Buy A2 Milk on infant formula expansion into Asia

a2 Milk expands into Asia

The highest-ranked stock in our global equity factor model is a New Zealand company called a2 Milk. The dairy company sells A2 protein-based milk in primarily Australia, New Zealand, China, the UK, and the US. Its main products are liquid milk and infant formula and it has one of the highest return on invested capital ratios in our global universe of 1,700 stocks.

Additionally, the company has very low leverage on its balance sheet and strong price momentum.

The reversal factor is also very high as the company has underperformed global equities massively in the past month. Disappointing revenue guidance on May 16 drove the share price down by 13%. Overall, the business is still growing fast with 12-month trailing revenue up 55% compared to a year ago.

Competition is heating up for a2 Milk as the fast growing company has seen other dairy firms shift their marketing focus on A2 protein-based milk (there is still a lot of uncertainty over the health benefits of A2 milk, but we will get back to that shortly).

New Zealand's a2 Milk is growing quickly with revenue currently at NZD 728m up from NZD 155m in 2015 (full-year fiscal ends on June 30). The EBITDA margin is at healthy 30.3% and the CAPEX levels are extremely low leading to a very high ROIC and free cash flow generation. Strong business fundamentals usually come with high valuation and a2 Milk is expensive with a 12-month trailing EV/EBITDA ratio of 34.9x compared to 11.7x for global equities.

This high valuation premium is naturally a key risk. In addition, the downward volatility factor is also quite bad indicating significant downside moves on negative surprises. It is important to be aware of these things before investing in a2 Milk.

As the segment table and charts below show, the fastest growing market for a2 Milk is China/Asia but the biggest is still Australia and New Zealand (80% of total revenue). The main growth is coming from infant formula, which is linked to the trend of parents being more aware of health issues related to their kids. According to a2 Milk, A2 protein-based milk is better for the stomach so the marketing campaigns are obviously focused on these benefits towards young families.

Based on the firm's growth rate, the strategy is working and the Chinese market has the potential to become the biggest market for a2 Milk as Chinese consumers have experienced horrible accidents with domestically produced infant formula. The consequent lack of trust in domestic producers will likely become a key driver of growth in China. In addition, a2 Milk announced in April that it is moving into South Korea, thus expanding further into Asia. 

We look to buy shares of New Zealand-based a2 Milk on the company's planned expansion into Asia.

There are several key risks to be aware of before investing in a2 Milk:

   • The benefits of A2 proteins may be overstated and could lead to brand damage if findings show no evidence of health effects.    • A2 Milk has avoided two lawsuits with the latest being settled in December with its competitor Lion Dairy & Drinks.
   • Increasing competition from other dairy firms expanding into A2 milk production, lower growth rates and operating margins.
   • Slowdown in Chinese expansion because the valuation hinges on massive growth in China.
   • Supply issues from A2 milk producers in New Zealand leading to production constraints and higher prices.
   • High valuation is a key risk as lower-than-expected growth could quickly lead to a sharp revaluation of the company’s shares.