We are initiating coverage of Three Squirrels Inc. (三只松鼠) with a positive investment view. Founded in 2012 by Zhang Liaoyuan (章燎原), Three Squirrels is a leading snack brand that achieves USD 1.5 billion sales in 2018 through selling nuts, seeds, dried fruits and other snacks. Three Squirrels is not only the first food brand tapping into e-commerce, but is also currently the largest snack retailer on major Chinese online retail sites. The company has successfully turned a relatively mundane product into a successful and recognizable domestic brand.

Investment positives

Unique brand IP creates customer loyalty

Tmall, the biggest revenue stream for Three Squirrels (64% of sales come from Tmall), impressively showed that searches for "three squirrels" or "three squirrel flagship stores" quadruple searches for "nuts" and more than double searches for "snacks". Sales volume of Three Squirrels has been ranking #1 in the “snacks/nuts” category from 2014 to 2018. Furthermore, Three Squirrels products have an average rating of 4.8 out of 5 on the Tmall website, compared to the industry average of 3.9 out of 5.

The positive reputation of Three Squirrels is likely driven by multiple branding strategies which its competitors lack:

1) Unlike traditional nut suppliers, who emphasize savory tastes and unique suppliers, Three Squirrels acts more like a product manager, using an exclusive, customer-friendly trademark to make customers remember the brand even at first glance. Chinese internet giants are known for successfully using animals in marketing, including Tencent’s penguin, JD’s puppy, Taobao’s cat and Ctrip’s dolphin. Three Squirrels has adopted a similar strategy - using three cartoon squirrels to give the nut brand a “warm, approachable personality” and to narrow the distance between the brand and its end-consumers.

2) The company uses squirrel images throughout the customer experience, reinforcing them on online stores and customer service accounts as well as physical store decor and packaging design. Throughout these venues, customers are consistently met with squirrel imagery.

3) Since 2017, the company has been producing 3D animation and mobile games, as well as investing in a theme park, all under the name of “Three Squirrels”. In particular, Seasons 1 and 2 of the animated “Three Squirrels” series has achieved viewership rates of over 300 million on the internet. We expect that the unique IP will continue to act as a core competitive advantage and that consumers will increasingly associate “Three Squirrels” with nuts.

Omnichannel to broaden customer reach

The internet is a valuable starting point for Three Squirrels to distribute snacks due to the higher efficiency the internet offers in comparison to traditional offline channels. Three Squirrels seized e-commerce opportunities in 2012, securing the first-mover advantage. While the overall market in nuts, dried fruits and other snacks has grown slowly over the last few years, sales of nuts, dried fruits and other snacks on Tmall has expanded significantly, with CAGRs of 55%, 37% and 55% from 2014 to 2016. As of June 2017, the number of Three Squirrels purchasers exceeded 45 million and the products had an average repeating purchase rate of over 35%. In the snacks industry which has a low barrier for entry, Three Squirrels has the scale.

Nevertheless, with only 11% penetration in the huge overall nut industry, future growth of the brand will largely come from offline channels. On November 11th, 2017, Three Squirrels realized CNY 522 million day sales, indicating a 3% YOY growth. This was significantly less than the 91% YOY growth in 2016. Given that more than 10% of annual sales would come from this Chinese shopping festival, the disappointing sales figure was a wake-up call for the management team. Since then, Three Squirrels decided not to solely rely on e-commerce, instead significantly expanding its offline networks. The company chose second and third-tier cities with relatively low online shopping penetration rates, including Wuhu, Suzhou and Nanjing. By the end of 2018, 45 self-operated stores had propped up, primarily located in Southeast China and averaging over CNY 8 million (USD 1.2 million) annual sales per store. The company expects to open 150 self-operated stores in 2019, in addition to 10,000 franchise stores by 2024, partnering with Alibaba and Suning’s offline channels.

Diversified product offerings to expand addressable markets and margins

While nuts are still the main source of revenue for Three Squirrels, nut sales dropped from 88% of total sales in 2014 to lower than 80% in 2018. The company has significantly broadened its food portfolio by introducing products with lower ASP but higher margins. Berries and herbal tea, in particular, have margins of over 40%. Although the squirrel image is more related to nuts, Three Squirrels has successfully made the transition to Western-style bakery items. For example, the company sells bread and cakes with 45-day expiration dates, differing from the 7-day or 6-month expiration date cakes currently produced by existing players. Three Squirrels’ bread category grew at over 100% in 2018, realizing over 400k of monthly transactions on Tmall, well exceeding the industry leader Panpan Bread (100k monthly transactions) and Daliyuan (20k monthly transactions). This success was clearly driven by stronger Internet distribution channels. As of now, Three Squirrels has over 200 SKU. Going forward, we trust in the company’s ability to introduce new products, diversifying their portfolio with creative, fun, and innovative snacks. It is prudent to say that the existing brand will bring consumers to other food categories at lower customer acquisition costs, resulting in a positive margin impact.

Investment risks

Food safety issues caused by excessive reliance on OEM and insufficient quality control

Three Squirrels have entered the IPO listing queue three times so far but unexpectedly suspended the process twice, likely due to its violation of food safety standards. According to company prospectus, 7 consumers sued Three Squirrels for discovering worms in its dried fruit products. The National Quality Inspection Department also found that several nuts products showed excessive fungus. Such incidents were likely caused by the large reliance on OEM production, a model allows Three Squirrels to meet surging production demands but raises concerns on food quality. In the event that Three Squirrels fail to inspect those issues or fail to maintain food quality during the manufacturing, storage and transportation process, the company may experience both headwinds on financials and a further delay in IPO.

