Bubs Australia(ASX:BUB) is Australia’s largest producer of goat...

Bubs Australia(ASX:BUB) is Australia’s largest producer of goat milk products.

Demand for Bubs’ goat milk products has risen exponentially because of a number of factors including:

• A growing consumer trend towards alternative baby nutrition options, particularly goat milk which is easier for children to digest
• Infant formula scandals in China, which have resulted in consumers preferring Australian made products as they are perceived to be safer and of superior quality
• The rise of e-commerce platforms such as Alibaba’s TMall and JD.com which have allowed a larger pool of buyers and sellers to connect

Key Stats

Headquarters: Sydney, AustraliaWebsite: https://www.bubsaustralia.com
Industry: DairyMarket Cap: $325 millionRecent Price: $0.73Data as of 11 March 2019

Buying Instruction

Place an initial limit order at A$0.77 or below. Bubs is a high-risk investment where a lot could go wrong. Carefully read the ‘Risks And When We’d Sell’ section before jumping in to buy shares; we recommend you start with a small initial starter position and build up as we get to know the business over the next several months.

We believe judicious use of limit orders and patience can help you get a reasonable starting price. Stick with the limit order for the first week. If your order does not fill within a week, buy a small allocation at the then-prevailing prices.

Remember, every time you pay 15 — 20% more than you need to for establishing a position, you eat into your potential returns and increase your potential downside.

The Business

Bubs Australia (Bubs) was founded 13 years ago by Kristy Carr in her kitchen, who after having children of her own realised there was a gap in the market for premium organic baby food. Since then, the company has grown from strength to strength and is now Australia’s largest producer of goat milk products.

As the company grew, it realised the need to have more control of its supply chain and set out on a path to vertically integrate its operations. To this end, Bubs has signed exclusive supply agreements with farmers and manufacturers whilst also making a strategic acquisition of NuLac Foods to increase its production capacity.

*Source: Company presentation

Why Do We Like It?

Top dog and first mover in its niche area

According to AgriFutures, Australia produces about 16 million litres of goat milk per year. Bubs Australia has exclusive access to approximately 20 million litres of goat milk per year when you include its supply agreements in New Zealand.

Such scale is very difficult for a competitor to replicate (at least with Australian goat milk) and places Bubs in the pole position to benefit from growing demand for Australian goat milk products.

Strong customer value proposition and a popular brand

When compared to cow milk, goat milk has a number of benefits. It has a higher calcium content, it’s easier to digest, it’s less likely to cause skin and gut reactions, and it results in greater absorption of nutrients, particularly for babies.

We’ll be among the first ones to admit that these benefits might be questionable from a scientific standpoint. That said, one could’ve made (and can still make!) similar arguments for the a2 protein and its namesake a2 Milk (ASX:A2M) but popular belief and marketing can take on a life of its own. We think goat milk hasn’t reached the dizzy heights of a2 protein, but there appears to be some nice early traction here.

When you then throw into the mix the tragic infant formula debacle in China and the strength of brand Australia, we have a powerful one-two punch and the numbers prove it.

Game changing partnerships and acquisitions

There are two partnerships and one acquisition that we believe could be game changing for Bubs.

First, the acquisition of NuLac Foods not only provides them with scale and long term supply of goat milk, but it also provides them with optionality on their product mix. Bubs products have higher margins than NuLac products (which are currently being sold in higher quantities). So as the Bubs branded products begin to gain traction, we expect the company to start diverting milk supply towards these higher margin products.

Second, we expect margin uplift as a result of a recent agreement with Tatura milk. As part of the agreement, Tatura will convert fresh goat milk from the farm gate directly into infant formula, bypassing the step were Bubs used to first convert the milk into a powder. This was a very expensive step with lots of lead time and the change has the potential to save costs and shorten the cash cycle.

Third, the distribution agreement with China-based Beingmate should help Bubs achieve scale quicker via the former’s network of 30,000 mother and baby stores. Management estimate that if they had tried to establish their own distribution network, it would have taken them at least 5 years to get anywhere near that level of scale.

Growth, growth and more growth

To says Bubs is a fast growing company is an understatement.

Gross revenue of $21m in the first half of 2019 was higher than gross revenue in the full year 2018. Bubs’ sales to China for the half grew by 901% (10x) from the previous corresponding half whilst sales in Australia grew by 412% (5x).

