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A2 Milk (ASX: A2M, NZX: ATM)- Track to Run on and Downside Protected

This is the first part in our analysis of A2 Milk where we see good upside and satisfactory downside protection. In this Part we provide an analysis of the industry drivers and company, Part 2 will present our valuation and recommendation.

A2 Milk Company Overview

The A2 Milk Company (ATM) is in the business of producing, marketing and selling premium branded dairy nutritional products in targeted global markets. It is a single-minded company focusing on A2 protein which is designed to be easier to digest and healthier relative to other cow’s milk in the market.

Despite Australia’s large and mature milk market, ATM have achieved significant success. ATM is the leading premium fresh milk brand in Australian supermarkets, with a grocery value market share of approximately 9.3%. a2 Platinum continues to be the fastest growing infant formula brand as of 2017, with market share increasing from ~16% to ~26%.

Group Strategy

As seen from the summary of ATM’s strategy above, it is evident that ATM is currently trying to expand its presence in APAC and the USA. ATM is still earning negative profits in UK and USA. This would explain ATM’s decision to increase marketing investment in USA as they intend to increase their presence in the region.

However, whether it would be better to increase investments/expansions into the US region as compared to using the amount for expansions in APAC is another factor to consider. In my opinion, it would be better to focus on its expansion in APAC instead of expanding in the US market given the lack of brand awareness and huge potential in the APAC region. Furthermore, if they choose to expand rapidly in the APAC region (which they are doing now), ATM would be able to leverage on its first-mover advantage and gain market share in the region.

ATM is also set to launch its pregnancy formula which is good news for investors. Given its popular demand among moms (as seen from the success of its infant formula), the pregnancy formula would be an interesting development for ATM.

Earnings Review

Financial Summary for FY17

Operating results have been strong for ATM with group revenue growth of +56% on pcp with a2 Platinum infant formula revenue +84%. The gross margin primarily reflects increased contribution from infant formula sales and lower infant COGS in FY17. As seen, ATM has grown tremendously over the years and is expected to grow even more with its entry into new markets like Hong Kong and Korea. Furthermore, operational efficiency has not been overlooked with its EBITDA margin increasing from 15.3% in 2016 to 26% in 2017.

Key Updates in 2017: UK segment achieved first annual operating profit, launch of platinum infant formula in Hong Kong, launch of Australian fresh milk into Singapore

ROA: 34.4%

ROE: 53.1%

Sector average for ROA and ROE is 11.8% and 20.6% respectively. This clearly indicates the effectiveness of ATM’s management when it comes to utilising its assets and investments from various investors.

The high ROE also serves as a bullish signal as to why an investor should invest in ATM. ROE has increased from 8.5% in 2013 to 53.15% in 2017 showing strong growth throughout the years for ATM.

Liabilities to Assets

Ratio: 28%

Current Ratio: 2.6x

Given that ATM is currently in the growth stage, one would expect ATM to be highly leveraged with its expansion in SEA.

However, looking at its leverage ratios, ATM is in a strong financial position with its current ratio improving from 3.8x to 2.8x.

While its liabilities to assets ratio has increased from 17.2% in 2013, this is not a cause for concern since the increase is due to an increase in accounts payable rather than an increase in debt.

Financial Summary for 1H18

The period of 1H18 is positive for ATM with strong top line growth derived from improved distribution, brand awareness and increased market share. Group EBITDA and EBITDA margin has increased tremendously over the years. EBITDA of $143m was 27% ahead of estimates by Macquarie.

Something to note would be an announced increase in marketing expense in 2H18 by $25-40m as ATM looks to expand/increase its market share in China and USA. However, this is not a cause for concern as it is more of an investment where the company would be able to derive revenue benefits in FY19 onwards.

Key updates in 1H18: Strategic relationship with Fonterra, entrance into Korea market, whole milk powder introduced into Vietnam, development of pregnancy formula

Industry Outlook

GDP Growth

Source: Euromonitor International

According to a report by Euromonitor, GDP growth is a major growth driver globally in baby food, particularly in Asia Pacific, where GDP growth is forecast to continue outpacing the global average, and therefore likely to have a greater positive impact on baby food sales.

Asia Pacific is forecasted to grow by approximately 5.5 % by IMF and is expected to remain strong. This is further substantiated by China’s One Belt One Road Initiative which offers tremendous economic opportunities in the Asia Pacific region.

