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Small cap series: Bellamy’s Australia Limited

Small cap series: Bellamy’s Australia Limited

With reporting season out of the way, we now can continue our series in small cap stocks.

One clear outperformer has been Bellamy’s Australia Limited (ASX: BAL). For those unaware, Bellamy’s is a Tasmanian firm producing organic baby milk powder and formula.

Over the last year alone its share price has risen almost fivefold and profits sevenfold – so what’s driving this? It turns out that Bellamy’s has had extraordinary success with Chinese consumers. Chinese Australians are paying retail prices to buy entire supermarket shelves of stock and exporting to China, where the same product sells for many multiples. Jared Lynch and Mark Hawthorne wrote an excellent article on the topic in the Sydney Morning Herald which you can read here.

The profits generated from this trend have been off the charts. Bellamy’s return on equity for example rose from circa 8 per cent in the 2014 financial year to circa 19 per cent in the 2015 financial year. Given its low debt levels, these statistics would likely make it a prospect for further investigation by any investor with spare cash burning a hole in their pocket.

What a value investor might first wonder however is how sustainable is this trend, after all, surely barriers to entry for the baby formula market would be fairly low?

It turns out that the answer isn’t so straightforward. Coriolis, a New Zealand consulting firm performed a study of this market and noted that overall barriers to entry are actually fairly high and note that baby formula tends to “sit on the dividing line between food and pharmaceuticals”. They explain that a combination of intellectual property protections, regulatory barriers and economies of scale protect incumbents from new entrants.

That being said, we’re not as interested in barriers to entry in western economies.  More interesting is the question of whether there exist barriers to entry in China. Because of a melamine scare some years ago in China, that killed babies and hospitalised tens of thousands more, some consumers are paying whatever it takes to ensure their children receive the foreign branded formula, substituting it for the domestically produced versions.

Microeconomics 101 will tell you that as new entrants begin to take market share in a relatively commoditised product (which it can be argued, baby formula is), you would expect profitability for incumbents will tend to fall and that over the long-run profits will return to approximately each competitor’s cost of capital. Because of this, one does wonder how long Bellamy’s shares, and others, can continue to defy gravity.

Under a commoditised framework, only cost advantages can drive any abnormal levels of profitability.

Coriolis notes that the Chinese government appears to be bringing some order back into the local market “According to local reports, the Ministry of Industry and Information Technology (MIIT) has indicated that it hopes to reduce the number of manufacturers to 3-5 firms with revenues exceeding CNY50b (US$8b) by 2018”. So whether the reputation of local Chinese producers under a more controlled structure will remain tainted over the long-term is a good question.

It appears for the moment businesses like Bellamy’s, Capilano Honey and Blackmores are enjoying the benefits of increased sales, but their shares are benefitting from a mini fad.

Scott Shuttleworth is an analyst at Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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11 Comments

  1. Hi Scott,on the topic of small caps,seeing what your thoughts are on a small company called Traditional Therapy Clinics (ASX:TTC). They own over 300 health clinics in China through own and franchises and are expanding quickly. According to Skaffold it rates them an A2, no debt, ROE over 88%, strong cashflows and are at a big discount to intrinsic value. Thanks.Nick

  2. RE : BAL: Thanks for reply Roger.

    Yes i am a shareholder at $2.
    Possibly not at intrinsic value at $7.85 and seems to be the flavour of the month with BKL.
    So how do you value a company when it is increasing its profit by 100% plus per year?
    I enjoyed reading the story on “Branding” by Scott today by the way, food for thought.
    Time will tell if Bellamys has what it takes to increase profits and market share and maintain that market share. But the Capital-lite structure is appealing, but also brings risk i know. The theme of selling food to the Chinese is appealing as the market is enormous. And finally for me at the $2 investment the dividend looks appealing.
    I will hold for now.
    Thanks again
    Adam.

