China's taste for Aussie milk

Today’s CEO is actually the Chairman of Keytone Dairy which is a newly listed company that came on this week. His name is Bernard Kavanagh, the CEO is James Gong, he’s not available so we’re talking to the Chairman, Bernard Kavanagh. Keytone’s shares floated at 20 cents and they’ve popped up to 36 cents in a few days, all pretty good for those who got in on the float and the company’s market capitalisation is $27 million dollars now. 

The question, I guess is obviously whether that’s a buy or not? The answer is, they’re selling about $2 million dollars’ worth of product at the moment and they are making a few hundred thousand dollars in profit so pretty small and definitely not at the moment justifying a $27-million-dollar market cap.  But they’re currently building an expansion to their factory in Christchurch from 1,500 tonnes to 5,000 tonnes, so they hope to be making a multiple of that next year. 

But the trouble with these businesses is that they’re all about China, exporting milk powder to China, and as we’ve seen with some of the ones in Australia including Bellamy’s, that can be a bit fickle and they can lose their licence. As it happens, Keytone Dairy does have a CNCA accreditation certificate to export into China which is a 4-year certificate and it was issued in August 2014, four years ago. They’ve got a month to go on their current certificate and have obviously applied for a new one which will last for another four years.

Bernard reckons it’s a formality but my sense about China is that nothing is a formality.  It’s clearly a risky proposition for that reason. I imagine that if they get their certificate renewed the shares will go up again and everything will be hunky dory, but to buy them in the meantime is a bit of a risk and obviously it’s an ongoing risk because they’ve got to renew their certificates every four years, it’s a four year proposition. They’re trying to get some geographic diversification to make sure they’re not so reliant on China and that’s a good idea it seems to me and they’re also widening their product range.

They’ve got a few pillars of growth as they call it, four pillars, including increasing the capacity of the plant in Christchurch. I think it’s obviously a hot area, milk powder dairy exports to China, particularly from New Zealand, which is why of course the shares have popped up from 20 cents to 36 cents.

Here's Bernard Kavanagh, the Chairman of Keytone Dairy. 

Bernard, just reading your prospectus, the one thing that really jumped out at me was that you’ve got a CNCA manufacturer registration in China, which I gather is one of your main assets of course, but it is a four-year certificate that was granted in August 2014, so therefore has a month to go.  And you have to apply for a new one at least a year before the old one expires, so I take it you applied a year ago, did you? 

Yeah, certainly, Alan, and the CNCA accreditation, that allows us to import into China a wide range of dairy products, milk powders, whey powders and those sorts of things.  The renewal, as you correctly state, is every four years.  We’ve commenced the renewal process and with the way that things work in New Zealand it does involve the New Zealand Department of Primary Industry assisting us with that process and they’re involved in a lot of communication with the Chinese regulators at their end.  But at this stage there’s no reason to suspect that there’ll be any issue with that and we’re looking forward to hearing that it’s been renewed for another four years very shortly.

Is there any reason to think that you would hear whether it was going to be renewed or cancelled?  I mean, is this something that they give you hints about or are they just, when the time’s due they just go bang, you go…?

Yeah, it’s generally problematic for people that have had quality issues and food issues or failed audits from the New Zealand government.  The company hasn’t had any quality issues, no food contamination issues and it has passed all the audits by the New Zealand Primary Industry so it should be a formality for us to get that approval for the next four years. 

I mean, obviously some of the Australian exporters, I’m thinking Bellamy’s here and there was another one as well, found that it was anything but a formality of course and lost their licence.  I’m just wondering, during the course of the four years, assuming it is renewed, are you guaranteed four years of accreditation.  The sense I get is that the Chinese can withdraw it whenever they like anyway.  

I think there’s two areas here.  The first one is our company has the CNCA accreditation which is the accreditation for dairy products being imported into China.  The other accreditation that Bellamy’s, A2 and all the infant formula companies have is a different accreditation altogether and as we’ve observed, that’s quite an unpredictable sector, lots of changes to regulations, lots of restrictions in the number of formulations and behind all this there’s been some very serious health issues with melamine causing deaths to babies and those sorts of things. 

We’re in an area that’s much more stable and it has a long track record and China is the largest importer of dairy products in the world and this is a rather stable area of the business where infant formula is quite unpredictable.

Yes, I note on the list of things for which you’re accredited, there is no infant formula on the list, it’s whole milk powder, skim milk powder and so on.  You’re saying that’s a totally different accreditation process.  Is it a different part of the Chinese government as well, is it?

Yes, different regulations and different requirements in relation to the company having control from the milk all the way through to the infant formula sale.  There’s been a lot of change to regulation there and for the infant formula companies it’s been a pretty challenging time for them. 

Indeed.  Is there any history of other companies, possibly New Zealand companies, with CNCA accreditation?  For those companies that export to China from New Zealand with that CNCA accreditation that it is always stable, that it isn’t withdrawn and it is renewed, is that the kind of way it works?

Yes, that’s been the case and in our deliberations about due diligence and those sorts of things, we need to descend quite a bit of detail and we’re very comfortable that there’s a lot of track record and quite predictable as to the process we need to go through and as I indicated, without having any quality issues, without having any audit failures or those sorts of things, it should be pretty much a formality for us to get the renewal through.

