A2M.AX - the A2 Milk company

[Arski]

So, this week I spent a lot of time on analyzing this company and wrote my first write-up. I am very curious about what you guys think. I hope you communicate with what you should do different and give feedback about what things could be done better.

 

The A2 Milk company write-up

This company was already in my portfolio before the -15% last week and added some more shares after that.

 

This opportunity exists because A2 Milk has downgraded their earnings forecast for the second time and therefore the market thinks A2 Milk has lost the growth it had in the past five years. I don't think they are going to grow at the same rates as before but the A2 Milk company is very well positioned and keeps investing for the long-run. So, I believe they will exceed everyone's expectations and be a growing company (again) with a strong brand and a long runway ahead.

 

Company Description

The A2 Milk company, together with their subsidiaries, manufactures and sells A2 protein-type milk under the A2 Milk brand and infant formula under the A2 Platinum brand in Australia, New Zealand, China, the United States and recently started selling in Canada and Korea. They stopped their operations in the UK because they think more opportunity for growth is available in China and the US. The company is incorporated and domiciled in New Zeeland.

 

A2 milk is somewhat special milk. It consists only of milk with A2 protein, whereas normal milk contains A1 and A2 protein. A2 milk is believed to be better for health than 'mixed' milk. Recently a study was published from Purdue University, Indiana USA,

"which involved 33 American adults with lactose maldigestion. The findings indicate that some people who suffer stomach discomfort after drinking conventional milk may have significantly reduced symptoms if they consume milk that contains only the A2 beta casein protein type and is A1 protein free."

The study was financially backed by the A2 Milk company.

 

Not only would the A2 beta casein prevent stomach pain. "At least one study showed a link between the consumption of A1 protein and incidence of type 1 diabetes, although this kind of study fails to prove that it is a direct cause."

A2 milk: Benefits, vs. A1 milk, side effects, alternatives, and more (medicalnewstoday.com)

 

The huge ~30% operating margins were established because of the price premium of the company's products. In Australia, A2 Milk is typically found at double the price of private-label offerings. In the US, A2 Milk is available for four times the price of store-brand milk and double the average private-label price. Despite the high prices the A2 Milk company's products keep gaining share.

 

Market Opportunity

Their biggest market shares are in the Australia, 11.7% for liquid milk and ~20% for their cross-border e-commerce (CBEC). For their infant nutrition in China their have a market share of 2.4%. Their products are available in the whole US since 2018, in Korea since 2019 and in Canada since July 2020, so their market shares are very tiny in those countries. China will be of major importance for their growth within five years.

 

A2 Milk is very active in expanding their business. For example they took a 75% stake in Mataura Valley Milk, which will expand and diversify their nutritional product manufacturing. Why would they a majority stake in such a company? The management believes:

"[it] will offer access to manufacturing margins and the ability to provide more flexibility for product supply. This includes the potential to pursue an additional China label registration and additional innovation opportunities."

 

The management also believes that the acquisition will be profitable in 2025, because of the transitional period which will take a long time. You could argue that the acquisition is a bad investment, but I think that the acquisition will pay off in the long-run (~10 years) because it will make A2 Milk less dependent, will improve distribution, flexibility and the quality of their products. All these things are going to be very important for the company if it wants to become a huge and very profitable company with a strong brand.

Furthermore, the ROIC of the business has been between 30-50% over the last five years, so I find it hard to question the management in their investments.

 

Competition

In Australia, their main competitors are Nestlé, Karicare and Bellamy's. A2 Milk's products are priced 50% higher and they still have captured a large market share.

In China, their main competitors are Danone, Nestlé and Mead Johnson. Prices of the infant formula are about the same.

 

In 2019, Nestlé and Danone have launched a rival A2 milk infant formulas, just like the A2 Milk company's infant formula, in Australia and in China. Whereas Nestlé's Atwo is priced at a significant premium to A2 Milk's infant formula. The market pressure would reduce the company's ROIC to 25-35% but will stay way above the cost of capital of 10%.

After all, last six months the A2 Milk company has enjoyed a 45.2% increase in sales to A$213 million of their infant product in China.

