The land of a2 milk and money

Until now, I have avoided the so-called ASX-listed “China” companies (Australasian firms selling goods to consumers in China). Firstly, because there was just so much hype about the growth opportunity and secondly, I am wary about the risks foreign companies face when doing business in mainland China. While some may label this as “Chinaphobic”, recent actions by the Chinese regulators re-confirm my view that investors require an additional premium for the country specific investment risk.

However, I am coming around to the view that there is a bit of value in some of these stocks and the company that has caught my attention is the a2 Milk Company (A2M:ASX).

A2 Milk’s story

Founded in New Zealand in 2000, the a2 Milk company produces milk and infant formula 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 30/6/19, 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%.

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%.

With those very impressive numbers, the share price (until recently) has also performed very strongly.

A2Milk - 3/2015 to 10/2019

Source: nabtrade

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%. A2M has announced that it is exiting its UK business, which in FY19 generated 2% of sales. Most of the group’s sales are from infant nutrition products, although in ANZ, 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. A2M says it is “channel agnostic” and will stay agile and adapt to changing consumer behaviour.

For FY20, A2 Milk says that it expects FY20 EBITDA as a percentage of sales to be broadly consistent with 2H19, approximately 28.2%. This reflects:

• increased full-year marketing to around 12% of sales (FY19 10.4%);
• continued investment in organisational capability to support future growth; and
• gross margin expected to be broadly consistent with FY19 (54.7%).

At 30 June, A2 Milk had NZ$464.8m of cash on hand. This was up NZ$134.5m on its position a year earlier notwithstanding that it spent NZ$162.3m in August 2018 to lift its investment in NZ dairy processing company Synlait (ASX: SM1) to 17.4%.

What do the brokers say

The brokers are positive on the stock but 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.  Earnings per share growth is expected to fall from 45.4% in FY19 to 18.0% in FY20 (NZ 46.3c), before accelerating in FY21 to 24.7% (NZ 57.8c).

According to FN Arena, there are two buy recommendations, two neutral recommendations and two sell recommendations. The consensus target price of the major brokers is $13.89, approximately 13.6% higher than Friday’s close of $12.23. Individual recommendations are set out in the table below.

On a multiple basis, the brokers have A2 Milk trading at 28.2 times forecast FY20 earnings and 22.7 times forecast FY21 earnings. No dividend is forecast for FY20.

Here’s my view

I like the look of A2 Milk. I can’t think of too many companies with these sort of growth rates, credible management team (led by Jayne Hrdlicka) and cashed up, strong balance sheet, trading on multiples under 30.

A share price around $12 is a lot more attractive than the $17.30 the stock was trading at in late July.

Technicians might argue that it is too early to buy, with the 60-day moving average (currently $13.59) recently slipping below the 200-day moving average ($13.94). They’d say to wait until the 60-day average had climbed back over the 200 day average, and that the technicals suggest that there might be more price weakness to come.

But this stock is definitely on my radar and I am looking to buy. A2 Milk holds its AGM on 17 November, where the company is expected to provide a trading update for the first four months.