Can you take us through the history of Keytone?

Yes…

I take it the business was started by James Gong in 2011, the factory built in 2013 and the accreditation obviously provided or awarded 2014.  Take us through that sequence of events.

Yes, I’m happy to do that.  Just at the outset, Keytone is a manufacturer, a blender, an exporter of dairy and nutritional products.  It’s production facility is located in Christchurch, New Zealand.  It’s a small but fast growing business.  In its short history under James’s control it’s achieved increasing volumes, increasing sales revenue and positive EBITDA.  He has also established some strong relationships and excellent channels to market in China.  As we indicated, the CNCA accreditation is something that allows to import a wide range of products and formulations into China.

Keytone’s production capacity is about 1,500 tonne at the moment which is rather small.  In thinking through the way forward, four pillars of the growth strategy was determined and the first one of those is to increase the production capacity in the first stage from 1,500 to 5,000 tonnes.  As well, we’ll increase the product range.  There’s a number of new products in the new product development sector.  The distribution channels are always changing and we’ll be looking to expand our distribution channels and as well there’s some new geographic regions that we’d like to explore. 

All that takes funding and it was decided that the best way forward was to proceed with an IPO to raise $15 million dollars to fund the growth strategy and list the shares on the Australian Stock Exchange.  James’s history, he was born in China, he relocated from China around 15 years ago, he spent 11 years at Westland Dairy as General Manager Sales & Marketing and then after that he decided to start up the Keytone business.  As I indicated, he’s had a lot of success and now we’re sort of looking to take the next step up on the ladder, to take a smaller business into a more significant business and our plan is to increase our market share in China and that’s where we’re sort of at now. 

We have successfully concluded the capital raising and listing on the stock exchange, now we’ve got a transformational year ahead of us where we need to build the new plant and develop the other three areas in new products, distribution channels and geographic regions to bring all that plan together.

Did James take Westland into China, is that what he did during those 11 years?

Yes, as far as I’m aware of the history, back at the time there was consolidation in the dairy industry in New Zealand.  In New Zealand they had the Dairy Marketing Board and the Dairy Marketing Board was the seller of all the dairy products that were produced in New Zealand so every manufacturer had to sell to the Dairy Board and the Dairy Board did the international sales.  Similar to Australia having deregulation, that model was discontinued and from that day it was up to the individual dairy company that didn’t join the Fonterra Group to come up with their own marketing arrangements.

My understanding is James was recruited at that time, basically started from zero because formerly the sales arrangements were through the Dairy Board and James proceeded to develop a sales function for Westland and he quickly increased international sales revenue in the order of $100 million.

Right, and then decided to strike out on his own?

Yes, well I think James in the Westland business probably was more focused on the dairy commodities, maybe skim milk powder, whole milk powder and those sorts of products, and he would have observed that there were gaps in the market where consumers and customers were looking for a different format and more functional products, so he thought that having a smaller business, he’d be able to deal directly with those customers and he’s demonstrated to date he’s made that quite successful.

Where does he get the money to build the plant?

He funded it himself and I’ve forgotten the date exactly, but a little while ago he introduced a new shareholder, Bergen Asset Management, who provided funding to build the initial plant and Bergen Asset Management or Long Hill are a shareholder on the register and in order to, as I said, take the business forward and there be a larger more successful business, it decided to raise funds from the public through the IPO.

With the increase in capacity of the plant from 1,500 to 5,000, I understand the slab has already been poured for that, when will it be finished?

We hope to have it finished around about the end of this financial year.   The plan will be to, as at the end of March hopefully we’ll have commissioned the plant.  Keytone has a March year-end and it’d be tremendous if the plant was commissioned and we had that available capacity from the start of our mixed financial year.  In the meantime, we’ll be looking to talk to customers about extending the arrangements we have with them for increasing volumes and additional new products and hopefully next year we’ll be in a position where we can fill up most of that new capacity that’s coming online.

Tell us how the sales into China take place?  Are there contracts and deals?  For the sales that you’re making now, do you just plonk them on the shelves of the stores over there and the online retailers?

Yeah, we have a number of arrangements.  We have a contract pack for, if you like, retailer owned brands.  We will contract pack for them in their labels.  We also have our own brands sold there and as well there’s going to be an increase in the online trade that we’re involved in as we move forward as well.

It’s interesting you’re talking about the four pillars of your growth, which I’m just trying to remember now.  Increased production, you’re going to increase the number of products or the range of products that you’re producing and I think the fourth one was geographic expansion.  I would have thought you’d be able to sell all of your production into China, why wouldn’t you just focus on that?

I think that’s probably correct and I’d be very happy that that is the case, but there are other areas around the world where there’s demand for dairy products as well and hopefully we’re small enough to be in a position where we can select the most beneficial contracts for the company.  There’s the Middle East and Asian countries, Japan’s a prospect as well.  Hopefully we’ll have a good array of geographic regions that we sell to and hopefully we can maximise the benefit to the company in doing that.

