22 June 2021
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a2 Milk is AOK

Paul Rickard
21 November 2019

Back on 21st  October, I advised Switzer Report subscribers that a2 Milk is “definitely on my radar and I am looking to buy”. The price at the time was just over $12. On Tuesday, a2 Milk (ASX: A2M) held its AGM and management upgraded earnings guidance. The shares closed yesterday at $13.84.

The point of this story is not to boast about how brilliant a stock-picker I am (although it is always nice to report a win) but rather to review the investment thesis for a2 Milk and following the price rise, reconfirm or not whether this still makes sense.

From the outset I should say that I had absolutely no idea that the company would upgrade its earnings guidance. This was an unexpected surprise. But I did think it was a well-run company, with a unique market position, that had been unfairly punished by the market. If not a “value” stock, a cheap “growth” stock that the market would in due course embrace again.

In particular, I liked:

  • That they were disciplined and had decided to abandon their European operation to focus on just two key growth markets – China and the USA;
  • They had a really good handle on how they would market and distribute in China;
  • They were bold enough to say that they were increasing their marketing spend and the impact this would have on gross margin;
  • Their track record: over the last three years, sales have grown at a CAGR (compound annual growth rate) of 55%, EBITDA at 96% and earnings per share at 107%;
  • Their leadership team (in particular CEO Jane Hrdlicka);
  • Other competitors moving into the space may not be as bad as the market was fearing – sometimes supply creates its own demand and competitor initiatives can be positive for the category; and
  • The company’s share price had peaked at $17.30 in late July and was now trading just a touch over $12.

In case you are not familiar with the a2 Milk story, the company was founded in New Zealand in 2000 and distributes milk and infant formula products from cows that only contain the A2 beta-casein protein. Most regular cows’ milk also contains the A1 protein, which according to the a2 Milk company, can lead to digestive discomfort for approximately 25% of the population.

In the year ending 30 June 2019, the a2 Milk Company posted revenue of a touch over NZ$1.3bn (A$1.2bn) and EBITDA of NZS413.6m (A$385.6m). Compared with FY18, sales grew by 41.4% and earnings by 46.1%.

64% of a2 Milk’s revenue comes from Australia/New Zealand (ANZ), 31% from China and its other key growth market, the USA, accounts for 3%. Most of the group’s sales are from infant nutrition  products, although in Australian and New Zealand, 16% is in liquid milk. In the USA, it is all premium liquid milk.

The Chinese market has become increasingly important for a2 Milk. Sales in FY19 were up by 73.6% on FY18, leading to a 6.4% market share of the infant nutrition market. Looking ahead, the Company remains very positive about the growth opportunity and is stepping up its marketing investment. Although most of its sales are originated through cross border e-commerce platforms such as JD Global, physical presence through “mother and baby stores”, as well as Daigou , remain important. With regard to the former, a2 Milk products are available in 16,400 “mother and baby” stores. a2 Milk says it is “channel agnostic” and will stay agile and adapt to changing consumer behaviour.

For FY20, a2 Milk says that it now expects full year EBITDA as a percentage of sales to be marginally higher than 2H19, in the range of 29% to 30%. Based on strong sales in China (infant label and cross border e-commerce) and the USA, first half revenue for FY20 is expected to be in the range of NZ$780m to NZ$800m, up from NZ$613m in 1H19, with an EBITDA margin of 31% to 32%.

What do the brokers say?

The brokers are marginally negative on the stock, worried about margin pressure as the company  pursues growth in China and the USA. They don’t seem to doubt the market opportunity or that it can build share, but rather the price of building brand and scaling distribution.  Some brokers are worried about the threat of new competitors in this “premium milk and infant nutrition category”. Earnings per share growth is expected to decelerate fall from 45.4% in FY19 to 19.4% in FY20 (NZ 46.9c), before accelerating in FY21 to 21.4% (NZ 56.9c). 

According to FN Arena, there are 2 buy recommendations, 2 neutral recommendations and 3 sell recommendations. The consensus target price of the major brokers is $13.71, approximately 1% lower than Wednesday’s close of $13.84. UBS is the highest at NZ$17 per share (approximately A$16.01), while Morgan Stanley has a target of just $10.80 per share. Individual recommendations are set out in the table below.

On a multiple basis, the brokers have a2 Milk trading at 31.2 times forecast FY20 earnings and 25.7 times forecast FY21 earnings. No dividend is forecast for FY20.

Here’s my view

The underlying investment thesis remains intact. The brokers are too bearish – looking for reasons that a2 Milk might fail rather than recognizing that this company is incredibly well led and has a terrific track record.

In my experience, poor performing companies are perennial poor performers, while good performers tend to repeat strong performance from one period to the next.

Following a rally of 15%, I am always a little more circumspect. Buy in weakness.

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