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Margins Stabilise As a2 Milk Lifts Investment

Australia | Jul 16 2018

This story features A2 MILK COMPANY LIMITED. For more info SHARE ANALYSIS: A2M

A2 Milk sustained strong growth rates in FY18 but expectations for FY19 have softened because of the increased investment designed to expand the company's presence in China and the US.

-Margin expansion likely to level off amid heightened investment
-Benefits expected from increased market share and new distribution agreements
-First signs pricing has begun to improve in China

 

By Eva Brocklehurst

A2 Milk ((A2M)) has an upbeat strategy to expand its scale and presence, which suggests the significant margin expansion previously experienced may level off over the next year or so. The company reported unaudited revenue of NZ$922m, slightly ahead of the guidance offered in May.

Sales growth was 68% over FY18 and operating earnings (EBITDA) were up 96%. Fourth quarter sales growth of 61% was slightly slower than the prior quarter. These growth rates represent strong demand but were also assisted by the cycling of stock shortages in the prior comparable period.A2 Milk should benefit from increased market share in all regions, new distribution agreements and incremental growth from both regions and products. Some form of capital management is probable, and Morgans will look for an update on investing in a blending and canning facility in Australia at the actual FY18 result.

A2 Milk is forecast to end FY18 with net cash of $262m. Morgans reduces FY19 and FY20 net profit forecast by -6.9% because of higher marketing expenditure and further investment in corporate overheads.

The company has indicated an FY18 operating earnings (EBITDA) margin of 30% and guided to a similar margin in FY19. This is because of higher marketing expenditure and investment in corporate overheads.

A2 Milk has provided qualitative guidance for further growth and Citi expects sales growth to slow to a still-robust 48% in the first half of FY19 and 23% in the second half.

Marketing

Although expectations for FY19 have been softened because of the increased investment, Morgans believes investing heavily in the brand is extremely important for the longer-term growth profile.

CLSA, not one of the eight stockbrokers monitored daily on the FNArena database, considers investing in sustainability is the right move despite missing out on margin expectations.

The broker had been concerned the company was not spending enough on marketing to build a sustainable presence in China and is encouraged by the commitment to higher expenditure.

Sacrificing short-term earnings to invest in brand and build the necessary infrastructure to support greater scale is considered prudent for a business with a long growth outlook.

Having said that, investors appear to have spent too much time considering the upside and not enough of the downside and the broker believes the positives are reflected in the share price. Hence, CLSA downgrades to Sell on valuation with a target of $10.25.

UBS suspects there may be modest downgrades to FY19 estimates given the guidance for margins, noting consensus was looking for margins around 32% which implies a -5% downgrade in guidance.

The broker retains a Neutral rating, as valuation is considered fair at current levels, but considers the outlook positive and the risk weighted to the upside for FY19/20 top-line forecasts. UBS forecasts three-year compound growth in earnings per share of 24%.

Pricing

Pricing has begun to improve and old-labelled stock has largely been cleared in China, setting the company up for a clear start to FY19.

Old-label products that need to work through the Chinese system remain, but the first week for 2018 has passed where Citi observes modest platform price increases. Still, the broker prefers to witness a sustained increase in re-seller pricing before concluding that inventory has improved.

Macquarie envisages medium to long-term value in the stock, as it is building a business that is synonymous with a disruptive and growing category. Surprises in FY19 are expected to be limited, other than more detail on product and market execution. The broker's channel checks remain positive and demand is expected to facilitate growth in market share.

As well as market expansion the company will have a number of new products being launched in FY19. The broker acknowledges it is unclear how much of the top line will be derived from new products and markets, but points out these tend to have lower margins initially because of the investment required to establish revenue opportunities.

This may be a factor that dilutes the margin in FY19 despite the increased scale the company is building. Beyond FY19 the US business is expected to move towards breaking even and Macquarie expects this to be positive for blended margins. Therefore, modest underlying margin expansion is expected.

The database shows four Buy ratings and two Hold. The consensus target is $11.72, signalling 11.9% upside to the last share price.

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