 

Competitive advantage

So, people are willing to pay a premium for milk, mainly because of the health benefits A2 milk has over traditional milk. You do also see a rising demand in Chinese market for international dairy brands, like A2 Milk and Nestlé. As stated earlier, a study was published which backed the finding of health benefits.

 

The A2 milk has several patents that prevents other companies from producing only A2 containing milk. These patents will expire in 2023. Besides that, A2 Milk has a license approval to import into China with the CFDA, whereas competitor Bellamy's has struggled to achieve this.

More information about A2 Milk's patents can be found here:

Patents Assigned to A2 Corporation Limited - Justia Patents Search

 

The company uses these advantages to build a meaningful brand for when the patents expire, so the company can still benefit from selling their liquid milk at a premium. They try to strengthen their brand through an increasing 11% of revenue spent on marketing in FY20.

Of course, they will have quite some competition from big international conglomerates (like Nestlé) but the infant nutrition market is big and the A2 Milk company should be able to capture a reasonable share by having a meaningful brand and high quality products while being cheaper than Nestlé's Atwo.

 

Management

The company was very fortunate to have Geoff Babidge back at the wheel after the old CEO resigned after 17 months. He keeps supporting the business to ensure a smooth leadership transition to David Bortolussi, which should be the CEO by now. Bortolussi has done a good job at his former firms: Hanesbrands, Pacific Brands and the beverage firm Foster and should be able to serve the company well.

 

Overall, the management has done a great job in the past with ROIC between 30-50% over the last five years. They have made sure that the company has strong strategic partners who support their growth and adaptability: Synlait (infant nutrition manufacturer and a 19.8% stake), Fonterra (fresh milk manufacturer), CSFA Holdings Shanghai (logistics and distribution partner in China) and Mataura Valley Milk (75% stake).

 

The Chairman of the board, David Hearn, has been at the company since 2014 and owns 0.14% of the company's shares outstanding (~$13.2 million). Other board members have in total a value of ~$11.5 million in the company. That's some ownership but not a lot. Furthermore the total share count has been increased with 5 million shares in both FY19 and FY20 through bonuses/options. Which is an increase of 0.7%, not a huge issue I think but is something to consider.

 

The old CEO who stepped down in december 2019 received a astonishing A$3.8 million a year (inclusive bonuses). That's way to much for a CEO and definitely a red flag. Current CEO Geoff Babidge who came back after Jayne stepped down, earns ~A$900.000 a year which a correct salary for a good CEO.

 

Maybe the most important aspect, which stand out in nearly every report is that the company puts a lot of emphasis on culture. In their last annual report they mentioned that "our people" is placed number on "our focus areas". I think having a great culture is one of the most important factors for a flourishing company.

 

Financials

LTM revenue is $1.2 billion and half year revenue was down 16% to $487 million. Operating margins were 30%+ last three years but declined last half year to 26%.

With a market cap of $5.2 billion, $557 million cash on hand and no debt gives an EV of $4.7 billion.

FY 2021 earnings will be down 30%, mainly because of a 20% decline in sales due to covid but also because of their new acquisition, huge advertising costs and expanding operations in the US, Canada and China. Therefore operating income will be ~$250 million in FY21. I assume revenue and margins going back to normal in FY22, which should result into ~$320 million in operating income. This gives us a forward EV/EBIT multiple of 14.7.

Free cash flow was on average 75% of operating income over the past five years and is something I'm going to use as a standard in the future for my DCF analysis.

 

Financing Risk

I see no financing risk for A2 Milk, mainly because their cash balance of $557 million and because they have not used leverage in the last five years. Their huge pile of cash will enable them to take advantage of very attractive opportunities when they come along.

 

Catalysts

When the market recognizes that sales have picked-up and start to see revenue grow again, the earnings multiple will probably expand from the level it's now. Further catalysts are not needed.

 

Future Expectations

Because covid is interrupting the daigou/reseller channel and the cross-border e-commerce, A2 Milk had lower revenue in H1 2021 and forecasted lower revenue in H2 2021 as well. They predict $1 billion in sales and an EBITDA margin between 24% and 26% for FY2021.

