The A2 Milk Company

Food & Beverages│Australia│Equity research│March 13, 2018

The A2 Milk Company Premium brand, premium rating

ADD Current price: Target price: Previous target: Up/downside: Reuters: Bloomberg: Market cap:

A$12.72 A$14.40 A$ 13.2% A2M.AX A2M AU US$7,292m A$9,270m US$47.86m A$61.06m 728.8m 100.0%

Average daily turnover: Current shares o/s Free float:

■ We initiate coverage of A2M with an Add rating and A$14.40 price target. ■ A2M’s 1H18 result (+150% NPAT growth) demonstrates the strong global demand for its a2 dairy products, which have digestive and health benefits.

■ We forecast strong growth over coming years as we expect A2M to continue to win market share across its product range in some big markets such as China. We therefore think consensus estimates in outer years will prove conservative and the upgrade cycle should continue.

■ A2M’s premium products generate high margins and therefore it deserves a premium rating, in our view. The company’s FCF generation is extremely strong and provides it with both growth and capital management opportunities.

Strong 1H18 led by a2 Platinum market share wins

Vol m

Price Close

Relative to S&P/ASX 200 (RHS)

13.3

557

11.3

474

9.3

390

7.3

307

5.3

224

3.3

140

1.3 50 40 30 20 10

57

Mar-17

Jun-17

Sep-17

Dec-17

Source: Bloomberg

Price performance Absolute (%) Relative (%)

1M 54.6 51.6

3M 79.2 79.5

Belinda MOORE T (61) 7 3334 4532 E [email protected] Kurt GELSOMINO T (617) 3334 4858 E [email protected]

12M 443. 6 439. 8

A2M reported a strong 1H18 result with sales up 70% on the pcp, EBITDA up 123% and NPAT up 150%. Margins continued to rise with the gross profit margin up to 49.8% vs 46.5% in the pcp and the EBITDA margin increased 790bps to 32.9% due to product mix (infant formula was 78% of revenue) and scale benefits. a2 Platinum remains the fastest growing infant formula brand with a market share of ~30% by value in Australian supermarkets. a2 Platinum’s market share by value is also rapidly rising in China and it is one of the fastest growing brands in this market (worth about US$20bn pa). It currently stands at 5.4% according to Kantar. Despite starting to rebuild its inventory, operating cashflow rose 205% and A2M ended the half with net cash of NZ$240.2m.

Well placed to continue to deliver strong earnings growth A2M is on a strong earnings trajectory as it builds a global branded dairy nutritionals business across ANZ, China and other Asia, UK and USA. We believe its strategic relationship with Fonterra should fast track A2M’s entry to its other priority markets (South East Asia and Middle East) where Fonterra has strong distribution. It will also see A2M expand its product range. The strong growth in a2 Platinum has transformed A2M’s earnings in recent years and we expect this to continue given there is plenty of market share to be won in existing and new markets. FY19 should benefit from the additional marketing spend in 2H18, a full year of CFDA approval and strong growth in Mother and Baby stores in China. In FY20, we forecast the US business to reach monthly break even and the Fonterra strategic relationship to make a positive contribution.

Initiate coverage with an Add rating and A$14.40 price target A2M’s point of differentiation (products only contain the A2 beta casein type rather than both A1 and A2 types found in conventional cows’ milk) with health and digestive benefits has allowed it to win market share across product lines and geographies. It has also allowed it to price products at a premium to peers. The company generates strong EBITDA margins, considerable free cashflow (capital light business model) and a high ROE. Its balance sheet should allow it to fund a blending and canning facility, its new products and global expansion plans whilst rewarding shareholding through dividends and other capital management initiatives. With low market shares in some very large markets (China, USA, UK), we believe A2M should generate strong earnings growth over the medium term. Importantly, A2M is led by an impressive management team that has successfully managed China regulatory changes at a time when others have failed. Financial Summary Revenue (NZDm) Operating EBITDA (NZDm) Net Profit (NZDm) Normalised EPS (NZD) Normalised EPS Growth FD Normalised P/E (x) DPS (NZD) Dividend Yield EV/EBITDA (x) P/FCFE (x) Net Gearing P/BV (x) ROE % Change In Normalised EPS Estimates Normalised EPS/consensus EPS (x)

Jun-16A 353 54.6 30.4 0.04 317.9 0% 176.0 499.3 (52.1%) 73.32 31.8%

Jun-17A 549 141.2 90.6 0.12 185% 111.5 0% 70.7 207.1 (50.1%) 40.76 48.4%

Jun-18F 980 305.7 210.5 0.28 129% 48.6 0% 32.6 77.2 (56.7%) 21.79 60.2%

Jun-19F 1,422 474.0 328.2 0.44 56% 31.2 0% 20.6 48.1 (60.1%) 12.70 52.7%

Jun-20F 1,813 611.8 425.6 0.57 30% 24.0 0% 15.5 36.1 (62.4%) 8.24 42.6%

0.97

1.14

1.17

SOURCE: MORGANS, COMPANY REPORTS IMPORTANT DISCLOSURES REGARDING COMPANIES THAT ARE THE SUBJECT OF THIS REPORT AND AN EXPLANATION OF RECOMMENDATIONS CAN BE FOUND AT THE END OF THIS DOCUMENT. MORGANS FINANCIAL LIMITED (ABN 49 010 669 726) AFSL 235410 - A PARTICIPANT OF ASX GROUP

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Figure 1: Financial summary (NZ$m) Profit and Loss Sales Operating Costs EBITDA Depreciation Amortisation EBIT Net Interest Income Pre-tax Profit Tax Underlying NPAT Exceptional items Reported NPAT Cashflow Statement EBITDA Other income Net interest Tax Changes in working capital Operating cash flow Capex Free Cash Flow Acquisitions and divestments Other Investing cash flows Increase / decrease in Equity Increase / decrease in Debt Dividends paid Other financing cash flows Financing cash flows Increase/decrease in cash Balance Sheet Assets Cash Debtors Inventory Other current assets Total Current Assets Fixed Assets Investments Goodwill Intangibles Other non-current assets Total Non-Current Assets TOTAL ASSETS Liabilities Short Term Debt Creditors Other current liabilities Total Current Liabilities Long Term Debt Other Non current liabilities Total Non-Current liabilities TOTAL LIABILITIES Equity Issued capital Retained earnings Other reserves and FX Minority interests TOTAL EQUITY

