Oatly

Q3 22’ SUMMARY

In Q3, Oatly delivered results that missed management’s guidance and consensus estimates. The results also missed Pragmatic forecasts by a wide margin. This underperformance was driven by an acceleration of operational challenges as Oatly struggles to scale up to meet the massive demand for the business’ products. As a result of the continued production issues, the leadership team was shaken up with key departures that were replaced with operational focused executives with proven track records of scaling brands.

In addition to the production challenges that suppressed growth and spiked expenses, Oatly faced continued headwinds from the zero-COVID policy in China as well as expansion challenges in Europe due in part to geopolitical tensions. On the positive side, Oatly’s products continued to deliver velocity rates that far exceed the competition. While many expected Oatly to lose share due to dozens of entrants into the massive and expanding plant based milk industry, the products continue to outperform comps by a wide margin.

Overall, consumers love the brand across the globe. Management has a plan in place to resolve the production issues so that the massive demand can be supplied. This positions Oatly to grab more share of the ~$20bln plant based milk market, which is experiencing an expanding TAM.

Key Takeaways from Q3 22’

Key Takeaway 1- geographic cross currents

• Trends in Americas market include strong product velocity despite competition.

• Trends in Europe were materially affected by FX headwinds as well as location expansion friction.

• Trends in APAC were abnormally affected by zero-COVID policy despite strong demand on T-Mall site.

Key Takeaway 2- Continued production challenges

• Leadership team has been changed to remove under-skilled members and add proven operational executives.

• Focusing on an asset-lite strategy to ramp production via hybrid model.

• Factory was down for weeks in America due to replacement time for sensor required in the plant.

Key Takeaway 3- massive Plant based milk tam

• Spending remained strong across the globe as consumers continued switching to plant based milk.

• Trends were strong in Americas with growth accelerating from 21’ levels.

• Growth was strong in Western Europe despite strong base effects and geopolitical tensions.

• Growth was moderate in APAC driven by China’s zero-COVID policy.

GROWTH TRENDS

growth Factor 1- global dynamics

While Oatly is still a scaling business, the brand is known globally with sales across several continents. In fact, the business is the leading plant based milk brand in every market served. Prior to the major production issues in Q3 22’, Oatly had driven immense growth from scaling the Americas and APAC businesses. This often came with major imbalances between supply and demand as Oatly was known to sell out at grocery stores and restaurants across the globe. This has been a major positive for the business from a growth perspective; however, scaling across the globe has compounded Oatly’s production problem.

Oatly’s EMEA business continued to represent the largest share of the company’s revenues; however, this region’s importance is starting to materially fall as the business scales in Americas and APAC. In Q3, the EMEA business faced several headwinds including slowed retail and foodservice expansion driven by reduced economic activity from geopolitical issues, massive FX headwinds from the stronger dollar, and production issues. These headwinds caused reported revenues to fall; however, revenues still increased on a currency adjusted basis. Even still, the compounding of issues suppressed revenues to levels that were far off normal growth trends.

Oatly’s business in Americas continued to scale despite massive production headwinds that suppressed growth as the company was unable to fill demand. This led to ACV being 36% as the supply constraints prevented the business from being able to replenish grocery stores and foodservice establishments at a rate that met demand. Despite the massive influx of competition, Oatly continue to drive greater velocity than comps even though the business raised prices. These price increases were accepted even though Oatly was already priced at a premium. These dynamics are clear indications that consumers have a strong demand for Oatly products, which they have demonstrated a willingness to pay up. In Q3, the Ogden plant was down for 3wks due to the business having to stop production until a necessary safety component could be sourced.

Oatly’s business in APAC generated strong growth despite significant headwinds from economic activity being disrupted by continued COVID lockdowns in China. This created a significant issue for the business as the majority of revenues in this region comes from foodservice establishments. These businesses are directly impacted by lockdowns as opposed to grocery stores that remain open for despite lockdowns. Additionally, this business was impacted by production issues as the plants were not able to operate at full capacity. Even still, this business has massively scaled from 5% of revenues in Q3 19’ to 22% in Q3 22’. Oatly maintains a strong hold on this market based on the commanding 24% market share of the plant based milk category.

growth Factor 2- production strategy optimization

Oatly’s production strategy has not been an effective one based on the business’ inability to smoothly ramp production as set out since the IPO. The infographics below show management’s production targets by process- co-packing, hybrid, and self. The business had laid out a clear path to rapidly scale production at company owned plants to meet demand in a highly accretive manner. While Oatly has been able to achieve a production capacity inline with targets (900ml litres by end of 22’), the business has been unable to actually realize this expanded capacity due to a very low utilization rate.

Given the immense demand for Oatly products, the business is able to sell virtually all of the product produced. In effect, Oatly is able to write their own checks so long as they can actually get the product out of the plants. Importantly, the business is now adjusting the production strategy to rely on hybrid relationships instead of targeting company owned plants representing the majority of production. While it would have been the most profitable strategy, it means nothing if the business is unable to actually utilize the capacity. Oatly has accepted that the business is great at developing premium products using their IP then branding their products to drive interest.

