Treasure Chest | Sep 04 2019
FNArena's Treasure Chest reports on money making ideas from stockbrokers and other experts. Changes to China's e-commerce laws have meant a2 Milk has revamped its strategy and margins are likely to suffer as a result.
-Direct distribution in China likely to require material investment in brand
-Step down in margins could be permanent
-Valuation remains highly dependent on success in China
By Eva Brocklehurst
As a result of changes to doing business in China, a2 Milk ((A2M)) has revamped its strategy, targeting a more diverse product, channel and geographical footprint going forward. Marketing costs and further investment in capability meant the recent FY19 result fell short of many expectations and the channel shift to direct sales in China was an emerging issue in the second half.
This change in mix is likely to accelerate in FY20, Bell Potter suggests, as shipments from Australia and New Zealand continue to demonstrate. Serving as a proxy for offline growth, there was 115% growth in Chinese-labelled product in FY19. There has also been a slowdown in daigou demand – purchases made in Australia for sale in China – following changes to Chinese e-commerce rules which came into effect in the second half of FY19.
Several companies have reported softer trading following the implementation of these new laws, although a2 Milk asserted there was minimal impact albeit, Credit Suisse highlights, on the interpretation that sales were pulled forward in the third quarter of FY19. Moreover, the broker points out that volatility in inventory levels makes it difficult to use export data to estimate top-line growth.
UBS observes the company is looking to corporatise – increasing channel capability and backing a US and Asian expansion. This is considered an expensive strategy and the future will be about tracking the return on investment, and whether it delivers more market share or just meets expectations. UBS expects a2 Milk's decision to "future-proof" growth should yield dividends in the long term.
The general view is that the transition to direct sales in China will result in an elevated gross margin that will counter the impact of rising marketing expenditure. Yet Bell Potter considers it more likely that marketing as a proportion of revenue will continue to rise while the change in margin is structural rather than a one-off.
Citi agrees that a step down in margins is likely to be permanent and expects further contraction over the medium term. Entities selling infant milk formula with a exposure of more than 90% offline have a material higher level of investment in brand than that of a2 Milk. Hence, as the offline presence of a2 Milk rises, a step change is envisaged.
Moreover those that service the channel have a materially larger personnel base compared with a2 Milk. The company's professional service fees were up significantly in FY19, as it leveraged external capabilities to drive growth ahead of investing in its cost base. Macquarie surmises there could still be cost savings as the company internalises some of the functions, given the high consultant margins.
a2 Milk has guided to flat gross margins and a -350 basis points compression in operating earnings (EBITDA) margins. The second half earnings margin of 28.2% compared with 35.2% in the first half. Credit Suisse is disappointed that operating earnings margin guidance for FY20 remains broadly consistent with the second half and agrees with the implication that non-marketing operating expenses will step up substantially.
Macquarie suggests the market will have to weigh up just how much the lower margin reflects more expensive revenue growth, as the company moves away from daigou, against the larger and better-understood market opportunity being sought through investment. Flat gross margins are an improvement on previous commentary regarding a decline, the broker adds, and to an acquirer this provides a more attractive business proposition given potential cost synergies.
As China infant formula and US fresh dairy sales become important revenue growth drivers, Bell Potter expects the margin transition will be unfavourable and, while this may be necessary, it implies a structural change in the earnings profile that is not reflected in the current premium rating of the stock.
The broker points out that it would be very unusual if a company that is growing at 30% per annum, with an incremental contribution margin of around 40%, experienced a contraction in operating earnings margins, even if investing in capability, and questions whether consensus should have upgraded revenue growth assumptions for FY20.
Credit Suisse, too, is cautious about just when operating leverage will re-emerge for the company, and finds it difficult to assess the required investment in capabilities amid increased complexity related to a multi-channel approach.
Direct growth in China is largely being driven through "mother baby stores" and cross-border e-commerce channels. The broker suspects these direct sales are more resilient in nature versus the less-formal daigou trade but are also a higher cost-to-serve channel.
Meanwhile, the company is undertaking an extension of its portfolio in the US while deciding to exit the UK liquid milk market, given the insufficient opportunity to achieve scale. The latter will be wound down over the first half, although Macquarie notes this does not preclude the business pursuing UK or European markets at some stage in the future.
The broker also points out the company has stepped away from providing a break-even date for the US business, prioritising the market opportunity over near-term profitability. A structural gross margin issue is not envisaged in this market. Citi expects the US business to be an increasingly important driver of growth going forward, yet valuation is still highly dependent on the company's continued success in China.
Bell Potter, not one of the seven brokers monitored daily on the FNArena database, retains a Sell rating and target of $12.25. The database has two Buy, three Hold and two Sell ratings. The consensus target is $14.18, signalling 3.7% upside to the last share price.
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