2015A 2016A 2017A 2018F 2019F 2020F Valuation details 154.8 352.5 549.3 980.5 1,421.7 1,812.6 -150.0 -297.9 -408.1 -674.7 -947.7 -1,200.8 A$ Share Price 4.8 54.6 141.2 305.7 474.0 611.8 A$ Price Target -1.9 -2.7 -2.7 -2.4 -3.5 -4.5 A$ Blended Valuation 0.0 0.0 0.0 0.0 0.0 0.0 WACC 2.9 51.8 138.5 303.3 470.5 607.3 -0.1 -0.5 -0.9 -1.8 -5.2 -9.5 Key metrics/ multiples 3.0 52.3 139.4 305.1 475.7 616.8 P/E -3.4 -21.9 -48.7 -94.6 -147.5 -191.2 Dividend Yield -0.4 30.4 90.6 210.5 328.2 425.6 PEG -1.7 0.0 0.0 0.0 0.0 0.0 EV/EBITDA -2.1 30.4 90.6 210.5 328.2 425.6 Per share data 2015A 2016A 2017A 2018F 2019F 2020F Diluted shares on issue 4.8 54.6 141.2 305.7 474.0 611.8 Normalised EPS (A$) 0.0 0.0 0.0 0.0 0.0 0.0 Dividends per share (A$) 0.1 0.5 0.9 1.8 5.2 9.5 Reported payout ratio -2.5 -9.7 -31.2 -94.6 -147.5 -191.2 -10.4 -23.9 -10.9 -76.4 -114.0 -140.8 EBITDA by Business Unit -8.1 21.5 99.9 136.5 217.7 289.3 ANZ -3.6 -2.1 -2.5 -4.0 -5.0 -6.0 Growth -11.7 19.4 97.5 132.5 212.7 283.3 China and Other Asia 0.0 0.0 -48.7 0.0 0.0 0.0 Growth 0.0 0.0 0.0 0.0 0.0 0.0 UK and USA -3.6 -2.1 -51.1 -4.0 -5.0 -6.0 Growth 0.0 44.2 3.8 6.4 0.0 0.0 Corporate and Other 0.0 0.0 0.0 0.0 0.0 0.0 Growth 0.0 0.0 0.0 0.0 0.0 0.0 Total 0.0 0.0 0.0 0.0 0.0 0.0 Growth 0.0 44.2 3.8 6.4 0.0 0.0 -11.7 63.7 52.5 138.9 212.7 283.3 Result quality Cash flow conversion 2015A 2016A 2017A 2018F 2019F 2020F FCF vs NPAT 6.1 39.9 4.8 9.7 60.5 9.3 0.0 11.0 6.2 1.8 28.3 88.9

69.4 45.4 52.6 15.1 182.4 8.0 0.0 10.4 6.0 3.3 27.7 210.2

121.0 72.9 28.4 36.0 258.3 8.4 62.0 10.0 3.2 2.0 85.6 343.9

259.9 130.1 88.2 36.0 514.2 10.0 62.0 10.0 3.2 2.0 87.2 601.4

0.0 28.5 0.0 28.5 0.0 1.7 1.7 30.2

0.0 66.4 0.0 66.4 0.0 10.7 10.7 77.1

0.0 71.5 0.0 71.5 0.0 31.0 31.0 102.4

0.0 112.0 0.0 112.0 0.0 31.0 31.0 143.0

86.3 -26.1 -1.6 0.0 58.6

130.5 4.4 -1.8 0.0 133.1

134.3 95.0 12.2 0.0 241.5

140.7 305.6 12.2 0.0 458.4

472.6 755.9 Gearing 249.7 397.3 Net Debt 127.9 163.1 Net Debt / Equity 36.0 36.0 Net Debt / EBITDA (x) 886.2 1,352.3 EBIT interest cover (x) 12.5 14.0 Invested Capital 62.0 62.0 Enterprise Value 10.0 10.0 3.2 3.2 Growth ratios 1.0 1.0 Sales 88.7 90.2 Operating costs 974.9 1,442.6 EBITDA EBIT NPAT 0.0 0.0 EPS growth 157.3 199.4 DPS growth 0.0 0.0 Operating cash flow 157.3 199.4 0.0 0.0 Margin analysis 31.0 31.0 Gross Profit Margin 31.0 31.0 EBITDA Margin 188.3 230.4 EBIT margin NPAT margin ROE 140.7 140.7 ROIC 633.8 1,059.4 12.2 12.2 0.0 0.0 786.6 1,212.2

Market Cap

$10,122.9

$12.72 $14.40 $14.40 9.0% 2016A 317.8 0.0% 0.0 176.0

2017A 111.5 0.0% 0.6 70.7

2018F 48.6 0.0% 0.4 32.6

2019F 31.2 0.0% 0.6 20.6

2020F 24.0 0.0% 0.8 15.5

2016A 706.1 4.3 0.0 0.0%

2017A 737.5 12.3 0.0 0.0%

2018F 746.6 28.2 0.0 0.0%

2019F 746.6 44.0 0.0 0.0%

2020F 746.6 57.0 0.0 0.0%

2016A 84.7 182% 9.2 395% -20.5 70% -18.8 87% 54.6 1035%

2017A 155.3 83% 32.7 258% -22.5 10% -24.4 30% 141.2 159%

2018F 247.1 59% 114.9 251% -27.0 20% -29.3 20% 305.7 117%

2019F 320.7 30% 205.7 79% -17.6 -35% -34.9 19% 474.0 55%

2020F 372.1 16% 283.9 38% -3.0 -83% -41.2 18% 611.8 29%

2016A 56.2% 63.8%

2017A 92.2% 107.5%

2018F 75.0% 62.9%

2019F 76.0% 64.8%

2020F 77.0% 66.6%

2016A -69.4 -52.1% -1.3 -111.5 63.7 9604.7

2017A -121.0 -50.1% -0.9 -156.1 120.5 9982.9

2018F -259.9 -56.7% -0.9 -167.1 198.5 9968.4

2019F -472.6 -60.1% -1.0 -90.5 314.0 9755.7

2020F -755.9 -62.4% -1.2 -64.3 456.3 9472.4

2016A 127.7% 98.6% 1034.6% 1711.7% 7323.4% 6860.5% n/a 366.2%

2017A 55.8% 37.0% 158.6% 167.1% 197.8% 185.2% n/a 365.4%

2018F 78.5% 65.3% 116.6% 119.1% 132.3% 129.4% n/a 36.6%

2019F 45.0% 40.4% 55.0% 55.1% 55.9% 55.9% n/a 59.5%

2020F 27.5% 26.7% 29.1% 29.1% 29.7% 29.7% n/a 32.9%

2016A 42.8% 15.5% 14.7% 8.6% 22.9% 81.4%

2017A 48.0% 25.7% 25.2% 16.5% 37.5% 114.9%

2018F 50.0% 31.2% 30.9% 21.5% 45.9% 152.8%

2019F 51.0% 33.3% 33.1% 23.1% 41.7% 149.9%

2020F 51.0% 33.8% 33.5% 23.5% 35.1% 133.1%

SOURCE: MORGANS RESEARCH, COMPANY

2


Overview of The a2 Milk Company (A2M) A2M was founded in 2000 in New Zealand by Dr Corran McLachlan who discovered that proteins in milk affect people differently. He then discovered there was a safe and simple way to identify cows who produced milk that was naturally A1 protein free. Since this time, A2M has successfully transitioned from an IP licensing to a brand-led FMCG company. A2M produces, markets and sells premium branded dairy nutritional products (milk, infant formula, skim and full cream milk powders, cream) that have perceived health benefits in its targeted global markets being Australia and New Zealand, China and other Asia, UK and USA. Its premium products attract a premium selling price and therefore the company generates attractive margins. A2M’s competitive advantage and key to its success has been the fact that its products contain only the A2 beta casein protein type rather than both A1 and A2 types found in conventional cows’ milk products. About a third of cows produce only A2 protein. A2M’s point of difference is supported by an integrated IP portfolio and growing scientific evidence. Research has shown that A1 and A2 proteins digest differently. Some scientists claim that research shows that the A1 type of protein can cause an intolerant reaction. For some people who experience discomfort drinking ordinary cows’ milk, they may experience relief when they switch to a2 Milk. A2M has been successful in marketing its products based on the premise that it helps avoid A1 milk protein intolerance. Figure 2: What is the a2 milk brand difference?

SOURCE: MORGANS RESEARCH, COMPANY 1 A1 and A2 protein refers to A1 and A2 beta casein protein types respectively

A2M has a comprehensive suite of global intellectual property rights. While some patents have expired in recent years, others extend to 2035 and the company is confident that ongoing R&D will be able to support extension and enhancement of these patents and trademark rights. A2M believes its IP portfolio provides barriers to entry. a2 Milk™, a2 Platinum™ and The a2 Milk Company™ are all trademarks of A2M. Figure 3: A2M’s IP portfolio continues to provide barriers to entry

SOURCES: MORGANS, COMPANY REPORTS

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Following its listing on the New Zealand Stock Exchange (NZX: ATM), the company also listed on the Australian Stock Exchange (ASX: A2M) in 2015. It recently joined the S&P/ASX100 index. It remains dual listed today.

