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Momentum Accelerates For A2 Milk

Australia | Jun 19 2017

This story features A2 MILK COMPANY LIMITED, and other companies. For more info SHARE ANALYSIS: A2M

A2 Milk is becoming a global nutritional dairy provider and increased production, still barely keeping up with orders, is considered a sign of unrelenting demand.

-Strong trading leads to increased FY17 revenue guidance
-Risks of competition moving in heightened with shortage of stock
-Expansion in the US fresh milk market a catalyst in the next 12 months

By Eva Brocklehurst

A2 Milk ((A2M)) is placed in the enviable position where product is moving out of the company's store room as fast as it is being produced. Demand for the a2 Platinum brand continues to exceed supply and the company is upgrading revenue guidance to NZ$545m for FY17, which suggests around 55% growth on the prior year.

UBS recently downgraded the stock to Neutral and retains this rating based on the strong share price performance and risks regarding the Chinese Food & Drug Administration's infant formula registration process. The broker believes there is increasing risk that the a2 Platinum brand may not be registered in time for the new regulations.

The company previously stated it expected Synlait Milk ((SM1)), a supplier of raw milk, to lodge its application with the CFDA by the end of May but this appears to have been delayed. UBS expects a small delay beyond January 1, 2018, when new regulations are due to be implemented, would not have material impact on a2 Milk, as other channels would likely take up the slack, but an extended delay may damage the brand's standing with Chinese consumers.

Citi estimates the revenue upgrade will equate to an upgrade to earnings per share of around 10% after taking into account that infant formula gross margins are higher than the company average and there is a reduction in marketing costs.

The broker believes the reduction in marketing expenditure, which has been flagged at around NZ$5m, is sensible in the short term because the company is short on stock, but would like marketing to increase to ensure the company builds a long-term sustainable business in China. Citi believes the the best time to be ramping up marketing in China is ahead of the CFDA-led brand rationalisation that commences in January.

The broker envisages risks to the sustainability of growth rates for monthly sales, which are up 18% in the June quarter versus the prior quarter, given prolonged periods when shortage of stock may lead to existing consumers switching to competitors and new consumers commencing with competitor brands.

In order for the broker to become more positive on the stock comfort is required regarding the margin outlook, as the company moves to a direct and sustainable model. The broker also envisages downside risks to a2 Milk for the Lion court case, regardless of the outcome, given the potential for negative press coverage. There is also the potential for competitor Bellamy's Australia ((BAL)) to get back on track later this year.

Catalysts

UBS forecasts cumulative investment in the US to be US$56m over 2015-19 and does not expect new "a1-free" competition to materially affect growth over the medium term. Nevertheless, this needs to be monitored as the company expands on the US east coast and patent protection rolls off.

Bell Potter envisages scope for further value creation from any sign the company's products are gaining traction in the US and UK fresh dairy markets, noting the stock is trading at around a -5% discount to its peer group, based on FY18 operating earnings forecasts.

The broker, not one of the eight monitored daily on the FNArena database, upgrades to Buy from Hold and raises the target to $4.22. Bell Potter upgrades profit forecasts by 11% for FY17, 21% for FY18 and 16% for FY19. These upgrades to FY18-19 reflect increased optimism the company can sustain around a 30% market share in a domestic infant formula category with re-worked supply agreements with Synlait Milk.

Increased production and delivery of infant formula to distributors is a sign of ongoing strong demand and an indication that the economic incentives remain attractive to channel partners, Credit Suisse believes. The broker notes a2 Milk has successfully capitalised on the emergence of the daigou in China and cross-border e-commerce. as well as some of the mistakes made by competitors in the marketplace.

Despite the product shortage, and a risk that end-customers may permanently abandon the company's product, there are no signs from sales momentum this is the case. In contrast, Credit Suisse notes a2 Milk appears to be gaining rather than losing momentum.

In evidence, the broker cites overall volume for all infant formula brands sold by retail channels in Australia appears to be down around -5% over the past year while, on its forecasts, a2 Milk sales volumes across all channels are projected to rise by 80% in FY17. By default, the company seems to be gaining share at the expense of other brands in Australia.

Credit Suisse believes the risk to the company's gross margin in FY18 is to the upside, as costs for one of the primary inputs for infant formula appear to have receded from the high levels witnessed at the beginning of this year. While not a base case, should the company continue to take share in a Chinese market that is projected to grow at 5-10% per annum, and lift overall sales to 45,000 tonnes of infant formula by FY2025, this would imply a lift in the broker's spot valuation to NZ$5.10 from NZ$4.09.

Key Products

The company sells branded dairy and infant formula product in Australasia, China, the US and UK. The milk contains only a2 protein rather than both the a1 and a2 proteins which are found in regular cow's milk and the company targets food markets where a premium can be generated.

A2 Milk's hypothesis rests on the single a2 protein and the benefits claimed for digestion, coupled with a suite of patents and trademarks, which have provided a marketing platform for premium-priced differentiated products. Credit Suisse retains a positive view on the stock based on the successful rolling out of these dairy products globally. The key is a successful management of channels to market and regulatory changes, and risks that come with exposure to the agricultural supply chain.

Moreover, the company and its strategic suppliers require certain licenses, approvals and consents in order to conduct business. At this stage no material changes in China's laws are expected but there remains the risk these could have a detrimental impact on the level of sales of Australian infant formula. UBS also believes the key near-term risk is a potential for de-stocking of infant formula in China in the lead up to CFDA registration.

There are three Hold ratings on FNArena's database and one Buy (Credit Suisse).
 

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