Description

Given the small market cap with about 25% free float and USD 100 k trading volume this idea is only actionable for small funds or PA.  

Summary: Natural Food International Holding (or “Wugu Mofang” as the company is called in Chinese after its flagship brand; translates to “grain mill”) is one of the leaders in a growing, niche health food category in China. The company currently trades at 13.2x LTM net income, 4.5x ex cash, but is likely underearning as its distribution is reliant on physical supermarket traffic. PepsiCo is a major shareholder (26% of the shares outstanding) and acquired their shares mid 2019 at a price of HKD 1.80 or a little over 3x the current share price. PepsiCo has been active in China for 40 years, is one of the leaders in a related category (breakfast cereal under the Quaker brand) and has a seat on the board (occupied by an SVP and GM of foods of Pepsi China). The bet is that earnings will increase with the normalization of supermarket traffic and the company’s growing online presence (which is growing at 40% yoy in H1 2021). I expect a total return of 28% over 2.5 years driven by earnings growth, modest multiple expansion from 13x to 15x and the use of a quarter of the cash balance in a non-value destroying way either an acquisition or a special dividend. In case things don’t go as planned, the moderate valuation and a net cash balance equalling about two thirds of the market cap should limit the downside.  

What does Wugu Mofang do? 

Wugu Mofang manufactures powders from grains, nuts and beans sometimes with additional ingredients that are perceived to be particularly healthy (e.g. goji berries). If that description makes you think of muesli you would not be wrong as the product is in part marketed for breakfast (as an alternative to congee, which is a bit more cumbersome to prepare) but also a snack or meal replacement (for example as an alternative to instant ramen) and it seems that this “use case” is a meaningful percent of consumption. 

A typical product is a 600g can that retails for about RMB 70-100 (some pictures below which hopefully will survive the upload). Most of ingredients are basic staples and gross margins are therefore high, consistently above 70%.

The products seem well liked by consumers and have more than a hundred thousand reviews on JD.com (which according to conventional wisdom are bit more reliable) with more 99% positive. The company has 9 MM members in his Wechat account and 27 MM customers with a loyalty account (offline). 

Unsurprisingly there are plenty of similar products on the market though the majority seems to retail at lower price points around RMB 30-50. The company claims to be the number one brand on Tmall for “Natural Powder” for the past 5 years and the number 5 brand in “cereal” on singles day with a recently introduced product. Note though that a lot of these claims are based on the exact wording of the search term, and I would not put too much faith in these data points. 

The products are distributed in three ways: 

1. Ecommerce

1. Historically a relatively unimportant channel that accounted for about 19% in 2018 prior to PepsiCo’s involvement and that has grown to 37% in H1 2021

2. GMV split: 60% T-Mall, 18% JD, 12% Tik Tok, 10% others (which I understand include about 5% from the company's WeChat presence and a tail of other platforms) 

3. The company does not break out profitability by channel, but I understand that e-commerce is less profitable both on an EBIT and gross profit level. With regards to gross profit the reason seems to be largely accounting as company includes some of the platform fees in COGS (though there are also incremental expenses for more elaborate packaging and freebees that are customary in Chinese online retail). The more important reason why the channel is less profitable is that it skews towards smaller, less profitable units and seems to be a bit more promotional. In addition, in most instances the company will have to pay for fulfilment which can be a significant percent of sales with items that are priced around USD 10-20 

4. Channel has grown by 20% annual per year for the last three years and recently growth has even been a bit higher than that 

5. Going forward there seems to be an opportunity to bring down fulfilment costs by gaining bigger presence with online supermarkets (scale and brand recognition are I think the obstacles here so far) or through community group buying which is gaining popularity but is currently negligible. In addition, take rates of the large platforms are coming down for political reasons which should be a tailwind for profitability 

2. “Concessionary Counters”

1. A “Concessionary Counter” is basically, a small section (six to eight square metres) in a supermarket exclusively focused on Wugu Mofang’s products and staffed by sales personnel the company sources from third party service providers. The supermarket that hosts the counter, collects the sales proceeds (you pay at check out) and keeps a percentage as rent for the space. While this may sound unusual, this business model is more common in Asian than in Europe or the US. Typically, these counters represent a capital investment by the company of less than RMB 70,000 (Picture below courtesy of the company) 

