Goodbye (Capilano) Honey…

Capilano Honey, a company which I partially owned since January this year, received a take-private offer early this week. This becomes the second take-private offer I received in my investment journey, after GLP in 2017.

The price? Cash offer of AUD 20.06 per share , translating to equity value of around AUD 190m, with the option to receive scrip shares in the new entity. This offer price represents a 28% premium over the last close price (AUD 15.65) and implies a FY18 P/E of 19.3x (on earnings which I consider to be still depressed) and FY18 EV/EBITDA of 12.5x.

The buyer? A private equity group (Wattle Hill), co-founded by Albert Tse (the husband of Jessica Rudd, daughter of former Australian prime minister Kevin Rudd… LOL), specialising in China-focused agricultural exports.

At the same time, Capilano also released its FY2018 results, which were quite good in my opinion.

  • Revenue increased by 4% to AUD 139m;
  • Operating profit increased by 19.6% to AUD 14.0m (disregarding the one-off non-operating capital gain of AUD 2.1m last year); and
  • Honey stock further improving to 6,746 tonnes from 5,953 tonnes last year with better season (although Eastern Australia started seeing increasingly apparent dry conditions in recent months).

Capilano FY2018 results summary

Kerry Stokes, who has 21% voting power via Wroxby Pty Ltd, has already indicated to vote for scrip consideration and the deal is likely to go through.

The offer valuation of AUD 190m lies towards the upper range of my valuation of AUD 170m to AUD 200m made in January 2018. And I feel that the offer price could have been a bit higher, at around AUD 200m or even slightly more (given the benefits that the buyer would accrue, from recovery in earnings and likely expansion into China utilisting their expertise and networks).

Capilano post in January
My valuation in January 2018

I purchased it at AUD 18.60 per share, or AUD 176m for the whole equity. And I received a dividend of AUD 0.34 per share in July, so this should imply a return of approximately 10% [= (AUD 20.06 + AUD 0.34) / AUD 18.60 – 1].

But my returns? It depends largely on how AUD performs against SGD in the coming months.

For now, assuming I hold it till take-private happening in 5 December this year and AUD-SGD remains at the current rate of 1.0x till then, my returns would be a mere 1.7% (after taking into transaction fee, of a whopping AUD 75 (or 2% of my purchase cost) from OCBC Securities, which I discovered it to be this high only after I received the transaction statement – I thought it would like in the range of AUD 25 similar to other markets, but lesson learned).

If lady luck is with me, and AUD appreciates back to 1.06 SGD (the rate I purchased in January) by December, then my return would improve to 7.4% (for 10 months), or annualised rate of 8.4%, which is sub-par and below my expectations. Nevertheless, still a good and interesting ride and a first attempt in buying an Australian company.

Capilano returns

Given that I am based in a foreign country outside of Australia, with my shares purchased through custodian by my brokerage firm, opting for scrip in the new entity would be risky and unwise for me in my opinion.

So for now, all I have to do is wait for the privatisation to happen end of this year and hope for an appreciation in AUD (I’m unlikely to sell before that, to avoid incurring the whopping high transaction fee charged by OCBC Securities again) (or hope for someone else to come in with a higher bid, which would be a blue moon LOL).

To end my journey with Capilano (I have been following Capilano hashtag on Instagram, joining Australian beekeepers forum on Facebook, checking out Capilano’s products whenever I am in a supermarket, etc), let’s hear back and enjoy this catchy Capilano song! (scroll to 14:53)


Is There Money in Capilano Honey (ASX: CZZ)? [Part 3]

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;
    1. 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);
    2. 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
    3. 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.
    1. 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;
    2. 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;
    3. 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 170m 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 150m (or AUD 15.50 per share) as a floor.

Capilano - Valuation (Jan 2018)

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:

  1. prolonged bad honey seasons (due to bad weather/diseases/crazy human acts resulting in bad crops and/or death of honey bees);
  2. 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);
  3. strong retaliation from competitors in the China market (in which it intends to strategically invest in (which requires capital)), resulting in prolonged price wars;
  4. cock-ups in its two JVs (maybe due to inexperience in bee farming);
  5. 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);
  6. departures of key senior management, including Ben McKee who has been appointed as CEO in 2012 and MD in 2013; and
  7. 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.

P.S. If you want to receive updates on my future posts, do subscribe to my blog by using the subscribe function (on either the right or the bottom of the page).

Is There Money in Capilano Honey (ASX: CZZ)? [Part 2]

In an earlier post, I wrote that, in my opinion, Capilano is a strong company with strong (and growing) moats with high returns on capital, and it’s worth looking at for the following reasons:

  1. Capilano’s honey packing business has good business economics, reflected by its strong financials.
  2. Capilano has very strong access to one of the most important ingredient to be successful in this business, i.e. good honey supply.
  3. Capilano has been investing and consolidating its businesses in the past few years, investing in additional resources, repairing its inventory and strengthening its balance sheet, and is ready to reap the rewards, with an improving honey production season to come after its worst few years in history;
  4. Capilano’s stronghold in Australian market (of >70% market share) provides it with strong and sustainable cash flows, which are partly returned to shareholders as dividends and partly reinvested for future growth in markets with high growth potential (e.g. China).
  5. Last but probably most importantly, I see Capilano as being able to grow and deepen its strong moat as time passes and has long runways for growth opportunities (from new markets, new products, greater sales volumes and potentially more M&A activities to expand its asset base).

Today, we will visit these points in turn.

Why I think Capilano is worth looking at?

1. Good business economics of Capilano’s honey packing business

Capilano’s honey packing business has good business economics, reflected by its strong financials. When it comes to business economics and financials, the most important thing that I look for is strong returns on capital (ROA, ROE and ROIC).

