BRRLY - Barry Callebaut: Sweet Quality At A Discount

2023-08-11 05:51:28 ET

Summary

• Barry Callebaut has faced challenges including a major factory closure, a management change followed by uncertainty over targets, and cocoa production troubles in West Africa.
• The company is pursuing steady above-market volume growth and EBIT margin improvements.
• Barry Callebaut's growth prospects and valuation make it an attractive investment opportunity.

We present our note on Barry Callebaut (BYCBF) (BRRLY), the world's leading manufacturer of high-quality chocolate and cocoa products with a Buy rating. The share price has been under pressure as a result of a few bad quarter prints followed by the exit of the CEO within only one year and a half on the job, uncertainty over targets as new management takes over, West African cocoa production troubles, and a stock exchange investigation. We are drawn by Barry Callebaut's high earnings quality, above-market growth, and attractive valuation. We will provide a brief overview of the business, analyze the main issues, and lay out our investment case and valuation.

Introduction to Barry Callebaut

Barry Callebaut AG is the world's leading manufacturer of high-quality chocolate and cocoa products. The company was created through the merger of Belgian chocolate producer Callebaut and the French Cacao Barry in 1996. It is now a fully integrated chocolate company active through the entire value chain of chocolate production including cocoa origination, cocoa processing, and chocolate manufacturing. Barry Callebaut's ingredients are used in a quarter of all chocolate products sold globally. The company supplies chocolate products to the entire food industry from industrial food manufacturers (consumer goods companies) to pastry chefs, bakers, restaurants, hotels, caterers, etc. who later brand and market the products. It operates in over 45 countries and has more than 65 production plants. Barry Callebaut generated annual sales of CHF8.1 billion in its last fiscal year and it is pursuing an ambitious strategy of above-market volume growth and above-volume EBIT growth driven by expansion in emerging markets, outsourcing and strategic partnerships, expansion in the profitable gourmet and specialties businesses, cost leadership, and innovation. The company is listed on the SIX Swiss Exchange and has a market capitalization of CHF8.8 billion.

Volume Weakness and Lack of Clarity Over Targets

In June 2022, after the discovery of salmonella in a chocolate batch, Barry Callebaut had to temporarily shut down the Wieze factory, its main production site, and the biggest chocolate factory in the world . The handling of the situation was excellent as production was stopped swiftly and no contaminated batches reached the customers. The closure had a negative impact on volumes with an approximate 2% effect on FY 2022 sales and a 1% effect on FY 2023 sales. The company eventually had to abandon FY2021-23 volume targets. Moreover, sales were hit by destocking as customers had built up inventories earlier due to supply chain issues.

Former CEO Peter Boone resigned after less than one year and a half in the job and was replaced by Peter Feld, the former CEO of Jacobs Holding with a solid track record of turnarounds at private equity-owned German companies.

Under the previous management, Barry Callebaut had announced 8-10% EBIT growth targets over FY 2024-26, however, the new CEO has not confirmed the targets. The strategy of Mr. Feld will be unveiled on the 1st of November 2023 , on the same day as the FY results. The lack of clarity over targets has put significant pressure on the share price.

Cocoa Production Troubles

Cocoa prices have hit multi-year highs as the rot-causing blackpod disease has ravaged West Africa's crops, which make up three quarters of global cocoa production. The disease, the spread of which has been accelerated by unfavorable weather conditions, causes cocoa pods to turn black and rot. Both the quality and output of the crop are likely to be disappointing this year.

In addition, Ivory Coast, the biggest cocoa producer in the world, has suspended sales for the 2023/24 season due to poor weather i.e., heavy rains and floods and uncertainty over harvests. However, Barry Callebaut has iterated its confidence in the ability to meet customer needs despite the suspension.

Moreover, the cocoa market is usually subject to a significant degree of speculation as the market is relatively small, pushing prices further up. Volume weakness as evidenced in the Q3 results and higher working capital needs are likely to negatively affect the company.

Swiss Stock Exchange Investigation

After an accidental early release of the FY 2022 results, Barry Callebaut has become the subject of a Swiss Stock Exchange investigation over the breach of ad-hoc publication regulations. This is a minor incident, rather than an indicator of significant misconduct, however, the timing is unfortunate as this piece of negative news flow is paired with other events putting further pressure on the share price.

Investment Thesis and Valuation

While historical volume growth has been impressive at rates much higher than the underlying market, Barry Callebaut is refocusing on profitability and returns rather than volume-oriented growth, steadily moving up the value chain and becoming more like high-end ingredient suppliers. This shift is powered by mix as the more profitable gourmet business grows faster, higher margins in outsourcing, and differentiated cocoa product offerings. This is underpinned by cost leadership through scale and market-leading sustainability.

We do not have a strong view on whether the targets will be maintained or not, but we believe the company is able to achieve the targets, and the new CEO should be viewed as a positive contributor towards that given his track record, which we acknowledge is not necessarily an indicator of future success.

The consensus for FY23 Sales stands at CHF8.4 billion, and we project 6% sales growth in FY24 with an 8% EBIT margin (10bps increase) arriving at an EBIT of CHF712 million and a net income of CHF480 million, broadly in line with consensus, implying a forward PE ratio of 18.3x. At 10% EPS growth in FY'25, this puts the valuation at 16.6x EPS FY'25. We find this attractive, and we view this as a chance to acquire shares in a high-quality company with appealing growth at a discount to historical multiples and peers' valuations due to temporary uncertainties. Barry Callebaut is trading at a discount to chocolate peers and high-end ingredient peers while having similar EPS growth.

We apply a target multiple of 21x forward EPS in line with historical rating and arrive at a target share price of CHF1846 or USD2106 implying 15% upside.

Risks

Risks include but are not limited to cocoa price moves, further volume weakness, pricing pressure, persisting cocoa production issues in West Africa, supply chain issues, a downgrade of the FY24-26 targets, a decline in cocoa production long-term, sentiment around cocoa linked to unethical practices, etc.

Conclusion

We recommend building a small long position on Barry Callebaut shares, especially in case of a further pullback, and if targets are reiterated.

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