Is a2 milk still a buy?

I wrote about a2 Milk (ASX: A2M) last October. It was $12.23 at the time. On Friday 21 August, it closed at $18.37.

This isn’t one of those “how smart I am stories” but rather, I want to set out why I continue to like a2M. Further, why growth investors should consider the post result mark-down an opportunity to invest.

The chart below summarises why I like the company:

But first, some background on the company, and then why I think it can continue its impressive performance.

The history of a2 Milk

Founded in New Zealand in 2000, the a2 Milk company produces liquid milk and infant nutrition (powder and toddler milk drink) 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.

Liquid milk accounts for 13% of sales, with the bulk in Australia and New Zealand and a developing market in the USA (3% in total). Infant nutrition is the main sales category, responsible for 82% of revenue. There are also fortified milk nutrition products for mothers and primary age children.

In infant nutrition, a2 Milk employs a “one brand, two labels approach” to distribution and sales. A premium English label brand (Platinum) that is available to Australian retailers and resellers, and on cross border e-commerce sites such JD Global. The latter achieved sales of NZ$341 million in FY20 (up 40.3%), while Australian retailers and re-sellers delivered sales of NZ$745, up 14.1%. Some of the Australian sales are purchases by retail daigou (Chinese travellers and students) who take the products back to China to use/on-sell.

The other infant nutrition label is a Chinese label which a2M describes as “super premium”. This is available in “mother and baby stores” (MBS) in China. Sales in FY20 rose by a very impressive 101% to NZ$338m as a2M invested heavily in marketing and expanded its distribution reach to 19,100 MBS stores in China.

And that’s the point about a2M, it is largely a marketing and distribution company. Interestingly, a2 Milk says its market share of the MBS market for infant nutrition products in China is 2%, up from 1.3% in June 19.

On overall sales growth of 32.8% to NZ$1.73 billion,  a2 Milk delivered EBITDA of NZ$550 million, up 32.9%. Profit after tax rose by 34.1% to NZ$386 million. These were largely in line with forecast, as was the EBITDA margin (earnings as a proportion of revenue) of 31.7%.

Covid-19 was considered to have had a “modest positive impact in FY20 on both revenue and EBITDA”, as pantry stocking of infant nutrition across online and resellers brought forward sales in Q3. Offsetting this was a softening of retail daigou, due to reduced tourism from China and international student numbers.

At 30 June, a2 Milk had NZ$854 million cash on hand, up NZ$389 million at the end of FY19. This strong balance sheet position provides scope for a2 Milk to fund future growth and potential participation in manufacturing. On Friday, a2M announced that it had entered into due diligence to acquire a 75.1% interest in Matura Valley Milk for NZ$270 million. Matura’s main manufacturing facility is in Southland, New Zealand. The other 24.9% is owned by a Chinese subsidiary of the China National Agricultural Development Group.

Looking ahead, a2M said that, notwithstanding the Covid-19 uncertainties (which could impact consumer behaviour in its core markets and the supply chain in China), it “anticipates strong revenue growth supported by our continued investment in marketing and organisational capability”. It didn’t provide guidance, but did say that it expects the EBITDA margin to be in the order of 30% to 31%.
 

What do the brokers say?

Following the result, Citi “double-downgraded” a2M from a “buy” to a “sell”. It thought that “the best days are behind the company” and is worried about a resurgence of Chinese brands and increasing geopolitical risk.

On the other hand, Credit Suisse upgraded from “neutral” to “outperform”. It thought that the result was “solid and broadly on expected lines”, and on the back of what it saw as “attractive growth prospects and strong valuation support”, it raised its target price to NZ$22.55 (A$20.50).

While the result was broadly in line (some brokers had it below their forecast, others had it above), several noted the increasing competition in the Chinese infant formula market. However, they also noted the company’s “strong revenue growth” forecast, strong balance sheet and upside from new products and markets.

For the major brokers, there are 2 buy recommendations, 2 neutral recommendations and 2 sell recommendations (source: FNArena). The consensus target price of the major brokers is $19.14, approximately 4% higher than Friday’s close of $18.37. Individual recommendations are set out in the table below.

The brokers have forecast EPS (earnings per share) growth of 16.5% in FY21 and another 16.4% in FY22 (this compares to a growth rate of 33.5% in FY20). On multiples, this puts a2 Milk on a multiple of 33.2 times FY21 forecast earnings and 28.5 times forecast FY22 earnings.
 

Here’s my view

A multiple of 33 times doesn’t seem to be too demanding for a company that historically has been growing earnings well in excess of 30% pa and is forecast to grow at 16.5% next year. Particularly in the current market where many growth stocks have yet to deliver any earnings.

I put a lot of weight on ‘track record” – increasing revenue each year, increasing earnings each year, increasing earnings per share each year – and in that respect, A2M has delivered in spades.

My interpretation of the sell-off post the result is that A2M has run pretty hard this year and that profit-taking was always going to happen at some level. The share price chart for 2020 (see below) shows that is has been virtually a one way ride this year, notwithstanding the Covid-19 crash of February/March.
 

A2 Milk in 2020

There is no doubt that the “China risk” has increased a notch for a2 Milk. If tensions continue between China and Australia, the obvious question is “what’s next after wine?” However, most commentators think it very unlikely that a ban would be extended to dairy and infant nutrition. Further, a2M argues that it is a New Zealand company, not Australian.

The ban on inbound international travel and international students could certainly have some impact on sales if these continue well into FY21. a2M says that corporate daigou are replacing retail daigou and the MBS (mother and baby store) channel is becoming more important. There are also expansion opportunities into other Asian markets, in particular, South Korea.

For growth investors, a2M is a buy.