 

I believe they are going to grow at 20%-30% for at least three years after covid is no issue anymore and the daigou/reseller channel and the CBEC are fully up and running.

Management is focussing on strengthening their brand and expanding operations in the US, China and Canada, where their market shares are very tiny (~2% in China and lower in US and Canada). They should be able to capture meaningful (~5-8%) market shares in those countries within ten years.

 

Risks

-  Scientific research indicating only A2-beta-casein protein containing dairy products have no health benefits over traditional A2 and A1 containing dairy products.

-  Regulatory responses from China

-  A2 milk not having established a strong brand and getting disrupted by competitors

-  Problems with suppliers; suppliers can't keep up the demand or the quality of the products could deteriorate.

-  The covid-19 crisis showed us that the company's daigou and retail channel, and cross-border e-commerce could be impacted heavily.

-    Management not capable of leading the firm properly. Their invests could pay off badly and they could position the company wrong strategically against the conglomerates.

 

Current Valuation

Base case:

For valuation I used a DCF analysis with the forecasted $1 billion in sales for FY21 and a 20% growth rate for the first year, 25% for years 2 and 3 and 20% again for year 4. So $1.2 billion for the first year of my analysis (FY22). After that I used a operating margin of 27% and increasing it 1% per year until it reaches 30% again and revenue growth that is being reducing slowly after year 4 and continues to being reduced until it reaches 10% per year in year 8. Finally, after deploying a 75% historical FCF margin (of operating income), a terminal multiple of 15 (because of the brand I think this is a high quality company) and a discount rate of 15% because I want to get at least a 15% return on any investment. I get a value $5.88 billion, which indicates a 18% margin of safety. This would result in a 17.8% return per year.

 

For the bear case, when the management is incapable and where the company has difficulty taking reasonable market shares, I get a valuation of $4.0 billion and a -21% margin of safety and a return on investment of 12.4%.

 

For the bull case, when management does seem very capable of getting a meaningful brand and therefore larger market shares, I get a valuation of $6.8 billion and a 29% margin of safety and a return on investment of 19.8%.

 

Huge differences in valuation is explained by the large discount rate used.

[Agrippa07]

Great write up, thanks for sharing!

 

A2 milk company came on my radar about 3 weeks ago and initiated a small position then, I doubled the sizing positioning last week after the -16% drop.

 

There is lot to like about this company:

High margins and ROIC

Long Runway

increasing market share in China and USA

 

However, as you mentioned there a plenty of risks, for e.g.:

Management turnover with CMO leaving recently.

China import tariffs and regulation

Daigou headwind

Lack of pricing power in China (compared to AUS)

 

 

As an additional catalyst I would probably add a partnership with a global distributor, see Monster Drinks and KO.

 

I don't believe there is any real benefit to A2 milk compared to regular milk. The research is not definite.

However, it's a compelling message and allows A2 Milk to differentiate themselves from other producers and demand a premium on pricing.

[Spekulatius]

The patent expiring in 2023 should be a huge concern. If not directly affecting market share it will affect the Premium it can charge over competitors who just duplicate. A2 milk’s formulation.

 

It won’t be like drug going generic but likely more used but still could affect profit margins considerably.

[Arski]

The patent expiring in 2023 should be a huge concern. If not directly affecting market share it will affect the Premium it can charge over competitors who just duplicate. A2 milk’s formulation.

 

It won’t be like drug going generic but likely more used but still could affect profit margins considerably.

 

Yes, but that's the patent of the liquid milk. The infant formula has already been copied by Nestlé and Danone, is still selling at a premium and has huge sale increases over the last few years. Infant formula in China in going to be the biggest proportion of their sales. Liquid milk could indeed be disrupted heavily.

 

The question to ask is whether people are willing to buy a premium brand over a normal brand. I would say no but A2 Milk's history says otherwise. I don't think it's going to be a problem for other brands to duplicate A2 milk at least.

 

Definitely a lot of uncertainty concerning A2 Milk.