I suppose it’s good to have some insurance against possible losing of your licence into China because with China it’s all or nothing, isn’t it?

Yeah, I think that China is a very interesting learning experience for everyone.  It’s a massive economy and in the past there’s been a way of doing business internationally and I think China is a really good demonstration of, if you do want to do business in a successful way you need to adapt a bit and make sure that you do it in the way that you can capture the most business in that part of the world.

Yeah.  Tell us what your run rate sales are now, can you bring us up to date?

Sales at the moment are quite modest.  We’re only, with the capacity we have, selling about $2 million in sales and with the expansion of capacity and the new product mix and those sorts of things we’ll have a different balance of sales.  The important thing for this year is it’s a really transformational year.  We’ve gone through the listing, we’re now just about to commence the work in regard to the plant and equipment and the other capital expenditure required to bring on the new capacity.  That will be a large part of our efforts for this year and as I indicated before, if we can get all that done and successfully commissioned so that we’re ready to roll with the new capacity at the start of the next financial year, which for us is April, that will be a really pleasing outcome.

How much do you think, if that happens and you manage to sell the new level of production, what sort of sales are you looking at then?

I don’t want to give a sales forecast because we haven’t sort of announced anything there.  But if we were filling up the 5,000 tonne, we go from 1,500 to 5,000 which is over three times what we’re currently doing now.  There are some other products that we’re looking to release, an AMF product which is a butter oil product.  James has identified some areas where there’s demand in Asia, particularly in the bakery and confectionary sector.  That is something we’ll be outsourcing and that will have a positive impact on our sales line for this year as well.

I saw that, that was an announcement today.  This is AMF, which stands for something milk fat, right?

Yeah, anhydrous.

Anhydrous milk fat, which is 99.9% milk fat.

Yes.  To explain a bit better, if you have butter and you melted it, it’s like 16% water and 2% pulp and the 80% is the butter oil.  That effectively is the ghee component.

With the AMF that you’re now going to sell, do you buy that from someone else and put your own brand on it or are you manufacturing?

Yeah, we buy it.

You’re just buying it in?

Importantly, I should have mentioned earlier on that Keytone doesn’t process milk.  It is, as I indicated, located in New Zealand.  There are large milk processes over there, 20 billion litres of milk is processed and we don’t see any necessity for Keytone to be involved in milk processing.  There are enormous facilities over there that make dairy products at very low cost and we are fortunate to be in a position where we can acquire our dairy products and dairy ingredients from those producers at the spot international prices.

So you’re buying the powder, are you, just buying the powder and then packaging it?

For the powder and powder formulations, yeah, we buy the powder.  Where it’s a blend, we blend the powder with other ingredients to make a particular formulation.  We buy the powder and in the case of AMF, we purchase the AMF product and we have another firm called [Bagels], who put that in the formats and to the recipe that we require.

Right.  What sort of gross margin do you operate under?

If we look historically, I think it’s about 35% - you’ve just got me on the hop but I think it’s about 35% gross margin.

So you buy it at $1 dollar for example for something or other and you sell it for $1.35?

Indeed, that’s what we’ve done historically and largely in relation to the powders.  In relation to AMF we have a bit to sort of do there.  Basically, we’ve got samples, we’ve provided them with customers and we’re looking to grow this business and it’s a little bit too early to say what the volume will be and what the profitability and margins will be on that business.

Can you slip the AMF into your CNCA accreditation into China or has that got to go to other markets?

I don’t know.  I don’t see why – I can’t remember the CNCA, but it does have milk powder and whey products and fat products and those sorts of things, so I would be quite comfortable that logically it does fit there.  It’s a dairy product, it’s not in infant formula and I haven’t got the CNCA list with me but I would be surprised if that couldn’t be achieved.

And what were the other four – as you say, there were four pillars of growth, we’ve got the increasing products…?

Capacity.

Increase in capacity, increase in geography – what was the fourth?

Distribution channels.

Right, tell us about what that involves.

Yeah, as I indicated, there’s the products that we pack for others such as supermarket chains.  We pack for Metro Supermarkets, a largely European supermarket that has a strong presence in China, we pack for them under their brand.  There’s other arrangements that we have that are similar.  We’re a contract packer, we pack our products and formulations in their brands, there’s also our own products that we sell under our own key dairy brand.  In the past we’ve been a bit limited because of limited production capacity as to what we’ve been able to do.  But now we’ve got new production capacity coming on, we can have meaningful discussions with customers about what we can do for them and what volumes we can supply. 

There’s that, there’s the online channels, the Tmall and other online stores.  We hope to do quite a bit of trade through there and those channels together with some of the new products we have coming on board.  We just released a goat milk powder, we have other opportunities in the sports and nutrition and also the medical formulation areas as well.  There’s a lot of new business opportunities we can pursue, now we have that increasing production capacity coming on board.  As well, there’s a lot of trade and opportunity in the business to business space as well.  Certain businesses require formulations for their specific purposes and products that they’re making, so I would hope that the business to business sector is something that provides us with a lot of opportunity as well.

That was Bernard Kavanagh, the Chairman of Keytone Dairy.