In the previous post, we talked about the five reasons why I think Capilano is worth looking at. Today, we will discuss what are the risks and how much I think Capilano is worth.
What are the risks?
Now that we have looked at all the positive points about Capilano, let’s consider the risks that Capilano faces:
- Honey production risks: The amount of honey crop is highly exposed to weather factors that are uncontrollable by the beekeepers. Bad weather conditions – too cold (the honey bees might die, or they need to consume more of their own honey to generate heat during cold winter), little rain or dry conditions (means less amount of nectar around for the pollinators), strong winds/cyclone (flowers and buds would be knocked off plants, resulting in less nectar available), El Nino, and warm winter (this is cited by an analyst report, to which I don’t understand why) – and pest/diseases can seriously jeopardise the honey crop for that year, and affect both the amount of honey stock (an important ingredient to ensure a smooth business operations) and the level of sales and profits.In my opinion, this is the biggest risk that Capilano, and all other honey packers/producers, face. However, I see this risk as affecting more of the short term business performance (which does not concern me with a long-term view that much), and less of the long term. This is because the stronger players with better cash flows and balance sheets would be able to hold out until the honey season turns better, and still perform reasonably well on average in the long run, unless the bad weather is prolonged over many many years. In fact, the big players might actually end up benefiting in some form. For example, in FY2015, where honey crop was really bad, Capilano took advantage of the situation of lack of honey supply in the market to procure honey and push its market share from 50% to 70% in the Australian market. Overall, I would monitor this risk by keeping an eye on the weather developments and the honey stakeholders’ (Capilano’s, its competitors’ and bee associations’) commentaries on honey production and seasons over time;
- Strong competition and expansion risks in overseas markets: Although Capilano is very strong in the Australian market, it is less so in the other markets, which it intends to expand its activities. For example, China, a strategic market which Capilano chooses to focus on, has already seen the New Zealand players, for example Comvita, developing and solidifying their bases there for some time, setting out distribution channels and partnerships with local firms. Although the overseas markets are still big enough, I would expect strong competition and retaliation/activities by the competitors, and therefore Capilano would have to plan and execute well in order to establish itself well and expand in those markets;
- Pricing power in Australia: Beekeeping and honey farming are very labour-intensive activities, especially for Manuka honey, and increasing labour costs would exert pressure on Capilano’s profitability. If Capilano is not able to pass on all the costs increase down to the distributor/retailer that sells to the end consumers, Capilano’s margins would suffer. In this regard, Capilano mainly sells to the big supermarkets in Australia (e.g. Coles and Woolworths) that have great bargaining power, so Capilano would face some pressure from this side too. Earlier, we have already seen Capilano’s gross profit margin declining from 46.3% in FY2013 to 41.5% in FY2016, although it started to stabilise and recover to 42.3% in FY2017. I think that this ties in to some extent with the first risk (honey production risk) too, as a bad season would see the beekeepers producing less honey and therefore demanding higher prices for them (which means higher costs to Capilano) to stay in business, which is probably what’s in play to a certain extent on Capilano’s declining GPM in the past few years (despite its switches in product mixes to higher margin products);
- Other risks, which include stronger competition in the Australian domestic market (which I think the risk is relatively lower given its stronghold), economic slowdown impacting honey demand, in Australia and/or the export markets (honey, especially Manuka honey, is more of a premium product, which people might consume less during economic downturns), acquisition risks (Capilano’s inability to manage and integrate its future acquisitions, including beekeeping operations, well) and overall development of the Australian Manuka honey industry (for e.g. the Kiwis are currently trying to trademark the use of the word “Manuka” to restrict to only honey produced in New Zealand, which of course, the Aussies stood up to fight against, and challenges on the scientific evidence of the superiority of health benefits of Australian and Manuka honey).
How much is Capilano worth?
And finally, the golden question – How much is Capilano worth? Or rather, how much am I comfortable with considering a position in Capilano (as valuation is an art, and there is no single right answer), as a good company can make a bad investment given the wrong price, and a bad company can make a good investment given the right price. Thus, value investing (value vs price).
Given that Capilano’s debt is minimal (considering its past capital structure) and I expect that its maintenance capex should be close to its existing D&A, to keep things simple, I would value Capilano using a multiples approach (which I commonly use), and in particular just a simple P/E ratio, instead of a EV/operating profit ratio.