Capilano has excelled in this area, for a packing/distributor business model, with strong ROA (around 9%-11%), ROE (16%-23%) and ROIC (12%-18%), and crazy ROPPE (24%-49%) in FY2014-17, while not employing moderate leverage (net-debt-to-equity of 13%-27%) during the same period.

Capilano - Returns on capitalCapilano - Leverage

To understand why Capilano is able to achieve such strong returns of capital, it is important to understand its business model and the assets that drive its returns and growth first.

In terms of business model, a honey packer, like Capilano, basically just purchase raw honey from the beekeepers families/enterprises at a reasonable price, filter them, pack them into nice containers or glass jars in its high-tech factories with a high level of automation (it has just over 120 employees who oversee the honey packing process in its head office, implying almost AUD 1m of annual revenue per packing employee), give them some branding labels and pushes the products into domestic retail channels (supermarkets/ pharmacies/ health food stores and grocery stores) and overseas markets (either as retail or industrial products).

In simple terms, it means Capilano is almost just a middleman who consolidate the honey and sell them. Therefore, Capilano’s most important asset is not its fixed assets (to be more specific, its PPE), but its inventory, i.e. raw honey stock.

A quick look at its balance sheet explain this. As at the end of FY2017, its total assets of AUD 96m is mainly made up of inventories (46% or AUD 44m), followed by receivables (25% or AUD 24m) and PPE (22% or AUD 21m).

Capilano - Assets

This makes logical sense, because to pack and sell honey to increase sales, you need honey in the first place. Since Capilano mainly sources its honey from others, it doesn’t require as much PPE (or biological assets, aka bees) to generate those honey. Therefore, inventory, and the ability to purchase and stock up sufficient inventory, is crucial for Capilano’s business. Fortunately, Capilano is good in this – it has a very strong access to honey supply, which is one of the factors I think Capilano is worth looking at, which I will touch on shortly.

Now that we understand Capilano’s business model and asset components, let’s go back to revisit its returns on capital and understand its components. To keep things simple and focused, let’s focus on just ROE.

Capilano - Returns on capital (short)As seen in the table above, Capilano’s ROE started at 16% in FY2014, went up to 23% in FY2015, before coming down to 17% in FY2017. Although the ROE in FY2017 sort of went back to its original level three years ago, its individual Du Pont components have changed quite some extent:

  • Equity multiplier has come down from 174% to 155%, which to me is a good thing, since the current returns are achieved on a less leveraged capital base (which also mean that future ROE can increase if the company can take on and manage more liabilities carefully – a large part of its liabilities is mainly payables (61%), followed by debt (26%));
  • Asset turnover has come down from 173% to 138%, which is not a positive thing to me, but the comforting part is it has started to stabilise and hopefully it would go up in the future. My take on the declining asset turnover is probably that the company has been acquiring many different companies/assets (which I will touch on later) which disrupts/changes the mix of the asset turnover, coupled with quite bad honey production seasons in the past few years (which I will also touch on later);
  • NPM has gone up by 45%, from 5.4% of revenue to 7.8% of revenue, which is a very positive thing. This indicates improving operating efficiency (even on the back of declining GPM) and Capilano’s ability to compete with competitors successful and still increases its profitability (by spending much marketing expenses in terms of % of revenue), which I attribute partly to Capilano’s strong brand (which is one of its moats, which I will touch on later).

The good part is that it is not just its existing returns on capital that are strong. Its incremental returns on capital are solid too, at north of 16% up to 24% depending on which returns on capital we look at (see table below – focus on the CAGR and not the yearly incremental returns which are quite volatile). One point to note is that Capilano’s RONE is lower than its RONIC, and is in my view slightly depressed, mainly due to the use of its retained earnings to pare down long-term debt during that period (resulting in a greater increase in the equity base than the invested capital base).

Capilano - Incremental returns on capital

These strong RONIC (and RONE) would ensure that our shareholder money is well spent and generate good returns when the company grows (which I call good growth – not all growth are good and value-accretive for shareholders).

These are all positive indicators, but remember, as we have just discussed, no matter how good the returns on capital are, the most important capital/asset that the company needs to grow is not the fixed assets which the company can build easily, but a strong and sustainable (and even better, increasing) supply of good raw honey at reasonable prices, which I will touch on next.

At this point of time, some of you might be also thinking if the ROIC and RONIC are so good, why aren’t other players coming in and taking a piece of the cake? The answer is it is difficult, as Capilano is protected partly by the difficult nature of beekeeping (it is much more difficult compared to other primary agricultural industries) and partly by its strong moats (intangible assets and efficient scale), which I will touch on shortly.

2. Strong access to honey supply

Capilano has very strong access to one of the most important ingredient to be successful in this honey packing business, i.e. good honey supply (at reasonable prices).

The first question to answer is what’s so difficult about procuring honey supplies, especially the Manuka honeys? The answer is that rearing bees and farming honey (especially Manuka honey, which requires beekeepers ensuring that the bees only pollinate from the Manuka plants) are not easy. I think OTC Adventures explains this very well, so I will just quote him.

I think Capilano is somewhat sheltered from competition by barriers to entry that honey suppliers face. First, adding honey-making capacity is a lot more complicated than, say, increasing corn or wheat acreage. A field can be planted with whatever crop offers the best prospective return at the moment, but increasing honey output requires building infrastructure that can only be used to produce honey. For bee-keepers to justify adding capacity, they must be confident that higher prices will last. Essentially, the honey price cycle moves much more slowly than those of easier to produce agricultural products.

Therefore, due to the difficult nature of beekeeping business, the supply of raw honey in Australia is limited and if we talk about Manuka honey, there is a strong under-supply due to strong and growing demand for this health product, especially increasingly from emerging markets (think China).