[KJP]

 

Current Valuation

Base case:

For valuation I used a DCF analysis with the forecasted $1 billion in sales for FY21 and a 20% growth rate for the first year, 25% for years 2 and 3 and 20% again for year 4. So $1.2 billion for the first year of my analysis (FY22). After that I used a operating margin of 27% and increasing it 1% per year until it reaches 30% again and revenue growth that is being reducing slowly after year 4 and continues to being reduced until it reaches 10% per year in year 8. Finally, after deploying a 75% historical FCF margin (of operating income), a terminal multiple of 15 (because of the brand I think this is a high quality company) and a discount rate of 15% because I want to get at least a 15% return on any investment. I get a value $5.88 billion, which indicates a 18% margin of safety. This would result in a 17.8% return per year.

 

For the bear case, when the management is incapable and where the company has difficulty taking reasonable market shares, I get a valuation of $4.0 billion and a -21% margin of safety and a return on investment of 12.4%.

 

For the bull case, when management does seem very capable of getting a meaningful brand and therefore larger market shares, I get a valuation of $6.8 billion and a 29% margin of safety and a return on investment of 19.8%.

 

Huge differences in valuation is explained by the large discount rate used.

 

If you could translate your base case DCF into prose, particularly the 30% operating margin assumption, I think it would say:  "This company will be a very premium brand that will be able to charge very high markups while growing sales quickly for many years."

 

Here are some comparison operating margins for companies that already have massive scale (I used 2019 to deal with COVID):

Nestle ex-water: 18-22% [source: https://www.nestle.com/media/pressreleases/allpressreleases/full-year-results-2019]

Diageo: 31.4%  [https://www.diageo.com/en/investors/reporting-centre/]

Coca-Cola: 27%  [p. 64 - https://investors.coca-colacompany.com/filings-reports/annual-filings-10-k/content/0000021344-21-000008/0000021344-21-000008.pdf]

 

So, your base case appears to be that A2M will be the Diageo or Coca-Cola of dairy.  If that is true you will do very well.  I live in a place (USA) where A2M hasn't been selling for very long, though I have seen it on the shelves. So it's very hard for me to try to make any assessment of its brand here, and how competition would effect it in the liquids post-patent expiration.

 

I also think this is good example for the thread asking about the difference between "value" and "growth" investing.  The typical value investor would say that the base rate of companies becoming the next Coke is low, so regression to the mean is going to bring down this company's operating margins substantially.  This approach screens out many losers but also some giant winners.

 

A growth investor wouldn't focus so much on base rates but rather try to analyze the specific facts of this industry and competitors and try to determine whether and to what extent this company can maintain high growth and very high margins.   

 

 

 

 

[hellowod]

The foreign brands you mentioned are not the only competition, given the intense competition in China with many local brands, which all are pushing up the premium curve, I don't know how long A2M advantages can last. Given the drastic decline in birth rate in China (10%-15%?), I think this market is going to be tough going  in the future.

 

And there are other A2 brands in Australia as well, I may be mistaken, but I though FF/Perich family also have A2 production in Australia? That being said, they do have a good brand/premium for now.

[Arski]

I've come to understand that the future of A2M is very uncertain. 30% margins are only established in the future if they will get a brand like Coca Cola, indeed.

 

The foreign brands you mentioned are not the only competition, given the intense competition in China with many local brands, which all are pushing up the premium curve, I don't know how long A2M advantages can last. Given the drastic decline in birth rate in China (10%-15%?), I think this market is going to be tough going  in the future.

 

And there are other A2 brands in Australia as well, I may be mistaken, but I though FF/Perich family also have A2 production in Australia? That being said, they do have a good brand/premium for now.

 

There are indeed other competitors for infant nutrition in Australia, for example Bellamy's, and still A2M is able to get a large market share.

 

I get the impression - after reading quite some articles about the infant market in China - that there's a trend toward infant nutrition from international suppliers and not domestic. Mainly because Chinese have more trust in the safety and quality of international brands then domestic. But, I have no direct prove of that.

