Clover Corporation (CLV) is a recent addition to the Oracle Emerging Companies portfolio as a “picks and shovels” play on the booming premium infant formula market. The company has a patented encapsulation technology that creates a nutrient rich dry powder from tuna oil that contains docosahexaenoic acid (DHA) which is important for the development of brain, nerve and eye tissue for infants.

CLV’s key customers are infant formula manufacturers who use the product to meet regulatory requirements for DHA in their formulas. The competitive advantage for CLV is that their technology allows them to achieve an “oil loading” of over 50% compared to competitors between 20-30%. Importantly, CLV is able to achieve the additional oil loading without any adverse taste or smell.

The most common method currently used by infant formula manufacturers to achieve DHA requirements is to apply “wet injection” of tuna oil directly to their formulas. While this can be used effectively in small doses, once you get above 10mg of oil the taste or smell of fish begins to overwhelm. The European Union is the first region to review the regulations on DHA in infant formula and have brought in new standards which requires 20-50mg of DHA for any formula manufactured after February 2020. While wet injection is cheaper than dry powder and manufacturers will use it as much as possible, at some point they will be forced to top up their formulas with dry powder to meet regulations without compromising taste or smell.

As well as the EU, China has released draft legislation to increase their minimum DHA levels to 15mg and the US FDA has asked for submissions to review their regulations as well. The mandatory increase of DHA levels of infant formulas globally will be a key tailwind for CLV over the next few years as dry powder takes market share from wet injection.

While CLV ticks many of the boxes we look for in an investment at Oracle, historically the business has had very poor cash conversion with large chunks of profits getting caught up in working capital. As I outlined in a previous blog post on TechnologyOne, poor cash conversion can often be a symptom of a deeper underlying problem with a business. However, in the case of CLV when we look closer we see this is not due to a weak business model but rather management investing very heavily in the growth of the business, something we believe the market is misunderstanding.

By far the largest contributor to CLV’s working capital is their inventory (around 90% of working capital). If you look at a snapshot of their balance sheet below, you will see a $9m increase in inventory from July to January, reducing the company’s cash balance from $8.3m to less than zero! This increase in inventory was also roughly double the $4.6m net profit the company earned over the period.

When we see something like this at Oracle we usually dig deeper with management to better understand the underlying economics of the business because it’s not normal to see a company spend twice their net profit in a period on additional inventory. Speaking with CLV management, we confirmed that the company took advantage of a temporary cheap supply of tuna oil from one of their key suppliers. Given tuna oil is able to stored for many years at room temperature, economically it can be very advantageous to wear the short-term cost of buying in large quantities as the company can then process and formulate the oil at a later date at higher margins (due to the lower cost of goods sold from cheaper oil).

Sure enough, the company provided a very positive update in late May with the following commentary:

While this benefit played out quicker than management expected due to strong pull-forward of consumer demand from Covid-19, it is a testament to the management team that they were well-positioned to take advantage of the situation.

For us at Oracle, CLV is another example where it is important to analyse the reported numbers in the context of the operating business. While CLV would screen poorly on any cashflow metric, this is due to management’s long-term view on the business and using their balance sheet effectively to take advantage of short-term opportunities in their market. Without any permanent impairment to the cash generation of their business model we expect CLV to earn large amounts of free cash flow in the future as the business matures.

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