Capital light business model Milk is carefully sourced from segregated A2 only herds. A2M assists farmers to implement breeding and herd formation. A2M has a large a2 milk supplier base given its strategy is to pay the leading farmgate price. The company runs an asset light business model whereby it contracts to third party processors. However it does have one milk processing facility at Smeaton Grange in NSW and we note the company has raised the possibility of investing in a blending and canning facility. Synlait Milk Limited relationship We view A2M’s most important processing relationship as the one it has with Synlait Milk Limited. A2M entered into an agreement with Synlait in April 2012. The agreement allows Synlait to source a2 milk from accredited New Zealand dairy farmers and manufacture a2 branded milk powder and infant formula at its state-of-the-art facility in New Zealand. In August 2016, Synlait and A2M announced a new supply agreement for a minimum term of five years and provides for a rolling three-year term after the first two-year period. The new agreement gives A2M access to an agreed level of capacity and an obligation to supply to order. Importantly, it does not include ‘take or pay’ provisions. A2M is Synlait’s preferred customer. This agreement gives Synlait exclusive supply rights for a2 Platinum infant formula into Australia, New Zealand and China. It also allows for A2M and Synlait to develop new products. In March 2017, A2M purchased an 8.2% shareholding in Synlait at NZ$3.275 per share for total consideration of NZ$47.9m. In September 2017, Synlait received the allimportant China Food and Drug Administration (CFDA) registration for A2M’s infant formula (Stage 1, 2 and 3). This was required from 1 January 2018 to sell a2 Platinum China labelled product to bricks and mortar stores in China. This requirement is designed to reduce the number of infant formula brands in China. With fewer brands in China, a2 Platinum is well placed to win further market share. New Fonterra strategic relationship In February 2018, A2M announced the formation of a strategic relationship with Fonterra Co-operative Group Limited. The term of the contract is for a rolling three years. The initial scope of this relationship includes: 

a Nutritional Products Manufacturing and Supply Agreement under which Fonterra will manufacture A1 protein-free products for certain priority markets in South East Asia and the Middle East exclusively for A2M. A2M and Fonterra will also explore the potential to establish a jointly owned blending and canning facility;



an exclusive licence to Fonterra for the production, distribution, sale and marketing of a2 Milk branded fresh milk in New Zealand;



the opportunity to leverage Fonterra’s sales and distribution capabilities in the priority markets; and



jointly evaluate opportunities for the sale of certain a2 branded dairy products such as butter, cheese and China sourced liquid milk in Australia, New Zealand and China.

Fonterra will manufacture the powder products at its Darnum facility in Victoria. Production will start during 2019. Given this facility doesn’t have blending and canning capability, this will be done from Fonterra’s facility at Canpac at Hamilton in New Zealand. We think that A2M is likely to invest in a blending and canning facility in Australia to solve this issue. The relationship leverages off each company’s relative strengths. We view this relationship as a strong endorsement of the strength of the A2M brand, the validity in its point of differentiation and health benefits and its future potential 4


given Fonterra is the largest (conventional) dairy producer in the world. This move is in line with A2M’s multi-site, multi-product and geographic diversification strategy. Having another manufacturer and in another country de-risks A2M’s supply chain and will help grow volumes. It will also increase and diversify A2M’s milk pools with new milk pools to be developed by A2M and Fonterra in both Australia and New Zealand. This move should fast track A2M’s entry into its other priority markets where Fonterra has strong distribution. It will also see it expand its product range. A2M has previously said it was progressing plans for the New Zealand liquid milk market after the expiry of its licence with Fresha Valley in May 2017, now we have clarity. In line with its move into other new markets, it will take time to build brand awareness and will require significant marketing dollars, which is likely to drag on short-term profitability.

Growth strategy A2M's strategy is to build a global branded dairy nutritionals business that is based on the health and digestive benefits of products containing only the A2 beta casein protein. It aims to create a broad portfolio of products extending from fresh milk to fortified dairy-based products for infants, children and adults. It also wants to continue to broaden its geographical footprint, initially with a focus on tightly-defined market segments in South East Asia (will now be fast tracked with Fonterra strategic relationship). In addition, its strategy involves continuing to invest in proprietary know-how and A2 protein expertise. Figure 4: A2M’s strategic priorities


In August 2017, A2M successfully launched a2 Platinum Stage 4, which is for children three years and above. This product was launched in both Australia and China. A China label product will also be launched shortly. Stage 4 doesn’t require CFDA registration. Management has said that this product is already performing ahead of expectations. A number of new product launches are planned for FY18 including an extension of A2M’s milk powder range. In the 2H18, A2M plans to launch a2 Platinum pregnancy formula. Management said this new product has received positive trade feedback. A further range of products is expected to be launched during the 1H19.

A global business Australia and New Zealand (ANZ) A2M entered the Australian drinking milk market in 2007 through a JV with Freedom Foods. In 2010 A2M assumed full ownership of the JV. A2M achieved much success in the Australian market with its a2 branded milk. Today this product is the leading premium fresh milk brand in Australian supermarkets commanding a grocery market share by value of 9.5%. In fact, a2 Milk is considered the top brand of choice for Australian millennials. It is the only brand distributed through all six key grocery outlets in Australia. According to Aztec, a2

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Milk as a brand, is larger than organic, lactose free and plant based milk segments combined. The product which really transformed the business in recent years and has led to a material step change in its profitability has been a2 Platinum infant formula (launched September 2013 in Australia). a2 Platinum is the fastest growing infant formula brand with a market share by value of ~30% in Australian supermarkets which is no mean feat given the brand competes against multinational companies, which says a lot about the quality of the brand, its reputation and its point of differentiation by offering unique health benefits. A lot of its sales in Australia find their way to China. The ‘Daigou’ channel has become a significant and growing sales channel from Australia to China for A2M and is a key focus for management. During the 1H18, A2M launched an online platform to improve access to a2 Platinum for Australian consumers. In January 2014, the company launched a2 Thickened Cream into the grocery trade in Australia. Whole milk powder in retail packs was launched in June 2015 and ice cream in August 2015 (however we believe this product is no longer available). Skim milk powder was launched in May 2017. A2M spends the most of any of its peers on media to promote its brand which has been important in educating consumers about the health benefits of its products and increasing brand awareness. Figure 5: A2M’s Australian product range


China A2M’s products are well suited to the Chinese market given their higher levels of dairy intolerance. In September 2016, the Nutrition Journal reported that consumption of a2 Milk increases natural production of the body’s key antioxidant, Glutathione (GSH), in self-diagnosed milk-intolerant Chinese consumers. In addition, a recently published clinical trial conducted in China, involving about 600 adult participants with self-reported lactose intolerance, found that those who consumed milk containing only the A2 beta-casein protein type had reduced acute gastrointestinal symptoms compared with those from milk containing the A1 and A2 beta-casein protein types. The authors said their findings demonstrated that, in some individuals, symptoms from consumption of conventional milk may be related to the presence of A1 beta-casein protein rather than lactose. In August 2014, A2M started exporting fresh milk into China. Shipments of infant formula to China occurred in December 2014. China regulatory changes during calendar 2014 limited direct sales to China in FY15. However sales took off in FY16 and have grown strongly ever since. In October 2012, A2M appointed China State Farm Holding Shanghai Co. Ltd (CSF) as the exclusive distributor of its products in China. CSF is a subsidiary of the China National Agriculture Development Group Corporation, which is a state owned enterprise. In November 2014, this relationship was amended so that CSF became the exclusive import agent for a2 Platinum into mainland China. A2M therefore took on the direct responsibility for distribution of a2 Platinum in China. A2M exports a2 Platinum infant formula to China from New Zealand. In 6


