from their 2018 IPO (easy to verify), and just a rough netting of subsequent years of after-tax profit less debt repayment, dividends, share repurchases, and capex gives me roughly the current levels of cash. Working through the working capital movements year-to-year would probably lead to a more precise match.

My HK$600M cash figure is basically using the lowest 5-year exchange rate between RMB to HKD, taking a 5% haircut assuming they were to dividend it out to shareholders and pay the associated taxes (although in reality you probably don't need such a big haircut since some of the deferred taxes have already been recognized), and round down to make for easier reading for everyone.    

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Couple of things I wanted to share; just to be transparent I am long:

1. Speculating a bit, but if you read the prospectus you will notice that the CEO took out a USD 40 MM loan to acquire shares prior to the IPO (at prices close to double the current one by the way) in 2017. Since then a fair portion of that has been repaid but I think he may still have a HKD 50-100 MM outstanding. Should help with the motivation to turn the company around. In addition there a quite a few options outstanding around HKD 1.5. 

2. What could possible reasons be for this not to work out?

A. It could be that their products lost their appeal over the last year or year and a half. Seems not very likely to me. Rate of change in food is way slower than in other areas of life. Don't think these things change from one year to the next. If you look for relevant key words, their products come up on Tmall and show significant current sales

B. Their model does not work in the absence of physical supermarkets and supermarkets visitation will be way down post Covid as people moved online. I don't have any data for the following, but I live in Asia and am always struck by how much Chinese are sticklers for fresh produce (me too). At home, we have tried some of the supermarket delivery apps and we do use them, but I find the quality of vegetables pretty poor. People also go way more often to the supermarket given how small fridges tend to be and the oddly short half live of vegetables and I feel that behavior is somewhat entrenched. Anyway, long wound way of saying that I don't buy that supermarket visitation will be significantly down post Covid, but if it is then the company will have an issue. 

C. Products popularity was fading for a while and it has only now become apparent. Hold that thought. They do have two kinds of counters: a small format which is the majority and a newer larger format of which they only seem to have a few. Ignoring this difference, each counter selling about about 10-15 cases at maybe on average RMB 100 (simplifying a bit here). Interestingly, the counters do seem to have either only very modes same store sales growth or even negative sales store sales growth (take this with a pinch of salt as the company does not publish enough information to calculate same store sales properly; I make the assumption each store is operation for an entire year). Let's assume for a sec that same store sales were slightly negative, low single digits and let's assume you decided to increase the number of counters significantly. What you would see is a few years of terrific growth and then the estate would mature and many of the counters would become loss making and you would have to start culling. Note how this narrative fits with what happened over the last few years. Not saying that this is what DID happen, but it is one plausible explanation in my view. This would also fit with with the decreasing WeChat sales numbers that used to be way ahead of other online channels (which is why the company decided to break them out in the first place and to their credit they did not drop them as so many companies do if they turn unfavorable) 

3. Pepsi understands this business better than I do, but too me it looks like they overpaid quite a bit (taking into consideration the information that they had at the time) and I at least would use that precedent with a pinch of salt

4. It is probably true that some of channel trimming was Pepsi's idea, but if you read the 2019 interim which predates Pepsi's investment, one will notice that about 2/3 of the closures happened prior to Pepsi's acquisition. The other observation I would make that in 2018 they closed 646 vs the 958 counters in 2019 i.e. there was already a fair amount of cutting going on way before Pepsi. 

 

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Cicero - that's some incredible sleuthing! Thanks for all your points, they're very well thought out. I do want to address some of your points though, as I view the narrative a bit differently.

Regarding the Wechat sales channel, I'm looking at their numbers all the way back to 2015 in their prospectus, and I don't see a single year where it was more than the other e-commerce platforms. I think the reason they explicitly broke it out separately was because they wanted to make the distinction between e-commerce platform and social media platform. They mention this online channel distinction in their prospectus. The peak Wechat sales in 2018 and drop-off since then coincides with Tencent's decision to stop pursuing e-commerce directly, and opt to go the partnership route. I did some work on Tencent, Alibaba, and JD back then, and remember Hillhouse Capital (a major Tencent and JD investor at the time) encouraging Tencent to pursue partnerships instead of plunging head-first into e-commerce and committing significant capital. You can see an example of such partnership in this article: https://technode.com/2018/06/14/wechat-jd-shopping/

Historically I think the company has used their Wechat channel as a means of marketing, and probably got some product sales as an ancillary effect. You can see that they mention in their 2020 report: "In terms of the ways of brand building, the Group carries out comprehensive content marketing mainly through social media platforms including WeChat, Xiaohongshu, Douyin, and Weibo." 

