Sunday 29 March 2015

Capilano Honey | ASX:CZZ

I’ve been looking at Capilano Honey for some time now and recently purchased a position after they released their half year results. Since then the price has had a fairly sharp rise, moving up to around $11.60 from my purchase price in the low $8s. This was likely on the back of the half year result. There has been some brokers initiating coverage which always helps especially with stocks like this with such limited liquidity.  I’ve gone over some metrics of when I purchased and based on the current price. At this price it’s no longer the bargain it was but I still think there remains some upside in the price with the potential for more if things go their way.

About

CZZ is Australia’s largest packer of honey and has been in operation since 1953. Packer is key here as they access their honey from approximately 500 apiarists around Australia whom they have entered into supply agreements. The Capilano brand is the company’s core product and is sourced entirely from Australian honey suppliers. Retaining the brand as 100% Australian honey is a key objective for Capilano. This has been achieved despite poor honey supply in recent years. Additional brands owned by CZZ include Wescobee, Beevital, Smiths and Allowrie.

To offset some of the decline in local honey supply, CZZ import honey from suppliers, largely from Argentina. The honey is then blended with local supply and used in the less premium products such as Allowrie.

CZZ has three production facilities: Richlands, Brisbane; Maryborough, Victoria; and Perth, Western Australia. Richlands is the largest facility, having capacity for around 40,000 tonnes. The Maryborough facility has been suspended, however will be reopened following the recent acquisition of Chandler Honey.  They have significant excess capacity available to them.

Investment Case

CZZ is the largest and most recognised honey packer in Australia. Its market leading position is protected by barriers to entry that exist in the honey industry. Despite a lack of honey supply, being one such barriers to entry, CZZ have alliances overseas which means they can import supply during lean years. They have also successfully been able to negotiate increases in their wholesale price which has meant margins have been maintained and will ultimately benefit them as retail honey prices stabilise in the future. The company has a strong balance sheet, high free cashflow and limited capex requirements. A lower earnings multiple is probably fair given the risk of honey supply, however CZZ seems to be trading well below fair value. Earnings for FY15 should come in around $7m which at the time of purchase places them on a PER of 10x (based on a share price of $8.25). The share price has since risen sharply to $11.60 or the equivalent of a PER of 14x. I think this represents a much fairer price however there could be further upside if weather conditions become more favourable, higher margin products such as Manuka are increased and as cost initiatives continue.

The Basics

Cash
CZZ
Share Price
$11.5
Shares Outstanding
8,520,198
Market Cap
$97,982,277
Cash
$3,449,657
Debt
$7,739,664
Enterprise Value
$102,272,284
Dividend Yield
1.7%
Underlying Gross Profit Margin (FY14)
43.9%
Underlying Net Profit Margin (FY14)
4.4%

Valuation Metrics
Current
At Purchase Price
NPAT (FY15E)
$7,000,000
$7,000,000
PER
14.0
10.0
EV/EBITDA (FY15E)
7.9
5.7
FCF Yield (FY14A)
9.9%
13.9%

Note that I’ve calculated underlying figures to strip out insurance proceeds and damage caused by fire. 

Brief Overview of Industry

CZZ is the leader in the market, with around 70% market share, the bulk of which (50%) comes from the premium Capilano brand. The number of large scale honey packers continues to consolidate with CZZ purchasing both Wescobee and Chandler Honey in recent times. Their main competitors are Beechworth Honey, Ancient Distributors, Byron Bay Honey and private label. Private label has been a significant threat to various retail products, however given the limited retail honey supply, private label sales have been reducing over the past 12 months. Additionally, the major supermarket chains make higher margins from CZZ’s branded products than they do from private label.

CZZ’s market share and leadership position is protected by the high barriers to entry that exist. The greatest challenge to competitors is accessing the dwindling supply. Significant capex and scale would also be required to be competitive against CZZ. These features make it unlikely that their competitive position could be threatened. 

1H2015 Result

Capilano recorded a strong result for the half year with revenues and earnings rising 34% and 73%, respectively on the 1H14. This was an impressive result given domestic supply was limited and the increased input costs from rising honey prices. The result was helped from two factors:

1 – CZZ were able to increase the wholesale price at which they sell to their customers (i.e. Woolworths, Coles). This resulted in top line growth and meant margins could be maintained. On a higher revenue base, earnings were magnified.

2 – A lack of domestic supply and CZZ’s ability to import supply, in some cases where other competitors do not, led to a large increase in market share.  FY15 will see the level of imported honey increase significantly.

From speaking with CZZ, it seems likely this wholesale price will be maintained even if there is a drop in the retail price. Where domestic supply improves there will be a two-fold effect on Capilano. 

