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Can baby formula small cap Bubs Australia Ltd (ASX:BUB) make a comeback?

Bubs Australia Ltd (ASX: BUB) is not yet competing in the same realm as big-name stocks in the competitive infant formula sector, with companies like Bellamy’s Australia Ltd (ASX: BAL) and A2 Milk Company Ltd (ASX: A2M) leading the pack.

Despite disappointing FY18 results, respected broker Morgans thinks there is still hope for Bubs if it treads carefully, and I agree.

Disappointing results

Bubs reported a larger-than-expected underlying loss for FY18 and a material write-down to the goodwill of the recently acquired NuLac Foods.

Bubs announced an underlying EBIT loss of $9.4 million – when Morgans had forecast the loss would be closer to $4.2 million.

Bubs gross profit margin also came in much lower than the broker expected at 13% – with Morgans having estimated 24.5%. The NuLac business generating its own EBITDA loss of $1.4 million over the first six months of Bubs’ ownership also did not help.

When Bubs took up NuLac it was a profitable business – generating pro forma FY17 revenue of $16.7 million, gross profit of $4.2 million and EBITDA of $1.4 million, but the understanding out of Morgans is that NuLac is not performing as expected – although the broker does expect things will improve in FY19 with a restructure.

What is to come?

For FY19 Bubs expects to increase its revenue by 100% or more off the back of a $17 million sales commitment from New Times Asia.

According to Morgans, if NuLac’s restructure is successful, gross profit margin improvement should also be seen there.

But the broker has voiced concerns about marketing costs, which are expected to rise in order to raise brand awareness in China.

On a positive note, Bubs has made progress with its SAMR application – the registration required to sell Chinese-labelled baby formula through China’s Mother & Baby stores – with Morgans expecting Bubs to have secured full SAMR approval by FY19 for sales in Chinese stores by FY20.

The company also undertook a recent capital raising to secure funds for the future, completing a $40.1 million placement via the issue of 53.2 million shares at 75c per share.

Bubs is expecting the capital to be used to “support the company to profitability” with $13.9 million put aside to build inventory to support the next cycle of its growth cycle.

Forecast downgrades

Despite the belief that Bubs can make a comeback if it executes its strategies well, Morgans has downgraded its forecasts with a target price of 60c per share, down from 82c, with a hold rating on the stock.

The broker expects the company to be profitable by FY21 and cashflow positive in FY22 with the forecast of a “material uplift” in company sales from FY20 onwards as Bubs gradually increases its presence in China.

Foolish takeaway

Bubs has posted disappointing results, but for a company in development stage it’s not altogether surprising, and I think it’s made some progress and will see things really ramp up when its Chinese distribution agreements are all in place. Investors might have to wait a while for the returns they are hoping for, but there’s no sign of things slowing in the Asian infant formula market yet, so the future could be bright for Bubs and its shareholders.

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Motley Fool contributor Carin Pickworth has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of A2 Milk. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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