Description

Given the small market cap with about 25% free float and USD 100 k trading volume this idea is only actionable for small funds or PA.  

Summary: Natural Food International Holding (or “Wugu Mofang” as the company is called in Chinese after its flagship brand; translates to “grain mill”) is one of the leaders in a growing, niche health food category in China. The company currently trades at 13.2x LTM net income, 4.5x ex cash, but is likely underearning as its distribution is reliant on physical supermarket traffic. PepsiCo is a major shareholder (26% of the shares outstanding) and acquired their shares mid 2019 at a price of HKD 1.80 or a little over 3x the current share price. PepsiCo has been active in China for 40 years, is one of the leaders in a related category (breakfast cereal under the Quaker brand) and has a seat on the board (occupied by an SVP and GM of foods of Pepsi China). The bet is that earnings will increase with the normalization of supermarket traffic and the company’s growing online presence (which is growing at 40% yoy in H1 2021). I expect a total return of 28% over 2.5 years driven by earnings growth, modest multiple expansion from 13x to 15x and the use of a quarter of the cash balance in a non-value destroying way either an acquisition or a special dividend. In case things don’t go as planned, the moderate valuation and a net cash balance equalling about two thirds of the market cap should limit the downside.  

What does Wugu Mofang do? 

Wugu Mofang manufactures powders from grains, nuts and beans sometimes with additional ingredients that are perceived to be particularly healthy (e.g. goji berries). If that description makes you think of muesli you would not be wrong as the product is in part marketed for breakfast (as an alternative to congee, which is a bit more cumbersome to prepare) but also a snack or meal replacement (for example as an alternative to instant ramen) and it seems that this “use case” is a meaningful percent of consumption. 

A typical product is a 600g can that retails for about RMB 70-100 (some pictures below which hopefully will survive the upload). Most of ingredients are basic staples and gross margins are therefore high, consistently above 70%.

The products seem well liked by consumers and have more than a hundred thousand reviews on JD.com (which according to conventional wisdom are bit more reliable) with more 99% positive. The company has 9 MM members in his Wechat account and 27 MM customers with a loyalty account (offline). 

Unsurprisingly there are plenty of similar products on the market though the majority seems to retail at lower price points around RMB 30-50. The company claims to be the number one brand on Tmall for “Natural Powder” for the past 5 years and the number 5 brand in “cereal” on singles day with a recently introduced product. Note though that a lot of these claims are based on the exact wording of the search term, and I would not put too much faith in these data points. 

The products are distributed in three ways: 

1. Ecommerce

1. Historically a relatively unimportant channel that accounted for about 19% in 2018 prior to PepsiCo’s involvement and that has grown to 37% in H1 2021

2. GMV split: 60% T-Mall, 18% JD, 12% Tik Tok, 10% others (which I understand include about 5% from the company's WeChat presence and a tail of other platforms) 

3. The company does not break out profitability by channel, but I understand that e-commerce is less profitable both on an EBIT and gross profit level. With regards to gross profit the reason seems to be largely accounting as company includes some of the platform fees in COGS (though there are also incremental expenses for more elaborate packaging and freebees that are customary in Chinese online retail). The more important reason why the channel is less profitable is that it skews towards smaller, less profitable units and seems to be a bit more promotional. In addition, in most instances the company will have to pay for fulfilment which can be a significant percent of sales with items that are priced around USD 10-20 

4. Channel has grown by 20% annual per year for the last three years and recently growth has even been a bit higher than that 

5. Going forward there seems to be an opportunity to bring down fulfilment costs by gaining bigger presence with online supermarkets (scale and brand recognition are I think the obstacles here so far) or through community group buying which is gaining popularity but is currently negligible. In addition, take rates of the large platforms are coming down for political reasons which should be a tailwind for profitability 

2. “Concessionary Counters”

1. A “Concessionary Counter” is basically, a small section (six to eight square metres) in a supermarket exclusively focused on Wugu Mofang’s products and staffed by sales personnel the company sources from third party service providers. The supermarket that hosts the counter, collects the sales proceeds (you pay at check out) and keeps a percentage as rent for the space. While this may sound unusual, this business model is more common in Asian than in Europe or the US. Typically, these counters represent a capital investment by the company of less than RMB 70,000 (Picture below courtesy of the company) 

2. This channel accounts for 64% of sales in H1 2021 but accounted for 80% of sales as recently as 2018. Currently obviously heavily impacted by Covid as supermarket traffic is still below pre-Covid levels 

3. The average counter sells about 10-15 cases of product or RMB 700-1100 of sales per counter and day on average. However, they are staffed on average by 1.5 sales representatives and the company pays the supermarket a share of the revenue as well. Exact numbers are not public but together these expenses approach 50% of sales. That means that even though gross margins run at c.75%, net profit margins never exceeded 12%. Why did the company pursue this channel if it is so expensive? 1. Company argues that it is a cheap way to create brand awareness 2. Online which the only alternative with scale is (currently) even worse 3. Some of the products are milled in the presence of the customer. Why do they do that? It shows the customer that the product is fresh and free from additives and that builds

4. trust with the customer. I felt sceptical about this claim, but in fairness it comes up often in customer feedback on the online platforms 

5. The cost structure of the counter channel is an opportunity to increase profitability. If they can move to cheaper distribution channels – granted that is a big if – the brand would have the potential to be very profitable. Speculating, but I think this potential is what attracted PepsiCo. 

6. The payments to sales representatives and to the hosting supermarkets have a fixed component and variable component, but I think it is fair to think about the payments to the sales reps as mostly fixed and the payments to the supermarkets as mostly variable. I estimate that the payments to the sales representatives are 15-25% of sales, so there should be significant amount of operating leverage if activity does pick-up 

7. As recently as end of 2018 the company thought they could grow the number of counters to about 6,000 esp. in less wealthy Northern and Eastern provinces which proved too optimistic. On the contrary beginning in 2019 the shift to ecommerce in groceries led some marginally profitable counters to be loss making and the company cut the number of counters from its peak in 2018 by 30% to the current number of 2,706. Part of the reduction seems to have been driven by PepsiCo who pushed the company to lean more heavily into ecommerce