The lid is lifted on Bellamy's

After a four-week suspension from trading, Bellamy's has updated the market with details of falling profits and an onerous supply agreement with Fonterra. The stock fell 20% on the day trading restarted on 11 January and has fallen another 23% since.

All up, the stock is down almost two-thirds since the beginning of December. How the mighty have fallen.

Bellamy's now expects revenue of $220m–$240m for 2017, earnings before interest and tax (EBIT) of $22m–$26m and net profit of $14m. That compares to figures of $244m, $54m and $38m, respectively, in 2016.

The lower EBIT includes shortfall payments of around $12m that are required due to a ‘take or pay' supply agreement with Fonterra. Critically, inventory levels have ballooned to between $105m and $110m, of which 75% is finished goods. This is up from $67m at 30 June 2016. With the increased production of infant formula, Bellamy's net cash balance has reduced to just $1m.

Chief executive Laura McBain has been dumped, replaced by Andrew Cohen, the company's chief operating officer and formerly a partner with management consultants Bain and Company.

Bellamy's canned

There are two key mistakes that Bellamy's has made over the last 12 months.

The first was to ignore the daigou channel, and focus its Chinese strategy on selling via Chinese online websites such as Tmall. The switch was driven by the belief that Chinese authorities would soon be cracking down on the daigou channel. But, with an oversupply of infant formula in the Chinese market, Bellamy's lowered its prices on Chinese websites; that took away its premium status and, with it, the profits for daigou traders. As a result, they promptly switched to other brands such as A2 Milk.

The second mistake was the signing of the supply agreement with Fonterra, which was done on the assumption that revenues would continue to rise. However, the contract provided no downside protection for Bellamy's in the event of demand falling. This is how boom and bust cycles work. As revenues rise, companies increase (and lock in) costs, only to find that these costs still need to be paid when revenues stagnate.

Bellamy's now has over a quarter of its market value tied up in a mountain of infant formula, which may need to be written down in the future. The contract also requires Bellamy's to pay shortfall payments of around $12m per year, adding to its cash flow woes.

The renegotiated contract includes a ‘poison pill' that will deter any takeover. It would be triggered if a shareholder group controlled more than 30% of Bellamy's voting shares. To add further insult, Fonterra is seeking to establish a second-ranking security over the assets of Bellamy's in case payment from Bellamy's is not forthcoming.

How Bellamy's came to sign this contract with Fonterra is a question many will be asking in the coming months. How could the chief executive, chairman, board and legal teams all allow this contract to get signed without questioning what would happen if revenues fell?

Bellamy's is now effectively in chains, and will stay that way unless it can find a way to return to revenue growth.

Not happy Jan

On January 4, Bellamy's announced that it had received a notice from its largest (and most mysterious) shareholder, the Black Prince Private foundation, seeking to replace four board members with new ones representing shareholders owning 35% of the company's shares.

The group of unhappy shareholders includes Jan Cameron (co-founder of Kathmandu), who believes the board has largely dodged responsibility for the company's predicament. It will be interesting to see if shareholders are willing to align themselves with the mysterious Black Prince foundation that is domiciled in the Caribbean island of Curacao.

The company faces further head winds with the likelihood of class actions being served. It wasn't until 2 December that Bellamy's first alerted the market that something was wrong, and that revenue would be flat. This was despite supermarket data showing that Bellamy's market share had been reducing throughout the year.

The signing of the Fonterra contract showed that management was expecting revenue growth to continue. When they noticed that revenue wasn't growing, they should have been aware of the havoc the ‘take or pay' contract would cause to the company's financials. Despite this, management remained tight lipped at the 19 October annual meeting and said nothing.

Greener pastures?

Can Bellamy's trade its way out of these difficulties? Yes, it's possible, but the company needs to increase revenues, which would mean re-engaging with the army of daigou shoppers. Growing revenue would reduce inventories, resulting in more cash in the bank. This would reduce the likelihood of a writedown and eventually lead to lower shortfall payments.

However, there's also the risk of revenue falling, which would magnify the negative cash flow, increase the risk of a writedown, and potentially force the company to raise capital.

In Bellamy's favor, the ‘demand' side of the equation is still there. With the growth of the Chinese middle class, and a lack of confidence in Chinese infant formula products, Chinese parents still prefer imported formula from safe countries such as Australia. There are, however, many companies wanting a piece of this pie.

Despite Bellamy's having the great qualities of being Australian and organic, management has kicked some own goals and the company is not positioned well for the challenges ahead.

Given the poor levels of disclosure so far, it's possible that current guidance may be optimistic, or there may be further issues yet to be disclosed.

There is also the issue of the Chinese government's tough new food safety laws, which take effect in January 2018. The new laws will require suppliers to obtain a registration and limit them to selling only three brands in China. The changes are expected to significantly reduce the number of brands in China. While this is currently causing some of the oversupply in the market, it may eventually restrict competition – so long as Bellamy's is successful in getting its registration, of course.

Putting it all together, the company still faces considerable risks and it's hard to have much confidence in a valuation. As a result, despite the price fall, it's also hard to pin down a price at which we'd be interested in the stock. AVOID.

Disclosure: The author owns shares in Bellamy's.