1 – Retail prices will come down and with a steady wholesale price, margins will rise.

2 – Increased supply will reduce the reliance on importing and allow CZZ to focus on export markets. CZZ have production capacity for around 45,000 tonnes of honey compared to the supply in recent years of around 10,000 tonnes.

There is a risk that domestic supply will continue to drop which will ultimately lead to further increases in the retail price. To maintain margins CZZ will need to pass on additional costs which may not be possible, however they have been successful in achieving wholesale price rises in the past. They are in a better position to negotiate given their market share.

Supply/Demand and Price

As can be seen below, supply for CZZ has dropped off over the past 10 or so years. The honey supply is contingent upon favourable environmental conditions and can be volatile from year to year. With recent acquisitions, such as Wescobee and Chandler Honey, CZZ has diversified its honey supply across Australia and is less susceptible to localised poor weather conditions.

CZZ has historically had a requirement that beekeepers must also own a specific number of shares per bee hive. This has recently been removed likely as it was prohibitive in attracting new supply. It also however raises the question of how loyal beekeepers will be to CZZ. With limited supply there may be increased competition between packers to attract new supply sources.

With the decrease in supply, the retail price of honey per kg has continued to rise, currently around $5 per kg. As I mentioned earlier, CZZ have been able to pass on these recent increased costs to their customers. Any further increases in the honey cost could hurt margins if these cost increases can’t be passed on. It is worth noting that recent years, in particular FY 14 have been among the worst in recent times. CZZ management have noted that conditions have started to improve, however it remains early days. If supply does increase, prices will likely fall somewhere towards the $3 range and there will be an immediate benefit to margins. If prices remain where they are, CZZ still looks attractive – the investment case is not dependent on supply increasing and prices moderating.

There is no danger in demand dropping off – Australian demand currently outweighs supply and there is also strong demand internationally particularly from Asia. Demand for honey has also increased as consumers become more health focussed and honey is used as a substitute for sugar and in various health products. Certain varieties of honey produced (Jarrah, Manuka, Jellybush) also have antibacterial qualities and are used for medical purposes. CZZ currently produce both Jarrah and Manuka products, which are higher margin products.

Upside
  • A re-rating based on valuation alone given metrics.
  •  Favourable environmental conditions would result in higher supply.
  •  Increased supply would have the following flow on effects:
    • Retail honey prices would likely decline and lead to higher margins
    •  Fixed costs remain stable which also assist margins
    • The reliance on imported honey is reduced
    •  It allows the company to target high value export markets
    • Reduction in imports and increasing exports is beneficial with the reduction in the value of the AUD vs peers
    • There is significant excess capacity so no additional capex is required
  •          Targeting the higher margin markets of Jarrah and Manuka. The issue here is accessing supply to these markets.
  •           Continued acquisitions as have been the case with Wescobee and Chandler Honey. Both transactions were done at favourable valuations for CZZ shareholders.
Risks
  • Continued decreases in the supply of honey would result in lower revenues. Margins would also be eroded as the price of retail honey would likely increase and fixed costs remain.
  • Beekeepers supplying honey to a competitor rather than CZZ.
  • Increased competition from competitors including private label brands. This remains unlikely given the shortage of honey, CZZ’s market share and export opportunities.
  • Threats to bee colonies from pests diseases such as the Varroa Mite.
  • The risk that imported honey is of poor quality or contaminated.
  • Pricing power taken away from CZZ by major supermarkets.
Financials

I won’t go over the financials in great detail here. The fire that occurred in the 2013 FY has somewhat distorted the income statement and ratios for FY13 and FY14. The company benefited from insurance proceeds which exceeded the extent of the fire damage that was expensed. The raw materials and consumables are primarily associated with the cost of honey. On an underlying basis the gross profit for FY14 was 44%, decreasing from 46% in FY13. I’d expect the gross margin to remain reasonably consistent with FY14, perhaps declining slightly, as rising input costs and increases to the wholesale price counteract. This has the potential to expand should the honey price reduce. There are also several fixed costs and margins would rise further as the top line grows.

The balance sheet remains strong:
  • Net debt is low at around $4m
  • CZZ is a fairly capital light business with capex of around $1-2m per year. Meaning more FCF can be either returned to shareholders or used to expand the business organically or via acqusitions
  • There is value in the working capital of the business
Free cash flow is strong – approximately $8m in FY14. The 1H15 FCF was around $5m, however it was assisted by the build-up in payables.

