Greg Smith: a2 Milk – when market darlings turn to custard

OPINION:

New Zealand has been living with Covid for just under 16 months (since the first case here), and both the economy and stock market have handled the pandemic much better than most expected.

Unemployment is under 5 per cent, while pent up savings due to closed borders and a surge in house prices have consumers brimming with confidence. Houses and flash cars are being bought like they are going out of fashion.

While underperforming many markets in 2021, the NZX50 (-7 per cent YTD) is above pre-pandemic levels, and has put in a solid, albeit not spectacular, gain of around 10 per cent over the past 12 months.

There have been big pandemic winners such as Mainfreight, and ‘losers’ (think Air New Zealand and Auckland Airport), but even the latter are generally sitting around or above where they were 12 months ago.

And then there’s A2 Milk.

In July last year the infant milk producer was worth $21 a share, had a market cap exceeding $15 billion, and was the second most valuable company on the bourse. The investment fraternity saw A2 as a ‘great’ company – several brokers had the stock on their ‘high conviction’ buy list.

The onset of Covid in China, the company’s main market, and the sweeping pandemic that was to follow, did not cause much initial alarm.

‘Pantry/panic stocking’ was a tailwind, and A2’s shares continued to climb through to August last year. The company was seen as a ‘market darling’ and therefore justified a substantial premium to the sector/market.

The ‘curdling’ since has been vicious (although still pales in comparison to the 16,000 per cent rise over the previous 10 years pre Covid).

Over the past 11 months investor funds have flown out of the ATM (the stock’s kiwi ticker) with the shares losing around 70 per cent in value as border restrictions have severely hampered the company’s daigou (cross border) trade into China.

The shares have had a slight lift this past week on the announcement that China will permit couples to have up to three children, up from two currently. Even if this is successful in lifting the country’s declining birth rates, I am not convinced this will be a magic bullet for A2.

Somewhat concerning is A2’s knack of delivering regular earnings downgrades in recent times.

In the latest, on May 10th the company revised FY21 revenue forecasts down to a range of $1.20b to $1.25b, from an earlier forecast of $1.4b made in just February, and guidance of $1.7b last year.

EBITDA margins have more than halved, with a forecast profit margin of between 11 per cent and 12 per cent, from February guidance of between 24 per cent and 26 per cent. So earnings estimates have been revised to between $132 million and $150m, down from $549.7m in the 2020 year.

Not great for a stock priced for significant growth. A baptism of fire for new CEO David Bortolussi – management instability has been another issue for A2 in recent years.

Sales in April have fallen short of expectations, and this has led to a surplus of inventory, a lot of which is being written off as new stock is switched in.

A2 expects to write down around $80m to $90m of its stock, and this follows a $23m write-down in the six months to December. A2 now plans to “rebalance” its inventory by reducing the amount sold through the daigou and reseller sales channels.

What is somewhat disturbing is that the company didn’t take action sooner. Third quarter English label sales in the ANZ segment and the CBEC (cross-border E-commerce) channel were down 11 per cent and a staggering 57 per cent respectively on the second quarter – this didn’t happen overnight.

At least the uptake of Chinese branded A2 milk has increased, and there are plans to lift marketing spend here. However, this may ultimately cannibalise the growth in English branded formula, as and when borders reopen fully, and why arguably why A2 has less appeal as a ‘reopener.’

A2 is also looking to implement wholesale price increases across its English label infant product range to restore its “premium price” positioning and mitigate cost of goods sold pressures.

It is natural to question how successful this strategy will be, and whether this could worsen the demand situation.

Many will say that A2 has a ‘great’ brand, and strong positioning in China. And the $270m acquisition of a majority stake in Matura Valley Milk will strengthen those ties.

However, A2 is one of a multitude of brand options, and competition is intensifying – global super-brand Nestlé is amongst those ramping up its presence. The deteriorating trade relationship between Australasia and China still stands as a risk as well.

A2 is reviewing its growth strategy, and perhaps not coincidentally as the company’s Asia Pacific CEO has resigned.

On the plus side A2 has the balance sheet and financial flexibility to take the time it needs to ‘repivot’ (with around $850m in cash currently, pre the MV deal), and potentially engage in share buy-back initiatives. But management have acknowledged any recovery will not be quick.

Some investors are understandably frustrated, and with reports of a potential class action by a group of shareholders surfacing over the past week.

Institutional exposure has moderated, however several retail brokers remain optimistic, with the majority maintaining ‘Hold’ or ‘Neutral’ recommendations.

Perhaps understandable given the esteem A2 was held in last year and with some clients joining the A2 party at elevated levels.

Has the punch turned to custard? At over 40 times FY21 forecast earnings, a premium to the sector, a number of material headwinds, and a host of uncertainties about the earnings outlook A2 is a long way off being ‘cheap.’

And if management is uncertain about the market outlook, and what direction the company is pointing, it seems a stretch for any analyst to claim a high degree of confidence in their models (some of which said A2 was a strong buy at $20).

Great brands can carry a company a long way, but not if that greatness proves to be finite. I could be wrong and maybe A2 does reach former glories, but I think that it will be a long road back if so.

– Greg Smith is the Head of Research at investment research and funds management house Fat Prophets.

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