Conflicting Views Abound For A2 Milk

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

A2 Milk delivered a first half result that generated some conflicting views as brokers try to assess the outlook.

-Are foreign brands regaining ground in China?
-Market focus turns to margins from investment
-Second half performance outlook unclear

By Eva Brocklehurst

The first two months of the second half have revealed strong revenue growth and robust demand for a2 Milk ((A2M)). Or has it?

There was no specific earnings guidance at the first half results and the company refrained from quantifying any impact from coronavirus. Bell Potter suggests the indicators of infant milk formula activity are conflicting.

Negative export trends from Australia to China are in stark contrast to the company's report of revenue growth. Yet it appears to Citi that Chinese consumers have been stockpiling essential items such as infant formula ahead of the New Year while foreign brands are winning back share from domestic brands amid credibility issues, which may be attributed to coronavirus. Perhaps.

This development would, if it continues, signal a sudden shift in the trend where Chinese domestic brands were gaining ground at the expense of foreign brands. However, it also could be based on the fact foreign brands are over-represented in e-commerce channels.

An inability of China's domestic operators to restart production and source raw materials is considered by Citi to be a short-term inconvenience. Marketing is weighted to the second half and the broker acknowledges there is uncertainty around coronavirus impacts on the supply chain.

While the infant formula business appears resilient, Ord Minnett is one broker concerned about negative channel margin mix, and the shift in emphasis to mother and baby stores (MBS) and away from daigou (personal shoppers in Australia delivering to China).

Bell Potter points out the ongoing ability of the company to repatriate margin from daigou customers, via lifting Australian infant milk formula prices closer to China's shelf prices, is a key driver of profit.

However, Wilsons believes the near-term outlook is favourable and the pulling forward of demand is more than offsetting logistical challenges. Moreover, the quantum of disruptions in MBS and corporate daigou appears to be moderating. UBS finds little evidence of margin dilution and lifts forecasts materially to reflect the increased sales velocity in MBS.

Margin Focus

The market's focus has turned to short-term operating earnings (EBITDA) margin after a multi-year investment phase, Ord Minnett points out. This makes the ongoing strategy less clear, particularly as former CEO Jeff Babbage has returned as the interim CEO this year.

The broker suspects the multi-year investment phase proposed explicitly in August 2019 was not acceptable to some stakeholders and so the commentary has retreated towards margins. Yet there was no insight into other elements of operating earnings so the outcome is unclear.

Macquarie likes the fact disclosure has improved following the change in management. However professional services costs remain high and corporate costs were up materially in the first half.

The company reiterated a medium-term target of operating earnings margins of 30%. While expecting FY20 margins will be maintained at 29-30%, after a strong first half performance Macquarie suspects a weak margin is likely in the second half around 26.5%.

Growth initiatives continue to be prioritised ahead of returning capital and the company considers it appropriate to assess participation in manufacturing capacity and capability. This could involve blending and canning, Macquarie notes.

The company is looking at building its own manufacturing capacity and while this reduces the attraction as a capital-light business, Citi believes it is necessary to ensure compliance with evolving Chinese regulations. Wilsons agrees vertical integration is largely a move to mitigate risks.

The company has noted that its Smart Nutrition business is showing signs of developing into a meaningful extension of the infant and children's nutrition portfolio. Chinese labelling was launched in January 2020.

For the first time, too, a2 Milk has a target in the US, towards annualised sales of US$100m. Management expects to be breaking even around this rate of sales. US losses widened to -$30m in the first half from increased marketing. Store economics are also showing little improvement on past periods, nevertheless, Citi asserts.

The broker finds it hard to ascertain whether a strong second half performance will come at the expense of FY21, from the pulling forward of sales and as a reduction in marketing impacts sales growth in FY21.

Ord Minnett expects competition will intensify and require a greater level of investment, or a lower rate of revenue growth, retaining a Lighten rating. At the other extreme UBS, with a Buy rating, believes the addressable market in China may be larger than consensus appreciates, which suggests the sales opportunity is greater.

Bell Potter, not one of the seven stockbrokers monitored daily on the FNArena database, has a Hold rating and $16.15 target while Wilsons, also not one of the seven, retains an Overweight rating and $17.88 target. The database has three Buy ratings, two Hold and two Sell. The consensus target is $17.34, suggesting 12.2% upside to the last share price.

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