Taking a sip at Keytone Dairy

I have been building a little position in KTD over the past few weeks.

For me, this stock falls under the category of a business that a) is experiencing strong organic revenue growth with structurally improving margins, b) is approaching cash flow break-even and profitability, and yet c) is being priced by the market at a relatively low multiple of its Revenue and Gross Profit run rate. Having seen several similar situations perform extremely well for shareholders over the past 12-18 months, and having been lucky enough to participate in a couple of them, I have decided to repeat the experiment here.

Going through KTD’s financial statements and presentations since their 2018 IPO, what seems fairly evident to me is that, since their Omniblend acquisition in July 2019, the Company have morphed into something different than the NZ-based, China-focussed powdered milk manufacturer they were at the time of listing; right now, I feel they’re best described as a health-and-wellness food & drink manufacturer, with a diverse set of branded products and a much wider addressable market.

Despite FMCG being a tough sector, an early-stage business with a niche set of products and good connections with the key distribution channels can still scale very well in this space, with the potential to build a multi-year growth runway; given the quality of its Board and the track record of some of its members (especially NED Andrew Reeves) in this specific sector, Keytone Dairy appears to tick all the right boxes.

Indeed, execution so far has been beyond reproach, with private label contracts (and/or distribution agreements) being won with the big supermarket chains and new branded products (Tonik, Super Cubes, Gran’s Fudge, Baileys, etc.) being rolled out across a broad range of distribution channels (including gyms, service stations and others); in particular the fact that the higher-margin branded products represent an increasingly large portion of total revenue, vis-a-vis the lower-margin contract manufacturing, has been the main driver of the ongoing improvement in Gross Profit margin.

Moving to the actual numbers: while it is easy to see that total Revenue and Gross Profit have been growing healthily (both in absolute terms and on a per-share basis) throughout KTD’s listed history, the acquisitions that have occurred along the way make it a not-so-straightforward job to compare apples with apples across different reporting periods.

In particular, because the relatively large Omniblend deal was completed in the middle of 1H20 (i.e. between March 31st and September 30th 2019), a proper Like-for-Like, semester-over-semester comparison for the current set of assets can only be made between 2H20 (30 Sep 2019 - 31 Mar 2020) and 1H21 (01 Apr 2020 - 30 Sep 2020).

For the sake of accuracy, Super Cubes did not count for the whole 2H20 (the acquisition was completed in October 2019), and AusConfec gave a small revenue contribution to 1H21; as neither acquisition was material in size, though, the growth numbers in the table below can largely be considered as being organic.

Looking at the semester-over-semester (1H21 vs 2H20) growth numbers (on the right in the table above), it can be seen that:

i) Revenue growth, mostly organic, is running at a very strong +61.7%.

ii) Gross Profit is growing at an even stronger +69.7%, reflecting the improvement in gross margin driven by the rollout of branded products.

iii) COGS is growing (+59.6%) at a much faster pace than Inventory (+40.4%), indicating increasing efficiency in turnover.

iv) Finally, but most importantly: Opex growth (+14.5%) is much lower than Gross Profit growth (+69.7%) and Operating EBITDA is very close to breakeven; therefore, at the current growth rates, there will be positive and strongly growing Operating EBITDA in the near future.

In terms of cash flow, the Company was still OCF negative in 1H21 (-4.5m$), but very close to breakeven in the December 2020 quarter (-0.1m$, as shown in the most recent 4C); looking at the growth dynamics above, it looks highly likely to me that KTD will be positive both in terms of cash flow and of Operating EBITDA in 2H21 (i.e. in the semester ending on March 31st). With a net cash balance of ~6m$ as of December 2020, I am therefore inclined to conclude that the business has already turned the corner of self-fundedness.

Moving to the topic of valuation: from the quarterly report released in January, it can be seen that KTD’s current revenue run rate is ~13.0m$ per quarter, or ~52.0m$ annualised, of which ~1.4m$ per quarter is represented by branded products, which are growing at +35% quarter-over-quarter.

Therefore, relative to an Enterprise Value of 256.6m*0.23$-6m$ = 53.0m$, KTD is currently trading at an EV/Revenue of ~1.0x on a run rate basis.

