The strong result from this consumer stock defies the naysayers

This dual-listed Australian and New Zealand company hitched its wagon to China right from the start - a business model that has had mixed results since it floated back in 2015.

Reliance on China has both helped and hurt many companies over the years, including the Big Three iron ore miners, who continue to profit from the country's seemingly endless property boom. Treasury Wine Estates ASX: TWE has also ridden both sides of the wave of Chinese consumer demand.

New Zealand-based milk and infant formula company A2 Milk ASX: A2M has faced C-suite changes alongside other challenges over the last few years, including the failed takeover by Freedom Foods. But today, the company posted NZ$115 million in net profit after tax, 50% up on the same period last year. The result will help management shrug off widely held concerns that the business’s heavy reliance on China, alongside its previous inventory build-up, are liabilities.

A2 Milk and its key supplier Synlait Milk invested in boosting production capacity in 2020 – just before the global COVID-19 onslaught smashed offshore demand for its infant formula product – and A2M’s share price too. The stock remains down around 70% from its $19 ASX price of March 2020, trading at around $5.40 at the close on Monday. 

But the company's share price has gained steadily since March this year, and Spheria Capital portfolio manager Matthew Booker is upbeat about the company’s prospects into 2023 and beyond.

In the following interview, Booker talks us through some of the standouts of the FY22 earnings results and his outlook for the next 12 months.

A2 Milk (ASX: A2M) FY22 KEY RESULTS

• Revenues up 20% to NZ$145 billion
• Net profit up 42% to NZ$115 million
• Underlying EBITDA up 59% to NZ$196.2 million
• Earnings per share of 16.5 cents, up 52%.

What were the key takeaways from this result? What surprised you the most?

The resumption of top-line growth has resumed and the company is seeing structural growth in China, particularly through its Chinese-labelled product and via bricks-and-mortar channels. So, today's result was a significant positive on that front.

Other key takeaways included the ongoing strength of the company’s cash flow and the good job that management has done in creating a "clean" inventory position. And it has done this during a very challenging period, with on-and-off lockdowns in China.

What was the market’s reaction to this result? Was this an overreaction, an underreaction or appropriate?

The share price gained around 10% in the hours following the result, closing at around $5.30 on the ASX.

If the market was less volatile, the stock would probably be up around 20%, the result was that good. I think it’s the backdrop of a weaker market that has constrained the share price performance today, though it strengthened during the day.

I think the share price growth will continue over the next six to 12 months. Management has the company on the right footing now, having been through the biggest challenges, and they now have some clean air ahead of them.”

Would you buy, hold or sell A2M on the back of these results?

I rate the company as a Buy - we own it and it's a stock we continue to buy. It’s one of those companies that ticks pretty much every box. It delivers strong returns and has a high-profile brand with strong cash flow generation and strong market share in a growing market. Fertility rates in China have been slow but that should improve. And the Australian business is strong, while the business also has the potential to head into the US.

A2M’s US business has been losing money and I think the market is capitalising those losses into perpetuity. But clearly, if management doesn’t get the scale needed, it will shut down those operations. They have the infrastructure there and if the company does get registered for that market, it could be a sizeable opportunity.

A2M wasn’t an overnight success in Australia, China or in the US - you've got to pay your dues before you achieve success.

What’s your outlook on A2M and its sector over FY23?

Chinese fertility rates will improve in China, where A2 Milk's market share is already good and the company is continuing to roll out mother and baby stores, further enlarging its footprint there.

Theoretically, the company should have good sales growth into 2023 and beyond. Its Australian business continues to do reasonably well despite challenges in this market with the Daigou buyers evaporating. But Australia remains a core cash cow for them, with potential blue sky in the US, where the company could go from significant losses to making significant money.

Are there any risks investors should be aware of given the current market environment?

A couple of class actions are still overhanging, with some potential liabilities, but those losses will be contained.

And if China continues with its lockdown strategies, that could impact demand – but I think we’re through the worst of it. There’s also the risk that China's birth rates won’t pick up. But I think we’re through the worst of it.

On the geopolitical front, relations between New Zealand and China have stayed reasonably strong (despite the tensions between Australia and China), but there’s always the chance of a left-field event.

From 1-5, where 1 is cheap and 5 is expensive, how much value are you seeing in the market right now? Are you excited or are you cautious about the market in general?

Rating: 2

There are pockets of very cheap companies and then there are pockets of overexuberance. So, it’s tricky to average it out. But from our portfolio perspective, we’re at a 2, though I can’t talk for the entire market.

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