Based on Australian Honey Bee Industry Council (AHBIC), as of August 2017, there were around 21k beekeepers and 647k bee hives in the whole of Australia, with 85% of the total bee hives owned by 8% of the beekeepers (the larger producers with more 50 hives or more), and most of the bee hives located in New South Wales, followed by Queensland, Victoria, SA and WA (Capilano sources from all these five territories/states).

Capilano - No of beekeepers

So how does Capilano manage to get this strong access to honey supply in Australia? Capilano got a strong and lucky hand, due to its origin as a bee-keeper cooperative in 1953, which allows it to develop strong and lasting relationships with many beekeepers for many decades (it currently sources from more than 600 beekeepers, on top of its wholly-owned beekeeping enterprises). Furthermore, in the past, the bee-keepers are required to own a certain number of shares in Capilano for each bee hive in operation (this has been discontinued), which gave them incentive to supply their honey to Capilano but not others.

Besides this natural advantage, Capilano has also been making it a priority to take good care of the beekeepers and paying them good prices for their raw honey, so that the bee-keepers will choose to sell their honey to Capilano and have confidence that Capilano would continue to procure from them at good prices even in difficult market conditions, as it knows that it needs these beekeepers to stay in business so that it would continue to get sufficient honey supply.

Capilano is able to do so (i.e. pay the bee-keepers good prices) as it is able to pass on some of the price increase to the end consumers due to its strong branding, with a >70% market share (which is one of its moats, falling under the intangibles category) and it has lower fixed costs per product unit due to its large business size.

Besides that, Capilano also spent a great deal of efforts to help the beekeepers. For example, Capilano undertook two initiatives in FY2015 – producing a Pest Management Pack for Varroa, a potentially serious pest of bees if or when it arrives in Australia, and a Manuka Information Pack, for the beekeepers.

The outcome of Capilano’s efforts in developing good relationships with a large network of bee-keepers (currently more than 600 bee-keepers) is the development of a strong moat, i.e. intangibles, relating to its strong and long-lasting relationship with bee-keepers, that allows it to gain access to sustainable supply of honey and protect its high returns on capital.

This limited supply market of honey also creates another moat (efficient scale) for Capilano, as the market is not large enough, from the supply side, to support more new entrants (which have to incur large capital costs that can be spread over less scale at the beginning), thus setting up high barriers of entry to new entrants.

Despite having a strong supply network of bee-keepers to source its honey from, getting sufficient honey supply (to ensure an efficient packing process and sufficient stock for sales) is still a difficult feat for Capilano, as the honey production season is highly affected by weather conditions. A bad season, like very cold weather or little rain (the plants grow less and flowers bloom less), can result in bad honey crops.

These bad honey seasons happened in the past few years, in FY2014 and FY2015, with some improvements seen in FY2016 and FY2017, as seen in the chart below (sourced from Capilano’s FY2017 AGM presentation).

Capilano - Honey supply security

To further ensure supply security of honey, Capilano has recently gone upstream into the bee-keeping business, which to me is a positive development since honey supply is such crucial in this business. In particular, Capilano invested in three entities (Kirksbee Honey in July 2015, Medibee Apiaries in July 2016, and Western Honey Supplies, also in July 2016):

  • Kirksbee Honey: On 30 July 2015, Capilano acquired 100% of the share capital in Kirksbees Honey Pty Ltd, a beekeeping enterprise, for AUD 5.3m (made up of AUD 3.2m of plant and equipment + AUD 0.13m of biological assets + AUD 2m of intangibles). Capilano also purchased the land and buildings associated with the business for AUD 0.75m, therefore paying a total of AUD 6m for the deal.This beekeeping enterprise is one of Australia’s largest active Manuka honey producers, which is located in Evans Head, New South Wales. The acquisition included the assets required to operate the business including bee hives, apiary sites, vehicles, related property, sheds and honey extraction equipment. In FY 2015, the beekeeping enterprise produced over AUD 2m worth of bee products, which implied that Capilano paid a P/S of around 3.0x for the deal (= AUD 6m/ AUD 2m). According to the company, Kirskbee was attractive to Capilano as a consequence of:
    – the notable Manuka floral apiary sites the business has access to;
    – the provision of future assurances in its supply chain with regard to high value Manuka honey supply;
    – the potential to grow production over time; and
    – the ability to train and foster new industry entrants to the beekeeping industry.A news article in March 2016 states that “[l]ast year Capilano bought the country’s largest Manuka beekeeping operation at Evans Heads in NSW for $6 million, in the hope it would cash in on the China-Australia free-trade agreement. Health-conscious Chinese are interested in the purported medicinal benefits of Manuka honey, which is produced by bees that feed on the flowers of the scrub-type tree species of the same name, native to Australia and New Zealand, well known for its antibacterial qualities. With China’s demand for Manuka honey increasing, Capilano Honey is ready to reap the FTA’s rewards, aiming to get ahead of its New Zealand competitors. Under the agreement between China and Australia, the 15 per cent tariff on natural honey and the up to 25 per cent tariff on honey-related products will be removed for Australian honey exports to China”.

