Tag: The a2 Milk Company Limited (NZX:ATM & ASX:A2M)

After listening to the recent Investor Call, and reading the Updated FY21 Outlook, I still feel unequipped to value ATM shares.

Despite recent COVID19 setbacks ATM is still a growth company and therefore should be valued based on forward earnings. However I don’t feel confident in the numbers provided in the updated outlook for FY21, because I felt that I picked up a little contradition between Geoff and Peter in the investor call, with regard to H2 speculation in the updated figures. This is not a slight against the directors, rather a comment on the fact that it’s all a bit of a guess on something that’s out of ATM’s scope of control.

Therefore any number I place on the value of ATM would be a guess. That said, lets look at the market’s guess on the value and see what assumptions might give rise to such a guess.

The current share price is basically exactly as it was this time last year (albeit slightly higher). Clearly the market pricing is based on statements in guidance that there will be no revenue growth – and assumptions have been made that there is no revenue decline.

Looking further ahead, ATM’s sales infrastructure isn’t damaged (other than the current, temporary Daigou situation). One could expect that growth should be quite significant once COVID19 issues are gone. This probably explains the slight upside on last year’s price.

So, is ATM a buy right now?

Well it’s a bit of a gamble on whether COVID19 will be cleared up (in Australia) by the end of H1 or early H2. Personally I’ve found that when I’ve gambled in the past, it’s always caused me to underperform my average and I’m better off trusting my calculations. Consequently I probably won’t be increasing my holding at this reduced price – but I certainly won’t be selling.

My current strategy is to hold, and wait to see if the existing sales channels that ATM have established ensure a fast recovery in sales once everything finally clears up (this year or next!). However, my position is somewhat hedged by my holding in FPH, which massively benefits from the COVID19 situation. Given that, I may buy more ATM shares if the price falls on news (good or bad), announcements are made that suggest that things are improving and if the price remains static, or if the COVID19 situation in Australia seems to be improving before H2.

Update

After having a bit of time to think about it, given the fervor from ATM’s investors and the fact that they should return to a similar size of sales after COVID19 issues are resolved, I expect that the share price should steadily creep upwards from it’s recent lows. In the event that things become more dire in Australia (in terms of a sustained lockdown), I expect the share price will dwindle and then return towards following the same pattern.

First of all, my apologies for not writing sooner, I’ve been knocked out with a doozy of a cold shortly after writing my last article. I’m still sick, but wanted to get this article done before the automated mailer goes out to my subscribers today at 13:00.

Lewis Hurst

Twelve days ago I wrote an article speculating why a2 Milk’s share price fell after a great results announcement. In the article, I speculated that investors could be hedging against risks that China had started blocking imports or that there were quality issues extending beyond what was said in the annual shareholder meeting, but ended up concluding that “…there is an element of pure market force in the ATM share price…”, and even if there were quality issues things would be back to normal soon. As a result, I topped up my ATM holding, which I stated at the end of the article.

After more consideration and research, I think I might have got to the bottom of why the share price fell. It’s something that’s been plastered all over various sharetrading forums, but something I was nervous to accept due to the timing of other events.

In short, I believe that the share price fell because insiders were selling, and this (and nothing else) spooked investors and created market forces pushing the price down.

The reason I say that, is because looking back at historical records, the share price always falls around this time, which is always after insiders start selling, and they always start selling after the results announcement, which was always a good announcement.

I feel almost embarrassed by the simplicity of this and not drawing this conclusion earlier, but the timing of the news of quality issues was too compelling. Specifically, if a director wanted to weasel his way out of a shareholding at the peak of the share price because there was an impending business destroying event, that’d be the best way to do it – give a great results announcement, sneak the news in at the end (to fulfill the legal obligations of not trading on undeclared inside knowledge), then sell like crazy.

I don’t believe this is the case, because selling is in line with prior year’s selling, and the share price has dropped with respect to the selling in those years.

