A2M Report - ACCT3013 - Group Assignment PDF

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Summary

Group assignment submitted for ACCT3013. Received a mark of 90%....

Description

The a2Milk Company (ASX:A2M,

Analyst SID’s XX

NZE:ATM)

Group Number XX

All Aboard the Growth Train Recommendation

Investment Summary

BUY

We recommend a Buy rating to reflect the high growth prospects for global infant formula sales. a2M has a unique product in the market and is expected to capture an increased market share over the long-term.

Current Price

NZ$16.14/share

a2M is a New Zealand-based producer of infant formula and branded liquid milk products. Dual-listed in New Zealand and Australia, a2M serves the New Zealand, Australia, China, UK and US markets. Its products are differentiated from existing products because of their perceived health benefits. a2M products only contain A2 protein, which is claimed to reduce the risk of diabetes. a2M uses this differentiation to yield a premium price for their products from health-conscious consumers.

Valuation

NZ$22.60/share GICS Sector Food, Beverage & Tobacco

Company Data (as at 22/5/2019)

Enterprise value

NZ$11,861m

Market capitalisation

NZ$11,861m

Shares on issue

734.9m

30-day VWAP

$16.30

12-month price range

NZ$8.67$16.98

We contend that the growth potential in China for a2M has not been factored into its price. a2M has a unique opportunity to leverage their product on a global platform as consumer preferences shift towards greater health-consciousness. In addition to the changes in customerpreferences, a2M’s growing investment in Synlait (NZE:SML) will create value for a2M shareholders by building a position of significant influence. This influence is expected to be used to aid a2M in securing a stable, longterm supply of milk and thereby reducing logistics-related risks.

Earnings Forecast

Historical Share Price

$18

2019

2020

2021

2022

2023

2024

2025

$1,463

$2,183

$3,053

$3,985

$4,830

$5,402

$5,537

Net income

$319

$488

$699

$933

$1,156

$1,322

$1,384

Residual income

$274

$417

$588

$765

$912

$983

$937

EPS

$0.43

$0.66

$0.95

$1.27

$1.57

$1.80

$1.88

EV/Sales

8.11x

5.43x

3.88x

2.98x

2.46x

2.20x

2.14x

30%

28%

26%

24%

22%

19%

17%

NZD millions

$16 $14 $12

Sales

$10 $8 $6 $4 $2 $0

ROE

02/19

08/18

02/18

08/17

02/17

08/16

02/16

08/15

02/15

Source: proprietary estimates

1

Industry Overview The dairy products industry is a large and well-established marketplace with many similar producers fighting fiercely to capture market share. Globally, the infant formula industry size was estimated to be c. AUD$24 billion while the liquid milk industry was estimated to be c. AUD$504 billion, in 2018 (Allied Market Research & IBISWorld). Global liquid milk sales are expected to grow steadily over coming years as East Asian countries appetites for dairy products increases. This trend will be driven by growing wealth and the rise of the middle-class in countries like China, where diets are becoming increasingly more Westernised (IBISWorld). More established markets like Australia, New Zealand, USA, and Europe are not anticipated to see significant growth in demand. Globally, he industry is expected to grow at a cumulative average growth rate (CAGR) of 1.5% till 2025 (IBISWorld). The global infant formula market is expected to experience a more dramatic growth curve than liquid milk, with some estimates suggesting a CAGR of 9.5% through to 2025 (IBISWorld). Again, this growth is expected to be driven primarily by East Asian consumers. This is likely a continuation of the trend of recent years where explosive growth was experienced by Australian producers, such as a2M and Bellamy’s. This growth was driven by a number of food quality scares in China, such as the 2008 Chinese milk scandal, which severely marred consumer trust in Chinese-made dairy products (Puddie & Burnie, 2018). Australasian infant formula producers have since become a preferred choice of Asian consumers. This is evidenced by a2M’s rapid sales growth rates (provided below). Australasian infant formula producers will likely continue to benefit from the trust it has developed with Asian consumer. Despite the expected growth in dairy-related industries, volatility of milk prices continues to mar the industry’s profitability (IBISWorld). Consequently, securing supply agreements will play an important role in ensuring the profitability of dairy product manufacturers in the future.

1,000

¥30,000

800

¥25,000

Liquid Milk

¥20,000

600

¥15,000 400

¥10,000 Infant Formula

200

¥5,000

Income5per5capita

Consumption5in5tonnes5 ('000)