 

I know there's still quite some competition in China, but that does not take away that the infant nutrition sales did grow with 45.2% for A2M in the H1 2021. This might give some indication of how Chinese think about the company.

 

Eventually, the success of the A2 Milk company will depend on whether they are capable of establishing a meaningful brand that allows them to take a reasonable market share and keep selling their products at a premium. And that's why we are also dependent on whether the Chinese consumers will accept A2M as their premium brand.

[kab60]

What happened to this Company in 2016, when the stock started to really take off?

[Agrippa07]

I've come to understand that the future of A2M is very uncertain. 30% margins are only established in the future if they will get a brand like Coca Cola, indeed.

 

The foreign brands you mentioned are not the only competition, given the intense competition in China with many local brands, which all are pushing up the premium curve, I don't know how long A2M advantages can last. Given the drastic decline in birth rate in China (10%-15%?), I think this market is going to be tough going  in the future.

 

And there are other A2 brands in Australia as well, I may be mistaken, but I though FF/Perich family also have A2 production in Australia? That being said, they do have a good brand/premium for now.

 

There are indeed other competitors for infant nutrition in Australia, for example Bellamy's, and still A2M is able to get a large market share.

 

I get the impression - after reading quite some articles about the infant market in China - that there's a trend toward infant nutrition from international suppliers and not domestic. Mainly because Chinese have more trust in the safety and quality of international brands then domestic. But, I have no direct prove of that.

 

I know there's still quite some competition in China, but that does not take away that the infant nutrition sales did grow with 45.2% for A2M in the H1 2021. This might give some indication of how Chinese think about the company.

 

Eventually, the success of the A2 Milk company will depend on whether they are capable of establishing a meaningful brand that allows them to take a reasonable market share and keep selling their products at a premium. And that's why we are also dependent on whether the Chinese consumers will accept A2M as their premium brand.

 

Regarding China. In 2008 there was a milk scandal (https://en.wikipedia.org/wiki/2008_Chinese_milk_scandal#:~:text=The%202008%20Chinese%20milk%20scandal,components%20being%20adulterated%20with%20melamine.) which let Chinese consumer losing trust in their local brands and opting to only buy international baby/infant milk. Their pricing in the Chinese market is similar to other international brands such as those from Nestle and Danone, so they don't have pricing power there compared to their competitors. Although you can argue that the pricing power is already included since they are an international brand.

 

 

[Arski]

What happened to this Company in 2016, when the stock started to really take off?

 

Infant nutrition was taking off in Australia and resulted in a 60% share of revenue while it was 10% of the revenue in 2014.

[Agrippa07]

FYI on 2016 infant formula, their 2016 Annual meeting presentation (it also has an overview of their patent and trademark coverage):

https://assets-au-01.kc-usercontent.com/bca3e5d5-83bd-02bf-1c27-acb036630e5b/0d960ed5-bcfb-4c83-bb07-66cd0bd5dc2d/a2MC-Release-2016-Annual-Meeting-Presentation_presentation-only.pdf

[Arski]

I've come to understand that the future of A2M is very uncertain. 30% margins are only established in the future if they will get a brand like Coca Cola, indeed.

 

The foreign brands you mentioned are not the only competition, given the intense competition in China with many local brands, which all are pushing up the premium curve, I don't know how long A2M advantages can last. Given the drastic decline in birth rate in China (10%-15%?), I think this market is going to be tough going  in the future.

 

And there are other A2 brands in Australia as well, I may be mistaken, but I though FF/Perich family also have A2 production in Australia? That being said, they do have a good brand/premium for now.

 

There are indeed other competitors for infant nutrition in Australia, for example Bellamy's, and still A2M is able to get a large market share.

 

I get the impression - after reading quite some articles about the infant market in China - that there's a trend toward infant nutrition from international suppliers and not domestic. Mainly because Chinese have more trust in the safety and quality of international brands then domestic. But, I have no direct prove of that.

 

I know there's still quite some competition in China, but that does not take away that the infant nutrition sales did grow with 45.2% for A2M in the H1 2021. This might give some indication of how Chinese think about the company.