2. This channel accounts for 64% of sales in H1 2021 but accounted for 80% of sales as recently as 2018. Currently obviously heavily impacted by Covid as supermarket traffic is still below pre-Covid levels 

3. The average counter sells about 10-15 cases of product or RMB 700-1100 of sales per counter and day on average. However, they are staffed on average by 1.5 sales representatives and the company pays the supermarket a share of the revenue as well. Exact numbers are not public but together these expenses approach 50% of sales. That means that even though gross margins run at c.75%, net profit margins never exceeded 12%. Why did the company pursue this channel if it is so expensive? 1. Company argues that it is a cheap way to create brand awareness 2. Online which the only alternative with scale is (currently) even worse 3. Some of the products are milled in the presence of the customer. Why do they do that? It shows the customer that the product is fresh and free from additives and that builds

4. trust with the customer. I felt sceptical about this claim, but in fairness it comes up often in customer feedback on the online platforms 

5. The cost structure of the counter channel is an opportunity to increase profitability. If they can move to cheaper distribution channels – granted that is a big if – the brand would have the potential to be very profitable. Speculating, but I think this potential is what attracted PepsiCo. 

6. The payments to sales representatives and to the hosting supermarkets have a fixed component and variable component, but I think it is fair to think about the payments to the sales reps as mostly fixed and the payments to the supermarkets as mostly variable. I estimate that the payments to the sales representatives are 15-25% of sales, so there should be significant amount of operating leverage if activity does pick-up 

7. As recently as end of 2018 the company thought they could grow the number of counters to about 6,000 esp. in less wealthy Northern and Eastern provinces which proved too optimistic. On the contrary beginning in 2019 the shift to ecommerce in groceries led some marginally profitable counters to be loss making and the company cut the number of counters from its peak in 2018 by 30% to the current number of 2,706. Part of the reduction seems to have been driven by PepsiCo who pushed the company to lean more heavily into ecommerce 

3. “Distribution Agreements” 

1. The company has started to sell products in supermarkets on-shelf i.e. without concessionary counters. So far, this initiative extends only Sam’s Club, Hema and Metro in about 220 stores. The sales contribution is not publicly disclosed, but the company hinted at low single digit percent. Prices seem to be a slight discount to online, which means that the profitability is significantly higher than other channels 

Market 

• Market shares: vary wildly depending on whether you look at breakfast cereals or “health food” the definition of which is naturally subjective 

• If you look at “health food”, the company commissioned a Frost & Sullivan market study at the time of IPO in which the company ranks #2 behind HaoXiangNi (Pepsico acquired its “Be & Cheery” snack brand in Feb-2020 for USD 705 MM) with a 1.7% share while the top 5 players having a 7.6% combined share. Why is the market so fragmented? Because Frost & Sullivan lumped together a lot of different products that have little to do with one another (snacks, sweets, cereals). Cereals accounted for accounted for only 7.6%. HaoXiangNi, the #1, for example focuses on nuts and snacks and competes if at all only in minor products with Wugu MoFang. If you focused on “healthy cereal” it seems Wugu Mofang is #1 followed by Quaker

• If you look at “breakfast cereals” (i.e. without any “health” attribute) the largest player by value is Quaker with a 18% followed by Guilin Sea Mild with a 15% value share (according to Euromonitor as of 2018). Wugu Mofang’s share in the broader category is negligible 

•  Growth

• There are several market forecasts for “health foods” out there projecting high single-digit to low double-digit growth 

• The reason for the optimism is essentially that consumption of health foods is relatively low (per capita consumption of RMB 924 in the US, RMB 662 in Japan vs. 117 RMB in China according to Hong Kong Trade and Development Council) while consumer preference seems to be roughly the same as elsewhere (BCG did a survey where 73% of Chinese consumers said they are willing to pay a premium for products they think are healthier vs. global average of 61%; several other sources say directionally the same)  

• Breakfast cereals are still a relatively small category in China with less than 10% of household consuming cereal regularly with richer households accounting for a disproportionate share 

What is the moat?

