My first write-up will be about A2 Milk. 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 Zealand.
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 (https://www.medicalnewstoday.com/articles/318577#Risks-of-A2-milk)
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 market 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 take 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, to produce A2 Milk's infant nutrition, 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 20-35% 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., because of a milk scandal that occurred in 2018 which let consumers to lose trust in local brands.(https://en.wikipedia.org/wiki/2008_Chinese_milk_scandal#:~:text=The%202008%20Chinese%20milk%20scandal,components%20being%20adulterated%20with%20melamine)
As stated earlier, a study was published which backed the finding of health benefits. Whereas there's no clear evidence or official research that indicates that A2 protein is superior to A1.
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:
https://patents.justia.com/assignee/a2-corporation-limited
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 that's why 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 (~$7.4 million). Other board members have in total a value of ~$12.6 million in the company with the CEO of the pacific region, increasing his stake recently with 181% to $8.7 million and a director dubbeling his stake to $2.8 million. 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. The other CEO Geoff Babidge who came back after Jayne stepped down, earned ~A$900.000 a year which is a reasonable 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
- CBEC and daigou and retail channel not impacted anymore by covid. Sales will growth at 20+% again.
- Partnership with a global distributor to strengthen their international position.
- Continued high growth of infant nutrition in China.
- Potentially: study that indicates that A2 protein is superior for health benefits to A1.
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, because I believe they are capable to get a strong brand. 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 20% margin of safety. This would result in a 18% 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% per year.
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 $6.7 billion and a 30% margin of safety and a return on investment of 20% per year.
Huge differences in valuation is explained by the large discount rate used.
Thanks for reading! I hope this write-up has helped you, but this is no investment advice and always do your own diligence. Let me know what you think about this write-up so I could improve my future write-ups.
P.S. I find it difficult to value companies, so don't take the 'Current Valuation' part too serious.
Update: I'M OUT. For the future, they basically rely on their brand and I'm not certain whether they are able to sell their products at a significant premium in the future as well. And there are several other interesting opportunities that I think are more lucrative.