China: Dairy Product Consumption Has Increased with Income

¥0

0 15

16

17

18

Source: CLAL & National Bureau of Statistics of China

Dairy5Industry5Size5 (AUD5billions)

a2M Is Expected to Gather A Growing Share of the Expanding Global Industry 6505

1.0%

6005

0.8% 0.6%

5505

0.4%

5005

0.2% 0.0%

4505 2018

2019

2020

2021

Dairy5Industry5size

2022

2023

2024

A2M5share5of5dairy5industry

Source: IBISWorld & proprietary forecasts

2

2025

Company Fundamentals a2M products are patent-protected and use proprietary processes. The result is a premium product which is aimed at health-conscious consumers. a2M’s main product-line consists of infant formula and liquid milk and generated 78.5% and 15.4% of their revenue in 2018, respectively. a2M’s infant formula products have been particularly popular with gross sales growing by a CAGR of 53% over a five-year period to 2018. Consequently, infant formula sales through established distribution channels form the crux of a2M’s revenue (see appendix A). a2M’s product value and source of competitive advantage is derived from its A1 protein-free ingredients. Whilst the claim that A2 protein-only products are healthier has not yet been proven conclusively by researchers, it has been used as an effective marketing point for the company since 2000. a2M’s competitive advantage has been sustained by relying on an active patent protection strategy (see appendix B). The strategy has been used to erect legal barriers to use of A2 protein-based products by potential competitors. Given a2M’s continued investment in R&D (NZ$4.3m in 2018), it seems reasonable to expect their exclusive rights to use of A2 protein products will continue for the foreseeable future. A key point of advantage over close competitors like Bellamy’s and Bubs is that a2M has been granted a SAMR certification. This allows a2M to export their products directly to China, whilst their competitors cannot, providing a2M with a significant advantage (Sun, 2019). To protect themselves from volatile milk prices, a2M is focussing on securing valuable supply-chain links. In 2018, an additional NZ$162.3m was invested in Synlait – a New Zealand-based liquid milk producer – increasing their stake in the company to 17.4% as part of a potential attempt to gain a significant influence over the company. Although the two companies have an existing strategic partnership, significant influence over Synlait would better enable a2M to ensure continuation of the supply agreement. A strategic relationship with Fonterra has also been entered into which will increase supply and demand opportunities. This relationship will provide a2M another liquid milk supply, and allow Fonterra to utilise the a2M brand-name to sell products in Australia and New Zealand. The new relationships with Synlait and Fonterra will support continued sales growth whilst reducing exposure to volatile milk prices which will protect a2M’s profitability over the long-term. Forecasted Infant Formula Sales Sales ('000,000)

$5,000 $4,000 $3,000 $2,000 $1,000 $0 2017

2018

2019

2020

2021

2022

2023

2024

2025

2024

2025

Source: IBISWorld

Forecasted Liquid Milk Sales

Sales ('000,000)

$750 $500 $250 $0 2017

2018

2019

2020

2021

Source: IBISWorld

3

2022

2023

450 119 509 460 042 053 470 031 342

a2M:NZE (NZD thousands)

(Last closing price NZ$16.14) 2019E

2020E

2021E

2022E

2023E

2024E

2025E

Assumptions Sales growth rate

58.5%

49.1%

39.8%

30.5%

21.2%

11.8%

2.5%

Net operating profits after tax/sales (NOPAT margin)

21.9%

22.4%

22.9%

23.4%

24.0%

24.5%

25.0%

6.9%

6.9%

6.9%

6.9%

6.9%

6.9%

6.9%

24.0%

24.5%

25.0%

25.5%

26.0%

26.5%

27.0%

-115.0%

-71.7%

-28.5%

14.7%

14.7%

14.7%

14.7%

1.8%

1.8%

1.8%

1.8%

1.8%

1.8%

1.8%

30.0%

27.9%

25.8%

23.7%

21.6%

19.4%

17.3%

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

$1,462,238

$2,180,900

$3,049,301

$3,978,998

$4,820,924

$5,391,221

$5,526,002

$319,511

$487,991

$698,306

$932,096

$1,154,624

$1,319,509

$1,381,500

End. net operating WC/sales End. Net operating LT assets/sales Net debt at end of year/net capital After tax cost of debt ROE Dividend payout ratio Income Statement Sales Net operating profits after tax Less: net interest expense after tax

$0

$0

$0

-$3,447

-$4,242

-$4,816

-$5,010

$319,511

$487,991

$698,306

$928,649

$1,150,383

$1,314,693

$1,376,490

$0

$0

$0

$0

$0

$0

$0

$319,511

$487,991

$698,306

$928,649

$1,150,383

$1,314,693

$1,376,490

End net working capital

$101,548

$151,456

$211,764

$276,329

$334,798

$374,403

$383,763

End net LT assets

$350,412

$533,600

$761,405

$1,013,557

$1,252,260

$1,427,508

$1,490,983

Net operating assets

$451,960

$685,057

$973,169

$1,289,886

$1,587,058

$1,801,911

$1,874,746

Net debt

-$519,528

-$491,431

-$277,563

$189,520

$233,182

$264,750

$275,452

Equity

$971,488

$1,176,487

$1,250,732

$1,100,366

$1,353,876

$1,537,160

$1,599,294

Net capital

$451,960

$685,057

$973,169

$1,289,886

$1,587,058

$1,801,911

$1,874,746

$274,117

$408,634

$602,204

$826,482

$1,060,498

$1,204,100

$1,250,926

0.9245

0.8547

0.7901

0.7305

0.6753

0.6243

0.5772

$253,417

$349,247

$475,817

$603,711

$716,150

$751,719

$721,977

351.3%

160.3%

82.6%

13.1%

5.0%

-3.1%

-11.2%

Net income Preferred dividends Net income to common Balance Sheet

RI Valuation Residual earnings Discount factor for equity Present value of Residual earnings Projected growth in book value of equity Starting book value PV residual earnings for finite horizon