October 2015, A2M entered into an exclusive distribution agreement for five key provinces in China with DKSH (China) Co., Ltd. Today A2M utilises about 65 local distributors in China. A2M has an online and offline distribution strategy with regards to the China market. In July 2015, ‘The a2 Milk Company’ store was launched on T-mall Global and it launched on JD.com in September 2015. A2M also has strong relationships with Mia, Kaola and VIP. A2M’s offline strategy is to sustainably drive sales through Mother & Baby stores. This will be done by growing the number of distribution points and significantly enhancing instore education and shopper marketing activities through investment in increased field resources and point of sale materials. Its Chinese label infant formula range is currently sold in over 6,700 Mother & Baby stores in more than 50 cities. We understand there are over 60,000 Mother & Baby stores in China. According to A2M, its China Label accounted for ~6% of group infant formula sales in FY17, strengthening to ~8% in 2H17 and ~12% in 1H18. a2 Platinum’s market share by value is rapidly rising in China and it is one of the fastest growing brands in this massive market (worth about US$20bn). It currently stands at 5.4% according to Kantar. Management’s longer term strategy is to achieve a market share of 10%. a2 Platinum’s premium pricing is associated with quality and prestige in China; it therefore sits in the premium category which is growing at the fastest rate. Between the growing middle class, the demand for overseas (safe) infant formula, low breastfeeding rates and the removal of the Chinese One Child Policy, a2 Platinum is uniquely positioned to excel from its competitive advantage. a2 Platinum is also a beneficiary of regulatory (CFDA) brand rationalisation. A2M also sells whole milk and skim milk powder in China. In addition, it sells a2 Milk (fresh) sourced from Australia in premium retail stores and through ecommerce platforms. Figure 6: A2M’s China product range


Asia a2 Platinum infant formula (English label) was launched in Hong Kong with initial distribution through 350 high end pharmacy outlets in November 2017. The launch was supported by advertising in high profile outdoor media. In August 2017, A2M launched Australian fresh milk into Singapore. Already A2M has achieved positive sales momentum with pleasing in-store velocities. Management said that shipments are now being made weekly from Australia and it is already considering the potential to broaden its product range and distribution in this market. A small test market for a2 Milk branded whole milk powder has recently been established in Vietnam. This has been done with an unnamed partner. Overtime, A2M will target other areas in South East Asia. Its new strategic partnership with Fonterra should fast track this strategy.

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UK In November 2011, A2M entered into a 50:50 sales and marketing JV with Robert Wiseman Dairies (UK’s largest fresh milk company) to market a2 milk in the UK and Ireland. A2M saw a big opportunity in the UK given approximately one in five British consumers have issues digesting regular milk, yet are not medically diagnosed as lactose intolerant. In 2012, Robert Wiseman Dairies was taken over by the Muller Group. In January 2014, the marketing and sales of a2 Milk products was assumed by A2M and Muller Milk & Ingredients continued to supply, buy, process and distribute a2 Milk on a cost-plus basis and A2M acquired the remaining 50% of this business. Given private label dominates the UK milk market, A2M made the strategic decision to reposition the company as a premium speciality milk supplier. It enhanced its price positioning through new packaging formats to improve its gross margins. A2M introduced UHT long life milk in September 2016 and infant formula in the UK during FY16. Infant formula is sold in the wholesale market. The UK business turned profitable in FY17. A2M is currently in all major supermarkets with distribution in over 2,000 stores in the UK. Figure 7: A2M’s UK product range


USA A2M’s strategy in regards to the USA has been to build brand awareness and progressively expand its footprint on a region-by-region basis. A2M entered the southern Californian fresh milk market in April 2015, followed by northern California in September 2015. It moved into the South East region – Florida, Georgia and the Carolinas in March 2017 through Publix which has 1,100 stores. A2M set itself a sales velocity target which was 30 units per store per week before it went into another territory. After achieving this, in January 2018, A2M announced its expansion into the North East region (New York, New Jersey, Pennsylvania, Connecticut, Rhode Island, New Hampshire, Massachusetts, Vermont and Maine), which represents 20% of the US liquid milk market. This will take the number of stores selling a2 Milk to over 5,000 in the USA. Despite milk consumption falling in the USA, it is important to highlight that A2M is operating in the specialty milk segment, which is growing. The USA milk market is highly fragmented and private label sales dominate the market. A2M’s product format is ½ gallon cartons which is consistent with the specialty milk category. a2 Milk is available in four varieties. A2M USA CEO has been quoted saying there are approximately 75m people in the USA who identify themselves as lactose intolerant which are potential targets for a2 Milk. A2M sources its milk locally and pays a premium price. A2M has two processors in the USA. Its milk procurement partner is Prairieland Dairy.

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Figure 8: A2M’s US product range


Business profitability has been transformed with infant formula A2M’s profitability has seen a step change over the last two and a half financial years following its success in the high margin infant formula category. Before this, it was largely an Australian focused brand with a significant presence in the liquid milk market. Infant formula generates a materially higher margin than fresh milk. As the infant formula business has scaled, A2M’s margins have expanded materially despite investing significant sums in the UK and USA. In the 1H18 infant formula represented 78% of the group’s revenue, up from 72% in FY17, 61% in FY16A, 27% in FY15A and 10% in FY14A. Figure 9: A2M revenue per product (NZ$m) 600.0

500.0

400.0

300.0

200.0

100.0

0.0

FY14A

FY15A

Infant formula

FY16A

Liquid milk

FY17A

Other products


Growth in A2M’s gross profit margin should slow down in the future, in line with the company’s changing product mix and the scaling of the US business, which as this stage purely sells a2 Milk (lower margin product). Growth in new lower margin products will also affect the company’s gross profit margin. Upside to our forecast is if A2M acquires a blending and canning facility which would add a manufacturing margin as volumes scaled.

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Figure 10: Gross profit margin

Figure 11: EBITDA margin 40.0%

60.0%

35.0% 50.0%

30.0% 40.0%

25.0% 30.0%

20.0% 15.0%

20.0%

10.0% 10.0%

5.0% 0.0%

0.0% FY14A

FY15A

FY16A

FY17A

FY18F

FY19F

FY20F

FY14A


FY15A

FY16A

FY17A

FY18F

FY19F

FY20F


FY18 outlook A2M hasn’t provided formal FY18 earnings guidance however it said that its performance in January was pleasing. A2M expects continued growth in revenue and earnings. It has also said: 

Revenue momentum looks good into the 2H18. We believe the market share wins and increased distribution in the 1H18 bode well for strong 2H18 revenue growth despite infant formula sales being seasonally skewed to the first half given sales for the three largest e-retailer events fall largely within this period being Tmall’s Singles Day, JD.com’s 12/12 and there is the initial build for Chinese New Year.



The gross profit margin is expected to be broadly consistent in the 2H18 to the 1H18.



Earnings growth in the 2H18 will be tempered by higher marketing expense. 2H18 marketing expense is expected to exceed the 1H18 by approximately NZ$35-40m (was NZ$30m) driven by increased spend in China and the USA to build brand awareness. This implies FY18 marketing expense of NZ$87-92m compared to NZ$42m in FY17. This spend should support strong sales growth in FY19.



Inventory levels will be increased to more sustainable levels. FY17A benefited from low inventory levels following strong demand for infant formula. We highlight that management likes some degree of inventory undersupply to maintain price stability.



