In order to decide whether to invest in the a2 Milk Company shares, a2 Milk Annual Report 2016-2017 (Report) and ‘Last Sale’ share price of March 27, 2018 were evaluated. The analysis of a2 Milk was divided into 5 parts:
- Company outlook
- Trend analysis
- Profitability analysis
- Liquidity and financial gearing analysis
- Investment analysis
1) a2 Milk Company outlook
A2 Milk is a producer of dairy-based nutritional goods with A2 beta-casein protein and free from A1 beta-casein protein. They contain the same amount of lactose as conventional cow’s milk but aim to prevent some symptoms of dairy intolerance (A2 milk stops some dairy intolerance symptoms, 2017). In FY17 the Infant formula generated 72% of annual revenue followed by branded fresh milk and whole milk powder. (The a2 Milk Company, 2017)
The company operates in several countries combined in 3 regions by revenue: New Zealand and Australia (80%), China (16%), US and UK (4%) with plans of further expansion. It is represented on NZX and ASX stock exchanges.
Annual financial results dated 30 June 2017 (NZ$) were strong compared to the prior corresponding period (pcp).
Total revenue of $549.5m increased by 56%. The main driver of this boost was growth in sales and market share in New Zealand and Australia of 48% and in China and other Asia of 133%.
EBITDA of $141.2m is higher by 159%;
Net profit after tax of $90.6m increased by 198%;
Operating cash flow of $99.9m and a cash balance of $121.0 million at year end;
Basic earnings per share (EPS) of $0.127 raised by 186%.
In future the company is intent on: a) broadening the range of products; b) continued annual growth; c) expanding the presence on existed markets and in South East Asia; d) improving supply and inventory management of key products in Australia and China (The a2 Milk Company, 2017).
2) Trend analysis
To analyse financial performance of the company and forecast future trends, total revenue, EBITDA and NPAT over the period of 2014-2019 were compared (Graph 1 and Table 1 in Appendix A).
Overall, the company shows significant growth of indicators for the last 4 years due to rising demand and market expansion. According to Forsyth Barr forecast for the next financial year, total revenue will show an increase of 64%, EBITDA will have a strong trend upwards (84%), NPAT will almost double with EPS 24 cents per share. Therefore, Forsyth recommends to buy the shares (NZX Company Research, 2018). Deutsche Bank states that they materially upgraded our a2 Milk earnings forecast (LR upgrade +55% by FY23E) to include better capture of the MBS China Infant Formula growth and channel economics and also to reflect the potential of the FSF agreement. In total, their earnings upgrade lifts their spot DCF valuation +53% to NZ$13.00, with the attribution of change broadly 30% MBS / 70% FSF agreement. Deutsche Bank rolls forward the spot DCF valuation of NZ$13 by the cost of equity to reach their target price NZ$14.
3) Profitability analysis
To analyse a2 Milk’s current profitability performance, three main coefficients were calculated over the financial periods of 2016-2017: gross profit margin, operating profit margin and return on equity (Table 2 in Appendix B).
Raised gross profit margin can be explained by better converting sales to gross profit in 2016. There are 3 possible scenarios: sales price per unit increased, cost price per unit reduced or sales mix was modified.
Operating profit margin almost doubled in 2017 compared to 2016. It means that a2 Milk became better at converting sales to overall profit.
Return on Equity (ROE) showed upwards trends of 64% which can be accounted to more effective usage of owner equity in 2017.
All ratios demonstrate an increase in profitability over pcp. Both gross margin and operating margin are up, which means that a2 milk efficiently controls its COGS and other expenses. More equity has been committed by the business, and the return on that has also raised.
4) Liquidity and financial gearing analysis
To analyse how well a2 Milk meets current commitments and claims against the assets, two main coefficients were calculated over the financial periods of 2016-2017: current ratio and acid test ratio (Table 3 in Appendix C).
According to current and acid test ratios, a2 Milk is able to fulfil short-term commitments in current liabilities as it has sufficient amount of assets. If such non-liquid assets as prepayments and inventory are excluded, a2 Milk can still satisfy its short-term creditors. Moreover, acid test ratio has improved over pcp.
As for the gearing, Debt:Equity ratio and interest cover ratio help to evaluate the balance between financing the business by borrowing money, or by using funds from the owners (Free, Hawke, 2017). Currently, a2 Milk does not have any non-current liabilities more than 100 000 NZD. Retained earnings are the main source of internal financing. So, there is low gearing, no interest expense, but also a strong return on equity.
5) Investment analysis
To analyse the returns and performance of a2 Milk stocks from the viewpoint of non-managerial shareholders, growth (profit in the future analysis to translate to capital gain) and income (dividends analysis) two motivations were evaluated. For growth motivation two investor ratios were calculated – Earnings per share and Price/Earnings Ratio (Table 4 in Appendix D).
EPS ratio shows the relation between the earnings and the number of shares on issue, the trend for the period 2013-2018 is positive (Graph 2 in Appendix D).
P/E ratio shows the relation between the share market value and EPS. The ratio is 67.26 (market average is 20-25), therefore there is a strong confidence in the company’s future earning power.
As for the income motivation, dividend cover and yield ratios cannot be calculated due to a2 Milk non-dividend policy. However, the dividend yield could be compared to ROE which is strong.
Overall, according to NZX Company Research (2018), ATM share price vs sector vs NZX50 was higher (Graph 3 in Appendix D). The company showed an increase of 279% in Gross Return compared to S&P/NZX 50 Return positive change of 22%. There were several price-sensitive factors contributed to such growth beside strong investor presentations and trading updates. Whilst sales were maintained in a very challenging environment for dairy products, there was a core factor caused profit increase. Growth in consumer interest in health and nutrition products resulted in greater demand for a2 Milk infant formula. In responding to this challenge and to strengthen further the relationship, the Company acquired an 8.2% shareholding in its manufacturing partner Synlait Milk in March 2017 (The a2 Milk Company, 2017).
According to external sources, a2 Milk is likely to show increase in profit and share price growth in FY18 due to its well-developed strategy (Fletcher, 2017) and strong management team (Hutching, 2017). It may also declare a special dividend in February (Gray, 2017b).
However, there are certain risks. The share price might decrease if investors are dissatisfied with the results of legal cases led by A2 Milk (Gray, 2017a). Analysts also warn that unpredictable US interest rate movements will be a key factor for international markets in 2018 (Boot, 2018). According to Deutsche Bank, key downside risks include: (1) food quality/safety issue, (2) adverse changes to Chinese regulations, (3) near-term single supply risk for infant formula, (4) management execution of growth options and/or (5) A2 Milk only medical/health benefits scientifically proven to be invalid.
a2 Milk Recommendation
a2 Milk demonstrated major improvement in all areas comparing to pcp. The profitability of the company increased, as well as its ability to meet current liabilities. Confidence level of investors is high due to a strong top management team, a2 Milk’s financial stability and a solid growth strategy. After defining positive performance and prospective of ATM, the recommendation is to buy A2 Milk shares and be a growth investor.
Table 1. ATM Profitability (‘000 NZD) – author’s calculation based on NZX Company Research (2018)
Table 2. Profitability ratios (‘000 NZD) – author’s calculation based on NZX Company Research (2018)
Table 3. Liquidity and financial gearing ratios (‘000 NZD) – author’s calculation based on NZX Company Research (2018)
Table 4. Investment ratios – author’s calculation based on NZX Company Research (2018)
Graph 1. EPS and Share Price in NZD (NZX Company Research, 2018)
Graph 2. ATM 12 Month Share Price Performance vs. Sector and S&P/NZX 50 Index (NZX Company Research, 2018)