    Given that the acquisition price was around AUD 6m (although the most part was for PPE and intangibles), which was about 77% of Capilano’s profits of AUD 7.8m in FY2015, and that Kirksbee seems to be one of the then largest Manuka operation in Australia, I would expect Capilano’s honey supplies to grow significantly after its acquisition. However, Capilano’s domestic honey receival in FY 2016 was only 11%, or 1,235 tonnes greater than the previous year (see table below), although I have limited information on these data and there may be other factors affecting the honey crop that year too. Overall, with Kirskbee, Capilano should have stronger and better access to Manuka honey supplies, although all these should have been reflected in the financials in the past two years (FY2016 and FY2017).
    Capilano - Honey stock

  • Medibee Apiaries: In July 2016, Capilano and New Zealand based Manuka specialist Comvita (CVT.NZ) formed a 50:50 JV, called Medibee Apiaries, to secure greater manuka honey volumes in Australia and to develop medical and natural health products. On 29 July 2016, Capilano sold its manuka beekeeping assets into the JV for AUD 9.225m. AUD 2m of these proceeds were redeployed as a loan to the JV to fund its growth.The FY2016 annual report describes this as “[i]n a significant departure from our previous dependence on the purchase of honey and bee products from other beekeeping enterprises, Capilano has begun to vertically integrate by investing in selected beekeeping enterprises, primarily in the production of high value Leptospermum honey used in our premium range of medical and natural health products. These operations will be managed by Medibee, a 50/50 Joint Venture with Comvita who are a New Zealand company that have extensive production and marketing expertise from their own operations in New Zealand and who currently operate in Australia in a sales and marketing capacity. We expect this new joint venture to assist our business by increasing the security of supply and by expanding our involvement in the international value chain for Leptospermum or Manuka honeys”.In FY2017 H1, Medibee has been focusing on growing the number of bee hives organically first, before focusing on the honey production. As stated in the FY2017 H1 report, “[t]his financial year we started two primary production joint-ventures, one a Manuka focussed operation in northern New South Wales and the other based in highly productive regions of Western Australia. In both cases we have organically grown beehive numbers to minimise disease risk, which requires splitting existing hives and initially reducing honey production. This work has increased hive numbers that will improve our production performance in coming seasons”.

    And in FY2017 overall, Medibee is still in the midst of developing the beekeepers’ skills and acquiring additional flora resources, and at the same time, increasing hive numbers to fully utilise current floral resources. In FY2017, after a full year of operations, Medibee incurred a net loss of AUD 246k (with a revenue of AUD 1.58m and total expenses of AUD 1.83m). Even though Medibee is still loss-making and is still building up its foundation, the honey production has already been quite promising. In particular, the management states that “[o]ur two primary production joint ventures have now completed a full year of operations and while the focus has been on expanding the hive numbers to allow them to fully utilize the resources they have access to, they have also produced a reasonable crop of honey. Most pleasingly, they have been able to match and in some cases exceed the production of other similar businesses that operate in the same geographic regions in a below average season” and “[d]espite a low production season this year that impacted profitability we remain confident of the future positive earnings potential of this venture, in addition to the benefits of improved supply security”.

    Overall, I am very positive about this development for a few reasons.

    First, this joint venture and move to upstream activities would allow Capilano to have more control and management over its honey supply base, on top of providing it with more honey supply to fulfil the market demand (over the years, Capilano has been importing honey from overseas (especially Argentina), which it blends with its Australian honey and sells under its Allowrie brand, to fulfil market demand. To get an idea of how big this issue is, in FY2015, Capilano bought 9,265 tonnes of domestic honey and 6,000 tonnes of imported honey, although I suspect the amount of imports has decreased since as the domestic honey production improves).

    Second, this is a joint venture with Comvita, the world and New Zealand largest Manuka player, with its more than double Capilano’s size in terms of market capitalisation, and has extensive experiences and skills in producing Manuka honey in New Zealand, and therefore Capilano would be able to leverage off Comvita’s experiences while Comvita benefits from Capilano’s Australian base. I suspect that Comvita wanted to come into Australia for honey production,because of the more difficult and volatile operating environment for honey production in New Zealand, compared to Australia (Watson & Son New Zealand, a popular Manuka honey brand, was put into liquidation in September 2016, due to the worst honey season in 35 years which affected Watson & Son’s cash flows).

    Third, this joint venture is already showing some results. In FY2017, Medibee was the single largest supplier of Manuka honey to Capilano, providing it with AUD 1.2m worth of honey, and it has around 3,600 hives as at October 2017 (according to Comvita’s data; Comvita had around 30,000 bee hives in New Zealand in June 2016). As Capilano gets from Medibee more and more Manuka honey, which commands higher margins, to sell them, I expect that Capilano’s gross margins would go up, in line with its strategic focus to switch to more premium high-margin products.

    Last, an analyst report states that “[i]n addition to the JV earnings, CZZ will also earn revenue from packing and supplying Comvita’s products in Australia”. This arrangement seems positive to me, but I have been unable to get more information on this.

  • Western Honey Supplies: Unlike Medibee, this is a joint venture that focuses on the supply of normal honey (and not Manuka honey). On 7 July 2016, Capilano Honey Limited acquired 50% of the share capital in Western Honey Supplies Pty Ltd for a cash consideration of AUD 2.5 million and established a 50/50 Joint Venture with Western Australia honey producer, Spurge Apiaries, to provide geographic diversity, secure supply and grow production. On 26 August 2016, Capilano Honey Limited sold 77 apiary site licenses to Western Honey Supplies Pty Ltd for AUD 363,116.Based on the FY2016 and FY2017 reports, “Capilano has entered a joint venture with an existing contracted honey supplier in Western Australia to assist the expansion of this already large honey producing enterprise. While these enterprises will help to secure Capilano’s supply base they will also give us a platform to train and assist potential new entrants into honey production either as employees or ultimately in their own right. We will endeavour to use them to assist rather than compete with our existing contracted supplier base who are mostly very efficient family based businesses” and “Western Honey Supplies is a Joint Venture with a large existing supplier based in Western Australia (WA). Its main focus is increasing supply security of premium floral and organic honey from WA. This venture has also made strategic acquisitions to increase floral resources and invested in increasing hive numbers. One of WA’s worst production seasons last year also impacted profitability, but enabled efforts to focus on hive number expansion and beekeeper skills development for the future betterment of the business. Western Honey Supplies was the single largest supplier of WA honey to Capilano this financial year and is one of our top five suppliers nationally”.
    Although Western Honey Supplies also made a net loss of AUD 122k (with a revenue of AUD 1.0m and total expenses of AUD 1.1m) in FY2017, I see it as a long-term strategic investment which is incurring start-up phase costs, where it was increasing the number of bee hives and floral resources. As with Medibee, the management said that “We are confident of the future positive earnings potential of these ventures, in addition to the benefits of improved supply security. A low production season over FY17 impacted profitability in both ventures”. Overall, I see this development as positive and crucial for Capilano’s strategic plan for its procurement of honey supplies in the future.