With regard to the Gross Profit run rate, my best estimate from looking at previous reporting periods is that branded products (as a whole) are running at a gross margin of ~40%, whereas contract manufacturing is running at ~20%; thus, the current Gross Profit run rate should be in the region of 1.4m$*40%+11.6m$*20% = 11.5m$.

So, KTD’s current EV/GP ratio is in the region of 53.0m$/11.5m$ = 4.6x.

Relative to the underlying growth rate, and structural shift towards higher-margin products, these look like attractive ratios to me. For instance, if branded products can keep growing at their current pace and gross margin over the next 12 months, their contribution to Gross Profit will be as high as 1.4m$*1.35^4*4*40% = 7.4m$ pa in 12 months, on a run rate basis; if the revenue run rate from contract manufacturing can grow even by just +25% over the 12-month period (which is a conservative assumption, because the expected 12m$ revenue increase from the Coles and Foodstuffs contracts alone will get them to that point), then the GP contribution from contract manufacturing will be 11.6m$*4*1.25*20% = 11.6m$. So, on a 1-year forward look, Gross Profit could be as high as 7.4m$+11.6m$ = 19.0m$, and EV/GP as low as 53.0m$/19.0m$ = 2.8x, on a run rate basis.

While projecting high growth rates several years into the future is always hazardous, if Gross Profit growth keeps outperforming Opex growth at anything close to its current pace, it doesn’t take a big stretch of the imagination to envisage an Operating EBITDA of 12m$, 15m$, or even 20m$, on a 3-year horizon; if that happens, the sense I get is that the Company’s Enterprise Value could end up anywhere between 100% and 300% higher than its current 53.0m$.

On the downside, it needs to be remembered that KTD (as it currently is) has been built by putting together businesses that, even before the realisation of synergies, were either EBITDA positive or close to that; Omniblend alone generated an EBITDA in excess of 2m$ in the year prior to being acquired. The subsequent increase in Opex was driven by the new management team investing into growth, and that investment appears to be paying off. If continued high growth failed to materialise, though, it should be possible to scale Opex down to a level that allows for an EBITDA of at least 3m$ pa; which, in turn, should support an Enterprise Value of at least 8*3m$ =24m$ (assuming a “downside” 8x EV/EBITDA) or (24m$+6m$)/256.6m = 11.7c/share.

So, at the current share price of 23c, I see roughly a -50% possible downside, but also a reasonable upside in the order of +150%/+250% on a 3-year horizon; this risk/reward asymmetry looks good enough to me to justify owning the stock.

Before concluding, there are two residual topics I would like to touch upon.

Performance shares: as can be seen in nearly every financial report of the Company, there are roughly 125m performance shares on issue, mainly as a result of the acquisitions made since the IPO. Looking at the hurdles for conversion (see for instance page 8 of the most recent quarterly activities report), it seems to me that the only classes of performance shares that have a reasonable chance for conversion are Class C (16.5m shares, subject to the NZ subsidiary generating 6m$ pa in revenue and the KTD SP averaging above 30c over a 30-day period before 31 Mar 2022) and Class D (23.3m shares, subject to Omniblend generating 2.6m$ EBITDA in a full financial year before 31 Mar 2022); so, there is a potential dilution up to a reasonable maximum of ~15% from the possible conversion of Classes C and D. All the remaining classes have such high hurdles, in terms of profitability and/or share price, that the associated dilution would be irrelevant.

Current share price: while I am general reluctant to comment on “price action” per se, it does catch the eye that the SP has been lingering around its post-IPO lows for the past few months, despite positive progress in the underlying business and despite a buoyant broader market. While it may or may not be related, it is also public information that the former CEO/COO of the Company (NZ side), exited the business and ceased to be substantial holders in June/August 2020. So, there may be a residual overhang of stock that needs to be cleared, before a significant re-rating can occur; and that might also be where the present buying opportunity originates from.

To conclude, this is not a business that I would personally invest heavily into, at the current stage of its corporate evolution, but it looks attractive enough to me to justify a ~1.5%*NAV initial allocation, with the possibility of a further increase at a later stage depending on continued successful execution and valuation.

As always, IMHO, DYOR, and all the usual caveats apply. Any feedback/comments are welcome.

Cheers