Whilst a lot of the current revenue growth is driven by the NuLac Foods acquisition, we expect the company to maintain solid top line growth as it continues to gain traction in China.

Founder led company

Bubs’ founder and CEO Kristy Carr has plenty of skin in the game and owns almost 5% of the company. John Gommans, founder of NuLac Foods (which was acquired by Bubs) also owns close to 5% of the combined group and is a Director of the company.

Scalable operating model

Bubs has made strategic investments into its supply agreements and production capacity to build a business that can cope with high growth rates and scale.

As the business has grown, gross margins have continued to grow from 12% in 2HFY18 to 19% in 1HFY19. Whilst that may sound very low, and it is, we think this will continue to grow rapidly and lead to profitability at scale.

The Numbers

With gross revenues growing rapidly, we think the company is on track to continue increasing its gross margins which now stand at 19%.

By way of comparison, the a2 Milk company has gross margins over 50% and Bellamy’s (ASX:BAL) margins are closer to 40% which gives us an indication of how far Bubs can go if it were to successfully achieve scale.

The company had negative cash flow from operations of $13.5m in the most most recent half, although this is supported by upfront inventory purchases of $7m and a healthy cash and term deposit balance of $26m.

The company’s external debt of $2m is manageable although it also has a payable relating to previous acquisitions which are contingent on performance.

There is a risk that goodwill from the NuLac Foods acquisition might be written off if the business does not perform. Whilst goodwill write offs are a non-cash transaction, they do provide us with an indication that the related business unit is no longer expected to generate sufficient cash flows in the future.

Risks And When We’d Sell

We must stress that this is a high risk investment idea. It ranks alongside some of the higher risk ideas on our scorecard.

Food scandal

Bubs is building a brand around the quality of its products. Should the quality of these products be brought into question perhaps through an infant formula scandal, this would have disastrous implications on their sales.

Chinese regulation including SAMR registration

Following the infant formula scandal, the Chinese government banned many foreign infant formula manufacturers and introduced strict limitations on the remaining licenced manufacturers. The current regulatory framework requires that each manufacturer can only have three unique infant formula brands. Bubs has a binding long term agreement with Australia Deloraine Dairy which is licensed to produce infant formula for export to China. The company has filed for State Administration and Market Regulation (SAMR) registration and is currently awaiting approval. Should this approval be denied or delayed, this would have a negative impact on the company’s outlook which is strongly reliant on successful infant formula exports to China.

There is also a risk that tensions between the Australian and Chinese governments could escalate and have a negative impact on Australian exporters to China, including Bubs.

Goat milk becomes a fad and loses popularity

Let’s face it, products such as goat milk are vulnerable to the vicissitudes of consumer behaviour. The same force that powers their growth can be the reason for their downfall. This is a risk that we will need to monitor continuously.

Financials and valuation

Bubs is still loss making and burning through cash as it invests aggressively for growth. Despite that, it is currently valued at more than 8x sales as the market anticipates that its high growth rate will continue. If that growth isn’t sustained to a point were the company can operate profitably, it could have disastrous outcomes for the share price. Even if the growth is sustained, the company might need to continue raising capital to invest in its operations which would dilute existing shareholders.

Unreliable partners

We have been impressed with Bub’s ability to forge strategic partnerships with manufacturers and producers in Australia, as well as distributors in China such as Beingmate. We do, however, note that Beingmate’s partnership with New Zealand dairy giant Fonterra (NZE:FCG) ended on a sour note. Whilst the terms of Fonterra’s partnership with Beingmate are fundamentally different, we cannot rule out the possibility that some of the strategic partnerships may not work out as planned.

Extreme Bottom Line

Bubs Australia is a fast growing company with a significant opportunity ahead of it. It’s taking advantage of the irresistible demand for its products by building competitive advantages through its scale and brand.

In the a2 Milk company, Bellamy’s and Blackmores (ASX:BKL), investors have plenty of examples on the ASX of what can go right and wrong when you build a business supported by strong demand from Chinese consumers. We like the risk / reward prospects that Bubs offers us today.

It’s time to make a healthy addition to your portfolio. Bubs Australia is a Buy.