At the same time, besides focusing on the bees for its future sustainable access to honey supplies, Capilano has also been focusing on the long-run development of beekeepers and the apicultural industry. It instigated a “Keeping Futures Program” to provide the next generation of beekeepers with career paths and training, whilst protecting the world’s healthiest population of honey bees found in Australia. In addition, in collaboration with Medibee Apiaries, it has also implemented a traineeship program that has just employed three new enthusiastic beekeepers that will be educated with a sponsored practical and theory component. These activities show that the company and management are willing to take the long-view, to ensure its long-term success, instead of just focusing on its short term performance, which to me is good because it is in line with my investing style of holding a good company for long (of course, assuming it is still good over time).

Now that we have looked at Capilano’s strong and sustainable access to honey supplies, the next question I would like to answer is is now a good time to look at Capilano? Which business development cycle is it in now?

3. Reaping rewards after a period of investing and consolidation phases

Capilano has been investing and consolidating its businesses in the past few years, investing in additional resources, repairing its inventory and strengthening its balance sheet, and is ready to reap the rewards, with an improving honey production season to come after its worst few years in history.

The table below, on Capilano’s generation and use of cash over the past few years, explains everything.

Capilano - Past use of cash

In FY2014 to FY2017:

  • Capilano generated profits of AUD 32m and operating cash flows before WC changes of AUD 39m;
  • Capilano spent those AUD 39m of OCF before WC and its existing cash balances on building up its WC (AUD 25m, of which AUD 26m relates to build-up of inventory) and investments in capex (AUD 19m for investments in PPE and associates, and acquisitions); and
  • in terms of financing, Capilano got AUD 17m of cash from share issuances (mainly in FY2016 which it said would be used to retire debt, fund acquisitions, new product development and capital equipment), which it used to retire AUD 7m of debt and pay out AUD 10m of dividends.

This means that, despite the enlarged share capital base (but with a more solid balance sheet due to retirement of debt), Capilano basically reinvested all of its operating cash flows (before WC of AUD 39m) in the past four years in either:

  • building up its honey stock, by a whopping AUD 26m to AUD 44m (an amount >4x its PAT in FY2017 of AUD 10m); or
  • investing in PPE (AUD 14m, mainly for upgrade of its second major packing line in FY2014; and production efficiency upgrades, installation of several new packing lines at its Maryborough site, replacement of temporary hotrooms at Richlands (QLD) and acquisitions of more beekeeping assets in FY2016) and entities (AUD 2.7m for acquisition of Kirksbee’s intangibles in FY2016, and AUD 2.5m for Western Honey in FY2017).

In my view, Capilano’s investing and consolidating activities have been established, and these investments are now ready to put Capilano in a good position to secure more honey supplies and grow its operations, sales and margins over the next few years.

First, with a better honey stock of almost 6k tonnes (and more beekeeping assets and enterprises) now, Capilano can run its operations in a smoother and more efficient manner, compared to few years ago in FY2015 where it had only a honey stock of 2.9k tonnes and it had to pack about 1k tonne of honey per month, which would put a strain on operation and distribution management. With a stronger honey stock now, Capilano is also in a better position to plan for and fulfil more sales both overseas and domestic, therefore improving its chances of increasing sales in the future.

Second, Capilano’s investments in the two JVs in FY2017, Medibee and Western Honey, are ready to bear fruit. Both the JVs made losses of AUD 0.25m and AUD 0.12m respectively, due to their investments in the foundations (securing more floral resources, developing beekeepers’ skills, and building more bee hives, instead of focusing on the actual honey production) and a moderate/bad honey season (especially in WA). The management is positive over the future positive earnings potential of these two JVs and expect production performance to improve soon. Given that these two JVs form large portions of Capilano’s existing honey supply, where they are the largest Manuka honey and WA honey individual supplier respectively, when their honey production improves over the long run, I expect them to contribute positively to both Capilano’s honey supply (which can improve its sales) and earnings (through switches in product mix to higher-margin Manuka honey, and more operating efficiency and operating leverage).

Third, with the stronger (and more normal) level of honey stock now, after the worst honey seasons few years ago, an improving honey season would fare well for Capilano’s business. The company is expecting a better season in FY2018. In the FY2017 annual report released on 7 August 2017, TR Morgan (the chairman) said that “[h]oney production has improved this season and with reasonable prospects for next season in most regions we hope to be able to take advantage of this additional honey to further expand sales into profitable overseas opportunities”, and Ben Mckee (the MD) said that “[t]he improved rain patterns in key production areas has led to a notable increase in honey supply in recent months, with our largest ever winter honey supply for many, many, years. Weather permitting, we remain very optimistic of the potential for increased honey production in the coming season from spring 2017”. During the AGM presentation on 17 November 2017, the company reiterated that “FY18 crop prospects are looking promising, with an above average crop forecast”. Therefore, it seems that Capilano is on track to secure a decent, if not a good, supply of honey and performance in FY2018.

Last, Capilano has been using its cash from operations to significantly “repair” and de-leverage its balance sheet, paring down its debt-to-equity (and its net-debt-to-equity) from 61% (and 60%) in FY2013 to 14% (and 13%) in FY2017, with strong interest cover too. This puts Capilano in a strong balance sheet and cash flows position (recall the big New Zealand player, Watson & Son that was put into liquidation in 2016, due to cash flow problems arising from bad honey seasons) to take up any future opportunities for expansions or acquisitions. I guess the management has learned from their lessons of not using excessive leverage, which dragged down the company’s profits and cash flows, during the years leading to FY2010 (with a debt-to-equity and net-debt-to-equity of 101% and 43%), and is now more careful of the capital management of the company, and has finally de-leveraged to a comfortable level after many years of efforts.

