Australia | Nov 20 2019
A2 Milk envisages strong growth in the year ahead despite the challenges in the Chinese infant formula market. The main issue for brokers is whether the necessary investment will deliver the expected returns.
-Marketing, investment and costs likely weighted to the second half
-Strong growth expected despite challenging trading conditions
-Re-negotiated supply contract with Synlait Milk highlights improved pricing
By Eva Brocklehurst
Broker opinions differ widely on the near-term outlook for a2 Milk ((A2M)) as the company negotiates complex changes in the Chinese infant formula market and advances its marketing of liquid milk in the US.
Ord Minnett assesses the step-up in investment that is required to access the significant opportunity in the Chinese infant formula and US liquid milk market is now more likely to occur from 2020 onwards.
There are also ongoing challenges in the channel mix and rising competition in the Chinese market for infant formula. Breaking even in the US liquid milk category is also expected to be long-dated. As the stock offers limited valuation support, the broker retains a Lighten rating.
The company recognises further growth in the Chinese market requires success in cross-border e-commerce and mother & baby stores, along with other bricks & mortar channels. Yet Ord Minnett points out the abandonment of the US break-even target to better pursue the opportunity has resulted in margin compression being deferred to 2020, rather than being avoided.
Morgans agrees the margin will still decline relative to FY19 as the company moves into an investment phase. Revenue growth will now come at a much higher cost than in the past given a2 Milk is not as reliant on daigou (product purchased outside China for sale in China).
Still, the broker considers the forecast for strong growth a credible outcome, in the light of peer results that highlight the challenging trading conditions, increased competition and regulatory changes. Declining birth rates in China are also cited as a limiting factor going forward, although the company argues that increased household penetration still contributes to the attractive category growth prospects.
FY20 margin guidance has been upgraded to 29-30% while the company has guided to a first half margin of 31-32%. The reason for this is that marketing, investment and costs are likely to be weighted to the second half.
The fact that gross margin drove the upgrade to the overall outlook is positive, UBS suggests, as it indicates a2 Milk is not discounting its product in order to create more volume, amid some concerns about inventory levels. UBS has become incrementally more positive after channel checks regarding inventory levels.
The main issue the company faces is about what is a realistic long-term share of the Chinese infant formula market and what level of profitability can be achieved. UBS forecasts long-term share of 11% and group operating earnings margins of 30%. This should mean this business delivers around 16% five-year compound growth.
Citi reiterates a Sell case, although acknowledges momentum appears strong. The broker believes margin expectations from FY21 do not reflect the impact of increased investment and are too optimistic. Competition is also heightened, as multiple operators enter the segment, although this will take time to play out as switching is not significant at present.
Morgan Stanley agrees, assessing the majority of the margin upgrade can be attributed to price/channel mix benefits and an earlier forecast that was conservative. Management has indicated that store velocity drove the majority of growth in China in the first half to date. Moreover, the broker suggests infant formula sales data, while imperfect, signals softer end-market pricing, which implies demand is slowing.
CLSA, not one of the seven stockbrokers monitored daily on the FNArena database, downgrades to Sell from Underperform. The broker implies, from the update, that the second half operating earnings margin will fall to around 28%. The issue is whether this is a reliable gauge for FY21 margins. While some recovery is expected it is not enough to turn CLSA bullish and a target of $12.80 is in place.
Bell Potter, also not one of the seven, sticks with a Hold rating and $13.55 target, noting, for the first time, the company has not released a four-month trading result but instead provided an update to guidance. First half guidance implies infant formula revenue growth in Australia is stronger than Bell Potter previously expected while China and US revenues are softer.
Wilsons, not one of the seven, takes a different view and upgrades to Overweight, believing the current share price represents an attractive entry point, retaining a target of $15.30. The broker is encouraged by the trading update, coming 10 months after the launch of China's new e-commerce law, as it demonstrates a smooth transition from the daigou-led market to a more direct sales model.
Wilsons had been uncertain about this aspect, as well as regarding returns from increased marketing expenditure, but now believes the renegotiated supply contract with Synlait Milk ((SM1)) provides a buffer. A2 milk has extended its contract to five years, with the main impact being improved pricing from FY21 and Macquarie expects this will drive gross margin expansion.
There was no reference to the 12% marketing-to-sales ratio which could otherwise be used to anchor revenue. Still, Macquarie assesses the size of price increases taken in FY20 reflect confidence in the outlook for demand.
FNArena's database has two Buy ratings, two Hold and three Sell. The consensus target is $13.28, suggesting -3.5% downside to the last share price. Targets range from $10.80 (Morgan Stanley) to $16.20 (Macquarie).
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