Before I discuss my valuation, let’s recap some of the important items that would affect the valuation:
- in terms of growth, the CAGR from FY2013-2017 for honey sales volume, revenue, gross profit and PAT is 12.6%, 16.5%, 13.9% and 31.6% respectively;
- In terms of return on capital, the ROE in the past two years (FY2016 and FY2017) is around 17%, with the most recent 16.6% of ROE in FY2017 achieved with the lowest equity multiplier (of 155%) compared with the past few years. The incremental return on capital, based on the CAGR from FY2013-2017, is between 17% to 24% (16.5% for RONA, 19.5% for RONE, and 23.6% for RONIC (remember RONE is, in my view slightly depressed, and lower than this RONIC due to the pare-down of debt)) during a period in which it deleveraged its balance sheet (i.e. reducing the equity multiplier) and building up its inventory (which increases asset base, thereby reducing asset turnover), which means that there is room for potential improvements for its incremental returns on capital;
- in terms of capital allocation, its past dividend payout ratio has been around 35% – 40% since IPO;
- in terms of balance sheet, as at the end of FY2017, it had a net debt of AUD 7.8m (AUD 9.0m of debt and AUD 1.2m of cash), receivables (AUD 24m) that were greater than its payables (AUD 21m), and an inventory of AUD 44m.
And here’s how I value Capilano:
- I value Capilano under three scenarios, which is normally what I do, being a conservative scenario, a reasonable scenario, and an optimistic scenario;
- I start off with Capilano’s latest PAT in FY2017, of AUD 10.3m;
- This FY2017 PAT, based on just accounting numbers, was overstated by one-off net gain of AUD 0.74m (gain on sale of beekeepers assets of AUD 2.07m, minus the downward revaluation of honey stock due to low honeyprice of AUD 1.33m);
- However, in my opinion, there are a few other factors that suppressed the FY2017 PAT – (i) losses from its two JVs totalling AUD 0.37m (loss of AUD 0.12m and AUD 0.25m for WA and Medibee respectively) due to start-up phase and bad honey season for WA, (ii) temporary issues for overseas sales, with FY2017 overseas sales declining by AUD 5.2m compared to the previous year, mainly due to tough international market (which is recovering now) and exiting of less profitable markets and products (which is more of one-off nature, and that the company can focus instead on sales of its honey stock in more profitable markets), and (iii) the increased spending of marketing costs for new products (Beeotic) of AUD 2.2m, of which either the costs would taper down after a few years (the company currently still wants to push this product a lot), or these marketing activities, if successful, would result in higher revenue which pulls up the PAT; and
- Therefore, I choose to make a net uplift to the FY2017 PAT of between 0% to 10% for the three scenarios, to arrive at a sustainable/normalised level of PAT going forward, for me to apply my assumed P/E on. I consider this 10% max net uplift (of around AUD 1m) to be reasonable, given the substantial decline in overseas sales of AUD 5m which could potentially recover (either soon or in one or two years’ time). This would be something that I would monitor in Capilano’s FY2018 H1 and full year report, to see whether my assumption is reasonable and whether any adjustment is needed;
- For P/E multiple, I use a range of 15x to 18x for my three scenarios, with the mid-point of 16.5x for my reasonable case.
- For my conservative scenario, I see it as a worst case scenario where Capilano does not garner any substantial growth in the future, and merely keeping up with inflation or rise in costs. In this case, given Capilano’s strong ability to convert profits into cash flows and low capex needs, I deem a 15x P/E, or 6.7% earnings yield, to be sufficient for my appetite, since it can almost distribute all of the 6.7% earnings yield as dividends, although this scenario is highly unlikely given the short term growth opportunities still available to Capilano;
- For my aggressive scenario, I choose a P/E of 18x, which is lower than its CAGR (FY2013-2017) for profits of 31.6% (which is artificially boosted by enlarged equity base) and closer to its CAGR for revenue of 16.5%.Now, let’s try to put the returns on capital into the equation. I would say I would expect Capilano to be able to achieve incremental return on capital of between 19.5% (based on its past RONE) and 23.6% (based on its past RONIC). To be conservative, I would use a lower number of 20% for my valuation. This means that my assumed P/E of 18x is still reasonable as it is lower than the 20% incremental return on capital (which, in most cases, sets the upper limit of the level of earnings growth). This also means that if I want a PEG of 1x, my assumed P/E of 18x would entail the company reinvesting about 90% of its earnings, which is possible, but unlikely.As a side point, if Capilano takes on slightly more leverage (than its current net-debt-to-equity of 13%) and can manage its working capital, especially inventory, better, there are still rooms for improvements for its incremental returns on capital;
- For my reasonable scenario, I take the mid-point of the two P/Es above, resulting in an assumed P/E of 16.5x, which I consider quite reasonable. If not for the high exposure risk of honey production to weather conditions, I would be more comfortable with paying a higher P/E.In addition, to achieve a PEG of 1x, or earnings growth rate of 16.5x, this means that the company has to either reinvest 83% of its earnings, which is unlikely (but still possible if there are sufficient reinvestment opportunities) as it is higher than its past reinvestment rates of 60% – 65%, or take on more leverage to boost its equity returns, or achieve an incremental return on capital of 25.5% (assuming 65% reinvestment rate), which is slightly higher than its past RONIC of 23.6%, and is possible.At a reinvestment rate of 65%, the growth in earnings of Capilano would be around 13% (= 20% * 65%). Also, at a P/E of 16.5x and an assumed dividend payout of 35%, this would mean that my dividend yield would be around 2% (= 1 / 0.165 * 0.35).