A2M’s capital management strategy remains under review by the Board. With the interim result, A2M announced it is accessing the opportunity to invest directly in a blending and canning facility. This investment could be either in full or in partnership with another party. Based on recent industry expansion, we think that N$50-80m would be required if A2M invested 100% in a new facility. The Board also continues to consider an on-market buyback and implementation of a dividend policy. We note that at the FY17 result, the Board said it intends to establish an on-market buyback over the next 12 months of up to A$40m.

In regards to each of its core geographies it has stated: 

Australian and New Zealand (ANZ) – The 2H18 should benefit from the improved level of inventory built towards the end of the 1H18.



China and other Asia – A2M’s marketing spend is expected to rise materially in the 2H18. A2M expects to expand further in the Mother &

10


Baby stores in the 2H18. In the 4Q18, A2M will launch its new Chinese packaging with a new Chinese brand name. 

UK and USA – A2M intends to invest another US$25m over FY18 and FY19 on building its brand in the USA before achieving monthly breakeven in FY20. Its marketing spend will be greater in the 2H18 than the 1H18. Specifically, A2M is expected to spend approximately US$7m in the 2H18 on increased marketing to support its Northeast launch. A2M is also investigating specific new product opportunities for the USA market to further capitalise on its growing brand awareness and expanded distribution. A2M is also assessing incremental opportunities in Europe and the Middle East. The opportunity to sell a2 Platinum into the UK retail market continues to be assessed.



Corporate and other (includes corporate costs, spend on patents, trademarks, R&D and other costs associated with business expansion activities) – this spend will continue to grow given the additional resources in place, A2M expands into new geographies and continues to develop its intellectual property portfolio which underpins its first mover advantage.

Morgans' forecasts The strong growth in a2 Platinum has transformed A2M’s earnings in recent years and we expect this to continue given there is plenty of market share to be won in existing and new markets. A2M will also benefit from its expanded distribution. In addition, new products and entering new regions should incrementally grow earnings over time. In FY18 we forecast NPAT to rise 132% to NZ$210.5m. In FY18 our forecast is roughly in line with Factset consensus but in FY19 and FY20 we are materially above. FY19 should benefit from the additional marketing spend in the 2H18, a full year of CFDA approval and strong growth in Mother and Baby stores in China. In FY20, we forecast the US business to reach monthly break even and the Fonterra strategic relationship to have a positive contribution. At this stage, we don’t forecast A2M to pay a dividend. We will model a dividend payout ratio when the Board announces its official policy. Figure 12: Morgans' business unit forecasts (NZ$m) Revenue ANZ Growth China and Other Asia Growth UK and USA Growth Corporate and Other Growth Total Growth

2014A

2015A

2016A

2017A

2018F

2019F

2020F

106.9

149.1 40% 4.0 47% 1.9 74% 0.0 -69% 155.1 40%

296.3 99% 38.2 844% 18.3 846% 0.0 10% 352.8 127%

439.6 48% 88.9 133% 21.0 15% 0.1 30% 549.5 56%

661.3 50% 284.4 220% 34.7 65% 0.1 0% 980.5 78%

861.1 30% 512.0 80% 48.6 40% 0.1 0% 1421.7 45%

1008.0 17% 742.4 45% 62.2 28% 0.1 0% 1812.6 28%

30.0 564% -3.1 75% -12.1 454% -10.0 -434% 4.8 35%

84.7 182% 9.2 395% -20.5 70% -18.8 87% 54.6 1035%

155.3 83% 32.7 258% -22.5 10% -24.4 30% 141.2 159%

247.1 59% 114.9 251% -27.0 20% -29.3 20% 305.7 117%

320.7 30% 205.7 79% -17.6 -35% -34.9 19% 474.0 55%

372.1 16% 283.9 38% -3.0 -83% -41.2 18% 611.8 29%

20.1% -76.7% -625.3%

28.6% 24.0% -112.2%

35.3% 36.8% -107.0%

37.4% 40.4% -77.8%

37.2% 40.2% -36.1%

36.9% 38.2% -4.8%

2.7 1.1 0.1 110.8

EBITDA ANZ Growth China and Other Asia Growth UK and USA Growth Corporate and Other Growth Total Growth

4.5 -1.8 -2.2 3.0 3.6

EBITDA margin ANZ China and Other Asia UK and USA

4.2% -64.7% -196.6%


11


Valuation – A$14.40 per share Our blended valuation is A$14.40 per share. We use a blended valuation methodology (PE/ EV/EBITDA/ and DCF) and have focused on FY19F multiples in relation to our PE and EV/EBITDA valuations. In setting the multiples we apply to A2M, we have compared it to other infant formula/dairy/FMCG companies with strong brands and who are selling into China. We include a DCF valuation to take into account some of the medium to longer term upside associated with A2M’s growth strategy. We apply a WACC of 9.0% and a long term growth rate of 4.0%. Our DCF valuation also includes A2M’s 8.2% shareholding in Synlait at its last closing share price. We use a spot exchange rate (AUD/NZD) to convert our valuation to AUD. Figure 13: Blended valuation (A$) Method DCF (includes Synlait shareholding) FY19 PE of 35.0x FY19 EV/EBITDA of 23.0x NZ$ valuation per share Spot currency A$ valuation per share

Valuation $15.62 $15.39 $15.61

Weighting 33% 33% 33%

Valuation per share $5.21 $5.13 $5.20 $15.54 $1.08 $14.40


Compco analysis We believe that A2M deserves to trade at a material premium to both its domestic and international peers due its track record in successfully managing China regulatory changes, its materially stronger growth profile, margins, ROE and balance sheet strength. Figure 14: Compco Mkt Cap Domestic and NZ Comps Treasury Wine Estates Limited a2 Milk Company Ltd. Costa Group Holdings Ltd. Bellamy's Australia Ltd. Blackmores Limited Bega Cheese Limited Synlait Milk Ltd. Freedom Foods Group Limited BWX Ltd. Comvita Limited Capilano Honey Ltd. Average Median International Comps Nestle S.A. Abbott Laboratories Kraft Heinz Company Danone SA Reckitt Benckiser Group plc Inner Mongolia Yili Industrial General Mills, Inc. China Mengniu Dairy Co., Ltd. Campbell Soup Company Saputo Inc. Meiji Holdings Co., Ltd. Aspen Pharmacare Holdings Limited Parmalat S.p.A. Health and Happiness (H&H) Hain Celestial Group, Inc. Bright Dairy & Food Co., Ltd. Class A United Natural Foods, Inc. PZ Cussons Plc Yashili International Holdings Ltd. Beingmate Baby & Child Food Co Dean Foods Company Average Median

PE (x) FY+1 FY+2

EV/EBITDA (x) FY+1 FY+2

EPS Growth FY+1 FY+2

EBITDA margin FY+1 FY+2

Div Yield FY+1 FY+2

ROE FY+1

FY+2

Net Debt/EBITDA (x) FY+1 FY+2

12,483.2 9,421.9 2,432.9 2,385.3 2,262.2 1,310.2 1,251.4 1,006.3 666.4 304.2 159.8

