Keytone Dairy Corporation was established in 2011 for production and supply of NZ dairy and nutritional products. The business was listed on the ASX in July 2018. Keytone manufactures dairy and nutritional products under their own brands, ‘KeyDairy’ and ‘KeyHealth’, as well as various contract manufacturing arrangements (including Walmart China (Sam’s Club)). In mid 2019 Keytone acquired Omniblend, an Australian-based product developer and contract manufacturer. The acquisition enabled Keytone to increase manufacturing capacity, expand product range throughout the health and wellness sector and allow potential further vertical integration opportunities (more M&A/PD). In late 2019 a futher consumer foods business was acquired, Super Cubes, which non-dairy product such as ready-made frozen smoothies.

The ASX(/NZX) has significant depth of dairy/nutritional product companies.

  • A2 Milk ($A2M) has no doubt been the star performer of the decade from developing a market for it’s proprietary blend of ‘A2’ beta-casein protein and tapping into the China infant formula market. The share price has appreciated >15x in the last five years.

  • Bellamys similarly saw strong growth since listing in 2014 and was acquired last year by China Mengniu (large Chinese dairy giant) for $1.5B.

  • Synlait (SM1) was primarily a dairy and nutritional product provider and has recently begun M&A to vertically integrate with the acquisition of Dairyworks, a large cheese manufacturer. Synalit has the most similarities to Keytone, originating as a processor and contract manufacturer and beginning the process to move upstream to consumer focussed products.

Key Challenges

Underlying profitability difficult to ascertain

Keytone are continuing to sign new supply deals with a number of large asian customers including Walmart, Nouriz and Iovate Health sciences which is promising promising. There is little commentary on underlying margin, however it would be reasonable to expect the margin is broadly consistent with historical margins. We note that capacity has increased substantially (3x in FY20 to date) so there should be economies of scale.

It would be useful to gain an understanding of margin, timing (how much is incurring in Q4 FY20) and expected likelihood of repeat orders.

Balance sheet and cash flow; healthy enough

From the latest (Q3 - Dec 2019) quarterly report provides some insight of financial position. Revenue of A$6.6m for the quarter, including ~100% YoY growth of properietary Keydairy brands. There is minimal sales data available on JD.com or TaoBao to support or give insight to this growth. It is unclear if Omniblend has been consolidated into these numbers (assumed not to be based on A$32m annual sales pre-consolidation). Closing cash of $6.7m for the period.

The statement provides little insight on overall gross margin. There are some comments on the high margin Super Cubes products (unclear is sustainable revenue going forward) and growing sales of Keydairy proprietary brands. Growing SG&A costs are partly driven by M&A and integration costs (c. $1m??) resulting in net OCF of A($2.3m).

Subsequent to the acwuisition of Omniblend, c. A$10m of cash should exist (minimal net debt) which should support the growth of the business for >12 months. I suspect now the business is at sufficient scale to allow debt to fund any further PPE and plant improvements without dilution.

Management team

Relatively corporate financier heavy and led by the Omniblend co-founder Danny Rotman. The prior CEO, James Gong, appears as an executive of the NZ business according to LinkedIn. It is interesting to note that the both the CEO and the Head of Sales for Omnibrands were acquired through M&A.

A cornerstone shareholder includes Long Hill Capital (15% diluted post cap raise); an Asia-based venture capital firm (ties with NEA in USA).

The IPO chairman, Bernard Kavanagh, departed several months after IPO.

M&A strategy; results to be proven

Two significant M&A deals in the last year which provide some insight to management strategy. The Omniblend acquisitionpresentation offers some insight into the overall strategy for Keytone.

The first one was the acquisition of Omniblend in June 2019. Omniblend is a contract manufacturer and product development company specialising in health and wellness products and UHT drinks products. The acquisition price was c. A$10m and supported by an share purchase plan at ~ A$0.40/share.

Key rationale was to vertically integrate and provide an opportunity to diversify customer base and product offering. The manufacturing capacity is to be expanded ~ 200% to support the growth. In addition a small portfolio of proprietary products were acquired including Tonik, a UHT fitness beverage merchanised in convenience stores across Australia.

The Super Cubes acquisition was completed for A$0.8m which was producing $0.65m of revenue p.a. New products have been announced which are expected to generate A$2.5m of annual sales in Woolworths alone in FY20. This represents a significant step change in revenue from acquisition and perhaps raises questions on how reasonable this revenue guidance is and at what cost to underlying profit? Their existing product range is on [clearance’(https://www.woolworths.com.au/shop/productdetails/880190/super-cubes-super-greens-smoothie) at 50% discount in Woolworths.

Key ingredients of the Super Cubes product range are fruit and dairy-free protein sources (i.e. tree nuts) which are quite different from the underlying Keytone business (dairy). Management may see this as a platform to develop and distribute dairy-based products however appears truly at odds with key competitive advantage of Keytone - being dairy nutritional product manufacturing. In a press release management have alluded that a key synergy of the M&A was to acquire a branded sales team and leverage Keytone channels in Asia to boost distribution.

There is a risk that the M&A strategy is distracting to management and a clear step away from the core legacy of the Keytone business. New product development is inherently risky particularly in the fast-changing consumer health and wellness sector where product, distribution and financial success are never guaranteed. However this could also enable a significant step-change in earnings and revenue potential with clear synergies achievable from sales and distribution. There are some positive with Omniblend founders remaining in the business with directorships and value of M&A is not significant.

Initial view

  • Business is driven by acquisitions; key highlight was Omniblend acquisition which the business has rallied around.

  • Still in high-growth phase, profitability unclear and ability to maintain and serve customers yet to be proven.

  • Management appear to be chasing margin through vertical integration rather than scale. This strategy may come unravelled as at its (small) core is a functional dairy products business pivoting to ‘health and wellness’. Super Cubes - which is proudly ‘non dairy’ - may be a distraction to management and financially challenging over the longterm.

  • Key management personnel yet to be proven in a vertically-integrated dairy and health and wellness business. The churn and essentially entire refresh of senior management and several board members since IPO is a little concerning.

  • Brand building is essential in building a succesful nutritional dairy product business in Asia. A2 Milk, Bellamys, Anchor (Fonterra Brands) have all done this at some expense.

  • Valuation; the share price has been largely stable since listing (IPO at A$0.38/share) but has been significantly diluted through acquisitions. The current market cap is ~ A$80m. It would be reasonable for pro-forma annualised revenue to be in the range of A$40-50m assuming Keytone processing is running at capacity. Increased profitability is theoretically possible through a shift to higher margin proprietary products but completely unproven and we should be vary wary of non-recurring costs (i.e. NPD and marketing costs etc). So is this reasonable? Synlait trades on ~1.3x revenue, Bellamys on ~4x revenue, A2 Milk on ~5x revenue. We should note scale, brand equity and cost structures are very different. The key question is can Keytone make it to scale? Depends if you have faith in churning management and their underlying (M&A) strategy which looks very challenging at this point in time.