  3. Hi Scott

    Firstly I love the Montgomery team. You have what I feel is a trusted “brand”.There are so many financial products and newsletters and blogs but once you have a brand you like and trust, you stick with it.
    I think you see where I am going with this. I am a parent with 2 children. I want a brand I trust. I trust Bellamys. Bellamys is the BEST product for my children.
    Now as an investor I look for a business that I trust firstly, with my hard earned money.
    Then I look for a business that as Charlie Munger puts it ,” can be explained in 2 sentences”.
    Then I look at the management. Laura McBain. Need I say more. Then the investors. Bruce Neil, you may know him, he is on the 200 rich list and like you guys, a fund manager and the sharpest in the business.
    Next the market : China’s 300 million babies who do not want to eat their own milk , EVER. They want a brand they TRUST.
    COME FULL CIRCLE NOW. Next share price $2 … Seems cheap considering the growth profile and ROE.
    Easy. Ok at these prices I am not sharp enough to work it out but I believe in this company, the management, the niche organic market but best of all they have THE BRAND. Which is SO important. Apple is not the best computer , it’s actually a big rip off but it has THE BRAND. Coca Cola is rubbish but they have the BRAND. NIKE has the BRAND.
    Keep up the good work but I think you have this one wrong fellas.

    • Hi Adam, thanks for the post but you should disclose whether you are a shareholder. I might also just point out that the price is $7.85 not $2. I think you got that one wrong!

  4. Hello Scott,
    Thanks for the post, an interesting business that I underestimated. What I can’t understand myself is that Tatura Milk Industries, wholly owned by Bega Cheese, which solely produces Bellamy’s Infant formula, has not produced its own private label formula and produced better margins on its production. It carries both Australian and Chinese organic accreditation, undeniably a current competitive advantage.
    Cheers,
    Sam

  5. Scott Shuttleworth
    :

    Hi Fei, Joe & Michael, thanks for your comments.

    I think you’re right Joe that most consumers would pay more for a brand of perceived higher quality than lower quality in the context of your example.

    However the purpose of my article was to point out that there are many large food production firms globally which can develop similar products with the perception of high quality and would also be able to reach Chinese consumers, i.e. competition. We’ve seen this before in the health foods industry so it would not surprise me to see it happen again.

    Recognising the drivers behind a firms current profitability is a important skill of the value investor but assessing what could change in the future is equally if not more important. The latter is tricky to do but is part of our process for risk analysis.

  6. Bellamy’s occupies within a niche. Certification for organic is extremely complex . They are know selling in china via tmall and will have access to the 300 million babies in china alone. As a pharmacist i get requests to purchase thousands of tins at any one time. Growth is only limited by supply and tins in china sell for 80 australian dollars. massive shareholder and bought at 1.80

  7. You mentioned that baby food is a ‘relatively commoditised product’. Surely the definition of a commoditised product is one where the customer will base their decision purely based on price.

    For example, air travel is a commodity, since most people will not fork out an extra $100 for a flight (unless they have safety concerns, or the lowest cost carrier has a terrible reputation). If I asked an extra $200 from you, over an above the cost of a flight you can get with a different carrier, you’ll most likely decline, since most airlines offer a very similar experience (at least in economy).

    On the other hand, Apple is not commoditized. A macbook costs much more than a similar PC laptop, yet I’m happy to pay Apple because of its superior operating system and user experience, which other companies simply cannot compete with. They have a sustainable point of differentiation, a sustainable advantage.

    Based on this definition of what is a ‘commodity’, surely baby foods are not commodities? If I asked you to pay x2 the amount of the low cost baby food, but promised peace of mind knowing that your precious baby was consuming something that was (A) much safer and (B) more nutritious and natural, surely most people with the means would happily hand over the extra cash?

    As Chinese consumers become more affluent, the perception of quality that comes with tags such as ‘organic’ will be important. The question then is, what does competition look like in this niche category? What are barriers to entry for organic, high-end baby food?

  8. If baby formula is commoditised product, we can argue coke cola (kind of unhealthy adult formula) is also commoditised product. Baby formula’s brand is a combination of parents’ perception of its nourishment and its taste to babies. Chinese like imported baby formula mostly because they have a perception that local product may be toxic and they cannot trust it.
    BAL is surely expensive at current market price, but it’s surely not commoditised product. It has different tastes and parents perception than other brands.

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