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Morningstar | A2M Updated Star Rating from 20 Sep 2018

The A2 Milk Company is set to enjoy high growth and stellar returns on invested capital, supporting our NZD 14.60 (AUD 13.30) per share fair value estimate and narrow moat rating. We also assign the firm a Standard stewardship rating. However, we assign a high uncertainty rating, which factors in a heavy exposure to Chinese infant formula demand, the potential for unfavourable scientific developments, reliance on a small number of suppliers, and intense competition from global dairy majors with vastly deeper pockets. Still, shares trade at a decent 15% discount to our valuation, suggesting the market is more than compensating for these concerns.

A2 is a New Zealand licensor and marketer of fresh milk, infant formula, and other dairy products that lack the A1 beta-casein protein. Dairy cows naturally produce two beta-casein proteins in their milk: A1 and A2. A2 milk is produced by cows that naturally produce milk only containing the A2 protein. The A2 Milk Company asserts that milk with only the A2 protein may positively affect digestive function.

Consumers have flocked to A2 Milk as a result of this perceived health benefit, with the firm expanding market share in Australian fresh milk, as well as infant formula in both Australia and China following the launch of A2 Platinum in 2013. These gains have occurred alongside A2’s premium price points. In Australia, A2 Milk is typically double the price of private-label offerings, while A2 Platinum enjoys higher pricing in Australia versus other leading brands, as well as price points above mainstream local infant formula manufacturers in China.

We estimate China makes up more than 80% of A2’s earnings, given strong consumer appetite for foreign infant formula brands and their high margins. We think A2 can continue to increase market share in China, supporting our forecast for 20% annual EPS growth over the next 10 years and justifying the lofty 40.6 price/forward earnings multiple our valuation implies.

In China, we expect A2 to enjoy about a point of market share gain annually, on average, to 15% over the next 10 years, owing to further acceptance and demand for A1-protein-free milk, alongside average price gains in line with competitors. Although we expect a falling birth rate in the country--stemming from demographic shifts that will lead to a declining population of women of childbearing age--to drive 3%-4% annual volume declines for infant formula sales, we forecast a continued consumer shift toward foreign brands to drive higher revenue per volume, and high-single-digit growth for overall value in the market. We see A2 growing revenue in this geography at a 20% annual clip through fiscal 2028, with Chinese infant formula climbing to more than 90% of the company’s consolidated EBITDA from about 80% today.

A2’s premium pricing affords it lofty profitability versus other dairy producers. The firm’s operating margins have rocketed to north of 30% from less than 1% in fiscal 2015, compared with midteens at Nestle, Danone, and Bellamy’s. We attribute the improved profitability primarily to mix shift, as infant formula generates higher margins than other dairy products. We estimate that infant formula made up nearly 90% of A2’s EBITDA in fiscal 2018, compared with just 7.5% for fresh milk and about 3% for other dairy. We see a ceiling to A2’s profitability upside, however, with more-limited benefits from positive mix shift going forward and increasing marketing spending offsetting positive fixed cost leverage and rising prices, leading to operating margins ticking up only 5 percentage points over the next decade, to about 35%.

Nonetheless, along with strong profitability, A2 Milk’s business strategy supports sky-high returns on invested capital. The company does not produce its own milk, but instead contracts with local dairy farmers or third-party producers to produce milk from genetically tested cows that do not produce the A1 protein. This milk is processed at A2-owned sites for fresh milk in Australia, but is otherwise sourced and produced by New Zealand company Synlait (of which A2 also owns a 17.4% share) for infant formula in Australia, New Zealand, and China; by Fonterra--under a recently signed agreement--for dairy in potential growth markets; and by third-party partners in the U.S. and U.K.

We assign A2’s management a Standard stewardship rating. The company has enjoyed massive growth and sky-high returns on invested capital since launching A2 Platinum, but new CEO Jayne Hrdlicka must allocate substantial growth in free cash flow while also managing a new supplier in Fonterra and continued sizeable competition.

Despite solid growth opportunities, A2 faces several risks. Foremost is the perceived health advantages of A1-protein-free milk. Although we think the A2 brand carries with it a mark of consumer trust, particularly in China, given past infant formula quality scares, scientific developments that call into question the actual benefit of drinking A2-only milk could drive down the company’s price premium. Moreover, A2 operates in an increasingly competitive market. The firm’s patent portfolio on genetic testing and other A2-only milk development has begun to expire, and while A2 still holds several protections on commercialisation and messaging, Nestle recently launched Atwo, a competing infant formula, in China. Moreover, A2’s reliance on a handful of suppliers could lead to limited availability in high-growth periods, or the potential for occasional price hikes.

Supplier concentration is another key risk. SynLait has proven highly capable to date, keeping up with more than 180% compound annual growth in infant formula since 2014, and gaining Chinese Food and Drug Administration approval for imported product in 2017. The relationship was extended in mid-2018 until 2023, suggesting both parties are happy with the arrangement. However, risk remains that SynLait’s future supply of A1-protein-free milk could become constrained, or that the firm could lift prices at a faster clip. To diversify, A2 has signed an agreement with fellow New Zealand milk producer Fonterra for fresh milk in New Zealand, as well as infant formula and other dairy products in future geographies. But there’s also a risk that volume growth may prove lower than anticipated, which could lead to oversupply in the market, price discounting by distributors, and pressure from suppliers who would feel a pinch after making sizable capital investments to support A2. We anticipate A2 Milk’s margins would suffer in such a scenario, owing to more-limited pricing power and likely higher costs to prop up its supply base.

But overall, we see ROICs averaging a stellar 313% over the next five years, owing to A2’s capital-light business model, and expect strong free cash flow averaging nearly 100% of net profit after tax. We assign a narrow moat to A2, and with a debt-free balance sheet, we expect A2 can invest in new products and geographic expansion. We don’t assign a wide moat to the firm, however, given the competitive pressures of the industry, uncertainty around future scientific developments, and potential regulatory responses from China or elsewhere.