• Brand reduces search costs 

• Plenty of food related scandals have made Chinese consumers rightfully sceptical. Trying to undercut on price is therefore a difficult strategy 

• Limited shelf space offline and online benefits larger players (that cuts both ways however)

Other interesting data points 

• The company was founded in 2007 and was essentially venture funded prior to its IPO in 2018. The history is complicated, and I won’t rehash it here, but the IPO prospectus gives a good overview. What is interesting is that the Zhang Zejun, the current CEO and founder bought shares prior to the IPO at a price close to 2.5x the current share price financed by a loan from one of the bookrunners. About half the USD 30 MM loan was repaid prior to the IPO and probably another half of the remainder since then, but it seems likely that about USD 7 MM in debt remains vs. the value of his current stake in the business of USD 70 MM (which I believe to represent the most of his net worth). Should help keep the CEO Zhang Zejun motivated

• Zhang Zejun, the founder and CEO, does not seem to be wedded to the business and is likely to be a seller at the right price. What makes me say that? He sold his stake in the business in 2009 two years after it was founded to a business partner that is still current shareholder. Subsequently, he bought the stake back (it’s a long-wounded story that can be found in the IPO prospectus as well)

• In Feb-2020, PepsiCo bought the local snack brand Be & Cherry from HaoXiangNi for USD 705 MM. The brand focuses on healthy snacks distributed online 

• PepsiCo’s board member Cheung On “Anne” Tse and seems to be a big proponent of ecommerce. In a previous role was VP of Ecommerce for Greater China and Asia and spent 10 years with McKinsey previously

• Prior to 2020, the company’s shares traded on average at around HK 1.5 and never below 1.17 and at an average LTM EV/ EBITDA multiple of 11.65 and a LTM PE 18.82 though admittedly the timeframe from the IPO in Nov-2018 to Dec-2019 is pretty short

• Concurrently with its H1 21 earnings, the company reinstated its dividend at the pre-Covid level. At current prices the dividend yield is about 7% and is close to 100% of LTM earnings, which seems to indicate some level of optimism about the current trajectory   

• As part of the IPO stock options were granted to key employees of which 67 MM are still outstanding each with a strike at HKD 1.468 per share. Zhang and his family own 4 MM of these options. They expire 2028

• Guilin Seamild which focuses on the mid-market segment (JM Smucker owned a stake in this business from 2012-2017), but has better margins given a more conventional distribution approach seems like a decent comp and trades at 30x LTM PE and 21x EV/ LTM EBITDA in Shenzhen 

• The company repurchased 33.5 MM shares or about a 1.5% of its market cap in 2019 at about HKD 1.66 per share 

• Company went public in December 2018 at HKD 1.62 per share (which was the low end of the HKD 1.62-2.10 offer price range) 

Valuation 

• Base Case 

• Currently trades at 13x with LTM net profit which does not seem excessive if you think the business can grow earnings at low single digits and LTM net profit is the new run rate 

• However, I think the growth rate will be higher. Why? Because the ecommerce channel is growing at 40% while accounting for 36.5% of sales. Even if you thought that the growth rate should moderate to its pre-Covid level of 20% it would imply mid to high single digit growth even if the offline business stays flat 

• Secondly, supermarket traffic is well below 2019 levels. True, the number of counters is lower than in 2019 and some of that traffic is probably permanently lost to e-commerce but some portion should return post-Covid. How big is the upside from increased supermarket traffic? Difficult to quantify, but sales are down 11% and net income 40% vs. 2019 levels. A 10-20% increase in net income post Covid seems plausible to me 

• Long winded way of saying I think the company can achieve HKD 1.9 Bn in sales and net income of c. HKD 115 MM in 2023 which would imply about 10% topline and net income growth per year. Note that in 2019 sales were HKD 2 Bn and net income HKD 141 MM and consensus (which consist of two local brokers; full reports are on Bloomberg) for what it is worth is at HKD 148 MM net income 

