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Treasure Chest: Slowdown Ahead For a2 Milk?

Treasure Chest | Mar 13 2019

FNArena's Treasure Chest reports on money making ideas from stockbrokers and other experts. Consensus projections imply a2 Milk will grow its infant formula business at a stellar rate, but is this the case?

-A number of headwinds developing in e-commerce, infant formula
-New product launches would help the business, particularly in the US
-Ingredient costs escalating, margins seen narrowing in China direct business


By Eva Brocklehurst

Have growth estimates become too aggressive for a2 Milk ((A2M))? Current views suggest the business will continue to grow at a start-up pace with compound revenue growth forecasts over FY18-21 of over 27%, on Bell Potter's calculations.

Assuming sales growth in the fresh dairy and adult nutrition categories can be sustained at over 25%, which was achieved over the last 12 months, then this would imply infant formula sales growth should continue at around 28% per annum.

Bell Potter finds a number of risks attached to current FY19-21 consensus estimates and asserts it is increasingly hard to justify the stock's 75% premium to its global peer group. Citi agrees there are a number of headwinds developing in e-commerce with increased competition, while declining birth rates will affect momentum in infant formula demand.

If the risks are borne out, a combination of earnings and multiple compression could occur simultaneously. Bell Potter is already witnessing signs of a dislocation between the refill of inventory, trade order fill and ultimate sales.

There are also rising ingredient costs and a need to invest. If the previously outlined assumptions for sales growth are achieved, the broker estimates this would make a2 Milk a $1.5bn turnover business in infant formula within the next two years.

Given around 90% of what the company sells in Australia ultimately gets consumed in China, this suggests it would become one of the largest infant formula companies in China, doing so as a single unit (SKU) operator when the majority of participants of that scale have product offerings across the value spectrum.

On reflection, the broker found the most disappointing aspect of the first half result was sales growth in China. Chinese sales per average store fell -21% in local currency terms. Given an increasing reliance on sales outside of the internet in China for future growth, Bell Potter would have expected accelerating growth rates on a per store basis.

UBS had no such qualms after the first half results, finding no sign of slowing demand in China and a strong customer response to the a2 brand. The broker also believes the benefits of marketing expenditure should come into view in FY20.

UBS retains a Neutral rating and remains concerned that there is just a single a2 brand and a rich valuation for the shares. The broker concedes new product launches would help the business, particularly in the US, which is considered an under-appreciated opportunity.

Bell Potter asserts current projections imply that a2 Milk will become a market leader in the Chinese infant formula category, rivalling Danone and Nestle. The problem is this growth is likely to occur against a background of weakening demand, amid declining birth rates, and at a time when the Canterbury (New Zealand) milk source is reaching capacity.

Hence, the broker assesses consensus growth rates imply a scenario where the company can achieve both a rapid expansion in its distribution points and sell-through rates, while absorbing market shrinkage, cost inflation and a higher cost to serve.

The cost of ingredients has sustained a meaningful uplift in recent weeks. Bell Potter estimates a 12% rise in the first half of FY19 and a 27% lift in the second half. The majority of this increase is likely to be absorbed in FY20.

Moreover, as the business transitions to a direct model in China the cost to serve should climb. Doing the maths, the broker finds margin growth on Chinese business has slowed and a lower margin at the group level is projected versus historical levels.

Bell Potter, not one of the eight stockbrokers monitored daily on the FNArena database, has a Sell rating and $11.50 target for a2 Milk. Morgan Stanley is the only one of the eight with an equivalent rating, Underweight.

While first half sales and earnings beat that broker's expectations, on the basis that the sustainability of sales via the daigou (external shopping agents) channel are slower, this was considered a low quality result.

The stock sustained downgrades by two brokers on the database in the wake of the first half result, largely because of the outperformance of the share price. While considering the expansion in China very promising, Morgans reduced its rating to Hold and Credit Suisse downgraded to Neutral.

The database shows two Buy ratings, four Hold and one Sell (Morgan Stanley). The consensus target is $13.63, signalling -1.8% downside to the last share price.

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