Date : 21/12/2020

The a2 Milk Company

ASX :

A2M

Market Cap : $7.65 Billion

Hold

52 Week Range : $9.82 - $20.15

Share Price : $10.26

The firm has been impacted by extended headwinds in the macros that are at play. We expect it to recover as fundamentally it is a very good business and hence, recommend members to "Hold" their positions.

Company Analysis

The A2 Milk Company (ASX: A2M) is a Kiwi company that is dual listed on the ASX and NZE. They produce, source, and supply a healthy and premium product and operate in the ANZ region, China, and the USA. A2M has been a very successful growth story in the past 5 years. From an ASX small cap they are now a blue chip with a market capitalisation of $7.64 billion.

Prior to addressing the elephant in the room, let us look at some of the fundamentals of the a2 milk company.

  • Overall Revenues have been growing at a CAGR of 62% over the past 5 years.
  • Operating Costs have been growing at a CAGR of 50% over the same 5-year period.
  • This steady profitability has resulted in the firm increasing its EBITDA margins to around 31% as of FY2020.
  • EPS grew by 33% in FY2020 and 45% in FY2019.

A2 Milk has 2 main products – infant nutrition and liquid milk, with the former being the most successful and accounting for 82% of its revenues in the latest financial report.

A closer look at the overall revenues show that in the past 3 years, the firm has seen growth, particularly in the Chinese market. The USA market has been growing quickly as well, but it still has a long way to go to be able to carry the firm forward. The ANZ market is the most mature for a2 milk and it is showing. While the segment is still growing, the growth figure is modest in FY2020 compared to the other geographical locations.

A2 Milk’s supply chain into China relies on a mix of shops and online channels and resellers are a very important part of this equation. These resellers are usually Chinese travellers and students that purchase the milk use the Daigou market to resell the products after they travel back to China. With the coronavirus travel restrictions still being upheld by Australia and New Zealand, there continues to be a massive roadblock in the biggest supply chain route for the firm’s products into China.

A2 Milk operates similar to a marketing firm. With a differentiated and superior product, they use aggressive marketing to increase their brand value. This strategy is important for the firm and it has served it well, especially in China as they have a lot more domestic and international competitors (including Nestle). The below graph shows that the marketing expenses line graph is very similar to the growth trajectory that the revenues have followed during the same period.

Company Updates

A2 Milk has been one of the good guys when it comes to keeping investors informed about what they think of the near-term future. They have constantly supplied investors with guidance forecasts during a very turbulent year. The initial guidance forecast for FY2021 that was released in late September was:

  • 1H FY2021 revenue of $725 million -$775 million
  • FY2021 revenue of $1.8 billion – $1.9 billion
  • EBITDA margin to stay the same from the previous year at 31%

This announcement was welcomed with a sell-off for 3 trading days as investors and the stock price dipped to $13.8 per share on the ASX.
Source: Tradingview.com

As news of the vaccine sent positive signals in early November, the stock price gained since there was increased positivity surrounding the Daigou channel. The second sell-off occurred on the 18th of November when the firm announced that they are having trouble forecasting the outlook due to the uncertainties that still exist in the markets.

Fast forward 1 month, on the 18th of December, we witnessed the biggest sell off in 2020 – 22% was slashed from the stock price and it currently trades at $10.26 per share. The Daigou channel continues to be upended and travel between China and ANZ looks to be a few quarters away. A2 Milk released an updated guidance forecast that downgrades their initial outlook:

  • 1H FY2021 revenue is expected to be $670 million
  • 1F FY2021 EBITDA margins to reduce to 27%
  • FY2021 full year revenues is expected to be in the range of $1.4 billion – $1.55 billion
  • Full year EBITDA margins are expected to be in the range of 26% – 29%.

These downgrades represent a decrease in first half revenues guidance of 10.5% and decrease in full year revenues by about 26%. This resulted in the stock price plunging 22% on the day.

Investment Thesis

Below are the headwinds that a2 Milk is facing – both from a macroeconomic and microeconomic perspective:

  • China – Australia trade relations are sore with a number of commodities being affected.
  • Closure of International borders have no end date yet – impacting both travellers and international students that make up the Daigou market.
  • Possible challenge to high growth in a post Covid19 economy if financial challenges persist.
  • A2 Milk has to decrease its reliance on the Daigou channel and continue to expand Chinese operations via shop sales.

The China – Australia trade relations have impacted a wide array of commodity exports into China. However, it is important to note here that a2 Milk is a New Zealand based company. Hence, we do not see it affecting the firm directly. However, indirectly, the sour relations are bad for business as the Daigou market channel is extremely reliant on Australia than it is on New Zealand.

Even though vaccination has begun in parts of the world and Australia is gearing up for the vaccination to begin in March next year, it may still pose challenges towards the opening of international travel to the extent that the Daigou market channel requires for smooth operation. The narrative here is that supply chain disruption has been disbanded and it looks like it will stay disbanded for at least the next 6 months even considering the best-case scenario. A2 milk has never revealed just how much the Daigou and cross border e-commerce channels account for as a percentage of the total revenues generated in China. This has added to the already deteriorated investor mood surrounding the guidance downgrade.


Source: a2 Milk

The fresh milk segment has been performing well in Australia and the guidance for ANZ revenues continues to be robust. The USA is another large market with the highest consumer spending. A2 milk has set-up distribution channels in the country and the present numbers are about 20.3k distributors. Thus, there is room for growth in the USA. In FY2020, USA accounted for $66 million of A2 Milk’s total revenues. In FY2021, we are expecting a growth of close to 50% and the firm ending the financial year with $100 million in revenues from the USA. The marketing expenses to support this growth is suspected to be high as it has been the prevailing strategy that a2 Milk has followed in all its markets, including the USA. Consumer behaviour will continue to promote health and wellness, and this should enable the firm to continue its growth once the world is rid of the pandemic.


Source: a2 Milk

We can see in the above two graphs that a2 milk’s channels of distribution in China is being diversified and it is very safe to say that this will continue. The reliance of Daigou has to be reduced by the firm in order to reduce the micro economic risks associated with its business operations. Going forward, our view is that a2 milk will enter new markets to not just reduce its reliance on cross-border e-commerce sales, but also to reduce its dependence on China.

The financial reports have not changed since our initial report on the company and members can click here for the complete financial analysis of its balance sheet and income statements as of FY2020.

Recommendation

There has been no structural change in a2 Milk’s fundamentals. The cause for the sell-off is accounted to what looks like a temporary disruption in supply-chain and investor momentum magnifying this disruption. The business model is still strong and there are avenues that the firm can venture into in order to diversify its segments. We recommend members to “Hold” their positions as this is still a quality stock with good upside potential once we see some of the temporary macroeconomic headwinds reduce.

 

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