A2 Milk the Cream of the Crop; Initiating With Narrow Moat and NZD 14.60 (AUD 13.30) FVE

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Equity Bottom-Up

<div class="content-highlight"><h2>Looking past the near-term risks to reap the high growth opportunities of the Chinese infant formula market.</h2></div><hr><p>Concerns over increasing infant formula competition and upcoming e-commerce law changes in China have driven down narrow-moat <a href="https://www.smartkarma.com/entities/22775" target="_blank" data-smartkarma-citation="entities:22775:1">A2 Milk Co Ltd (A2M AU)</a>'s share price nearly 20% over the past three months. While we see potential short-term volatility from these factors, we remain confident in the company's long-run growth potential in Chinese infant formula. This market is critical for a2; despite the company reporting only 23% of revenue from the geography, we estimate that adding indirect sales leads to more than 70% of revenue and nearly 80% of underlying EBITDA stemming from the country. With our forecast for high single-digit end-market growth and substantial market share gains for a2, driven by the firm's strong brand intangible assets, we expect earnings per share to grow at a 26% CAGR through fiscal 2023, justifying our NZD 13.70 (AUD 12.90) fair value estimate and resulting lofty 41.5 forward price/earnings ratio.</p><h2>Key Takeaways</h2><ul>
<li>A2's success relies on its large and highly profitable Chinese infant formula business. We see high single-digit growth for this end market, and continued market share opportunities for a2 leading to 18.5% yearly top-line gains for the company.</li>
<li>Infant formula offers higher margins for a2, and despite the higher marketing spending necessary for brand-building in China, we see some EBIT profitability improvement in coming years, with margins climbing to 34% in fiscal 2028 from about 30% in fiscal 2018.</li>
<li>Several short-term factors, including uncertainty around changing Chinese e-commerce laws and new competition, have added to the long-run risks which already surround a2. But we believe the market has overly incorporated these issues, even after a solid early start to fiscal 2019 reflected at the company's recent annual general meeting, offering a solid margin of safety for investors.</li>
</ul><p><em>Analyst: Adam Fleck, CFA</em></p>

Looking past the near-term risks to reap the high growth opportunities of the Chinese infant formula market.Concerns over increasing infant formula competition and upcoming e-commerce law changes in China have driven down narrow-moat A2 Milk Co Ltd (A2M AU)'s share price nearly 20% over the past three months. While we see potential short-term volatility from these factors, we remain confident in the company's long-run growth potential in Chinese infant formula. This market is critical for a2; despite the company reporting only 23% of revenue from the geography, we estimate that adding indirect sales leads to more than 70% of revenue and nearly 80% of underlying EBITDA stemming from the country. With our forecast for high single-digit end-market growth and substantial market share gains for a2, driven by the firm's strong brand intangible assets, we expect earnings per share to grow at a 26% CAGR through fiscal 2023, justifying our NZD 13.70 (AUD 12.90) fair value estimate and resulting lofty 41.5 forward price/earnings ratio.Key Takeaways
A2's success relies on its large and highly profitable Chinese infant formula business. We see high single-digit growth for this end market, and continued market share opportunities for a2 leading to 18.5% yearly top-line gains for the company.
Infant formula offers higher margins for a2, and despite the higher marketing spending necessary for brand-building in China, we see some EBIT profitability improvement in coming years, with margins climbing to 34% in fiscal 2028 from about 30% in fiscal 2018.
Several short-term factors, including uncertainty around changing Chinese e-commerce laws and new competition, have added to the long-run risks which already surround a2. But we believe the market has overly incorporated these issues, even after a solid early start to fiscal 2019 reflected at the company's recent annual general meeting, offering a solid margin of safety for investors.
Analyst: Adam Fleck, CFA

Inner Mongolia Yili Industrial Group (A) (600887 CH)

The Market's Souring on A2 Milk Offers a Sweet Deal for Investors