On the other hand, Oatly is not great at actually operating a manufacturing plant. The business’ rapid scale in the last couple of years happened to quickly for Oatly to learn what it did not know then actually correct these blind spots. Importantly, the business now has the right leadership in place and the right approach to scale the business albeit at a lower margin level than anticipated. Overall, what matters most is growing revenues and profits first then optimizing the actual margin percentage later. Given that Oatly is coming from negative margin territory, realizing margins that are positive is a great target. The hybrid approach is definitely the “Goldilocks scenario”.

growth Factor 3- channel mix

Oatly’s core product has wide appeal across many use cases. This positioned the business to sell to both consumers through grocery stores (retail) as well as foodservice establishments. The products are used as a milk alternative at home as well as at coffee shops and restaurants. Oatly has spent resources scaling across each channel, which has developed at varying rates in each market. In Q3, Oatly’s moderated growth was experienced across both core channels as the driver was supply availability rather than demand. As the business solves the supply issues, Oatly will be able to resume growing both channels in a manner more consistent with historical trends. This is why the hybrid production process is so critical as it enables Oatly to address the demand in a much more rapid manner.

OPERATIONAL EFFICIENCIES

Oatly’s efficiency was abysmal in Q3 22’ as the business incurred even greater margin compression that was primarily driven by operational issues. These issues stem from production problems at company owned plants primarily in the US, which was the result of ramp up expenses being much higher than anticipated as well as an issue with a safety mechanism in a piece of equipment. While the safety mechanism was relative cheap to fix, the business had to stop production for weeks until the part became available. Additionally, the business faced under-utilization in the new plants in the APAC region due to the massive impact of the zero-COVID policy in China. Given the business’ significant sales from restaurants in China, the lockdowns had a massive effect on commerce at restaurants.

Importantly, the business made significant strides in Q4 so the inefficiency should have bottomed in Q3 after reaching a truly unsustainable level. The margin profile should materially expand as the business transitions to a hybrid manufacturing strategy which will be much more reliable than Oatly doing the manufacturing. The business has a great brand and high value IP on making oat milk, management made the right move to outsource the areas of production that Oatly clearly does not have the skillset to reach in a timely manner. On a positive note, the negative results in Q3 create a very low base that the business will be compared to in 23’.

INDUSTRY TRENDS

The plant-based milk industry is rapidly taking share from dairy as consumer diets shift to healthier and eco-friendly alternatives with oat gaining immense popularity. Oatly is a beneficiary and benefactor of the plant-based milk trend as the company is raising awareness for the overall category while capturing a material portion of the spend. This is a major tailwind for Oatly as milk is a globally consumed product thus creating a massive industry. In 22’, global plant-based milk spending is estimated to have increased by 6% to $19bln, according to Euromonitor. This is strong growth considering the massive 16% increase in 21’ driven by continued adoption of plant based milk. The growth is expected to occur in APAC, North America, and Western Europe with each region expected to realize an increase in spending of 4%, 9%, and 8%, respectively. Going forward, it is estimated that growth in global plant based milk spending will actually accelerate to 9% growth in 23’. This continued expansion is expected to come from growth in APAC, North America, and Western Europe of 6%, 8%, and 16%, respectively.

FORECAST AND VALUATION

Oatly’s near term outlook is much weaker than previously expected driven by continued suppression of growth from production issues. Additionally, the business is likely to experience continued negative effects from the zero-COVID policy that was recently lifted in China. While this will certainly be a much welcomed tailwind, the change occurred during the quarter so the full effects will likely materialize in Q1 23’. The business is likely to experience tailwinds in Europe as macro tensions ease and the headwinds from the stronger dollar start to reflect the normalization underway in the FX market. The business is likely to deliver another quarter of profits that fall well short of expectations driven by the under-utilization across the plants. The pressure is likely to start easing in Q4 relative to Q3 as improvements have been made from quarter to quarter.

Importantly, the underlying demand for Oatly’s products remains firmly intact with no indication that consumers have shifted preference to the dozens of competing brands. Even with all the production issues, Oatly is still a highly coveted brand as the supply problems have had a negative effect on the business whereas the customers are largely unaware of these issues. Unlike prior periods, customers have not had to deal with scarcity of Oatly products as production has been above that base level. The real issue is the lost revenues from having a lack of product to supply existing customers more frequently. Additionally, the lack of supply has limited Oatly’s ability to supply new customers who would purchase Oatly products had they been available. While the production issues have set the path to massive scale back, this is more of a speed bump as the underlying issue has a limited window.

As the production issues are resolved, margins will rapidly expand above and beyond levels in 22’. The shakeup in leadership is a positive for the business as the previous members responsible for the operational challenges have been exited. Their replacements have already brought upon meaningful change in the form of abandoning the ambition to achieve vertical integration. As a result, the business will be able to avoid the massive capex from owning plants, the massive unexpected expenses during the ramp up period, and rapidly scale production beyond levels possible in an owned scenario. All of these changes position the company well over the next 1-2 years in such a manner that should stoke confidence in management, which will bring about renewed interest in the stock. Given the positive set up from lapping the headwinds (production, zero-COVID, and Eurozone tensions) that plagued the business and the sharp decline in valuation, the stock is poised to materially increase from current levels as 23’ plays out both from an Oatly and broader market perspective.