Capilano - Leverage

4. Strong sustainable cash flows to fund dividends and growth

Capilano’s stronghold in Australian market (of >70% market share) provides it with strong and sustainable cash flows, which are partly returned to shareholders as dividends and partly reinvested for future growth in markets with high growth potential (e.g. China).

As Capilano is not a capital-intensive business (in terms of PPE), its earnings power has been strong. As seen in the table below, its OCF before WC changes has been consistently above 100% of PAT, except for FY2017 at 90% (but that was depressed due to some one-off non-cash gain).

Capilano - Cash flows

Capilano’s WC changes have exerted a large drag on its free cash flow generation capability, but that’s due to the need and intention to rebuild its inventory base over the past few years, which I think would not happen at the same magnitude again going into the future. Its latest capex on PPE in FY2017 was lower than previous years (which saw more capex due to the investments in new packing lines and replacement of temporary hotrooms due to the fire at Richlands in 2012), at about AUD 1.4m (as it pursued a disciplined approach to capital investment and capital was deployed for select production efficiency upgrades and expense improvement projects), slightly lower than its D&A of AUD 1.6m, and I expect that its maintenance (plus a bit of growth) capex going forward would not deviate much from its D&A, and would in the region of AUD 1.5m – AUD 2m.

In my opinion, Capilano is able to achieve such strong and steady (profits and) cash flows due to its strong branding and strong base in Australia, where it commands an impressive 70% (and still growing) market share since FY2015, which it increased from slightly less than 50% in FY2014 (by smartly exploiting the lack of supply to its advantage in FY2015 – a whopping 20% market share jump (based on the information that I am aware of)). A large market share conveys Capilano with much benefits – for e.g. with its products occupying more shelf spaces in more supermarkets in more locations, consumers become more and more exposed to and familiar with its brand over time, and is more likely to choose its products on average. Bigger size also means that Capilano can spread its marketing costs over a much larger base, thus having an edge on profitability and pricing power than its competitors. As at FY2017, Capilano also commands about 30% of repeat customers. In addition, Capilano’s new products (for e.g. Beeotic) would also help it to gain more customers in the future, by either attracting new consumers to the honey category (who would be exposed to its existing honey products too), or by attracting existing honey consumers to switch to its brand in trying out its new products.

This stronghold of cash flows in its domestic base is an important point which makes me prefer to look at Capilano more than its New Zealand competitors, as the strong market share leadership really entrenches Capilano’s ability to continue to extract significant amounts of cash flows, with less uncertainty, from its domestic business, which made up of a large chunk (83% in terms of revenue) of its business.

With these strong sustainable cash flows from its domestic business, Capilano would be able to return some value to shareholders by distributing some of them as dividends (the company doesn’t appear to have any fixed dividend policy, but its dividend payout has been stable at around 35%-40% since IPO), and use the remaining funds to reinvest in its business at high returns on capital (as we have previously examined, its CAGR from FY2013-17 of return on incremental capital ranges between 17%-24%, depending on which asset base you consider).

The near-term growth areas/opportunities that Capilano can/is reinvesting its capital in includes:

  • Expansion of the sales of its new products, in particular its new innovative healthy prebiotic honey, Beeotic®, which was launched in late September 2016 in Australia (and launched in Singapore in around November 2017 with free sampling events). Beeotic is the world’s first clinically-tested prebiotic honey, and is 100% Australian honey. This product has been developed on the back of extensive industry research over several years, has been listed with the Therapeutic Goods Administration (TGA) and is exclusive to Capilano. It sells for more than double the price of normal honey. In Singapore, its Beeotic honey (500gm) is selling for SGD 22, i.e. about 265% of the price of its normal honey (SGD 8.25) (see pictures below, taken on 6 January 2018).

    The company states that “[m]ore advertising, product development and strategic marketing is planned to support the product and further educate consumers. Beeotic has brought new honey consumers to the honey category and the product is awaiting regulatory approvals in a range of key export markets, noting we are currently selling into China as a priority establishment market”.

    According to an analyst report, “[p]ositively, Beeotic is attracting new, health-conscious consumers, upgrading CZZ’s existing customers and growing the overall honey category. The product has good distribution in Australia”. Another article states that “[i]mportantly, for the first time in many years, CZZ will actively market this new product”. Indeed, Capilano’s spent a significant AUD 2.2m in FY2017 on the marketing of new products (which should largely be attributable to the Beeotic product), which took up about 14% of its total marketing and promotion expenses (of AUD 15.3m in FY2017). If this product takes off well and gets sold in more markets after the relevant regulatory approvals, it should contribute much to Capilano’s revenues and, more importantly, its earnings given the better margins for the Beeotic product;

