The A2 Milk Company: Big job still to be done

About the author:

Belinda Moore
Author name:
By Belinda Moore
Job title:
Senior Analyst
Date posted:
10 May 2021, 2:30 PM
Sectors Covered:
Agriculture, Food & Beverage, Travel and Chemicals

  • A2 Milk Company's (ASX:A2M) downgrade didn’t come as a surprise given our channel checks suggested that trading wasn’t improving. However, the quantum of the downgrade did and it has includes another large stock provision.
  • The actions A2M has been making to improve pricing, sales and inventory levels, have clearly not worked. More aggressive strategies are now in place.
  • While uncertainty remains given the lack of transparency in some of A2M’s channels, earnings growth is targeted in FY22. We note that a reversal of stock provisions alone would underpin significant earnings growth.
  • While A2M is potentially nearing the worst of it, given earnings uncertainty remains and trading on a relatively full valuation (FY22 PE of 26.2x and a premium to peers), we maintain a Hold rating with a new price target (login to view).

4th downgrade to FY21 – now 59-61% below last EBITDA guidance

FY21 revenue guidance has been revised by 11-14% to NZ$1.2-1.25bn (down 28-31% yoy). The revision to the group’s February update reflects the impact of lower than expected 4Q21 sales and further actions to rebalance the channel (i.e. reduce sales) in May/June.

Disappointingly, the one area that was performing strongly (1H21 sales +45% on pcp), MBS China label sales, has slowed materially and there is now excess inventory in this channel.

A2M’s EBITDA margin guidance has been materially lowered to 11-12% (excluding MVM transaction costs) compared to 24-26% previously. Margin guidance now implies FY21 EBITDA of NZ$132-150m, down 73-76% on the pcp.

The mid-point of guidance implies a 2H21 EBITDA loss of NZ$42.1m. The materially lower than expected margin guidance reflects the combination of the lower sales, as well as a stock provision of NZ$80-90m (in addition to the NZ$23.3m recognised in 1H21) and one-off costs of NZ$8m associated with implementing its new ERP system.

A2M will also increase its level of marketing in 4Q21 and FY22 to help drive increased consumer demand.

Too much inventory out there

A2M’s has too much inventory in its relevant channels. Consequently, the company is now taking more aggressive measures to fix its business.

Not only is A2M replacing new IF tins for old tins which are nearing their used by date, it is also rebalancing inventory by further reducing sell-in to the daigou/reseller and CBEC channels. Consequently, a stock provision of NZ$103.3-113.3m will be recorded in FY21.

The question is whether this write-off is enough and what damage it does to brand health metrics. A2M cautioned it will take some time to rebalance inventory and restore channel health and an immediate recovery is not expected.

A2M highlighted that if the one-off charges and sales reductions to reduce inventory in the trade were backed out of this year, it would have had revenue of ~NZ$1.3bn with an EBITDA margin in the low to mid-twenties. We have used this as a base for our FY22 earnings forecast and note that there are both downside and upside risks to this view.

We make material revisions to our forecasts; uncertainty remains

We have reduced our FY21/22/23 NPAT forecasts by 57.5%/26.0%/25.5%. In FY22, we forecast 100% NPAT growth however we stress that a large component of this growth reflects a reversal of the FY21 provision and one-off items.

While we expect earnings growth to resume at A2M from FY22 onwards, we forecast it to be much less than in the past reflecting regulatory changes and border restrictions impacting the daigou, China’s declining birth rate and increased competition from Chinese companies (government has a 60% self-sufficiency target).

Post funding MVM, we forecast A2M to finish FY21 with NZ$585.6m of net cash.

While the Board is considering capital management, given the future capital requirements with MVM and to maintain a conservative balance sheet due to near term uncertainty, we would be surprised if A2M bought back more than 5% of its issued capital. Our valuation has fallen from A$8.34 (login to view).

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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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