Australia | Oct 29 2021
This story features A2 MILK COMPANY LIMITED. For more info SHARE ANALYSIS: A2M
a2 Milk has outlined a bold 5-year strategy and revenue target which require a meaningful recovery in its infant formula sales
-Performance of higher-margin English label product key to FY22
-Significant downgrade to longer-term margin outlook
-Material expenditure on marketing now required by a2 Milk
By Eva Brocklehurst
While there was no substantial change to FY22 expectations at the company's investor briefing, a2 Milk ((A2M)) has set out a medium-term strategy that includes a $2bn five-year revenue target, while the margin outlook is now below most expectations.
Macquarie points out the revenue target assumes China label share doubles to 5% and half of the decline to date in English label revenue is recouped. It also anticipates growth in other dairy and nutritional products in China and further growth in Australasia and the US.
Still, Morgans believes the business is "through the worst of it" albeit earnings and regulatory uncertainty continues. All channels are running below the broker's expectations with the exception of the higher-margin English label product.
Pricing for English label has increased and further improvement is expected, and the performance of this higher-margin product will be a key determinant of the current year's performance.
What has not changed, Morgans asserts, is a strong brand that has significant opportunity to grow in China, although achieving targets will require significant investment.
In terms of English label sales, Credit Suisse believes there is a reasonable case for a recovery, given cross-border channels and daigou were shut down because of the pandemic.
The broker had been concerned that English label had lost its market position to domestic brands at similar prices, yet the company has assured investors that English label will soon benefit from a brand upgrade and innovations.
UBS observes a base is in place for a significant lift in store-based market share over the next five years amid brand strength, expansion of stores and higher marketing expenditure.
The broker also ascertains a meaningful recovery can occur in both daigou and CBEC infant formula sales over the next three years as well as market share gains in China label through the store roll-out.
In China, Macquarie notes the infant formula market has undergone premiumisation and intense competition and agrees this will place pressure on players to ramp up promotional activity.
Meanwhile, product innovation has been relatively limited and the company is still testing the brand's ability to move into new categories. Yet the broker observes company's “health” credentials in China are strong.
Despite the challenges of China's falling birth rate, a2 Milk has lifted its market share. UBS points out a2 Milk was the only major international brand for infant formula to gain market share in the mother and baby store channel during FY21.
Macquarie also acknowledges there are opportunities for a2 Milk to acquire capacity in China such as blending and canning and launch additional products while lowering its cost base. Online sales are also becoming a larger channel for first purchases and this continues to be a significant evolution in behaviour, the broker adds.
Credit Suisse upgrades to Neutral, noting the company is investing to recover lost English label sales and has gaps in its market share for China label that can be closed. The main catalysts for upgrades include proof that further market share can be obtained.
Jarden, not one of the seven stockbrokers monitored daily on the FNArena database, also upgrades to Neutral from Underweight with a target of NZ$6.60, on the back of evidence the business has retained its position in its key end market, China. The broker now envisages increased valuation support should offset the transition risk that exists in returning to growth.
UBS believes investors are being cautious and only a limited recovery is being priced into the stock. The broker continues to expect earnings will be back at pre-pandemic levels by FY25, which is about 20% ahead of market consensus and reflecting a stronger recovery in high-margin English label sales.
Macquarie points to the loss of a club channel customer in the US, which has meant first quarter volumes were down, and notes the distribution cost pressures in this market. As a result the path to profitability the US is being deferred again with a target now of FY25-26.
Based on expected revenue growth of $100m and an EBITDA margin of more than 10% the broker does not believe the US "prize" is material. Yet Jarden points out management is committed to the US growth option, although profitability does require further scale and optimised costs. Furthermore, brand awareness and household penetration metrics are improving.
As the company has set its target margins in the "teens" based on anticipated conditions and possibly the "low-to-mid twenties" longer term, Macquarie is hopeful this is the final material downgrade.
Nevertheless, the broker believes there is significant risk and uncertainty around a resumption of growth. The margin outlook is materially below consensus which had margin estimates of around 25% for the medium to longer term and a pre-pandemic outlook for 30% in operating earnings (EBITDA) margins.
Another dampener is the outlook for the Mataura Valley Milk business, with profitability now expected in FY26 rather than FY25 as previously disclosed.
Credit Suisse is now modelling $420m in EBITDA for FY26, on less ambitious sales, more ambitious margins and a 3.8% volume share in China, assuming a recovery in English label sales.
Morgans believes over the medium to longer term margins in the low to mid-20% region are possible if English label sales recover well. The company's margin peaked at 32.3% in FY19 yet the business has now changed amid a declining birth rate in China and increased competition.
The company needs now to increase marketing expenditure having previously relied on daigou and the underspend by competitors, the broker asserts. In addition, there are the losses of Mataura Valley Milk to contend with and the broker considers the valuation "full", downgrading to Hold from Add.
On a qualitative basis the company indicated English label sales will be weaker in the first half comparatively, albeit running ahead of expectations. On the positive side, UBS points to a material improvement in retail pricing and reseller margins. China label sales in the first quarter were down while distributor offtake and retail sales were up in double digits.
Australasian fresh milk sales were lower than Morgans expected in the quarter, largely stemming from adverse FX rates. The broker notes the company's trading update was noticeably weaker than peers.
US milk sales were lower mid distribution cost pressure and Mataura Valley Milk nutritional demand was weaker too, following a decline in third party volumes. As a result first half net profit is likely to be materially lower while the second half should be higher on a comparable basis, Morgans suggests.
The database has two Buy ratings, two Hold and one Sell (Macquarie). The consensus target is $6.94, signalling 15.1% upside to the last share price, and compares with $6.09 ahead of the update. Targets range from $5.20 (Macquarie) to $10.20 (UBS).
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