  • Expansion of overseas market, focusing on high returns market, especially China. China is a lucrative market for natural honey, especially Manuka honey, given its people’s strong demand for natural and overseas high quality food. According to an article by Alizila (the news hub for Alibaba Group that runs TaoaBao and TMall), “[the majority of Tmall’s customers’] spending habits are reflected in types of products that sell on Tmall Global. The platform’s best-sellers include Victoria’s Secret lingerie, Swisse cranberry capsule (health supplements) from Australia, Manuka honey from New Zealand, skincare products sold by Japan’s Matsumoto Kiyoshi, milk sold by German supermarket chain Metro, olive oil sold by British retailer Sainsbury’s and other name-brand items from abroad”. The China market has been buying a lot of Manuka honey from New Zealand, with Comvita’s honey being a very popular brand in the China market.Although Capilano is not as strong as its New Zealand competitors in the China market, with wide distributions and local partners there, Capilano has expressed much intention in proactively investing in this market (see its FY2017 AGM slide below). Historical revenue data on its exports to China has been limited, but what I can gather indicates that Capilano’s sales to the China market has grown by 57% and 39% in FY2016 and FY2017 respectively, albeit from a smaller revenue base.According to an analyst report in August 2017, “[c]entral to the company’s target of growing its premium and higher margin products (Manuka, Jarrah, Beeotic and Apple Cider Vinegar) is increasing export sales, with China identified as a key market. CZZ has tripled its export department to achieve its export led growth strategy. The company currently sells into China through pharmacy and grocery channels. It is in about 2,000 Chinese pharmacies and is hoping to increase this to 3,000 in the short term. The company is looking to increase its brand awareness in China by training staff and increasing online marketing. CZZ launched its China TMall e-commerce site earlier this year. CZZ will also look to expand into additional export markets in the future”.
    Capilano - China expansion
    In addition to the China market, there are also bright sides to the other export markets in the near future. In FY2017, Capilano’s total revenue decreased slightly by 0.4% from AUD 134m to AUD 133m, mainly due to a significant decrease in export revenue of AUD 5.2m (from AUD 27.7m to AUD 22.5m). This was because of lower international honey prices and greater competition, mostly notably in lower margin industrial segments, and that its export sales that year were impacted by a now resolved trade restriction to one of our biggest markets in the Middle East.

    In relation to this underperformance, the company said that the “[i]nternational bulk honey markets have been relatively stable following the softening in price we saw last year, with competition remaining strong in most overseas markets. Capilano has reluctantly ceased supply to some international industrial segments due to unsustainable prices and insufficient margin”. In November 2017, during the AGM, the company stated that “[i]nternational prices for Manuka have been rising and the market is changing”, implying a potentially brighter FY2018 for export sales.

  • Ramp up of the two joint ventures. As discussed earlier, Capilano is still investing in its two joint ventures (Medibee and Western Honey), which it started at the beginning of FY2017. As these two joint ventures stabilise and increase honey production, they should drive Capilano’s sales and profits.
  • Driving of more sales volume. As and when the honey production season turns better, Capilano would get to procure more raw honey (both normal and Manuka), which it can spend efforts on driving the packing, sales and distribution of more honey sales.

5. Strong and growing moats, with runways for growth opportunities

Last but probably most importantly, I see Capilano as being able to grow and deepen its moat as time passes and has long runways for growth opportunities (from new markets, new products, greater sales volumes and potentially more M&A activities to expand its asset base).

Ultimately, high returns on capital would eventually attract returns-seeking capitalists, which eventually push down the returns on capital to moderate rates, which is why it’s of utmost importance for a wonderful company to have strong moats to protect itself against any impending competition. I see Capilano as having two strong moats that help reduce the attacks by its enemies, i.e. intangible assets (strong branding and relationship with a network of beekeeper suppliers) and efficient scale, which we have discussed earlier.

What I think is even more powerful is that I see Capilano as having a positive moat trend (a concept devised and used by Morningstar) too. This means that I see Capilano as being able to deepen its moat more and more over time. The reasoning goes like this:

  • Capilano has strong moats now and currently has the largest market share and size in Australia;
  • This allows Capilano to spread its fixed costs (packing machines and factories overheads, distribution costs, and marketing costs) more, thus commanding lower fixed costs per unit, and has stronger balance sheets;
  • This in turn allows Capilano to achieve better profitability than the competitors, and thus more able to pay more competitive prices, if necessary (especially during bad times), to the beekeepers in Australia for their raw honey, and continue to source continuously from them even during tough times;
  • This begets trust and confidence from the beekeeper suppliers, resulting in stronger relationships between Capilano and the beekeepers;
  • This results in Capilano having better and more sustainable access to more honey supplies, which in turn allows it to achieve higher sales and grow bigger in size; and
  • The whole cycle continues again and again, strengthening Capilano’s moats over time, and at the same time setting up stronger barriers for impending competition.

In addition, I also see Capilano as having sufficient runways for it to reinvest its capital for the long term, in areas like:

  • new product development (which the company has listed as one of the few key strategic priorities for its 2020 strategy), ideally on products that incorporate more value-add (and thus higher margins) than raw honey, for example the recent Beeotic product;
  • expansion of honey production, either through increasing activities in its two joint ventures, or new ventures including M&A activities;
  • additional marketing and sales activities, especially for higher margin products (Manuka, Jarrah, Beeotic and Apple Cider Vinegar), enhancing its branding more and making more advances in the various distribution channels (supermarkets, pharmacies, groceries and health food channels);
  • expansion into overseas markets, especially Asian markets where Manuka demand would still exceed supply for some time

Warren Buffett says in his 1992 letter that “[l]eaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return”. Hopefully, Capilano would have sufficiently long enough period and opportunities for it to reinvest its capital at high returns (supported by its moats and pricing power), and produce considerable value for its shareholders.

Now that we have looked at all the positive things about Capilano, we shall discuss the risks that Capilano faces in my next post, so stay tuned.

Disclosure: The author has long position in Capilano as at the time of writing.

P.S. If you want to receive updates on my future post, do subscribe to my blog by using the subscribe function (on either the right or the bottom of the page).