In the Asia Pacific region, Australia’s GDP has been below expectation for 2017 and a slower jobs growth was observed. However, analyst feel that the slower jobs growth in recent months is probably more about statistical payback after a year of crackerjack jobs growth rather than something more sinister like a sudden tanking of the current underlying strength in the labour market conditions.

Linking the outlook to the impact on ATM, given that the main bulk of their revenue stream is derived from the Asia Pacific region, the rising GDP is definitely in their favour as consumers would tend to go towards premium products. The effect can no doubt be seen in ATM’s current financial position where their revenue soars during periods of strong GDP growth.

Rise in Female Employment

Source: Euromonitor International

According to a report by Euromonitor, a correlation between female employment rates and milk formula consumption per infant is apparent. In most large emerging markets in Asia Pacific a high proportion of female adult population in employment correlates with high milk formula sales. By contrast, in India, and in most markets in the Middle East and Africa, low participation of women in the workforce is accompanied by low milk formula consumption. A rise in female employment is forecast to lead to increased milk formula sales. This contributes to the prevalence of infant milk formula sales in key emerging markets in Asia, notably Indonesia, Thailand and Vietnam.

Source: International Labour Office: World Employment Social Outlook

In 2014, G20 leaders committed to the “25 by 25” target to reduce the gap in participation rates between men and women by 25% by 2025. Furthermore, looking at the table above, labour participation rate of females in Asia Pacific remains one of the highest throughout the entire world. This bodes well for ATM as this would result in higher infant formula sales leading to greater growth. Infant formula sales contribute to 78% of ATM’s 1H18 revenue and will continue to be a significant portion of ATM’s business.

Population Growth Rate/Birth Rate

A growing birth rate and population growth rate is beneficial for the infant formula sector since it would lead to a greater consumer base. World population growth will continue to slow down in 2015-2030 due to the declining rate of natural change. While the world’s population is ageing rapidly due to increasing life expectancy and falling births rates, nearly half will be aged 30 years and under in 2030.

Source: Euromonitor International

Birth rates have been forecasted to fall over time globally. Looking at the data provided by Euromonitor, birth rates in Asia Pacific are experiencing a steeper decline as compared to the ones in Australasia. This could be a result of the increasing female employment trend where women are more career focused now as compared to the earlier days. With an increase in female employment, they will tend to focus more on their careers especially in the early stage of their career. This will hence result in a falling birth rate over time.

Like other world regions the birth rate in Australasia will decline in 2015-2030, from 12.9 births per ‘000 in 2015 to 11.7 in 2030, significantly lower than 15.4 in 1980. However, the birth rate will be higher than that of the European regions and North America in 2015-2030. Despite the falling birth rate, the number of live births will continue to rise every year in 2015-2030 from 366,400 in 2015 to 411,300 in 2030.

Asia Pacific had the third highest birth rate out of world regions in 2015 after Middle East & Africa and Latin America, by 2030 it will be joint second with Latin America.

Source: Euromonitor International

Looking at the data provided by the United Nation Statistics Division, aside from Middle East & Africa, Australasia and Asia Pacific are in the top 3 in terms of the growth index. These would indicate strong growth potential in the geographical markets for baby food i.e. infant formula as compared to the other regions.

Looking at China, the most populated country in the world, they have recently updated their policies to increase its population. The famed one-child policy in China has now been changed to a two-child policy allowing all families to have two children. However, the birth-rate in China fell in 2017 despite the country easing its family planning policies and allowing all couples to have two children, reflecting the stresses of urban life. There were 17.2 million births in the country last year, down from 17.9 million in 2016.

Currently, more focus should be placed on how China’s policies will pan out with their recent scrapping of the commission responsible for administering the two-child policy. This would have a strong impact on ATM’s growth given its current expansion and competition in China. Furthermore, China’s large population base which would be beneficial to any company expanding in the region.

Conclusion

ATM is currently looking into expanding in the APAC region which is positive for investors given its current success there. With the strong 1H18 results that ATM has shown, they are expected to continue growing rapidly in terms of revenue with release of its pregnancy formula. Furthermore, increasing GDP and female employment in the APAC region will no doubt boost the growth of ATM. However, declining global birth rates is something which might harm the future revenue growth for ATM. ATM would need to venture into new markets and boost its revenue in liquid milk to ensure sustainability.

 



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