- I deduct a net debt of AUD 7.8m from my valuation, to be conservative (although this is theoretically wrong given that I have used P/E, instead of EV/operating earnings, in the first place). I would say this is quite conservative, given that if we look at Capilano’s last working capital position, its receivables is higher than its payables (by a few millions) and it had a closing inventory of AUD 44m, which it had paid in cash for and could use to generate revenues and profits without incurring any cash costs (although acknowledging that it would require a reasonable level to inventory to run its operations, which in FY2014 and FY2015, it was surviving at about half of the current inventory (AUD 14m and AUD 23m respectively, although it has a much larger operations now with more JVs and acquired companies).
Based on these assumptions, I value Capilano (see table below), in today’s terms, at around AUD 180m to AUD 200m, or around AUD 18 to AUD 21 per share, based on my reasonable and optimistic scenarios. In my conservative scenario, which I consider to be a very unlikely worst scenario, Capilano would still be worth around AUD 155m (or AUD 15.50 per share) as a floor.
Going with my reasonable valuation scenario, I would expect my returns from being a partial owner in Capilano, based on a 35% dividend payout, to come from a 2% annual dividend yield and the capital appreciation of Capilano arising from an increase of its operating earnings by around 13% per annum, giving me a total return of approximately 15% per year. This 15% total return is purely a guide, and of course, would be affected by both positive and negative fundamental developments over the years, and the lack of adequacy of my analysis. Hopefully, I would see more positive developments (e.g. a recovery to a higher level of normalised/sustainable earnings, and/or higher RONIC, arising from either better pricing power, better asset turnover, switch to higher-margin products, more efficient operations, good honey seasons, etc).
On the last point, Charlie Munger always likes to say that “all I want to know is where I’m going to die so I’ll never go there”. Putting myself in this shoes and thinking what could kill my investment in Capilano, I see the worst worst case scenario as one where there are:
- prolonged bad honey seasons (due to bad weather/diseases/crazy human acts resulting in bad crops and/or death of honey bees);
- worsening of Capilano’s performances in its export markets (due to increasingly stronger competition) and probably its local market too (declining gross profit margins, or if competitors decide to scale up or undertake price cuts in good honey seasons);
- strong retaliation from competitors in the China market (in which it intends to strategically invest in (which requires capital)), resulting in prolonged price wars;
- cock-ups in its two JVs (maybe due to inexperience in bee farming);
- sabotage of Capilano’s branding in Australia (we have seen one in 2016, in which Victorian apiarist Simon Mulvany waged a social media campaign against Capilano, accusing it of selling “toxic”, imported honey and of using misleading labelling);
- departures of key senior management, including Ben McKee who has been appointed as CEO in 2012 and MD in 2013; and
- New Zealand winning its bid to trademark “Manuka” honey, which would create a mess for the worldwide Manuka honey market.
In a simulated quite awful and unfortunate case, with probably up to four of the factors above happening at the same time, I see Capilano’s profits dropping to around AUD 7.5m (about 73% of its FY2017 profits), and at a P/E of 15x, it would be worth around AUD 110m, i.e. ~35% less than my reasonable valuation of AUD 170m. Hopefully, I won’t get to validate the accuracy of such a valuation. In any way, forcing myself to think about these disasters, or where I would die, would make me more alert to which are the most important factors to monitor and stop me from going there (hopefully, in time).
Note: This is not a recommendation to buy or sell. As with all (value) investments, it’s of utmost importance to do your own due diligence. And as Peter Lynch puts it, “know what you own, and know why you own it”.
Disclosure: The author has long position in Capilano as at the time of writing.
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