New Zealand Professional Investment Services Firm

Forsyth Barr

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New Zealand Professional Investment Services Firm, Forsyth Barr

Equity Bottom-Up

The a2 Milk Company An Udder Downgrade

NEUTRAL
The a2 Milk Company (ATM) downgraded FY21 guidance for the fourth time since September 2020, with no signs of a turnaround in well-signalled issues, meaning ATM is taking greater corrective action at the expense of short-term profit. ATM has a number of redeeming features, including strong free cashflow, attractive returns, a highly-regarded brand and optionality provided by a net cash position. However, the substantial re-basing of earnings and feasible future growth has been rapid and painful. Opaque/complex channels to market, an increasingly difficult macro backdrop and a strategy review amplify the near-term uncertainty. Any signs of a stabilisation in infant formula (IF) revenue and/or return to growth could be a positive catalyst, however, we think this is still some time away. NEUTRAL.


What's changed?&nbsp;



Earnings:&nbsp;Medium-term underlying EBITDA lowered -25% to -35%, with FY21E magnified by inventory provisioning.
Target price:&nbsp;Lowered to NZ$7.50 (-32%), consistent with longer-term earnings cuts.



Key points of interest



Market share broadly stable:&nbsp;The issue has been the rapid shift in mix, away from channels where ATM over-indexed historically.
English label IF pressures haven't abated:&nbsp;9m21 revenue is down -48%, retail prices still suppressed, inventory elevated and the retail&nbsp;daigou&nbsp;market (previously ~NZ$250m revenue for ATM) is now near non-existent. These are not new issues&nbsp;but continue to take longer than expected to alleviate. Further changes are being made,&nbsp;however&nbsp;any turnaround will take time and structural changes mean it is unlikely to return to prior highs. We assume a medium-term recovery for&nbsp;daigou&nbsp;to ~70% of pre COVID&nbsp;levels.&nbsp;
China label IF growth slowing:&nbsp;This was a key negative surprise to us.&nbsp;3Q21 revenue growth of +5% is a marked slowdown from +45% in 1H21, not helped by excess inventory which ATM is proactively managing (a new issue). ATM appears increasingly&nbsp;focussed&nbsp;on this channel for future growth. We still see runway for market share gain&nbsp;and a return to strong growth, however,&nbsp;this is likely to be materially below levels achieved historically and requires a step-up in marketing spend.
Inventory issues continue:&nbsp;Corrective measures are being amplified to address excess inventory&nbsp;and aged stock&nbsp;through the supply chain in English label and Stage 1 China label IF. This includes&nbsp;swapping aged product with fresher product, stock write-offs and materially slowing sales to the channel. Changes are sensible, albeit arguably should have occurred earlier, with the removal of excess supply important to return product scarcity (a key success driver historically) and improve channel pricing.&nbsp;ATM expects to action changes in 4Q21 and some of 1Q22, however, there is risk it takes longer to address.&nbsp;
Challenging macro backdrop:&nbsp;Like its competitors, ATM also referenced a more difficult industry backdrop primarily due to (1) lower birth rates, down -15% in 2020 with a risk that this gets worse in the short-term, and (2) increased competitive intensity.
Valuation:&nbsp;Using our revised forecasts,&nbsp;ATM is trading on a cash-adjusted 12m forward PE of ~21x, or ~19x also adjusting for US losses. This is largely consistent with the NZ market median and we see risk/reward as broadly balanced.




Chelsea Leadbetter, CFA
chelsea.leadbetter@forsythbarr.co.nz
+64 4 495 5262





Matt Montgomerie
matt.montgomerie@forsythbarr.co.nz
+64 9 368 0124



A2 Milk Co Ltd

The A2 Milk Company: An Udder Downgrade