 

Eventually, the success of the A2 Milk company will depend on whether they are capable of establishing a meaningful brand that allows them to take a reasonable market share and keep selling their products at a premium. And that's why we are also dependent on whether the Chinese consumers will accept A2M as their premium brand.

 

Regarding China. In 2008 there was a milk scandal (https://en.wikipedia.org/wiki/2008_Chinese_milk_scandal#:~:text=The%202008%20Chinese%20milk%20scandal,components%20being%20adulterated%20with%20melamine.) which let Chinese consumer losing trust in their local brands and opting to only buy international baby/infant milk. Their pricing in the Chinese market is similar to other international brands such as those from Nestle and Danone, so they don't have pricing power there compared to their competitors. Although you can argue that the pricing power is already included since they are an international brand.

 

Interesting, thanks for the clarification!

[globetrottinguy]

Great write up. Thank you for sharing. It will be an interesting year or so ahead.

[Madalin.C]

Hello guys! I think the most important  thing in this complicated equation  is the management.  If the management  will execute good and very good, then the company has potential to be a multibagger

[n.r98]

Price has fallen further ~10%; valuation is increasingly becoming more attractive. "Beverages" seem a rather tricky, Coke dubbed by Buffett as inevitable doesn't seem so inevitable anymore. The "benefits of A2" research seems to be entirely internally done and delving a little deeper, there isn't anything special about A2 in general. Moreover, cow milk has been getting pushbacks in recent years; of course A2's financial statements contradicts every background doubt. Anyone has an insight why A2 deserves to sit on the board of fellow great consumer brands?

[Madalin.C]

it is very curios that A2 company was hit by covid19 effects after 6-12 months after the pandemic. In the last months the price crashed like March 2020:)) It doesn't seem it will rebound that fast...

Edited May 10, 2021 by Madalin.C

[Lakesider]

I think it was a health fad in china. Same thing happened with Manuka honey companies, they had tremendous china growth for a while, suddenly the growth dissapeared. 

[Arski]

Yeah, I don't understand the situation completely and I have no faith in their prospects, so I'm out with a 25% loss.

[MrB]

The reasons for the recent sales drop is discussed in their recent presentations and transcripts and together with headline news in Aus should leave one in little doubt about what's going on. Not reflected in the above discussions, which make you wonder about the level of research. 

I expect more. 

Edited May 12, 2021 by MrB

[Lakesider]

Comvita also had an explaination why their sales drop was temporary. 

[Agrippa07]

I didn't expect the market to be so surprised by the sales drop, Daigou channel is basically a non starter as long the travel restriction remain in place for Australia and New Zealand (until mid next year)

In regards to the Chinese market, they need to work on increasing MBS footprint, which they have done and is up to 22.6 (from 22.0), although market share remained the same. 

The decision by the new CEO to clean up inventory and increase marketing spend are the rights one, painful, but necessary. 

I will try to share more on my view/analysis this weekend, fundamentally I am still bullish on the company and the long term outlook. Hence I have added to my position this week; mix of shares and call options ( Aug and July 2021), currently a mid sized position in my portfolio (~7% )

 

[Madalin.C]

11 hours ago, Agrippa07 said:

I didn't expect the market to be so surprised by the sales drop, Daigou channel is basically a non starter as long the travel restriction remain in place for Australia and New Zealand (until mid next year)

In regards to the Chinese market, they need to work on increasing MBS footprint, which they have done and is up to 22.6 (from 22.0), although market share remained the same. 

The decision by the new CEO to clean up inventory and increase marketing spend are the rights one, painful, but necessary. 

I will try to share more on my view/analysis this weekend, fundamentally I am still bullish on the company and the long term outlook. Hence I have added to my position this week; mix of shares and call options ( Aug and July 2021), currently a mid sized position in my portfolio (~7% )

 

Thanks for sharing! I am looking forward  for your view. My opinion is the same. We investors in the company will have to endure some pain (I am -40%) but the reward can be awesome. We have to wait at least 2 years on this short term problem. There will always be pessimism on a downtrend and bad news... We need to give it time...