• Under that scenario I would expect the shares to rerate a bit to maybe conservatively 15x. Together with HKD 0.08 in dividends you get to about HKD 0.87 or 58% upside 

• And then there is the net cash of HKD 794 MM or about two thirds of the market cap. Certainly not the only company in Asia with a significant cash balance which often ends up being a trapped asset, but in this case, I would give them at least partial credit for it, because of the willingness to return cash through buybacks/ dividends and PepsiCo’s involvement. However, the company cannot buyback more shares because of minimum freefloat requirements, so it’s either a special dividend or an acquisition. Most likely outcome is a special dividend in my view as I believe that the founder has margin debt which could be elegantly eliminated through a special dividend. I therefore give them credit for 25% of their cash position or HKD 0.17 per share 

• In summary slightly above 1.00 HKD per share or 88% above the current share price 

• Downside Case 

• I assume HKD 0.36 per share which is the net cash balance per share. Of course there is no rule that a company cannot trade at less than net cash balance and in fact you do see that sometimes in Hong Kong happening even for profitable companies (though if the discount is meaningful and persists for a long time there are usually real issues). However, if the shares traded below that level for an extended period, I would expect an offer by the founder and Pepsico to take the company private and I do not think PepsiCo would want to be seen as opportunistically taking advantage of minority shareholders and would at a minimum offer net cash per share. This would of course value the business at zero 

• A little bit less pessimistically, one would note that there would probably be value for PepsiCo in having full control over their own local brand esp. in the current climate of rising tensions between the US and China. Shortcutting the lengthy and expensive brand building process through an acquisition would probably be attractive and in fact they bought a local snack brand in 2020 that has similarities to Wugu Mofang for USD 705 MM. As mentioned earlier, Zhang Zejun does not seem to be sentimentally attached to the business and might be willing to sell, but I am confident that he would ask for a lot more than net cash per share. Bottom line is that the true downside is probably very small

• Upside Case 

• The market is growing and fragmented, so there is the opportunity to outperform the modest growth assumptions I have laid out above 

• Distribution costs should come down if they can grow distribution agreements with supermarkets or find a way to reduce fulfilment costs either by going through online supermarkets or community group buying which would be very margin accretive. If they are successful in getting distribution right the valuation Pepsico paid of HKD 1.8 per share does not seem excessive to me

Risks

• Products are a fad: 

• Possible, but oatmeal with beans and fruits seems not particularly faddish to me 

• The company blamed the recent reduction in sales on Covid and that seems like a plausible explanation 

• There are fashions in food, but the rate of change seems way slower than for example clothing 

• Company was founded in 2007, so has a 13-year track record 

• Fraud/ Governance risks: Possible, but unlikely given PepsiCo’s involvement 

• Related party transactions: The sister in-Law of Zhang owns a specialty store that sells Wugu Mofang’s products. Seems natural enough to me and the volume associated with this relationship is less than USD 1 MM so I don’t lose sleep over it 

• Shift to ecommerce: Two thirds of sales are from brick and mortar and a higher percentage of profitability. However, company has adapted well to the shift so far and ecommerce continues to grow (+43% yoy in H1 2021). If there was an acceleration of the shift to ecommerce it would clearly be an issue for the company, but not necessarily an existential one 

• New entrants: Wugu Mofang seems to be the largest player in the “healthy cereal” niche, but the market is far from being mature. If another player gets to a larger market share, the company could have an issue. Quaker would be well positioned to be that other player, but PepsiCo’s conflict of interest should help mitigate this threat  

• China Macro: Nothing intelligent to say, but the company’s product is a discretionary item. If China’s economy does badly, I would expect the company to do badly too 

• Political risk: These days it is hard to be confident that any sector is immune, but healthy cereal seems to be on the less controversial end of the spectrum 

• PepsiCo: The investment hinges in many ways on PepsiCo’s continued involvement. If PepsiCo sells the thesis is probably broken 

Catalyst

Ecommerce growth 

Supermarket traffic normalization