BYND: Beyond Multiples

BYND: Beyond Multiples

I have been thinking about Beyond Meat, a recent US IPO that basically tripled from its $25 IPO price to $66 in a short period of time.  It is possible that the new era business model of delaying profitability in favour of maximising growth proves me wrong, and I want to get down some thoughts based on what I think I know about stocks and manufacturers, with a view to revisiting them in a couple of years.

Beyond Meats S1 (Prospectus)

The bull case

The bull case as it was explained to me is that this is the first burger that is nutritious enough and tasty enough to be a plausible substitute for meat. It is a product leader in vegetarian faux meat products. Second, it is good enough to tempt meat eaters who may want to replace a meat meal with a vege meal a couple of times a week. Anecdotally (/ company data suggests) this is a reasonably large percentage of meat eaters and a large target market. Beyond Meat wants to position its product adjacent to meat, not in the specialist vegetarian section of supermarkets.

Third, there is a general trend towards more vege protein production because meat production, beef especially, is resource intensive. Fourth, there is rapidly growing demand for cheap protein that costs less than meat, especially in Asia. Five, Beyond Meat is investing heavily on growth and brand up front, pushing back economic profitability in return for scale and a land grab, essentially. 

So, Beyond Meat is a market leading product, growing quickly and executing well in a market that has several powerful long term tailwinds. Ideally the total market size will grow several times larger over the next 10-20 years, and consumption of non-meat burgers will become normalized relative to their current status as edibles for quirky lefties. There is an argument this type of fast-growing business should not be judged on present profits, and I agree, however I think that with Beyond Meat, the returns of stock ownership have been pushed so far into the future that the likelihood of making money by buying the stock at today’s prices is slim. 

The bear case

The problems start when you look at the economics of the business and the industry.

First up, I would guess anyone who is buying the company today will likely see a decline of somewhere between half and three quarters of their investment in the next couple of years. Perhaps there are some rabbits to be pulled out of hats and expectations to be exceeded in relation to revenue and profit growth, but even so it is extraordinarily difficult to pay >40x sales (or ~20x FY19 sales) for a low-margin manufacturer and expect to make a positive return, even with a considerable ramp up in sales and a degree of operating leverage. The prospectus did not contain forecasts that I could see, but here’s a rough estimate of what I imagine Beyond Meat’s business could look like over the next few years, assuming widening margins and significant sales growth:

2017 and 2018 numbers from SEC prospectus. 2019 and 2020 assume ~20% QoQ growth every quarter starting from the Q1 2019 $40m revenue (from prospectus). 2021 revenue assumes +25% annual growth. This is a very rough guesstimate of what I imagine the business could look like if it grew very rapidly, margins widened, and it was not constrained by capacity or funding.

Many of those assumptions are questionable. Could Gross Margins go to 40%? Doubtful. Maybe SG&A could go lower, although you would expect spending on sales here to increase in order to build a strong market share ahead of likely competition. For what it’s worth, an extremely rare 40% Gross Margin (more on this later) and 15% SG&A would give you $122m in EBITDA in 2021, for a still-lofty 31x EBITDA multiple. If the above assumptions hold true, the company is trading on an EV/EBITDA of ~300x its 2021 numbers.

You can model whatever you like, but if you accept the idea that a dollar today is worth more than a nebulous future dollar, and you also accept that you expect an 8-10% annual return (on average over time) from investing in stocks, and you discount future profits in whatever year to today’s value at a 10% discount rate, the probability of achieving your target return is slim, in my opinion. I have spent a reasonable amount of time on this and I just can’t make the numbers work. I struggle to see how this company is worth $110 a share, or $6bn in 2024 (which would reflect a ~10% annual return from today’s stock price of ~$66), even if it does $1bn revenue in that year.

Where I would be wrong, is if Beyond Meat is capable of achieving a meaningful market share of what it estimates is the $35bn faux-meat market, which it likens to growth in faux milk products (almond milk, soy milk etc). If Beyond Meat can do $5 billion in sales in the next 10 years then I would probably be wrong, although even then some rough numbers (12% FY29 NPAT margin, 20x P/E multiple, $12bn mcap, 10% discount rate) suggest it’s a close race. More importantly, if this is the likely end state, I think there is a good chance of being able to pick the stock up at a much more attractive valuation in a year or so.

Rationale for the doubt

The growth trajectory of manufacturers is typically constrained by two key concepts. Firstly, capital expenditure is a necessary evil – you normally need to have twice the capacity if you want to produce twice as much, and your working capital/inventory requirements get a lot larger as your distribution and sales increase. Additionally, depreciation becomes a much greater expense over time and this limits the profits that can be generated by the business (depreciation is not included in the above table). These things limit growth because the company has to spend money basically in proportion to (and in advance of) future sales, and it also has to replace past investments (equipment) as it wears out. This suggests that the long term returns from owning an asset-heavy business are limited to the return on capital employed (ROCE/ ROIC) that the company achieves. Very good manufacturers get 20-30% ROCE’s.