Now going forward, there is a chance the WeChat figures grow in future years and might be re-categorized under e-commerce platforms, mainly because Tencent seems to now be making a shift again to break into e-commerce more directly. But too early to say for sure at the moment. See this article: https://technode.com/2020/07/16/wechat-is-testing-a-new-e-commerce-mini-program-feature/

Regarding the counters, I actually think negative same store sales are natural, mainly because I think it's only a temporary sales channel. If you think about the counter business model, it's rather suboptimal in regards to profitability. Not only must they pay the standard commission on product sales to the supermarket, they also have to pay the nutrition consultants to physically man the counter, as well as other associated promo costs to lure consumers to the counter. The counter's "experience-based" retail model is great/ necessary if you need to educate the consumer on a new product type/category, which is exactly what the company had to do. But once the consumer is familiar with the product, most would likely just buy it direct off the shelf or online instead of going through the counter again. Anecdotally, having lived in Asia as well, I've discovered many new products through counters (some great, some not so much). But if a certain product resonates with me, I would never gone back to the counter again (except maybe to gorge on their samples) and instead just go directly to the aisle or online to buy. That's why I think longer term, if they can maintain customer mindshare, the business could be more profitable than what historical financials show, and perhaps that's what Pepsi saw as well when they paid what they did.

Just my two cents. But thanks for bringing up the great points Cicero, enjoy the discussion. 

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Thank you RVP. 

On WeChat: To clarify, I did not mean to say that WeChat was the largest channel. What I meant (and I worded it poorly) was that for a while it was the fastest growing channel and I thought that is why they broke it out historically. But you are right, it is a bit different from the other e-commerce channels and maybe there are other reasons to break it out. Ultimately, maybe best not to put too much emphasis on that one data point. 

On the counters: The counter as a way to try out a product and create a habit that hopefully sticks makes sense. And it is true that it is way more common in Asia than in other markets. I also agree on profitability, it is not a very efficient way of distribution (I find it quite helpful to think about the numbers on a "per counter basis" makes you realize why gross margins are so high and operating margins so poor). But I think if they were entirely successful with that strategy, you would expect their sales to hold up better in a year such as 2020 and a bigger shift to online. The good news is that it is so cheap that if they succeed even in a mediocre way this could work out very well and with Pepsi they have the help of a best in class operator. 

 

 

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Couple of data points that I came across  

Market: 

# The competitors reference in the Frost report in the prospectus are - in order of size - HaoXiangNi (listed in Shenzhen), Natural Food, YanZhiFang, Quaker and GSY (in the prospectus they are anonymized).  The market is defined as health foods and lumps together cereals (7.6%) and non-cereals (92.4%). If you look at the market leader HaoXiangNi, they seem to make dried fruits and such. In my mind this market segmentation is completely arbitrary. HaoXiangNi for example probably competes against Three Squirrels, but probably not really against Wugu Mofang. Why did they use this market segmentation in the prospectus? Perhaps they thought it would be good to show Wugu Mofang as market leader and this is probably the only way to get there

# there is an Euromonitor report that covers breakfast cereals. Quaker oats has an 18% value share for breakfast cereal in china vs. 15% for Guilin Seamild. Probably not perfect either, but makes more sense to look at competition through that lens in my view. Note also that this market concentration also more closely resembles other markets globally   

# there was a study on Chinese breakfast habits done in 2015 that looks at incidents of consumption of western breakfast foods in a given week, which I thought was interesting. Note the correlation to per capita income and the still fairly small share of cereals 

Tab1Tab2

Guilin Seamild:  

# there is an interesting competitor called Guilin Seamild that is listed in Shenzhen. Trades at 30x earnings and seems to be the local incumbent in this category albeit at a lower price point and more plain vanilla products such as oatmeal 

# Focus seems to be hot cereal which makes some sense given that congee is a hot as well

# All disclosures + website are in English, so not easy to look too closely, but you do see their products on Tmall fairly high up if you use the relevant search terms 

# Significantly more profitable at mid teen net profit margins, but lower gross profit margins in the high 50s 

# Interestingly, there seems seems to be some margin compression in 2020, but nothing remotely close what happened at Natural Food

# JM Smucker bought a stake a few years ago and then sold before the IPO (went public in 2019). Not quite clear why they sold; was a pretty small stake for them so not much commentary 

Other: 

# company told analysts (Cinda) that that there were three reasons for the bad 2020 results: 1. Increased promotions 2. Product facilities are in Hubei province (of which the capital is Wuhan). Lockdowns disrupted production and they therefore did not have sufficient product. 3. Online products are less profitable due to a mix issue. Offline they sell bigger SKUs that are more profitable. Thought that points 2 and 3 were a bit odd as they were not really discussed in the company's disclosures 

 

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Thanks for the interesting data points Cicero.

