Description

Ausnutria is an infant formula manufacturer with production facilities in the Netherlands, Australia, New Zealand, and China. The company’s formula brands include Kabrita, Allnutria, and Hyproca 1897. The company has grown sales at a 23.7% compound annual rate over the last five years, and sales growth has been accelerating. Sales and net income grew 38% and 106%, respectively, in 2018. The company holds a small 5% share of China’s $19 billion infant formula market and thus has a decade-long growth runway. The stock trades at 16X 2019 earnings.

Attractive Industry Structure

The Chinese infant formula market is dominated by global multinationals such as Nestlé, Danone, Abbott, and Reckitt Benckiser. The top five companies hold about 50% of the market and this concentrated industry structure leads to muted price competition. In fact, Chinese regulators fined six companies more than $100 million for price fixing in 2013. An industry that runs into trouble for price fixing is likely a good industry for shareholders.

There are also barriers to entry. A brand reputation for quality and safety is essential and must be built over many years. Chinese consumers also perceive foreign-sourced infant formula as superior to domestic formula. A retail distribution channel also takes time to build. One unique feature of the Chinese market is the growth of “mama & baby” stores over the last decade. The “mama & baby” store channel has grown to 55% of the market in 2017 from 36% in 2011. This channel is made up of small chains and is highly fragmented with an estimated 80,000 store locations. A significant investment of time and resources is required to move products through all these locations.

Ausnutria began operations in 2003 and has built good brand equity over time. The company’s infant formulas were declared free of melamine by the Chinese government during the 2008 melamine scandal. Ausnutria has a full product portfolio ranging from super-premium organic formulas to lower-priced basic formulas. The customer reviews of Ausnutria’s brands on JD.com are excellent.

Ausnutria has most of its production capacity in the Netherlands, Australia, and New Zealand. The foreign sourcing is featured prominently in the company’s marketing and labeling. Ausnutria does have two facilities in China that produce formula for the company’s budget brands. The company has also made good headway into penetrating the “mama & baby” store channel with its products in 24,000 stores.

New Regulations Reduce Competition and Erect Another Barrier to Entry
After the 2008 melamine scandal that killed six infants and made hundreds of thousands of other infants ill, the Chinese government has rolled out a strict regulatory framework to build consumer trust. A new regulation came into force in January 2018 and requires all infant formula to be registered with the State Administration for Market Regulation. An infant formula production facility must be inspected by regulators and each facility may only register three brands of formula. The new registration requirements substantially reduced competition in the Chinese infant formula market. Previously there were more than 3,000 infant formula brands in the market, the majority of which came from small companies that put their own labels on generic formula. These small brands have been pushed out of the market. As of June 2018, regulators have approved 205 production facilities and 390 formula brands.

This is a good thing for obvious reasons. First, competition has been dramatically reduced. Ausnutria estimates that after the Chinese government completes all its inspections, there will be no more than 540 infant formula brands in the market. Not only is a less competitive market a more profitable market, but all the market share held by the smaller brands is now up for grabs. Second, the requirement that all infant formula be traceable to an approved manufacturing facility creates a new barrier to entry. A new entrant would have to invest significant capital to build a manufacturing facility and then go through the registration process before it could even start on the formidable tasks of building brand equity and retail distribution.

The infant formula industry generally has attractive characteristics, and the new registration requirements have made the economics even better for investors. The large multinational companies have taken note and started to flex their power to raise prices, some by up to 10%. Ausnutria is maintaining stable prices for now to capture ever more market share.

Goat Milk Infant Formula

Ausnutria owns Kabrita, the leading imported goat milk infant formula brand in China. The company estimates that Kabrita accounted for 67% of total imported volume in the first-half 2018, up from 38% in the year-ago period. Ausnutria’s goat milk segment is also enjoying accelerating growth. The segment grew 48% in 2016, 60% in 2017, and 68% in the first-half of 2018. China accounts for nearly 90% of Ausnutria’s goat milk sales, but the company is working to expand globally with Kabrita now available in 66 countries.

Goat milk gives Ausnutria another vector to capture global market share. Goat milk is currently a niche market, but one that is growing faster than the overall infant formula market. There is science that shows goat milk formula is less allergenic and easier to digest than cow milk formula. The company is sponsoring clinical studies in both China and Europe to better understand the advantages of goat milk. To the extent that more consumers convert from cow milk to goat milk, Ausnutria will benefit disproportionately.

