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Morningstar | A2’s China Market Share Aspirations Remain A-OK, with Solid Gains in 1H; FVE Up 5%. See Updated Analyst Note from 19 Feb 2019

The tremendous China growth story continued for narrow-moat a2 Milk in the first half, in line with our longer-term forecasts. But the near-term outlook exceeds our expectations. Revenue from infant formula--the key product in this geography--grew 45% versus the previous corresponding period, or pcp, as the company continued to rapidly expand distribution and gain market share. This improvement outpaces our prior full-year forecast for 27% growth. Moreover, despite management confirming our expectation for increased marketing expenses to drive lower second-half margins, full-year profitability will likely prove slightly better than we had previously forecast.

A2 estimates consolidated fiscal 2019 revenue will grow in line with first-half results of 41%, with EBITDA margins increasing to 31% to 32% from 30.7% in fiscal 2018, compared with our prior forecast for 26% top-line growth and flat margins. We lifted our fiscal 2019 EBITDA projections to NZD 404 million from NZD 354 million. But we’ve already incorporated continued market share and margin expansion into our long-term results. As such, our fair value estimate increases 4% to NZD 14.20 (a greater 5% to AUD 13.60 given a strengthening New Zealand dollar). Shares screen as fairly valued.

A key piece of our thesis is market share gains for a2 Platinum infant formula in China, and the firm did not disappoint in the first half. Management notes value market share ticked up to 5.7% from 5.1% at the end of fiscal 2018, nearly hitting our previous full-year target of 5.9%. We’re encouraged by strong execution across several selling channels despite operating in a competitive market, including minimal disruption from China’s new e-commerce laws, further expansion into the country’s mother and baby stores--to 12,500 from 10,000 only a few months ago. We still see market share climbing to 15% in China over the next 10 years, but now expect this achievement on slightly faster trajectory, reaching 6.7% in fiscal 2019.

Faster infant formula sales growth has an outsize effect on a2’s bottom line. The product made up nearly 81% of revenue in the period, up from 78% in the pcp, and formula’s high-margin profile helped to boost EBITDA margins to 35.5% from 32.7% a year ago. We expect increased marketing efforts to drive down this profitability in the second half of the fiscal year, but management now projects fiscal 2019 EBITDA margins of 31% to 32% versus a prior outlook for broadly flat performance. We had already forecast margins climbing to 34% over the next decade, which remains unchanged, but we now project EBITDA will reach 31% of sales in fiscal 2019, up from about 30% previously.

Outside of infant formula, we’re impressed by a2’s fresh milk performance in the half. Revenue for this product grew 20%, ahead of our full-year 10% forecast, with solid performance in Australia--up 11.7%--and continued distribution expansion in the U.S. Although this business line made up only 14% of consolidated revenue in the half, and an even slimmer portion of EBITDA by our estimates, continued growth of the product helps to expand a2’s brand presence. We expect further above-market annual gains, averaging high-single digits past fiscal 2019, and are encouraged that the U.S. business remains on-track to reach positive monthly EBITDA contributions in fiscal 2021, in line with previous commentary and our expectations.

The one concern we have in a2’s first-half results is poor cash conversion in the period. Free cash flow of NZD 110.5 million was only 72.4% of NZD 152.7 million NPAT, compared with 117% in the pcp and an average of about 97% over the past several years. Nonetheless, we attribute this largely to timing issues around receivables and inventory, and continue to forecast 98% cash conversion for the full year. Moreover, a2’s balance sheet remains strong, with no debt and NZD 288 million in cash on hand.