Why do they sell each year? Well, I guess that’s their business. I imagine they’ll have tax obligations that they can’t afford because of their share options / allocations from incentive programs. I imagine that the prospect of grabbing the money as close to the value that is allocated to them (which I guess they’re taxed on?) reduces the risk of not being able to afford the tax bill if a black swan event causes them to have to sell at a lower rate later in the year. I imagine that the prospect of having too large a percentage of their personal financial portfolio’s in ATM would also not be preferable for them… And of course, the prospect of getting the money would probably also entice.

So, what I have done about it? Well, I’ve written an email to a2 Milk on Friday (6 days ago) to confirm that the issue of milk quality isn’t a large issue and to see how they’re dealing with it. They have not responded, which is a bit of a governance issue and a little frustrating, but I feel more confident than I did last week that I understand the reasons for the drop in share price, so I took the opportunity to top up. Going forward, I expect that I will do so each year to take advantage of the directors selling (following analysis of the results, of course).

A2 Milk’s share price fell by up to 7% in the day after announcing an NPAT of $385.8 ($6.2m or just 1.6% less than my most recent prediction). As a 34.1% increase on last year, this is undeniably an impressive result. So why did the share price fall?

I have a couple of ideas on what caused the share price to fall. The first is a little sinister, while the second is more benign.

Is China Blocking Imports?

A recent post on Sharetrader.co.nz by user 44wishlists brought some interesting articles to my attention. The articles stated that:

It’s possible that this could be the cause of the fall in share price. $10m in itself isn’t a big number against normal annual growth or NPAT, but the concern for me is that either:

• China is charging ahead with its goals to be the biggest producer of its own infant formula, and is using its favorite method of blocking trade, which is to hold imports up in customs due to fictitious or unrealistic requirements.
• There is a quality problem with the product.

Both possibilities are concerning, but I think that it’s probably unlikely that China is holding things up unreasonably because the populace need food. It’s more likely that (as stated in the article and at the presentation) the quality was within the standards agreed with the manufacturer, but not up to the Chinese import standard.

This is worrying for a few reasons. The fact that the news is a recent development causes uncertainty. Questions come to mind such as whether this will be an issue going forward, how much stock in the pipeline is affected, can the issue be fixed and at what cost, and whether a2 Milk are contractually obliged to keep buying the milk from the supplier even though they can’t sell it.

Are We Seeing Normal Market Behaviour?

Given the massive percentage increase in NPAT, it’s possible that the drop in share price is just normal market behavior.

The difference of just a few percentage points in growth can make a massive difference to the value of a company over the period of 5 years. Compare a compound growth graph showing 7% annual growth vs 9% and you’ll see the result is significantly different over a long period. This creates two factors that result in wildly different valuations:

• Firstly, as any discrepancy in estimated growth is magnified and discrepancies are bigger in bigger numbers, this causes big discrepancies in valuations.
• Secondly, depending on your investment timeframe, very large compounding growth over the years makes a very different result on the final calculation of ROI. As different investors have different timeframes of investment return, this creates a difference in valuation.

Therefore, I think there is an element of pure market force in the ATM share price. That said, given that the ATM share price is not too far from my own valuations (the methodology to calculate this is shared on this website), I feel that it’s more likely that not all shareholders were aware of the issues with getting milk to customers in China, and the fall in share price is probably a reaction to this news.

How significant this situation will be in the future is anyone’s guess at this stage, though certainly it felt downplayed during the presentation.

My current view is that a2 Milk’s suppliers will be forced to meet the new standards at their cost, otherwise they won’t be able to sell their milk after any existing contracts expire. Given this, they would likely want to fix this asap because the success of a2 Milk is in the suppliers interests if they wish to keep trading. Therefore, even if this costs a bunch of money and delays sales, it’s likely only a setback for part of this year, and therefore won’t impact long term holders too much (though the share price should definitely reflect this issue if it turns out to be greater than the $5m to $10m stated in the presentation).

On this logic, I took advantage of the price drop and topped up my holding, though admittedly I didn’t get the lowest price and I suspect there may be better buying opportunities to come. However, I’m not a trader so I don’t need to get the best price because the price I paid was close enough to my valuation to be acceptable.