35.8x 49.1x 30.2x 50.0x 31.7x 25.1x 21.1x 67.9x 24.6x NA 16.8x 35.3x 31.0x

28.0x 35.1x 25.9x 35.3x 25.8x 22.1x 17.7x 31.8x 17.6x 14.6x 15.2x 24.5x 25.8x

20.7x 31.8x 17.5x 32.5x 19.7x 14.0x 12.2x 26.3x 17.4x 11.7x 10.9x 19.5x 17.5x

16.8x 23.4x 14.8x 22.7x 16.1x 12.2x 10.3x 16.2x 12.3x 9.8x 9.8x 14.9x 14.8x

21.8% 123.1% 24.5% 55.2% 22.0% 41.7% 58.7% 12.8% 25.3% 366.0% -7.8% 67.6% 25.3%

27.8% 40.1% 16.6% 41.6% 22.6% 13.8% 19.3% 113.5% 40.2% 19.2% 10.5% 33.2% 22.6%

25.1% 32.5% 13.8% 21.5% 17.3% 7.2% 13.7% 11.3% 26.8% 15.9% 10.9% 17.8% 15.9%

27.4% 32.6% 14.4% 25.3% 19.1% 7.8% 15.3% 13.4% 27.0% 15.8% 11.5% 19.1% 15.8%

1.8% 0.0% 1.9% 0.2% 2.5% 1.7% 0.0% 1.0% 1.6% 2.4% 2.3% 1.4% 1.7%

2.4% 0.7% 2.2% 0.4% 3.1% 2.1% 0.0% 1.1% 2.3% 2.9% 2.5% 1.8% 2.2%

10.0% 42.1% 18.0% 22.4% 36.7% 8.1% 14.5% 4.5% 9.5% 10.5% 14.4% 17.3% 14.4%

12.2% 39.6% 19.0% 24.5% 40.3% 9.0% 14.9% 9.1% 12.5% 11.9% 14.4% 18.8% 14.4%

0.8x -0.9x 1.4x -1.1x 0.4x 2.1x 1.1x 3.5x 1.0x 1.9x 0.5x 1.0x 1.0x

0.5x -1.2x 1.0x -1.2x 0.3x 1.7x 0.8x 2.1x 0.5x 1.4x 0.3x 0.6x 0.5x

319,087.6 141,287.9 104,937.9 71,174.1 70,905.8 37,771.8 37,608.2 16,784.7 16,665.1 15,807.8 14,345.0 12,514.6 8,820.2 5,187.3 4,721.8 3,373.6 2,915.5 2,153.5 1,277.7 1,110.4 1,073.6

19.9x 22.3x 17.7x 18.1x 16.9x 28.9x 16.4x 35.8x 14.1x 21.6x 17.8x 15.1x 40.9x 28.1x 21.5x 25.5x 15.1x 17.4x NA NA 13.3x 21.4x 18.1x

18.3x 19.8x 16.6x 16.5x 15.8x 23.5x 15.3x 25.1x 13.6x 18.8x 17.3x 13.6x 24.8x 22.4x 18.7x 23.3x 13.3x 16.0x 99.1x NA 11.3x 22.2x 17.8x

14.0x 16.2x 13.5x 12.6x 13.6x 20.1x 11.5x 17.7x 10.9x 13.0x 9.0x 12.3x 11.6x 14.8x 12.6x 8.5x 7.6x 10.6x NA 51.3x 5.4x 14.3x 12.6x

13.2x 14.5x 13.0x 11.4x 12.7x 16.1x 11.4x 14.1x 10.5x 12.0x 8.7x 11.1x 9.4x 12.2x 11.2x 8.0x 6.9x 9.6x 25.5x 23.6x 5.0x 12.4x 11.4x

8.3% 14.1% 7.8% 7.1% 3.8% 15.1% 2.9% -437.8% 1.9% 3.7% 7.1% 18.3% -16.0% 5.5% 36.5% 17.0% 17.3% -2.8% -50.1% NA -12.9% -17.7% 6.3%

8.7% 12.5% 6.8% 9.8% 7.3% 22.8% 7.2% 42.6% 3.7% 15.2% 3.0% 10.8% 65.1% 25.4% 14.9% 9.3% 13.4% 8.6% NA NA 17.8% 16.1% 10.8%

20.1% 25.4% 30.7% 18.8% 28.7% 12.7% 21.6% 8.3% 21.9% 11.4% 11.3% 28.6% 6.6% 26.2% 11.2% 8.5% 3.4% 15.5% -5.1% 4.7% 4.4% 15.0% 12.7%

20.7% 26.0% 31.2% 19.4% 29.3% 14.0% 22.2% 9.3% 21.9% 10.5% 11.5% 29.6% 7.6% 26.6% 11.8% 8.6% 3.3% 16.1% 6.1% 9.5% 4.7% 16.2% 14.0%

3.3% 1.8% 3.8% 2.9% 3.0% 2.1% 3.8% 0.7% 3.3% 1.5% 1.6% 1.3% 0.7% 0.3% 0.0% 1.6% 0.0% 3.0% 0.0% 0.2% 4.0% 1.9% 1.6%

3.5% 1.9% 4.0% 3.2% 3.2% 2.6% 4.0% 1.1% 3.5% 1.7% 1.7% 1.4% 0.7% 0.5% 0.0% 1.6% 0.0% 3.1% 0.2% 0.6% 4.2% 2.0% 1.7%

18.9% 16.9% 7.1% 14.8% 16.4% 24.6% 36.9% 10.3% 70.0% 17.1% 13.1% 15.8% 3.9% 22.7% 8.2% 12.2% 8.3% 12.8% -2.6% -10.6% 9.4% 15.5% 13.1%

20.6% 17.9% 7.5% 15.1% 16.1% 26.5% 37.2% 13.3% 60.5% 18.0% 12.3% 15.4% 6.1% 22.5% 8.6% 12.3% 8.5% 12.9% 1.1% -3.5% 10.4% 16.2% 13.3%

1.0x 2.0x 3.4x 3.0x 2.6x -1.7x 2.8x 0.7x 3.3x 0.9x 0.6x 3.2x -0.5x 2.2x 1.5x -0.6x 0.9x 0.9x NA 10.4x NA 1.9x 1.5x

1.1x 1.5x 3.2x 2.5x 2.2x -1.6x 2.9x 0.1x 3.1x 1.4x 0.5x 2.8x -0.8x 1.5x 1.0x -0.5x 0.5x 0.6x -14.4x 4.4x 2.5x 0.7x 1.4x

Prices as at 12 March 2018. SOURCES: FACTSET

12


Forward PE chart Given A2M only started reporting a material level of profitability in FY16, our PE band chart has limited history. A2M is trading on an FY19 consensus PE of about 35.1x. Based on our above consensus forecast, A2M is trading on an FY19 PE of 31.2x. We note that A2M’s PE is somewhat inflated by the losses produced from its US business and the modest level of profitability achieved from its UK business despite the substantial capital being invested in these businesses. Backing out the UK and USA businesses, A2M’s FY19 PE falls to 30.1x, based on our forecasts. Figure 15: A2M forward FY19 PE chart 45

40

35

30

25

20

15

10 Jan-2016

Apr-2016

Jul-2016

Oct-2016

Jan-2017

Apr-2017

Jul-2017

Oct-2017

Jan-2018


Investment view – Add rating and A$14.40 price target We initiate coverage on A2M with an Add recommendation and A$14.40 price target. While A2M’s share price has risen strongly so far this year, with the upgrade cycle far from over, we believe the stock will continue to appreciate. A2M’s point of differentiation by offering consumers both health and digestive benefits has allowed it to win market share in each of its product lines and across its geographies. It has also allowed it to price its products at a premium to peers. The company generates strong EBITDA margins, considerable free cashflow and a high ROE. Its balance sheet (strong net cash position) should allow it to fund a blending and canning facility, its new products and global expansion plans whilst rewarding shareholding through dividends and other capital management initiatives. With low market shares in some very large markets such as China, the USA and UK, we believe that A2M should generate strong earnings growth over the medium term. Importantly, A2M is led by an impressive management team that has successfully managed China regulatory changes at a time when others have failed. Catalysts for share price appreciation include – earnings upgrades (A2M has a track record of surprising on the upside), new product and/or new geographic launches, new geographies achieve profitability sooner than expected, accretive investment in a blending and canning facility and corporate activity. Key risks include: 

China regulatory risk. Any change in regulation may impact A2M unless it is able to change its business model in a timely manner. However we note that A2M has a flexible multi-channel infant formula strategy in both China label (offline and online) and cross border English label (online) to achieve growth and best position the brand to meet changes in the regulatory environment over time. From the end of December 2018, CFDA approval and Chinese labelling may be required through CBEC. Given A2M already has both of these in place, it will be well positioned for any change. 13




Key person risk given the senior management team has been integral to the company’s success. Jayne Hrdlicka has been appointed Managing Director and CEO, to succeed Geoffrey Babidge who will retire from this role during calendar 2018. Jayne was most recently employed for over five years in the role of CEO of the Jetstar Group. She has also been a partner at Baine & Company focused on consumer-orientated businesses. Jayne is expected to start in July 2018. Geoff has agreed to remain available to the company until the end of 2018 as an advisor to Jayne and the Board as required to ensure a smooth handover and transition. Jayne will also be supported by a very strong senior management team.



