a brutally candid assessment

There is clearly a significant amount of confirmation bias on a forum such as HotCopper, with participants invariably talking up the prospects of stocks in which they hold positions.

While this is understandable, I try very hard to be brutally objective; not just because I want to be seen to be "fair" or "nice", but because highlighting any warts also helps me crystallise my own thinking.

Too often, I suspect, investors - irrespective of their levels of experience - see and hear only that which they wish to see and hear, with the consequence that they make investing mistakes.

Being brutally frank with oneself can often minimise, or even avoid, losses.

Which brings me to BKL:

I have been a long-time investor in BKL, and the company has created significant wealth for its shareholders over the past decade or so.

It stands to reason that very few companies have business models (and successions of management teams) that permit those businesses to undergo supernormal earnings growth and generate supernormal returns indefinitely.

One fundamental dictum of efficient markets says that capital goes where excess returns are to be had.

The result of this new capital is increased competition in the economic sector that had been generating the supernormal returns, causing lower margins and/or a fade in returns generated by the initial capital that had been invested.

Despite my favourable disposition to BKL, if I am to be completely candid, then I have to concede that in BKL’s latest financial result I think I am seeing the first signs of this classical return fade cycle occurring.

At first glance, this looked like a strong result under the circumstances of a subdued consumer environment (and let’s face it, BKL sells products that are both discretionary and expensive).

What surprised me initially when I started to analyse the result was the strength in the revenue line in the second half: up 14% on the previous corresponding period (which, itself, was a strong comparator period given it being 11% higher, in turn, than its pcp).

And that fast rate of growth wasn’t just due to the small starting base of Thailand and Malaysia (revenue growth of 23% and 28%, respectively), but the all-important Australian region (three-quarters of total group revenue) grew revenues by an impressive 13%, which is a commendable outcome given the parlous state of the consumer discretionary sector.

Problem is, this did not come easy.

While all other P&L cost items displayed BKL’s usual cost management disciplines:

• raw materials & consumable costs (35% of total operating costs) fell to 69.3% as a % of revenue from 69.6% in pcp,
• employee benefits (25% of total operating costs) rose by just 2.8%, and
• all other expenses (selling costs, lease costs, professional & consulting costs, repairs & maintenance, freight costs, banks charges and “other”) collectively actually went DOWN by 1.6%, which is almost unheard of against top-line growth of 11%,

...there was a massive investment in promotional expenses and rebates (18% of total costs), which rose by an alarming 76%.

As a result of this aggressive rebating for extra revenue, EBITDA rose by just 2.4% (or 7.8% if the $1.2m in legal fees relating to the dispute with the builder of the new head office, are excluded).

For further context, this does not appear to be a simply a one-off promotional tactic, but part of a seemingly unavoidable and unfavourable ongoing trend in promotional expenses & rebates as a % of revenue:

FY2005: 7.7%
FY2006: 7.5%
FY2007: 8.0%
FY2008: 8.6%
FY2009: 9.3%
FY2010: 8.9%
FY2011: 9.8%
FY2012: 12.5%


Over this same period, BKL’s Return on Invested Capital (ROIC) has faded, as follows:

FY2005: 29.8%
FY2006: 28.9%
FY2007: 30.0%
FY2008: 24.1%
FY2009: 21.4%
FY2010: 21.0%
FY2011: 23.3%
FY2012: 21.6%

While some drag on ROIC in recent years will have been due to the capital invested in establishing new businesses in Asia, it is clear to me that the mineral supplements business in Australia is becoming more competitive, with keen marketing aggression on the part of brands such as Suisse and Natures Way.

This is perfectly intuitive: when an industry offers stable returns close to 30%, new participants will ultimately enter it in order to win a share of that lucrative industry.

How does this change they way investors should view – and value – BKL?

Well, historically, given its first mover advantage and given its many-times-above-system growth, I have been happy to pay over 17x P/E, 10x EV/EBITDA, and 6% FCF yield.

However, with the change in industry structure which I have be sensitised to in recent years, but which I now have to acknowledge is in full sway, I believe intuitively that valuation multiples closer to 15x P/E and 8x EV/EBITDA are more appropriate for BKL in order to provide me with an adequate margin of safety.

On my modelling, which incorporates the $40m acquisition of Bioceuticals, the stock is trading on FY13 valuation metrics of 16.5x P/E, 10.6x EV/EBITDA and 5.3% FCF yield.
It is therefore not cheap, in my view.

I believe BKL will continue to increase in intrinsic value in the years to come, but it will just not be as fast as it has been over the company’s history.

Prudence first

Cam