The A2 Milk Company: Heightened earnings risk

About the author:

Belinda Moore
Author name:
By Belinda Moore
Job title:
Senior Analyst
Date posted:
21 April 2021, 6:00 PM
Sectors Covered:
Agriculture, Food & Beverage, Travel and Chemicals

  • Channel checks suggest that trading isn’t materially improving for The A2 Milk Company (ASX:A2M).
  • We now think that its FY21 guidance looks difficult to achieve. We note that it was dependent on a significant improvement in 4Q21 vs 3Q21. We have consequently lowered our forecasts.
  • Given earnings uncertainty and the chance of another earnings downgrade, we move to a Hold recommendation.

Trading conditions remain tough

E-commerce platform pricing in China doesn’t appear to be materially improving and in Australia we have noticed that the retailers and pharmacies are discounting stock to clear aging inventory. A2M is not alone as many brands in the category are being discounted.

We have also noticed that A2M’s other nutritional sales which are more suited to the Chinese consumer (pregnancy, Manuka and Smart Nutrition products) are being discounted. This comes at a time when A2M was purposely tightening its inventory levels to drive scarcity and increase pricing.

A2M needs pricing to rise so that reseller margins improve and therefore demand for its products increase. Our industry feedback suggests that there has been no real improvement in the underlying operating environment.

A2M’s manufacturer, Synlait, recently said that visibility on A2M’s outlook and the extent of its recovery remains low over 2H21 and FY22.

Furthermore, we believe that there are structural changes being increased competition from Chinese companies such as Feihe and Junlebao which are winning market share (government has a 60% self-sufficiency target) and there is a declining birth rate in China (down 15% in 2020).

COGS pressures given rising dairy and vegetable oil prices are also a risk. FX remains a headwind.

On a positive note, A2M’s China brand metrics remain strong and we expect that its points of distribution in MBS continues to grow. With only 2.4% market share in China’s MBS channel, there is plenty of growth to be had over coming years.

The liquid milk business in both Australia and the US is also performing well albeit growth is expected to moderate in the 2H21 vs 1H21 as COVID-19 restrictions ease and there is less at home consumption.

Guidance looks difficult to achieve

In light of the above, we can’t rule out the possibility of a fourth downgrade from A2M. To us, the fact that stock is being discounted, is slow to sell and is aging, would suggest that A2M has potentially a larger inventory issue than it has previously estimated.

In our view, further stock provisions can’t be dismissed. In 1H21, a stock provision of NZ$23.3m was booked.

The company’s FY21 outlook assumed that its actions to re-activate the daigou/reseller channel delivers a significant quarter-on-quarter improvement in the 4Q21 vs the 3Q21 (cycles pantry stocking in the pcp). At this point, our channel checks would suggest that a large 4Q uplift is unlikely.

We revise our forecasts

We have reduced our FY21/22/23 NPAT forecasts by 7.1%/5.2%/4.4% respectively. Our new FY21 revenue and EBITDA forecasts of NZ$1.35bn and N$324.7m are now below implied guidance for revenue of NZ$1.4bn and EBITDA of NZ$336-364m (margin guidance was 24-26%).

We stress that forecasting A2M’s earnings is difficult given the lack of transparency in some of its channels. However we do think that consensus estimates look far too high across the forecast period.

Too much earnings uncertainty; move to Hold rating

Following forecast changes, our blended valuation has fallen (login to view). We have also applied lower multiples given we think that A2M’s growth profile will be lower in the future than what it has been pre-COVID-19.

Given earnings uncertainty, we move to a Hold recommendation. If a fourth downgrade was to emerge this would be another blow to A2M’s credibility. We would consider turning more positive once there is greater visibility that earnings have bottomed/stabilised.

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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