an instructive case study

One thing I don’t want to do is come across in “I-told-you-so” form, but I feel obliged to comment on BKL’s interim result, especially in the light of some alarm bells that I heard ringing during 2012, first relating to what I thought was a “left-field” acquisition in July and also from the company’s FY12 full-year result.

I went back to read through my file notes relating to these two events:


Relating to the Bioceuticals acquisition, my thoughts were:

“Over the past 15 years this company has created significant wealth for its owners and has generated exceptional shareholder returns: Revenues have grown by a compund rate of almost 10% pa and EPS has risen by CAGR of around 15%pa over the past decade.

DPS is today approaching $1.50/share per annum, almost half of what I paid for my first share in BKL in 1997...that's a 50% running yield.

Over this period, BKL has paid a whopping $10.20/share in dividends in total, and DPS has grown at a compound rate of 13% pa. (Somewhat better then the CPI!)

And all of this growth...and this is very important...has been achieved without any recourse whatsoever to shareholders for funding.

And equally importantly, nor has it been achieved by taking on excessive financial risk: for most of the company's history it has run almost debt-free, with Net Interest Bearing Debt-to-EBITDA averaging less than 0.7x, and EBITDA-to-Net Interest being in the high teens over time.

The only time Net Debt exceeded EBITDA was in 2007/8 during which time the company invested over $40m in the construction of its expanded production facility at Warriewood, NSW.

But the high cash-generation of the business (Operating Cash Flow has, on average over time, exceeded Stay-in-Business Capex by a factor of 7 times!) resulted in the NIBD-to-EBITDA falling from 2 times to less than 1 time within a mere 18 month period after the completion of the Warriewood campus. “

So, with this embarrassing riches of organic growth opportunity, it begs the question: why this $40m acquisition of Bioceuticals, which was announced today?

At an EV/EBITDA acquisition multiple of 8.7x on FY13 EBITDA forecasts (which is merely marginally below BKL's multiple of 9.3x, I estimate) it isn't exactly the world's most accretive deal. And because the acquired entity is going simply going to continue to be run as a discrete entity, without any integration into BKL's manufacturing process or supply chain, there will be no synergies available to be pulled out.

I estimate this acquisition will be 5% EPS accretive, and will leave the balance sheet in still-excellent shape, with FY13 NIBD-to-EBITDA at an acceptable 1.4x and EBITDA-to-Net Interest of 9.3X (both less conservative than the company's long-run historical average, but still eminently comfortable)

But it is very out-of-character for BKL. They've never done something like this, and on this scale.

All in all, it has me scratching my head a bit.”

[End quote]


An then, following the full-year result, I penned the following:


“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.”

[End quote]

The company’s interim result provides some important updated insights into these two quizzical events.


Firstly, in terms of the performance of the Bioceuticals business, Note 7 (“Business Combinations”) to the interim financial statements shows that the acquisition contributed $21.5m in Revenue and $1.01m in NPAT since the acquisition took effect from 5 July 2012.

Crudely, then, one can extrapolate and say that for the full 6-month period, the revenue contribution would have been roughly $21.5m divided by 5, then multiplied by 6, i.e., $25.8m, or a little under $52m on an annualised basis.

Similarly, annualised NPAT (crudely) from the acquired business is around $1.01m divided by 5, multiplied by 6, then doubled to get a full-year figure of $2.4m.

Now there are a few “early inferences” one can make from this:

Firstly, while 5 months might not be fully representative of a full-year performance, this certainly looks like a margin-dilutive acquisition for BKL. BKL’s long-run NPAT margin is over 10% (11.2% since the GFC), while Bioceuticals in its first 5 months of ownership by BKL has yielded a NPAT margin well less than half of that, namely 4.8% (Annualised NPAT of $2.4m divided by annualised Revenue of $51.6m).

Second, valuation-wise it is looking expensive, at an implied annualised P/E multiple of over 16x (~$40m acquisition consideration divided by annualised NPAT of $2.4m).

