Three Squirrels Beats Mars and Mondelez in China – Initiate with Hold [2/2]

This article is part II of our analysis on Three Squirrels – check out part I before you read. 

Three Squirrels pursues a supply chain that combines directly managed and outsourcing models. In the procurement stage, Three Squirrels outsources the work to large procurement managers but has established a wholly-owned subsidiary as well as a product manager mechanism to conduct quality and safety oversight. 

In the production and warehousing stages, Three Squirrels recently started to run on a 'union strategy,' whereby it partners with high quality mid- and small-size manufacturers to build factories together, and these factories function both as production lines and front-end warehouses. By co-investing, Three Squirrels creates a risk and reward sharing mechanism between itself and its partners, which leads to strong communication in the supply chain while maintaining 'asset-light' business characteristics.  

With the current model, we think Three Squirrels is the leading player in both efficiency and cohesiveness aspects of the snack supply chain. One concern is whether this supply chain model can still bring efficiency to Three Squirrels' rapid expanding offline sales channels. Currently, there are about 600 Three Squirrels offline stores – among them 80% are franchise stores. With the aim of expanding its total offline presence to 10,000 stores in 5 years, we expect a heavy emphasis on the franchise model, allowing independent store owners to take on the majority of responsibilities. This could mean looser communication and controls. It is still too premature to say whether Three Squirrels’ current supply chain is capable of handling offline franchising at such a scale.

Channels

Three Squirrels emerged as an online player in the snack industry, but due to 1. Lower online margin and 2. Larger offline market, Three Squirrels' transition to offline sales is inevitable. We will analyze both Three Squirrels' online performance as well as the upside and downside of its current offline expansion.

As shown on the graph, online sales are still the major source of income for Three Squirrels, but there was a continuous margin contraction in both 2019 and Q1 2020. In 2017/2018/2019, online sales took 95%/89%/93% of Three Squirrels' revenue respectively. While established IP is one factor in online sales increases, another catalyst is increasing e-commerce penetration. This rate rose by 8% from 2016 to 2018 in upper-tier cities and by 10% in lower-tier cities.

For offline channels, Three Squirrels has established directly managed and franchise stores, with a current 1 to 4 ratio among these two categories. In comparison, offline channels are able to capture at least 1.5x margin compared to online channels because consumers are less sensitive to prices in offline shopping. Specifically, directly managed stores are about 4x larger in scale and can generate as much as 8x revenue compared to franchise stores. 

One upside we see in Three Squirrels' offline store is the SPA model (specialty retailer of private label apparel) in its directly managed stores. This model is originally adopted by clothing retail brands including Zara and UNIQLO, its core is to use a comprehensive store as a way to capture consumer preference and to efficiently relay downstream feedback to upstream R&D and supply chain processes. It allows brands to control inventory risks and produce a variety of products. 

We think both of the above characteristics fit well with Three Squirrels' strong suits. First, the offline stores provide valuable feedback to Three Squirrels' data center and aids in quick and accurate product targeting. Second, it supports Three Squirrels’ strength in creating a variety of products by enabling effective inventory management. 

On the downside, the scale of offline channels for Three Squirrels is still limited. It is facing immediate competition with Bestore, the same market cap snack retailer that started in offline sales. Currently, Bestore has a much more mature offline franchising system, where the brand franchisees serve as investors, and Bestore controls supply and operating aspects of the stores. On the other hand, Three Squirrels' franchising system puts franchisees as the investors, operators and main risk takers and the brand itself only as a supplier. We think Bestore’s model can bring more quality and can better ensure a unified brand image than Three Squirrels at this stage. So, even with success in the supply chain, Three Squirrels' large offline scaling can raise some concerns.

Valuation

We drive our price target of CNY 72.5 from a three-stage DCF methodology, assuming a WACC of 9.87%. Our price target implies a 6% upside – therefore, Initiate with a Hold rating. The revenue growth forecasts for 2020/21/2022 are 26%/32%/35% reflect Three Squirrels' ramping up offline channel expansion and leadership in online distribution and horizontal expansion into categories. We expect short-term gross profit margin will improve slightly due to a refined supply chain efficiency and better inventory management, growing to 28.0% in 2020 from 27.8% in 2019. Still, the launch of new products and brick-and-mortars stores may pose challenges here. We also expect the net margin to grow from 2.3% in 2019 to 3% in 2024 due to improving operating efficiency; however, we note that net margin can be decreasing from 2020 and 2024, to reflect potential high competition against offline leaders like Bestore. We apply a 15% medium-term growth, a 2% perpetual growth rate. Our bull case and bear case scenario valuations suggest a 33% upside and 40% downside, respectively.