Is There More Upside For a2 Milk?

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

A2 Milk has been a beneficiary of the pandemic restrictions, with strong sales in online and re-seller channels, but will the effect of stockpiling subsequently unwind – and sharply?

-Market share gains likely to be sticky
-Higher margin and currency benefits in FY20
-Is the stock fully priced?
 

By Eva Brocklehurst

Strong revenue in infant formula in China as well as liquid milk in Australasia and the US has underpinned a robust March quarter for a2 Milk ((A2M)), although the extent of any unwinding of stockpiling in the June quarter is uncertain.

The company has benefited from foreign brands winning back share in China against domestic brands, and Chinese consumers stockpiling essential items such as infant formula.

Macquarie suspects customer acquisition and market share gains may be sticky and quality imported products are likely to be favoured. Citi also points out, along with market share gains, there is a potential for a second spike in COVID-19 cases that may drive more stockpiling.

However, should customer stockpiling turn out to be a headwind in FY21, then Bell Potter expects growth will slow materially. Moreover, the stock is trading at the upper end of its historical trading band so the broker, not one of the seven monitored daily on the FNArena database, has a Hold rating and $17.70 target.

Morgans asserts the company would be one of the few that has been a beneficiary of the pandemic and its restrictions, having upgraded FY20 earnings guidance. Revenue guidance is for NZ$1.7-75bn and operating earnings (EBITDA) margins of 31-32%. Guidance also assumes the planned marketing investment of NZ$200m will be spent entirely in FY20.

Revenue growth has been across all regions, in particular infant nutrition sold in China and Australia and in the online and re-seller channels. Inventory is elevated, which will buffer any risks to the supply chain and there is also a benefit from a lower NZ dollar as the China segment is transacted in US dollars.

Benefits have accrued from higher gross margin nutritional products and favourable FX as well as lower costs, however the company asserts these factors are not sustainable, reiterating a target margin of around 30% for the medium term.

Citi considers FY20 margin guidance conservative, as this assumes the entire marketing budget will be spent in that year. This could be difficult, given the challenges in obtaining returns from marketing campaigns amid social distancing measures, and better sales arguably reduce the need for more marketing.

Bell Potter notes improving margin guidance has been a feature of the business over FY20 with changes, largely reflecting movements in the NZ dollar. The broker considers the medium-term margin target reasonable, given the material impact that occurs with volatility in the NZ dollar.

Valuation Support?

Macquarie also suspects, while the upgrade was solid, a muted share price reaction could reflect existing expectations of positive trading as well as the belief that the benefits may be one-off.

Ord Minnett is in this camp, believing the share price incorporates expectations for further upgrades and indicates a lack of valuation support. Morgan Stanley also believes the stock is pricing in little room for error.

Wilsons, not one of the seven, continues to like the brand but believes the valuation gap has now closed and reduces its rating to Market Weight from Overweight, with a target of $20.

Outlook

Beyond FY21 Wilsons continues to expect sales growth will be driven by China and the rolling out of Mother & Baby stores amid further growth in e-commerce platforms. Material improvements in the US remain upside to the broker's forecasts.

Morgans raises forecasts to the top end of guidance and ascertains there is potential upside risk if elevated demand continues and some operating expenditure is deferred into FY21.

Still, the broker warns that peers such as Coca-Cola Amatil ((CCL)) and Freedom Foods ((FNP)) have flagged a slowdown in stocking trends in April and agrees the market has largely priced in the positive outlook.

Credit Suisse also struggles to find sufficient valuation support and considers a2 category competition and price convergence key emerging risks. On the company's side, it has brand strength, a tailored proposition in China and critical mass.

UBS forecasts the business can attain a 9% value share in FY25 in the Chinese infant formula market. The brand is uniquely positioned, resonating strongly with consumers and remains under penetrated in tier-2 cities.

While the addressable market, particularly in China, may be much larger than consensus appreciates, the broker considers North America is unlikely to contribute 10% of group operating earnings by FY25, noting a2 Milk has stepped away from expecting the US will reach monthly break-even during 2021. The larger opportunity in the US is new categories, notably coffee creamer, but UBS does not include this in estimates.

FNArena's database has three Buy ratings, two Hold and two Sell. The consensus target is $19.36, suggesting 3.3% upside to the last share price.

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