adding to the shrill shrieks

To my mind, this result has thrown up are three key issues that warrant consideration.

1. The QUALITY of the DH12 result,

2. Putting FY13 full-year guidance into some kind of perspective, and

3. The Keurig Distribution Agreement.


In terms of items 1 and 2, these don’t concern me in the least.

The result quality was, in fact, of BRG’s usual high standard and accounting cleanliness.

But what stood out for me was the investment in the brand awareness, specifically in advertising expenses, which rose by over 40% on pcp, to $12.8m.

For context, that level of marketing spend equates to 4.8% of Sales, which compares to a long-run average of 3.3%.

Put another way, if BRG had matched DH11’s rate of investment in marketing (namely, 3.9%), EBITDA would have been some $2.4m (or around 5% higher).

So, if management wanted to inflate the short-term number they could easily have manufactured EBITDA “growth” of 15%, which would suddenly have had the market – in its short-term habit - of applauding a “beat” of guidance.

And when an owner of good brands invests in making a global customer base aware of those brands, then prudent investors should far prefer that outcome as a path to shareholder value creation, than the near-sighted and naive alternative of plundering the P&L for a short-term kick.

And importantly, this marketing investment is clearly a good use of company capital, because the Gross Profit Margin for the half was at a near-record high of 37.8% (compared to the long-run average of around 32%), despite management citing “competitive market conditions”.

If the company was needing to discount heavily in order to make sales, AS WELL AS needing to throw money into advertising, then that would be a concern for me.

But the investment in brand is clearly manifesting itself in the high return allocation of capital

Also, as a result quality measure, Employee Expenses-to-Sales in the half was 9.8%, an all-time low, and having fallen in the past five successive periods, a clear indication of minimal slippage of scale benefits.


Now to the “guidance”:

Effectively, full-year guidance EBITDA guidance of 4% to 8% implies JH13 EBITDA largely unchanged on JH12 EBITDA.

At first glance, this might sound alarming, but two things need to be borne in mind here:

1. JH12 was a VERY strong half, with EBITDA being up a whopping 39% on pcp, due to every single global region firing red hot at the time (North America EBITDA was up 65%, Australia was up 25%, NZ was up 20%, and Global EBITDA (basically Europe and Asia) was up 38%)

2. I suspect very strongly that management – again, just like the past 6 months – is investing heavily this half in brand awareness and marketing. I’ll wager that the full-year results will again reveal a propensity to invest in medium- to long-term sustainable organic growth, with little regard to “meeting short-term market expectations”. Put another way, if management wanted to “guide” to 10% to 15% EBITDA growth for full-year FY13, they have enough P&L levers to pull to get there.


That’s the problem you’ve got here (and not just here: in many situations like this): you’ve got a mismatch between:

• On the one hand, a board and management team that understand what it takes to build a durable, reputable brand that is able to generate superior organic earnings growth over an extended period of time, and

• on the other hand, the neurotic capital market that shrieks shrillingly: “Disaster! Calamity! Guidance is Weak! Guidance is Weak! Quick! Flee! Sell! Run Away!”, after reading one sentence in the Outlook statement without for a minute contemplating and digesting what is really happening on a granular, fundamental company level in terms of shareholder wealth creation dynamics.


Now Keurig.

Keuring is a real issue, and as I had tried to warn on this forum on occasions before, the termination of the Keuring had the potential to upset the apple cart (which it has), and which is why I have been waiting for some clarity on Keurig before I added to my legacy holdings of BRG.

(NB. I read some posters saying, “Hey, this Keuring news is not such a big deal, it’s merely $20m-odd out of total revenues of $500m”. But I must caution: that’s a flawed understanding. Because it is of a commission nature, it’s akin to near-100% margin revenue, so really the way to view it is to say that it represents $20m out of $77m of EBITDA, or out of $70m of EBIT. So, contrary to some assertions, it IS a big deal)

Well, the Kuerig commissions have now been quantified – so we now know where we all stand.

My sense has always been that the distribution agreement, if BRG retained it, would be at far less generous terms than we shareholders had enjoyed over the past 5 years.

Let’s face it, it was a gouge, and like all good gouges, they must end.

Clearly negotiations between BRG and Green Coffee Mountain Roasters, the owner of the Keurig brand, are well underway. The first prize for BRG shareholders, obviously, would be for the arrangement to simply be rolled over for a further 5 years.

The worst case scenario would be for the arrangement to simply be terminated.

BRG management are indicating something in-between is likely, i.e., continue the Agreement, but with reduced commission rates to BRG.

In my modelling I have applied – conservatively, I suspect – a near-halving of the Commission under a new agreement, to some $11m pa, from the current level of $19.5m pa.

At that heavily discounted commission level, incidentally, BRG’s earnings for FY14 remain roughly in line with FY13, as organic growth from BRG’s core business essentially compensates for the loss of half of the Keurig commissions.

So, when after the loss of a significant source of earnings, you still end up being square that, I think, speaks volumes for the underlying quality of the business.

Following today’s share price fall (to $5.60) where it is at the time of this going to post, and adjusting for half the Keurig commissions disappearing in FY14, leaves the stock on valuation metrics as follows:

P/E = 15x
EV/EBITDA = 8.6x
DY = 4.6% (not fully franked, mind)
FCF Yield = 7.4% on EV

I think the events of today are poorly understood, not just by retail investors, but even by institutional investors.

I strongly suspect that this to be one of those situations where will look back in 18 months time and reflect on what a great opportunity it was to buy a piece of a wonderful business, whose underlying organic growth rate is in the mid- to high teens.

It certainly has been the moment for which I have been waiting.

But don’t expect too much share price joy in the short-term...it is going to take some time before the shrill shrieks die down.


Prudent Investing


Cam