It’s been a while since I ran the numbers on ATM and declared it as a good buy. The Market Capitalisation (MC) has since increased, and with the dwindling share price over the last couple of days I thought that it’s probably time to do a price check on a2 Milk to see if it’s still a buy, given todays share price.

Over all, the ATM share price has gone up since I last analysed ATM’s 1H20 (1st Half of 2020) result on the 4th of April, and the MC now sits at $15,418m. Since that date, there has also been a trading update and FY20 Outlook been published. This gives me the opportunity to fill in some blanks and update my speculation based on the guidance provided.

There is no guidance on FY20 NPAT (which is my prefered number to measure value on), so I will have to guestimate this based on the number we do have in the FY20 Outlook.

Based on the 1H20 result, I previously estimated that annual NPAT for FY20 would be $370m (double 1H20 NPAT). Applying the same logic to the 1H20 revenue, one can extrapolate that I had expected FY20 revenue to be ~$1,600m. The new guidance states that due to a number of factors in ATM’s favour, guidance is ahead of their previous predictions and now sits at $1,700m with an EBITDA margin of 31% to 32%.

I’m not feeling in the mood to dig around to try to guesstimate their EBITDA to NPAT ratio, so I’ll assume that NPAT is 23% of revenue (based on the 1H20 results of ~$185m NPAT to ~$807m revenue).

If we say that FY20 NPAT is 23% of $1,700m revenue, that gives a figure of $391m. Based on my last guess of $370m NPAT and adding 23% of the additional $100m revenue ($1,700 from the FY20 Outlook, minus my estimate of $1,600m) that gives an estimated NPAT of $393m ($370m + $23m). Both methods line up pretty well, so I have a high level of confidence in my guess of NPAT against revenue, which I can use in my modelling.

However, there is some other news that will affect NPAT since my last analysis. ATM have been looking into acquiring a manufacturing facility. For the purpose of modelling, I will ignore this because I have no guarantee that it will happen, no way to model return and I’m happy to assume that such a purchase would be earnings acreditive (otherwise they wouldn’t do it) and therefore any reduction in NPAT would simply be shareholder value in another form.

So, given an NPAT of $392m (splitting the difference between my two NPAT calculations of $391m and $393m), and a current MC of $15,418 minus cash in the bank (let’s assume the $620m from 1H20 + $80m for the quarter [annual NPAT divided by 4]), that gives a ratio of 37.5 for a company growing at a rate of 20% pa.

I now consider a2 Milk to be slightly expensive. I expect this new pricing has come about since ATM’s inclusion into the S&P/ASX50 Index. My preference would be to see these priced closer to $19.50 per share to be in my buying range, though no doubt they will increase in value over time, I just feel that they are currently slightly overpriced for the return I would have liked to see.

Throughout May, the a2 Milk share price has had somewhat of a downward trend. I would like to offer my opinion about why that is.

Certainly the prospect of global recession from the COVID19 black swan doesn’t help the price of stocks, nor does the political turmoil between China and… well, just about everybody, really. But it is my opinion that, despite these malfeasant influences on the stock market, Chinese parents still want to buy high quality milk that is safe and healthy for their babies. What parent wouldn’t? It is therefore my belief that there is another factor that is responsible the general fall in the a2 Milk share price in May 2020.

That factor is the value of the Chinese Yuan (RMB) against the USD. It is my understanding that a2 Milk trades in USD with China (presumeably as a safer currency), and that a fall in the value of the RMB will make a2 Milk’s products relatively more expensive than that of it’s competitors.

Take a look at this chart showing the value of the RMB against the USD throughout May:

The correlation is quite clear, and this will continue to cause a fall in the share price as the RMB falls, until the a2 Milk price reaches a point of value beneath which shareholders are unwilling to trade. Any further drop will likely be due to an announcement citing unfavourable trading conditions to support a lower valuation, or an alternative market trigger.

Personally, I still see value in a2 Milk, and will be looking for a lower price to increase my holding.