Now, while I acknowledge that extrapolating 5 months of performance might give a less-than-perfect picture, it is still enough for me to conclude that this doesn’t look one bit like the world’s greatest deal.

So I still get back to my original questions: Why did they pursue this transaction? And why did they pay such a full price for what looks like a more marginal business?

I think the performance of the core business in DH12 result (or its significance UNDER-performance, more like it) provides a lot in the way of answers.

Firstly, Revenue for the half (INCLUDING that attributable to Bioceuticals) was $164.3m, and impressive 29% increase on the previous corresponding period (DH11), and 23% higher than the prior period (JH12). Even if one strips out the Bioceuticals contribution, Revenue growth in DH12 was still an impressive 12% higher on pcp, and 7% higher than JH12.

So far, so good at the top line.

But analysing the bottom line performance tells a completely different story:

Reported NPAT for DH12 was $13.6m, down 5% on DH11 and flat on JH12.
Not too bad, one might be tempted to argue, given the challenging state of the consumer spending in the back end of 2012.

But if one strips out the $1.01m debut NPAT contribution from Bioceuticals then the core business generated NPAT of $12.6m, which is 12% lower than the pcp.

In fifteen years of my following BKL, core NPAT has never deteriorated by that magnitude...the next worst performance to this was the mere 2% decline in NPAT during DH08, during the heart of the GFC!

Adding the DH number to the ROCE profile listed above demonstrates how starkly the returns of the business are stalling.

FY2005: 29.8%
FY2006: 28.9%
FY2007: 30.0%
FY2008: 24.1%
FY2009: 21.4%
FY2010: 21.0%
FY2011: 23.3%
FY2012: 21.6%
FY2013: 14.9% (interim result, after annualising for Bioceutical contribution)


And the alarming thing is that the source of this return fade is not confined to just one factor; it has multiple causes, as shown below.

[Keen students of Du Pont analysis might recognise that Returns on Assets is the cross product of Asset Turn and Margins;
Represented arithmetically as: ROA = Revenue/Assets X Profits/Revenue = Profits/Assets ...Revenues cancel each other out]

1. Asset Turns (Sales divided by Assets) are declining:

DH09: 1.57x
DH10: 1.59x
DH11: 1.61x
DH12: 1.47x

2. Margins are declining. Observe EBIT/Sales:

DH09: 18.0%
DH10: 18.5%
DH11: 17.3%
DH12: 13.0% (a near-decade low)!!


As an aside, it is a useful exercise to look at the driver of the deterioration in margins. Again, it’s not confined to one factor:

Promotional Expenses as a % of Revenue have ratcheted up:
DH09: 8.3%
DH10: 8.4%
DH11: 9.5%
DH12: 10.6%

Promotional Expenses and Rebates as a % of Revenue look even worse:
DH09: 8.9%
DH10: 10.1%
DH11: 10.4%
DH12: 14.9%

This all looks to me like a business operating in an environment that has become acutely competitive.

I suspect BKL management will continue to respond by investing in the brand and in promotional activity, but my concern is that the competitor(s) appear to be commercially aggressive and intent on gaining share in what, after all, is a sector that has historically generated supernormal returns for the incumbents.

However, it looks clear to me that, like all excess return opportunities in the economy, capital tends to migrate to those opportunities, with the ultimate result being a fade in returns.

I suspect that the end game will be some degree of consolidation in this space, but before that will be forced on the various participants, there will need to be a lot more pain.

Because as it stands today, even after the fall in returns, this still remains a lucrative economic sector.


I present this analysis not to gloat or to wish the share price down.

BKL is a great brand, and the company has always been – I believe –prudently managed.

I just think that there some other well-branded, well-managed businesses have arrived in town, and are adversely affecting BKL’s superior financial performance, as the analysis above seems to clearly suggest.

If nothing else, this is a great case study (for me, anyway) in how even businesses that appear bullet proof, can come under competitive assault.

The important thing, I believe, is that as individual investors we need to be vigilant for these sorts of tectonic shifts in the business environment, and we should learn how to identify them, and then act accordingly.


In the interests of prudent investing

Cam