Pricing pressure from major retailers. A2M is reliant on significantly large retail outlets in some markets which dictate supply terms and retail shelf space presence. The retailers are also focused on growing their private label sales. However, we note A2M’s products have appeal given their strong demand and premium price allows the retailers to earn attractive margins.



Rising input costs which can put pressure on margins if the increased cost can’t be passed onto customers. Milk is A2M’s main COGS input. Volatility in the farmgate milk price has an impact on the company’s gross margin.



Supply issues such as loss of a major A2 dairy supplier such as the Leppington Pastoral Co (Perich Family) or Moxey Farms. Effective 1 July 2017, A2M’s milk supply arrangements with Moxey Farms and Leppington Pastoral Co were extended for a further three-year term. The renewed arrangements provide for increased committed and available A1 proteinfree milk volumes and the removal of the previous ‘at will’ termination rights. A2M’s previous protections around its intellectual property rights, herd maintenance and quality assurance and controls are continued, whilst authority was given for the sale of milk surplus to the company’s requirements subject to specific conditions. A2M has said that its contracts provide access to milk pools which exceed its current usage requirements.



Concentration of manufacturing (particularly with Synlait) and not being able to keep up with demand. a2 Platinum has had out of stock issues in the past. Prolonged out of stocks could have negative implications on demand and may see switching to competitors' products. This issue should be somewhat resolved over time given the new Fonterra strategic relationship.



Food safety or quality issues leading to brand damage. Management has made sure that the key focus for its supply chain management and partners relates to minimising the risk of product substitution or counterfeit, particularly for infant formula in China. Significant progress has been made around new security technology and advances in quality and authenticity proof points which will be implemented during FY18.



Consumer demand for A2 protein could wane or scientific studies or reports refute the benefits, therefore impacting sales and likely its premium pricing status.



Intellectual property rights expire. Over many years, A2M has built a portfolio of patents, proprietary processes, brands and trade-marks across many different countries. Some patents have already expired. There is a risk that third parties infringe on the company’s intellectual property, although we expect the group will actively pursue legal action if this occurs as we saw with the Lion Dairy case. However, the patents have finite lives, so this form of protection will diminish over time.



New competition. Even if new competitors were to enter the market, we believe that A2M’s first mover advantage, well established brand name and leading market share will be difficult to break down. A2M’s interlocking patent portfolio also provides barriers to entry. New competitors can also bring credibility to the benefits of the A2 protein. In December 2017, A2M settled its legal dispute with Lion. While the terms of the settlement are 14


confidential, we understand that Lion is still able to claim its products naturally contain A2 protein. At the 1H18 result, management recognised that there has been new competition (particularly in the US and China) however it also said that it has tested these products and doesn’t believe that they are 100% A1 free. Freedom Foods Group (FNP) recently announced that it is launching a new Australia's Own dairy range across one and two litre UHT milk, milk powder and cream. It said that included in the range will be A2 protein milk and milk powder. FNP highlighted that its product will be the only UHT A2 protein milk offering in Australian retail at this point in time. These products will be sold in Australia and throughout Asia. 

Adverse FX movements. Adverse movements in the AUD, USD, Pound or Chinese Yuan Renminbi against the NZD can impact A2M’s earnings on translation.



New country and product risk. When A2M enters a new region, it spends millions of dollars building its brand. In particular, there is a risk that A2M doesn’t achieve profitability in the USA in the targeted timeframe or it costs materially more than expected. It is fair to say that A2M’s expansion in the UK and USA has been more costly and has taken longer than expected to achieve an acceptable return. While A2M has achieved much success in the fresh milk and infant formula market, there is a risk that new products aren’t as well accepted by consumers as we saw with its launch into the Australian ice cream market.



Volatile market conditions and investor sentiment towards high PE stocks. With the company trading on an FY19 PE of 31.2x, there is no room for disappointment or the stock will be punished.

Appendix - 1H18 result summary A2M’s 1H18 result was materially stronger than consensus estimates. Its 1H18 NPAT was more than what it reported for the entire year in FY17. This result was driven by improved distribution and market share wins in all markets and across all key products, particularly infant formula. Margins continued to scale with the EBITDA margin increasing 790bps. Given the company released its first four months of trading at its AGM, its last two months of the 1H18 were extremely strong as the company benefited from key selling events in China. In the first four months, A2M was generating average revenue per month of NZ$65.6m and EBITDA per month of N$19.6m (29.9% EBITDA margin). For the last two months of trading, average revenue per month rose to NZ$86.2m and EBITDA was N$32.3m (37.5% EBITDA margin). While the company rebuilt stock, cashflow conversion was strong and the company is in a strong net cash position. Result summary: 

Underlying NPAT increased 150% to NZ$98.5m. The underlying tax rate fell to 31.0% from 37.4% due to a lower weighting of international tax losses (not tax effected) and non-deductible expenses.



Sales revenue increased 70% to NZ$434.6m. Sales growth was once again led by infant formula (sales grew 85% and represented 78% of group revenue). Liquid milk sales rose 14% and other product sales (largely milk powders) increased 124%.



Gross profit margin increased to 49.8% from 46.5% the pcp (was 48.0% in FY17). The improvement in gross profit margin reflected an increased contribution from its high margin infant formula, higher selling prices and the benefits of scale. Favourable currency movements offset raw material cost increases. During the 1H18, A2M implemented a price rise across all channels.

15




Underlying EBITDA was up 123% to NZ$143.0m. The EBITDA margin increased to 32.9% from 25.0% (was 25.7% FY17A). The margin benefited from positive product mix and increased scale.



Underlying costs rose 34%. Distribution costs/sales continued to benefit from scale at 3.0%, down from 3.7% the pcp. Marketing is A2M’s largest expense item. Marketing costs/sales were 6.0%, down slightly from 6.3% the pcp. In aggregate, Marketing costs increased NZ$10m on the pcp with most of the spend directed to supporting growth in China and the US. Employee costs rose 65% as A2M built capability in its core markets. Other operating expenses fell 19% however we note the pcp included a one-off A$2.4m impairment on intangibles and the 1H18 benefited from an FX gain of NZ$2.9m.



D&A fell 34% to A$1.1m reflecting last year’s write-down of USA intangibles.



Operating cashflow rose 205% to NZ$116.4m compared to NZ$38.1m in the 1H17. Working capital benefited from improved debtor days and the timing of payments with suppliers (cNZ$20m benefit which will reverse in the 2H18), partially offset by an increase in infant formula inventory to more sustainable levels. Cashflow conversion was 113%, up from 97% the pcp.