A Trustworthy Incentive Structure

I trust incentives much more than I trust people, so I look for incentive structures that I can trust. Ausnutria has one of the better structures.

Insider Ownership – Ausnutria’s CEO owns 9.5% of the company. The Chairman owns 9% of the company. Both the CEO and Chairman spent money out-of-pocket to purchase a significant part of their stakes. Earlier this year a block of 81.1 million shares came up for sale from one of the original owners because of estate planning. Insiders purchased the entire stake. The CEO purchased 43.1 million shares to increase his ownership from 6.2% to 9.4%. The Chairman purchased 12 million shares to increase his ownership from 8% to 9%. The remaining 26 million shares were purchased by other members of management including the CFO. The CEO’s ownership stake is worth many multiples of his annual compensation. On October 11th, the CEO purchased another 200,000 shares on the open market at a price of $7.45. I feel our interests as outside shareholders are aligned with management.

A Lesson Learned – Ausnutria went through a two-year accounting restatement after their auditors, Ernst & Young, refused to sign off on the company’s 2011 financials. In November and December 2011, the company’s China subsidiary recognized RMB123 million of revenue before the products had been properly delivered to distributors. The goal was to inflate reported 2011 revenue. While this incident was a painful experience, the company emerged in a much stronger position. The Board fired all the people responsible and installed new management. In addition, Ausnutria undertook an extensive review of internal controls that spanned the entire company. The review identified the control deficiencies in the China subsidiary and weaknesses in other subsidiaries. As a result of these findings, the company installed new systems to prevent future accounting issues[1]. Ernst & Young, who has proven they are not asleep at the wheel, remain as Ausnutria’s auditors to this day.

The Chinese Government – Put yourself in the shoes of the Chinese government. The 2008 melamine scandal was a tragic incident that broke public trust in both the Chinese government and Chinese businesses. The government has spent the years since building a strict regulatory framework to ensure a similar scandal never happens again. To ensure the traceability of all infant formula, the government is willing to reduce competition and erect entry barriers, all to the benefit of Ausnutria and other large infant formula companies. Moreover, a state-owned agricultural investment fund spent HK$1.29 billion to purchase a 24% stake in Ausnutria earlier this year. Now after all that, if Ausnutria’s management engaged in any funny business to damage public trust in the government, how mad would you be? Or let’s flip this around. How scared for your life would you be as a member of Ausnutria’s management team? I say this only half-jokingly. The Chinese government did execute two people in response to the melamine scandal.

Valuation Drivers

Don't listen to internet strangers about valuation, but here are thoughts around the key inputs/assumptions.

Revenue – Ausnutria gained about 1% market share in 2017. Given that the company has been capacity constrained and four new facilities are opening in 2018, I think there is room to accelerate market share gains. The company invested 130 million euros to open two new facilities in the Netherlands, 36 million New Zealand dollars to open a facility in New Zealand, and 100 million RMB to open a facility in China. These new facilities should roughly double Ausnutria’s production capacity. In addition, Ausnutria is in only 24,000 of the 80,000 “mama & baby” store locations. The company is working hard to widen its distribution in this important channel. The CEO believes Ausnutria can grow at a minimum of 30% over the next few years.

Gross Margin – Ausnutria historically had a significant private label business, but as the company has shifted capacity over to its own brands, its gross margins have improved. Ausnutria’s gross margins will continue to expand as its higher-margin own brand business becomes an ever-larger proportion of total revenue.

Operating Expenses – Ausnutria is in growth mode and I expect the company to continue to invest in its business. While there is operating leverage in administrative expenses, selling expenses will increase as Ausnutria invests to further penetrate the “mama & baby” store channel. Increased depreciation from the new production facilities will also add to expenses. Increased investment is absolutely the right capital allocation decision. The registration requirements have opened the field and Ausnutria should be investing to capture market share and further its competitive advantages with manufacturing capacity, brand, and distribution.

[1] For example, PricewaterhouseCoopers found that data in the warehouse inventory system could be manually altered. In response, the company “purchased and installed a bastion host (an equipment that keeps track the access and changes made to the servers which store all the critical business information of the Company and the China Subsidiary) to monitor operation on the IT System. In addition, an administrator from the IT department of the China Subsidiary is assigned to examine, on daily basis, the access and change log, which contains detailed information of log-in user names, operations and operation times.” This is a single example. If you’re curious, you can read about all the internal controls Ausnutria put into place here: https://doc.irasia.com/listco/hk/ausnutria/announcement/a140801a.pdf

Catalyst

Earninngs growth over time