New Zealand Professional Investment Services Firm

Forsyth Barr

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New Zealand Professional Investment Services Firm, Forsyth Barr

Equity Bottom-Up

<h2>The a2 Milk Company<br>The&nbsp;Grinch&nbsp;Stole Christmas</h2>
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<p><strong>OUTPERFORM</strong></p>
<p>The a2 Milk Company (ATM) provided a disappointing pre-Christmas update, materially downgrading FY21 guidance with a sharp and protracted decline in&nbsp;daigou&nbsp;not made up for by other channels. Since August, ATM’s cash-adjusted 12 month forward PE has contracted to ~24x, from 32x, on what we view as suppressed EPS (down ~-40%). The market now appears to be pricing some combination of (1)&nbsp;daigou&nbsp;not recovering or getting worse (geopolitical tensions and/or changed behaviour), (2) Chinese consumer demand moderating for the brand and/or (3) inventory issues. We view the issues as largely temporary (stemmed from COVID-19), with brand metrics and end demand seemingly positive, and expect growth to return from FY22. It will likely take time to rebuild market confidence.&nbsp;At current levels we see favourable risk/reward, with re-set expectations.</p>
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<h3>What's changed?&nbsp;</h3>
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<li><strong>Earnings</strong>:&nbsp;Materially lowered by -26% to -34%. FY21E forecasts near&nbsp;the bottom of&nbsp;ATM's&nbsp;guidance range.&nbsp;&nbsp;</li>
<li><strong>Target price</strong>:&nbsp;Lowered to NZ$15.50 primarily due to earnings revisions.</li>
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<h3>Guidance cut a further ~-30%; FY21 a year to forget</h3>
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<p>The magnitude of&nbsp;ATM's&nbsp;FY21 (and 1H21) guidance downgrade was a shock. Revenue is now expected to be NZ$1.40–1.55bn, -10% to -19% against the prior year. Data and anecdotes suggest the brand is still in demand by Chinese consumers and market share within channels maintained. However, the sharp decline in&nbsp;daigou&nbsp;(where ATM over-indexed), has not been made up for by other channels.&nbsp;ATM's&nbsp;update disappointed across the board, with a revenue decline for English label IF (daigou&nbsp;pressure and recent contagion into cross border&nbsp;ecommerce) while 1H21E growth in China label IF of &gt;+40% was below our forecasts, despite further market share gains and a slowdown on recent trends. The latter wasn't well explained and is only partly attributable to currency.&nbsp;Guidance is also for FY21 EBITDA margin contraction of&nbsp;-275 to -575bp; given operating de-leverage and unfavourable channel mix.</p>
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<h3>Where to from here?</h3>
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<p>There is a lot of unknowns, with recent announcements a stark reminder visibility is low and the high margin of error in earnings forecasts. ​​​​​​​​​​​​​​ATM does appear to be prioritising longer-term brand positioning and brand health, rather than short-term profit. Our base case is daigou pressure is largely temporary and it recovers slowly when daigou margins improve (to ~70% of prior levels by FY24E), and ATM continues to take market share (off what is still a low base) in Mother &amp; Baby Stores, with its China label IF. This supports a return to growth from FY22E. If we did assume no recovery in the daigou channel our DCF would fall to ~NZ$12.70, and if we assumed a further material decline, to ~NZ$11.90. The path forward is unlikely to be smooth. FY21 is not risk-free, channels to market are opaque with very limited visibility (including for management), geopolitical risk heightened and ATM credibility materially dented; hence, it will take time for any rebuild in market confidence. The company does have a large cash balance which provides the option to help market confidence with a share buyback — this is “being considered”.</p>
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<div><strong>Chelsea Leadbetter CFA</strong></div>
<div><a href="mailto:chelsea.leadbetter@forsythbarr.co.nz" target="_blank" rel="noopener">chelsea.leadbetter@<wbr>forsythbarr.co.nz</a></div>
<div>+64 4 495 5262</div>
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<div><strong>Matt Montgomerie</strong></div>
<div><a href="mailto:matt.montgomerie@forsythbarr.co.nz" target="_blank" rel="noopener">matt.montgomerie@forsythbarr.<wbr>co.nz</a></div>
<div>+64 9 368 0124</div>
</div>
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The a2 Milk Company The&nbsp;Grinch&nbsp;Stole Christmas

OUTPERFORM
The a2 Milk Company (ATM) provided a disappointing pre-Christmas update, materially downgrading FY21 guidance with a sharp and protracted decline in&nbsp;daigou&nbsp;not made up for by other channels. Since August, ATM’s cash-adjusted 12 month forward PE has contracted to ~24x, from 32x, on what we view as suppressed EPS (down ~-40%). The market now appears to be pricing some combination of (1)&nbsp;daigou&nbsp;not recovering or getting worse (geopolitical tensions and/or changed behaviour), (2) Chinese consumer demand moderating for the brand and/or (3) inventory issues. We view the issues as largely temporary (stemmed from COVID-19), with brand metrics and end demand seemingly positive, and expect growth to return from FY22. It will likely take time to rebuild market confidence.&nbsp;At current levels we see favourable risk/reward, with re-set expectations.


What's changed?&nbsp;



Earnings:&nbsp;Materially lowered by -26% to -34%. FY21E forecasts near&nbsp;the bottom of&nbsp;ATM's&nbsp;guidance range.&nbsp;&nbsp;
Target price:&nbsp;Lowered to NZ$15.50 primarily due to earnings revisions.



Guidance cut a further ~-30%; FY21 a year to forget


The magnitude of&nbsp;ATM's&nbsp;FY21 (and 1H21) guidance downgrade was a shock. Revenue is now expected to be NZ$1.40–1.55bn, -10% to -19% against the prior year. Data and anecdotes suggest the brand is still in demand by Chinese consumers and market share within channels maintained. However, the sharp decline in&nbsp;daigou&nbsp;(where ATM over-indexed), has not been made up for by other channels.&nbsp;ATM's&nbsp;update disappointed across the board, with a revenue decline for English label IF (daigou&nbsp;pressure and recent contagion into cross border&nbsp;ecommerce) while 1H21E growth in China label IF of &gt;+40% was below our forecasts, despite further market share gains and a slowdown on recent trends. The latter wasn't well explained and is only partly attributable to currency.&nbsp;Guidance is also for FY21 EBITDA margin contraction of&nbsp;-275 to -575bp; given operating de-leverage and unfavourable channel mix.


Where to from here?


There is a lot of unknowns, with recent announcements a stark reminder visibility is low and the high margin of error in earnings forecasts. ​​​​​​​​​​​​​​ATM does appear to be prioritising longer-term brand positioning and brand health, rather than short-term profit. Our base case is daigou pressure is largely temporary and it recovers slowly when daigou margins improve (to ~70% of prior levels by FY24E), and ATM continues to take market share (off what is still a low base) in Mother &amp; Baby Stores, with its China label IF. This supports a return to growth from FY22E. If we did assume no recovery in the daigou channel our DCF would fall to ~NZ$12.70, and if we assumed a further material decline, to ~NZ$11.90. The path forward is unlikely to be smooth. FY21 is not risk-free, channels to market are opaque with very limited visibility (including for management), geopolitical risk heightened and ATM credibility materially dented; hence, it will take time for any rebuild in market confidence. The company does have a large cash balance which provides the option to help market confidence with a share buyback — this is “being considered”.



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





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



The A2 Milk Company: The Grinch Stole Christmas

A2 Milk Co Ltd

The A2 Milk Company: The Grinch Stole Christmas