Portfolio: Lunar Capital and China's Joysun

Around 700 million people are expected to tune into China's Spring Festival Gala, which airs on state broadcaster CCTV on the evening of February 9. A 10-second advertising slot for this event is among the most expensive in the world at RMB215 million ($34.5 million), not including production costs.

Fourteen years ago the rates were less than one third current levels but the outlay proved almost fatal for Sichuan Zhiqiang. The state-owned walnut-based beverages producer was the biggest buyer of commercial airtime during the 1999 gala, projecting its Joysun brand nationwide and in the process racking up debts that couldn't be serviced. A local entrepreneur picked up the business as a distressed asset and from there it began to stagnate, not so much mismanaged as misdirected in a changing consumer environment.

"It's a well-known brand that has become a little old-fashioned - in much the same way you would think of Ovaltine in the West," says Derek Sulger, managing partner at Lunar Capital, the private equity firm that bought a 60% stake in Sichuan Zhiqiang in March 2012 for around $50 million. "We thought if we could buy a majority interest in the company and then reposition the brand, it would be a great opportunity."

Identify and acquire

Lunar looked at about 100 potential food and beverage targets before settling on Sichuan Zhiqiang. The brand's safe and healthy qualities - walnut-based products are well known in China for their nutritional value - were seen as well suited to current consumer priorities.

Convincing the entrepreneur to give up majority control after eight years of ownership presented another challenge. Lunar's approach was to build up trust and then present the case that capital alone wouldn't solve the company's problems: It was obvious that Sichuan Zhiqiang should expand its product line to incorporate ready-to-drink (RTD) as well as the existing powder-based beverages, but achieving this goal required new management and a new strategy.

Eventually they settled on a 60-40 split, with the entrepreneur retaining a seat on the board in addition to his equity holding.

The individual charged with executing the new strategy is Simon Liu, who was brought in as CEO. A veteran of consumer businesses in China, having previously worked for the likes of Sun-Rype, Coca Cola, Mentos and Vitasoy, Liu's initial role was to conduct due diligence for Lunar on potential investment targets in the sector. There was a general understanding that he would likely become CEO of any resulting portfolio company.`

Liu's brief is as follows: achieve stability in the business in 2012, expand the product portfolio in 2013, and become the category leader in walnut-based beverages within a few years.

Achieving stability first and foremost meant ensuring product quality and safety. "This is the number one concern in China," says Liu. "There are international standards we adhere to, but we also have our own internal standard: If you have a three-year-old kid, would you give our products to your kid? The plant and systems needed a major overhaul and that was the first decision on which the board reached a consensus."

Equipment was updated and the plant was partially reconfigured, but steps were also taken on the "soft side," improving systems and oversight all the way through the supply chain from farm to warehouse.

Located in Dazhou, a city in western Sichuan province, the company's plant is close to Dabashan, one of China's two major walnut-growing areas. Raw walnuts are sourced from farmers by a handful of specialist wholesalers who send people into the mountains to collect, crack and grade the product, before putting it into atmospheric storage for transfer to market.

Conscious of the supply chain weaknesses that have created food safety issues in other industries, Sichuan Zhiqiang limits the number of wholesalers it will work with and includes quality standards in contracts. "We need to make sure we aren't buying from wet markets or off-and-run suppliers," Liu explains. "We deal with specialists who know how to separate low grade from high grade at a significant scale of operations."

The ultimate objective of this quality drive was to secure Hazard Analysis & Critical Control Points (HACCP) accreditation, a globally recognized food safety management standard. Accreditation arrived in December of last year, but not before company's employees had been put through rigorous training and assessment processes on everything from personal hygiene to appropriate headwear. Sichuan Zhiqiang's shift manager was replaced due to concerns that he couldn't meet the required standards.

Senior management was also bolstered through the addition of department heads for operations, trade marketing, human resources and sales and marketing. Furthermore, Lunar introduced improved financial systems that allow proper budgetary disciplines as well as being used to carry out margin analysis on different product lines. This resulted in the culling of half the 50 product lines that existed when Lunar invested due to underperformance. At the same time, six new products have been launched.

With RTD beverages not yet part of the product portfolio, Sichuan Zhiqiang's business is currently split evenly between powdered beverages and ingredients. The company is the largest walnut ingredients supplier in China, serving dairy firms such as China Mengniu Dairy and Yili Group, which sell walnut-flavored milk. On the powdered beverage side, Liu sees a handful of local competitors, but the company is already seeking to differentiate itself.

"In 16 years the packaging and formula didn't change much but consumer tastes and demographics in China have changed," says Liu. "The future of the brand will be determined by people born in the 1970s, 1980s and 1990s and plastic pouch packaging doesn't really appeal to them. When we took it over, the products only appealed to people aged 45-plus. While still an important consumer group, they are only a portion of the market we are seeking to serve."

Segmentation strategy

The fruits of these efforts will become apparent after Chinese New Year. Sichuan Zhiqiang's new product lines are entering the shops now, united by a common design to make Joysun synonymous to walnut nutrition but divided in terms of segment. Although there is a degree of geographical differentiation - gift packs sold in Beijing must be red in color and bulky, regardless of how much powder is inside, whereas in Shanghai there is a preference for understated quality - this segmentation is almost entirely driven by demographics.

At one end of the scale are products that emphasize nutritional quality for health-conscious adults; at the other are products packaged to appeal to the youth market, although the ultimate buyers might be parents looking to boost the nutritional value of their children's diet. Over the next year, Sichuan Zhiqiang's segmentation strategy will continue, with a particular focus on pregnant and breastfeeding young mothers.

"We carried out consumer research on expecting mothers and the first thing that jumped out is ‘walnut is good for you and for your baby,'" Liu says. "This is passed from generation to generation. You don't need public education on the nutritional value of walnut; it is all about making the brand relevant."

Should Sichuan Zhiqiang achieve the 2014 objective and consolidate its position as a category leader, Lunar sees three possible exit avenues: a stand-alone IPO, a merger with other assets in the portfolio, or a trade sale, most likely to a Chinese buyer. "What we see in the food and beverage sector is large companies are moving away from build-everything-yourself and becoming more acquisitive," says Sulger. "They are looking to buy other brands that are category leaders."

SIDEBAR: Walnuts by numbers

Flavored milk beverages accounted for one quarter of China Mengniu Dairy's liquid milk sales in the first half of 2012, or RMB4 billion. Walnut is the most popular flavor and Sichuan Zhiqiang is the largest national supplier of walnut-based ingredients used to make the product.

Walnut consumption in China has grown 18.5% per annum for the past 12 years and total domestic net output ran to 1.3 million tons in 2011. Half of this was consumed raw: cracking the shells and eating the contents. The remainder was processed into walnut-based products.

According to Simon Liu, CEO of Sichuan Zhiqiang, the average wholesale value of one ton of nuts is RMB35,000, which implies total value for raw materials used in processing of over RMB20 billion. Factor in the retail mark-up and the value-add of food processing, and Liu estimates the processed walnut market is comparable in size to the RMB50 billion in annual China sales recorded by Coca Cola and Pepsi.

Of course, ingredients supplied to Mengniu and its industry counterparts are just one part of this market. In addition to powder-based and ready-to-drink walnut beverages, there is a huge food industry - ranging from biscuits to baked goods to ice cream - that derives from the nut.

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• Topics
• Consumer
• Greater China
• Buyouts
• Lunar Capital Management
• China
• Consumer
• buyout
• Operating partners