$555,709 $3,872,038

PV of terminal residual earnings

$12,736,458

Total

$16,608,496

Number of ordinary shares Market price per share

734,897 $22.60

4

Valuation Assumptions Sales growth: as global diary consumption continues to grow, a2M’s unique product will allow them to capture a greater market share. However, the rapid growth rate experienced by the company of late is unlikely to continue beyond the next 5 years without conclusive verification of A2 protein’s superiority to regular dairy products. In order to reflect this in the valuation, the growth rate for 2018 (68%) was used as a starting point from which a reduction on a straight-line basis to the terminal rate of 2.5% (the RBA inflation target) is extrapolated. NOPAT margin: a2M produces superior quality dairy products which achieve a premium in the marketplace. Subsequently, looking to the industry average for an indication of the optimal NOPAT margin for a2M would be misleading. Instead, the margin achieved in 2018 (21.3%) was used as a starting point, with 25% being selected as a target margin guide to reach by the model’s horizon. Like the sales growth forecast, a straight-line method was used to extrapolate indicative margins for years 2019 to 2025. Working capital to sales: in recent years, a2M’s working capital has fluctuated as a proportion of sales. As a2M matures in coming years we expect that its working capital will be stabilised. This will likely be driven by the supply agreements with Synlait and Fonterra which will require regular payment terms. Blackmore’s (ASX:BLK) was used to provide an indication of an ideal ratio (6.9%) as a large and mature Australian company with a presence in the infant formula market and a stable financing structure. Long-term assets to sales: like the working capital, the long-term assets to sales ratio has been volatile since 2014. As in the case above, when the company matures the requirement for fixed assets should become more predictable by management. A moderate increase from the base year of 2018 through to the horizon has been modelled in light of a2M’s continued investment in Synlait. Blackmore’s was used to derive a terminal value of 27% as it is deemed to provide a fair indication of what a2M’s financial position might look like as a mature company. Capital structure: as a2M matures, utilising debt will become necessary to optimise the capital structure. This is necessary to lower the overall cost of capital and provide greater financial flexibility to pursue investment opportunities as they arise. An after-tax cost of 1.8% has been derived from the median of the comparable companies analysed. A gradual increase in the net debt position is forecasted up until 2022 when an optimum gearing ratio of 14.9% (also derived from the industry median) is expected to be maintained indefinitely. Discount Rate To calculate the discount rate (12.53%) for a2M, the following assumptions were made: -

-

A risk-free rate of 2.8%, which was sourced from Fernandez (2019) Market risk premium of 7%, which was sourced from Fernandez (2019) A beta of 0.83 which was calculated by regressing the returns of a2M against those of the All Ordinaries Index (AORD) for a 4-year period (since a2M’s initial listing), calculated monthly. The AORD was chosen as a benchmark as it is commonly used to represent the total market in Australia. This is appropriate for use as a2M is dual-listed in Australia and New Zealand a2M does not have debt currently, so the cost of debt was not calculated

To calculate the implied cost of capital, the solver function in excel was utilised to back-solve the the price-to-book ratio (derived from the residual income model). The inputs for this were as follows: a2M’s price-to-book was estimated at 21.34 times; ROE at 35% (from 2018); growth rate of 2.5% (being the RBA target). The implied cost of equity achieved was 4.04%, which was not included in the calculation of the cost of equity as it does not inadequately reflect the risks inherent to equities.

5

Ratio Analysis (Historic) 2014

2015

2016

2017

2018

Profit Margin

0%

-1%

9%

17%

21%

Return on Equity

0%

2%

27%

40%

35%

Return on Assets

2%

2%

2%

2%

2%

CEL

0%

0%

0%

0%

0%

131%

152%

158%

142%

130%

Asset Turnover

0%

187%

236%

198%

173%

Profit Margin

0%

1%

10%

18%

21%

EBIT on Sales

0%

1%

15%

25%

30%

Operating Efficiency (EBIT on Margin)

0%

0%

8%

14%

18%

Profitability

Av. Assets to Av. Equity

Production Efficiency

200%

199%

185%

175%

170%

Sales:Average Fixed Assets

0%

1677%

4052%

6676%

10215%

Sales:Average Inventory

0%

2969%

1228%

1356%

1993%

Sales:Average Receivables

0%

460%

826%

929%

1333%

Sales:Average Cash

0%

1403%

934%

577%

400%

31%

52%

58%

42%

30%

0%

0%

0%

0%

0%

Current Ra...