Where did you get specific competitor names from? I agree that consultant reports are often flattering, and should be taken with a grain of salt. However I do think that the specific niche is still quite nascent to accurately categorize. I think the important thing to keep in mind is that there aren't dominant players in the niche yet, and everyone is still positioning/ grabbing share. 

Regarding the Euromonitor report, Quaker is the leader, but why are they only #4 in the Frost report? Also, is Guilin's 15% market share accurate, given Natural Foods does more revenue than them?  

I haven't looked deeply into Guilin, but it seems to me that they are prioritizing profitability vs reinvestment. This is also indicative in their pretty high dividend payout. You also mention their lower price points and more plain vanilla products. Put together, could this mean they don't see their brands being particularly competitive in the natural health food niche and want to squeeze as much juice out of the business as possible? Again, I haven't looked into Guilin enough, so this is just conjecture. But if you have great margins (both existing and incremental) while growing in an attractive industry, I find it strange that dividends are the answer. All the competitors mentioned here (HaoXiangNi, Three Squirrels, Natural Foods) are making significant reinvestments into their brands via SG&A; I think this is the right move in the land grab stage within an attractive niche. Interestingly, Natural Foods has the highest gross margins by far, giving them more relative firepower to reinvest. If they can really move the needle on sales, this could get really interesting.   

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The specific competitor names are from a research note from Cinda. They replicate the graphic from the prospectus but with the names of the competitors. Presumably the data comes from the company. 

How is "natural health food" being defined in the Frost report: excludes "staples", fresh stuff, and anything with artificial and synthetic additives. Which leaves you with dried fruit, cereal (7.6% of the natural health food category) and probably fairly large "other" box. Now why is Qaker the leader in breakfast, but only #4 in Frost? I don't know, but I think a good chunk of what they do is oatmeal which is probably classified as a "staple" in the frost Report and they probably also have a few products that are disqualified because of additives.

I agree that what NF is doing is a bit of a niche, but if I had to pick competitors I would look to the cereal guys rather than looking at a manufacturer of dried fruit or turtle jelly, because as a consumer cereal is a substitute for NF's products while dried fruit or turtle jelly at least in my mind is not. 

On Guilin: Possibly. Product portfolio does not seem very innovative to me. One thing I have observed with other long standing brands in China is that they seem to me to "age" a bit faster than in the west. Perhaps because their customers grew richer so quickly that they are outgrowing some brands that can't innovate fast enough. Jiashili would be an example in my mind. Not a destiny though; you also have Pei Pa Koa for example.

On the margin: It is true that Natural Foods gross margin is very high. I think though one reason is the distribution channel they are using. Imagine for a second they would sell into "normal" retail without any self operated counters etc. and the price for the end consumer remains the same. Since the retailer has to make margin as well, NF would have to accept a lower price i.e. a lower gross margin, which would be OK because they would also not have to pay for the counters and the sales people etc so they would have lower SG&A as well. Not easy to isolate how much this effect contributes because they do pay the retailer effectively rent for the counter space, but I think this could easily explain 10%pts of gross margin perhaps as much as 20%pts. Still a very high margin, but I think gross margin comparisons with other brands are very difficult given the differences in distribution. Gives me a bit of comfort though, I thought that the 70% was pretty odd given where all the comps are. 

 

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Yes I would also comp them against the cereal folks if forced to do so. Though the differentiating aspect of NF's cereals/ grains (and what made them incredibly successful) was their mix of Chinese-style ingredients in their products (yam, black sesame, red bean, red dates, etc.), so I can kind of see why they would be compared with the dried fruit type players. Nonetheless, I don't think it's very useful/ practical to rely on consultant reports.

You're right, if they switch to normal retail distribution, gross margins might contract (if they recategorized distributor commissions from SG&A to COGS). But they also have about 20%-25% of salesmen/ promotion expenses (as of 2015 - 2017) they can cut, and there's possibly room for distributor commission rates (also 20% - 25%) to go down if the brand grows and becomes a "must have". I also think they have broader tailwinds on the distribution channel margins as China clamps down on the e-commerce take rates, and of course traditional retail has perpetual competitive pressures from e-commerce. It's a good time to be a successful brand in China.

Most important thing IMO is whether they can further strengthen their brand/ products appeal, and everything should flow from there. This is where I think having Pepsi on the board could be prove to be quite helpful.         

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Agreed that there may be margin upside and that Pepsi's involvement will be helpful in this regard. 

Will be interesting to see how this plays out. 

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