Return On Capital Employed is calculated as EBIT divided by (total assets minus current liabilities) and I use this metric because it is pre-tax but post-depreciation, BYND has net cash, and so I think it is useful for our purposes. While the above model excludes capex, if we use ROCE as a kind of proxy for the future earnings of the business, we can get another guess at what the company might generate in earnings. 

Including the $240m that BYND raised, plus its $130m in assets minus whatever its current liabilities end up as, I would guesstimate Beyond Meat will have say $250m-$300m in capital employed this year. While the business is loss-making, a generous 30% ROCE at maturity implies $90m in EBITDA versus its current market capitalisation of $3.8bn. You are likely to lose money if you buy this business today. (note also that $90m in EBITDA is far in excess of what the above table implies in earnings over the next few years).

At the IPO valuation of $1.2bn (i.e. $25 share price), $90m in possible future EBITDA sounds ok (13x EBITDA) given the frothy state of the US market and BYND’s strong growth prospects, but it is important to remember the business is currently lossmaking and may never achieve a 30% ROCE.

Third, the physical nature of the business and factories imply that this is not a globally scalable business. This is because, to be cost effective and achieve a decent amount of volume, a food company often needs a local factory with local (fast) distribution in each major region. It’s hard to sell a large number of fresh faux meat products in Australia at a competitive price when you are shipping them from factories in Missouri. It’s also hard to achieve a strong brand in every region. To be a global manufacturer with a chance of earning enough profits to justify its valuation, Beyond Meat needs a lot of new factories/supply/distribution and a lot more capital. (It could also outsource manufacturing – more on that later).

Fourth, following on from the above, who holds the industry power, and who does the $$ accrue to?  Generally, food brands that can sell large volumes on popular and differentiated products seem to be able to build defensible market positions, but there aren’t many food product manufacturers that hold the kind of economic power that would let them extract 30% ROCE’s from their business. Companies like Fevertree and A2 Milk get ROCE’s north of 40%, primarily due to outsourcing manufacturing. The laws of economic gravity militate against Beyond Meat justifying today’s valuation unless it is able to outsource most of the capex. 

A search of a financial data provider suggests that there are ~4300 publicly listed companies globally in the food and packaged meats industry. ~1200 of those achieved a gross margin above 25% last year. 75 companies, or 1.7%, achieved a return on capital (slightly different calculation to ROCE) above 20% last year. Only 58 companies, or 1.3% of the sample size, achieved both a 25% gross margin and 20% return on capital. Almost all of these companies are in emerging markets like China, India, Russia, Pakistan, and Vietnam; those that aren’t include asset-light businesses like A2 Milk. Compare this to my estimates above and form an estimate of where you think BYND sits.

Causes for optimism

It’s already clear that there are a few things Beyond Meat can do to improve its business. One is to outsource the manufacturing, a la A2 Milk Company (ASX:A2M). As we just saw with Fevertree and A2 Milk, the economics of owning the brand are substantially more favourable if you can outsource all of the capital-intensive, low-return jobs to somebody else.  Two, the company could create new products, and Three, it could improve its supply chain substantially and squeeze out costs. Four, it is already somewhat dependent on a single supplier, but it could for example aggregate the industry or supply and have a quasi-monopoly on pea protein or faux meat products in the USA. Five, BYND has ample excess capacity and could I guesstimate maybe triple last year’s revenue with current facilities; it is also well-funded and investing in new factories for the future. With back of the envelope calculations based on their 2018 numbers, I could generously see it doing maybe $500m in sales by 2021 or so, assuming the demand is there.  From a business perspective, things are going really well. From a valuation perspective…

The most sensible strategic decision Beyond Meat could make right now, in my opinion, is raise as much capital as it can as fast as possible. If it can raise enormous amounts of money at a valuation that implies like a 1% cost of equity, and then reinvest it into the business over time at a much higher rate of return, it could greatly increase the intrinsic value of the company.

The bottom line

This is not a software company. There are a few obvious levers that Beyond Meat can pull that would lead to a meaningful improvement in the intrinsic value for its business. I can, if I squint, just about convince myself that I could make money at the IPO valuation of $25/share. I’d bet my hat it’s a loser at today’s prices, however.

Food for thought.

I have no position whatsoever in any company mentioned. This is not investment advice and simply reflects the author’s thoughts at the time of publication. This is a disclosure and not a recommendation.

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