Income Statement
FY 2008
FY 2009
FY 2010
FY 2011
FY 2012
FY 2013
FY 2014
1H 2015
Sales
63,805,608
78,387,396
72,037,247
63,014,149
67,705,182
71,963,218
85,893,265
57,871,333
Other Income
371,211
105,232
118,269
177,093
73,522
197,178
110,226
261,930
Insurance Proceeds
0
0
0
0
0
4,694,337
2,296,993
0
Raw materials and consumables
-70,831,570
-77,028,387
-68,392,104
-56,632,333
-37,052,760
-38,753,436
-48,144,663
-52,662,880
Gross Income
-6,654,751
1,464,241
3,763,412
6,558,909
30,725,944
38,101,297
40,155,821
5,470,383
EBITDA
-6,654,751
1,464,241
-1,345,011
6,558,909
6,652,988
7,945,305
9,267,506
6,400,000
Depreciation
0
-1,400,000
-1,650,000
-1,660,000
-1,732,767
-1,820,051
-1,873,956
-929,617
Amortisation of Intangibles
0
0
0
0
-38,535
-38,430
-40,357
EBIT
-6,654,751
64,241
-2,995,011
4,898,909
4,881,686
6,086,824
7,353,193
5,470,383
Finance Costs
-2,440,408
-2,071,291
-1,942,695
-1,194,967
-1,207,142
-1,092,014
-863,070
-352,004
Income Tax Expense
1,646,745
-85,699
-1,041,289
766,487
-1,121,722
-1,548,206
-1,871,112
-1,520,637
NPAT
-7,448,414
-2,092,749
-5,978,995
4,470,429
2,552,822
3,446,604
4,619,011
3,597,742

Income Statement
FY 2012
FY 2013
FY 2014
Underlying EBITDA
6,592,951
7,138,573
8,051,682
Underlying EBT
3,614,507
4,188,078
5,274,299
Underlying NPAT
2,511,112
2,889,929
3,753,711
Underlying NPAT Margin
3.71%
4.02%
4.37%

Balance Sheet
FY 2008
FY 2009
FY 2010
FY 2011
FY 2012
FY 2013
FY 2014
1H2015
Assets
Cash & Equivalents
1,312,700
239,535
472,375
637,197
675,555
239,902
1,103,559
3,449,657
Receivables
11,458,695
10,962,893
10,628,939
11,807,346
10,571,276
15,205,167
14,922,176
18,305,538
Inventories
17,421,285
17,808,187
12,160,225
9,194,261
12,973,235
18,328,709
13,736,111
16,615,755
Other Current Assets
342,844
299,665
163,552
164,083
235,005
266,677
262,519
612,718
Total Current Assets
30,535,524
29,310,280
23,425,091
21,802,887
24,455,071
34,040,455
30,024,365
38,983,668
Net Property, Plant & Equipment
19,591,561
19,911,271
19,697,479
18,984,627
19,566,144
19,744,122
19,634,969
20,551,168
Intangible Assets
5,480,247
5,354,976
180,324
141,789
103,253
64,823
24,467
4,067
Deferred Tax Assets
3,758,213
3,726,444
2,708,380
3,474,867
2,353,145
804,939
0
142,321
Other Financial Assets
1,858,351
897,195
0
0
0
0
0
0
Total Non-Current Assets
30,688,372
29,889,886
22,586,183
22,601,283
22,022,542
20,613,884
19,659,436
20,697,556
Total Assets
61,223,896
59,200,166
46,011,274
44,404,170
46,477,613
54,654,339
49,683,801
59,681,224
Liabilities & Shareholders' Equity
Payables
7,581,995
7,631,886
8,093,727
9,357,960
8,200,448
11,119,964
9,394,986
16,952,836
Short term borrowings
2,128,837
11,090,656
3,518,947
1,565,928
2,070,188
1,355,887
1,291,904
1,273,930
Provision for dividends
0
0
0
1,278,030
426,010
0
1,704,285
0
Deferred tax liabilities
0
0
0
0
0
0
891,972
2,491,689
Total Current Liabilities
9,710,832
18,722,542
11,612,674
12,201,918
10,696,646
12,475,851
13,283,147
20,718,455
Long term borrowings
28,928,670
18,207,358
15,389,460
9,526,648
12,030,045
14,937,644
7,404,958
6,465,734
Long term provisions
408,299
316,033
309,224
270,026
250,652
338,870
303,128
315,378
Provision for income tax
0
0
0
0
0
0
108,653
0
Total Non-Current Liabilities
29,336,969
18,523,391
15,698,684
9,796,674
12,280,697
15,276,514
7,816,739
6,781,112
Total Liabilities
39,047,801
37,245,933
27,311,358
21,998,592
22,977,343
27,752,365
21,099,886
27,499,567
Net Assets
22,176,095
21,954,233
18,699,916
22,405,578
23,500,270
26,901,974
28,583,915
32,181,657

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