Is There Money in Capilano Honey (ASX: CZZ)? [Part 1]

Executive summary

Capilano Honey logo

Capilano Honey (ASX: CZZ) is Australia’s largest honey packer that sells honey products (both normal honey and premium Manuka honey) in both Australia and overseas markets, with a market capitalisation (in January 2018) of around AUD 175m. It was listed on ASX in July 2012, and thereafter from FY2013 (ending June 2013) to FY2017, it has almost doubled its revenue (AUD 73m to AUD 133m), tripled its net profits (AUD 3.4m to AUD 10.3m), while increasing its honey sales volume by more than 40% (from 9,800 tonnes in FY2013 to 14,000 tonnes in FY2016) and expanding its number of outstanding shares by 11% only. In my opinion, Capilano is a strong company with strong (and growing) moats with high returns on capital, and it’s worth looking at for the following reasons:

  1. Capilano’s honey packing business has good business economics, reflected by its strong financials.
  2. Capilano has very strong access to one of the most important ingredient to be successful in this business, i.e. good honey supply.
  3. Capilano has been investing and consolidating its businesses in the past few years, investing in additional resources, repairing its inventory and strengthening its balance sheet, and is ready to reap the rewards, with an improving honey production season to come after its worst few years in history;
  4. Capilano’s stronghold in Australian market (of >70% market share) provides it with strong and sustainable cash flows, which are partly returned to shareholders as dividends and partly reinvested for future growth in markets with high growth potential (e.g. China).
  5. Last but probably most importantly, I see Capilano as being able to grow and deepen its strong moat as time passes and has long runways for growth opportunities (from new markets, new products, greater sales volumes and potentially more M&A activities to expand its asset base).

This will be a long post and therefore I am splitting it into three parts:

  1. Introduction to Capilano Honey;
  2. Why I think Capilano is worth looking at; and
  3. What are the risks, and how much is Capilano worth?

Introduction to Capilano Honey

Capilano Honey was founded in 1953 as the co-operative Honey Corporation of Australia to help protect the interests of beekeepers, by purchasing honey from them and helping them to be price-setters instead of price-takers.

It was initially listed on the Bendigo Stock Exchange in 2004 following legislative changes that deemed Capilano ineligible to operate an internal market for trading shares between beekeepers in the co-operative (the beekeepers have to hold a certain number of shares per hive owned). It was subsequently forced to move to ASX in 2012, because BSX was changing the nature of its exchange to make it a clean energy exchange.

Capilano - Product range

It currently sells mainly (about 95%) honey products (both normal honey and premium Manuka honey (Manuka honey is produced from the Leptospermum species of plants that are native to Australia and New Zealand, and this honey is recognised for its scarcity and unique clinically proven antibacterial qualities and consequential premium price) and some (about 5%) non-honey products (apple cider vinegar and beeswax). It is a very popular brand in Australia with a market share of more than 70%. The Australian market contributes to 83% of its revenue in FY2016, with the remainder coming from more than 30 countries (as of 2016) in Asia, Middle East, America, Europe and other countries.

The video below provides a good introduction into Capilano Honey and the beekeeping and honey packing businesses.

In terms of operations:

  • its head office and main packing plant are in Brisbane, with two other packing plants in Perth and Maryborough;
  • it has just over 120 employees who oversee the honey packing process in its head office;
  • it carries a few honey brands that target different market segments, i.e. Capilano Honey, Allowrie, Barnes Natural Brand, Wescobee and Beevital Manuka honey;
  • it has a honey market share of >70% in Australia, and Manuka honey market share of around 11% worldwide;
  • it sources its honey mainly from more than 600 beekeepers in Australia, and has also gone upstream into its beekeeping businesses since mid-2015. In terms of Capilano’s honey suppliers, they vary greatly in size, including “hobbyist/amateur” beekeepers with 100 hives, medium producers with 600-700 hives, and large producers with more than 5,000 hives, where the big commercial guys would produce 100 tonnes of honey a season for Capilano;
  • it purchases, subject to the amount of available supply, around 10k-11k tonnes of honey from beekeepers annually (in FY2016 and FY2017), and imports honey from other countries (e.g. Argentina) to make up the shortfall;
  • it packs more than 1,200 tonnes of honey per month (with a total of 15k tonnes packed in FY2017);
  • it sold about 14k tonnes of honey in FY2016 (no data on FY2017); and
  • it had a honey stock of around 6k tonnes at the end of FY2017 (Jun 2017).

As seen in the figure below, Capilano sources its honey from various areas in Australia, with some of them being more premium honey.

Capilano - Honey sourcing regions

Capilano’s competitors include other honey brands in Australia, New Zealand and other countries. In terms of Manuka honey, which is produced only in Australia and New Zealand, Capilano faces competition mainly from the popular New Zealand brands, which include Comvita, Watson & Son, Nature’s Way, Pure Honey New Zealand, Ora Honey, Streamland, and Arataki Honey.

In terms of financials, let’s have a look at its revenue and profitability over the past few years. As seen in the tables below, from FY2013 to FY2017:

  • revenue has been growing at (0.4)% to 40.5% per year, with a CAGR of 16.5%. These growths are mainly driven by mainly increase in average selling price (ASP), followed by sales volume (CAGR of 12.6% from FY2013-16); and
  • gross profit has been growing at a CAGR of 13.9%, driven mainly by revenue growth, offset by a decline in GPM from 46% to 42%. The decline in GPM was due to increasing costs of raw honey supply due to lack of honey supply (with Capilano passing on some of these costs hike to the consumers, but not fully), offset to an extent by Capilano’s switch to higher-margin products to help improve GPM, although the end result was still a decline in GPM; and
  • net profit has been growing significantly at a CAGR of 31.6%, driven mainly by revenue growth and improvements in operating margins as the business scales up in size (with NPM increasing from 4.8% to 7.8%). The increase in NPM was driven mainly by declining marketing expenses (from 16.0% to 11.5%), declining depreciation expenses (from 2.5% to 1.2%) and declining interest expense (from 1.5% to 0.3%).

Capilano - Revenue and profitsCapilano - Costs

In the next post, I will talk about why I think Capilano Honey is worth looking at for a value investor. Do subscribe to my blog to make sure that you receive the updates.