Slower-than-expected growth due to intense competition and commoditized products

As mentioned before, Three Squirrels saw its revenue significantly slowed down in 2017 due to shifting in channel preference toward offline, before posting a strong rebound in 2017. Although the current omnichannel business model makes it more competitive in the market, fierce competition remains a source of risk as competitors such as Be & Cheery, BESTORE and Daliyuan are aggressively leveraging both online and offline channels to take on a greater market share. Given that the types of products and pricing are very similar across these brands, future growth will mainly come from channels and brand effects.

TAM and competitive landscape

The relatively mature and stable snack industry was estimated at CNY 485 billion (USD 72 billion) in 2017, with a CAGR of 6% in the past 6 years, according to Guohai Securities. Benefiting from the secular growth of e-commerce, snack sales have partially shifted from offline mom-and-pop shops and retail stores to online venues. The online penetration grew to 11% in 2017. Assuming the online penetration of snack sales will grow at the current pace, reaching 15% by 2022, the online addressable market for Three Squirrels is approximately CNY 93 billion (USD 14 billion).

According to Sealand Securities, the CR3 of the Chinese online snack sector was 23% in 2018. The three leaders were Three Squirrels, Be & Cherry and BESTORE, with respective market shares of 11%, 7% and 5%. While snack industry has a low barrier to enter, the sector leaders are benefited from scale advantages, which allow them to develop additional barriers (for instance, allocating more capital on marketing, developing more distribution channels, increasing warehouses and logistic centers, etc)

Financial outlook

Top-line: Revenue grew at 121% and 116% in 2016 and 2015, respectively. We expect the top-line momentum to be driven by new snack offerings and offline expansion. Risks come from potential pricing pressure, as we do not see meaningful differentiation across Three Squirrels, Be & Cherry and BESTORE from a product perspective.

Gross margin: Most companies in this sector are running low margins (under 50%). COGS has declined significantly from 76% of total sales in 2014 to 70% in 2016, driven by higher ASP and lower material costs from suppliers. As a result, gross margin has been improving at ~300bps per year from 2014 to 2016. We see GM to continue to expand mainly due to the economy of scale and the addition of higher-margin products. We believe the 35~40% gross margin, comparable to the industry average, is achievable in the long-term.

Sales & Marketing: The largest operating expenses come from Sales & Marketing which took 21% of total revenue in 2016. The number was slightly lower than the industry average of 23% and has been declined by ~400bps in 2 years, driven by lower logistics fees, marketing expenses, platform service fees and employee salaries as % of the total revenue. We see the S&M/Revenue to continue to drift lower as the top-line builds scale.

Valuation based on comparable public companies: With similar business models and financial profiles, we believe Hao Xiang Ni (the parent company of Be & Cheery), Toly Food and Qiaqia Food are comparable companies. Based on the average FY18 P/S of 3.2x and average FY19 P/E of 2.7x forecasted by major brokers, we believe Three Squirrels could be worth around CNY 30 billion or USD 4.5 billion given its estimated FY18 sales of USD 1.5 billion.

Business overview

Products:

Capturing the growing trend among Chinese consumers of consuming nutritious and healthy snacks, Three Squirrels mainly offers the following items:

Nuts: pistachios, Hawaiian nuts, Badam nuts, pine nuts, almonds, pecans, peanuts, etc.;

Desserts: bread, small cakes, cookies, popcorns, chocolates, etc.;

Dried fruit: dried mango, dried strawberry, dried durian, dates, raisins, etc.;

Meat: beef sticks, pork chops, etc.;

Drinks: coffee with nuts, herbal tea, etc.

Supply chain:

Nuts are either sourced domestically or imported from the U.S., Brazil and Australia. They are then processed in China and other Asian countries and sent to one of three logistics centers in Beijing, Wuhu or Guangzhou (a new logistics facility in Chengdu is currently under construction). Freshness is one of the most important factors in food, and Three Squirrels relies on technology and information system to keep the products fresh. As an added measure, they also deliver products to customers within 60 days of being produced.

Online channels:

1) ~70% of sales come from DTC channels, including Three Squirrels flagship stores on Tmall and JD.com in addition to Three Squirrels mobile app.

2) ~25% of sales come from third-party online distribution. The company partners with the primary Chinese e-commerce platforms including Tmall, JD.com, Suning.com, No.1 Mall and Dangdang.com. These platforms purchase Three Squirrels products and in turn distribute them to end consumers.

Offline channels:

1) Self-operated stores: There are 45 self-operated stores called “Three Squirrels Feeding Store” and the number is expected to rise to 150 by the end of 2019. The entire store looks like a forest; pine trees and small squirrels are integrated into every corner. Other than selling snacks, the stores also sell products that are not available on the Internet, including phone cases, school bags and pillows with the squirrel logos.

2) Franchise stores: Franchise stores are expected to reach 10,000 in 5 years (open 5 stores per day on average). In order to maximize the franchise stores, Three Squirrels does not charge franchise fees or management fees and removes 90% of rules. Shop owners will have the freedom to personalize franchise stores based on their own preferences, in addition to designing exclusive promotional activities.

3) Partnership with Suning and Alibaba offline stores: Three Squirrels also collaborate with Alibaba and Suning to have the snacks sold in their physical stores. Doing so can not only fasten Three Squirrel's offline expansion process, but also allow it to take advantage of these tech giants’ logistic systems and broad customer base.

*Please note that all data was sourced from Three Squirrel's prospectus unless otherwise stated.