Capex rose to NZ$2.1m from NZ$0.9m the pcp reflecting offshore expansion.



As at 31 December 2018, A2M was in a net cash position of NZ$240.2m compared to NZ$108.4m the pcp. The company has no debt.



Inventory stood at NZ$53.6m, up from NZ$30.0m in the pcp and NZ$28.4m in FY17 and was in line with the company’s strategy to rebuild stock levels. In particular, management said that it increased its China labelled inventory in response to regulatory changes from 1 January 2018 and due to increasing demand.

16


Figure 16: Result summary (NZ$m) FY14A 110.6

1H15A 74.7

2H15A 80.1

FY15A 154.8 40%

1H16A 139.1 86%

2H16A 213.4 166%

FY16A 352.5 128%

1H17A 256.0 84%

2H17A 293.3 37%

FY17A 549.3 56%

1H18A 434.6 70%

2H18F 545.8 86%

FY18F 980.5 79%

FY19F 1421.7 45%

FY20F 1812.6 28%

70.8 39.8 36.0%

48.5 26.1 35.0%

51.8 28.3 35.3%

100.4 54.4 35.2%

82.1 57.0 41.0%

119.4 94.0 44.0%

201.5 151.0 42.8%

137.0 119.0 46.5%

148.7 144.5 49.3%

285.7 263.5 48.0%

218.2 216.5 49.8%

272.1 273.8 50.2%

490.2 490.2 50.0%

696.6 725.0 51.0%

888.2 924.4 51.0%

n/a

n/a

n/a

n/a

11.8

6.8

8.6

9.7

6.9

3.4

15.0

9.3

15.0

36.5

23.0

26.9

15.4 31% 10.3 6% 24.3 62% 49.9 37%

6.6 0% 13.3 96% 10.0 46% 8.5 -9% 38.5 67%

8.9 0% 13.8 60% 23.0 582% 12.6 -16% 58.3 116%

15.5 0% 27.0 76% 33.0 222% 21.2 -13% 96.7 94%

9.5 44% 13.7 3% 16.0 60% 15.8 85% 55.1 43%

10.7 20% 18.7 36% 26.0 13% 12.2 -3% 67.6 16%

20.2 30% 32.4 20% 42.0 27% 28.0 33% 122.7 27%

13.0 37% 21.8 59% 26.0 62% 12.8 -19% 73.6 34%

14.6 37% 22.7 21% 61.0 135% 12.9 5% 111.1 64%

27.6 37% 44.5 37% 87.0 107% 25.7 -8% 184.7 51%

35.7 29% 56.9 28% 127.8 47% 30.8 20% 251.3 36%

42.3 18% 68.3 20% 166.2 30% 36.0 17% 312.8 24%

Other income - includes royalties Growth

0.2

0.1

0.2

0.3 37%

0.1 8%

0.1 -23%

0.3 -10%

0.1 7%

0.1 3%

0.3 2%

0.1 -27%

0.1 27%

0.2 -27%

0.2 0%

0.2 0%

Underlying EBITDA Growth EBITDA margin

3.6

3.3

1.5

3.2%

4.4%

1.9%

4.8 35% 3.1%

18.7 35.9 54.6 472% 2225% 1035% 13.4% 16.8% 15.5%

64.1 243% 25.0%

77.1 115% 26.3%

141.2 159% 25.7%

143.0 123% 32.9%

162.7 111% 29.8%

305.7 117% 31.2%

474.0 55% 33.3%

611.8 29% 33.8%

D&A

1.9

0.9

1.0

1.9

2.7

1.6

1.1

2.7

1.1

1.3

2.4

3.5

4.5

Underlying EBIT Growth EBIT margin

1.7

2.4

0.5

1.5%

3.2%

0.6%

2.9 72% 1.8%

17.4 34.4 51.8 640% 6686% 1712% 12.5% 16.1% 14.7%

62.5 258% 24.4%

76.0 121% 25.9%

138.5 167% 25.2%

141.9 127% 32.7%

161.4 112% 29.6%

303.3 119% 30.9%

470.5 55% 33.1%

607.3 29% 33.5%

0.0

0.9

-1.3

-0.4 10.1 20.3 30.4 -4200% 1039% -1667% -7523%

39.4 290%

51.3 152%

90.6 198%

98.5 150%

112.1 119%

210.5 132%

328.2 56%

425.6 30%

0.0% 10.6% 8.8% 13.6%

0.0% 9.1% 9.2% 12.5%

0.0% 10.7% 4.2% 18.7%

3.7% 5.4% 6.3% 6.2%

3.6% 6.4% 8.9% 4.2%

3.7% 5.9% 7.6% 5.1%

3.0% 5.0% 6.0% 2.9%

2.7% 4.2% 11.2% 2.4%

2.8% 4.5% 8.9% 2.6%

2.5% 4.0% 9.0% 2.2%

2.3% 3.8% 9.2% 2.0%

Sales Revenue Growth Cost of Sales Normalised Gross Profit Gross Profit Margin % Distribution expenses Growth Administrative expenses Growth Marketing expenses Growth Other expenses Growth Total Costs Growth

Underlying NPAT Growth Distribution/Sales Administration/Sales Marketing/Sales Other Expenses/Sales

0.0% 9.9% 6.6% 15.7%

1.3

4.8% 9.5% 7.2% 6.1%

1.5

4.2% 6.5% 10.8% 5.9%

4.4% 7.7% 9.4% 6.0%

SOURCES: COMPANY REPORTS, MORGANS

Result by geography: Australian and New Zealand (ANZ) – Revenue grew 47%, with strong growth in infant formula, fresh milk sales rose 3% and A2M also had solid whole milk powder and skim milk powder sales. EBITDA increased 65%. The EBITDA margin rose to 38.3% from 34.1% the pcp. According to scan data, a2 Platinum’s market share (by value) in the retailers rose to about 30% compared to 26% at the end FY17 and was 16% at the end of FY16. China and other Asia – The strong performance from China was the highlight of the result. Sales increased 204% and EBITDA was up 252%. Both 1H18 sales and EBITDA were in excess of what A2M reported for the entire FY17 year. The EBITDA margin rose to 42.3% from 37.1% despite A2M investing across sales, distribution, marketing, quality, regulatory affairs and finance. The 1H18 benefited from key promotional events, particularly in November and December. a2 Platinum achieved number one infant formula brand on Kaola.com, number two on JD.com and third place on Tmall. A2M also benefited from material market share wins. According to Kantar, a2 Platinum’s market share rose to 5.4%, up from 3.6% in the final quarter of FY17. During the period, A2M expanded its channels to market. It is now in approximately 6,700 Mother & Baby stores, up from 3,800 at the end of June 2017 (c1,450 at the end of FY16). UK and USA – While revenue increased 36%, the loss rose to NZ$8.4m from NZ$7.7m the pcp. Despite a challenging retail environment, fresh milk volumes were up more than 50% in the UK as A2M benefited from further improvement in sales velocities in-store and gains in distribution (c2,000 stores, up from 1,600). Sales of a2 Platinum in the UK to the wholesale channel were flat. The UK continued to report a modest profit in this highly competitive market. In the US, 17


A2M achieved its key objectives which were to grow brand awareness, sales velocities and store numbers. The company also said that it saw improvement in gross margin and distribution costs. Corporate and other (includes corporate costs, spend on patents, trademarks, R&D and other costs associated with business expansion activities). The 8% increase in this spend during the 1H18 compared to the 1H17 reflected increased spend on business development and R&D costs associated with a higher level of business activity. Figure 17: Result by geography (NZ$m)

Sales 1H15 2H15 FY15 ANZ 72.8 76.3 149.1 China and other Asia 1.1 3.0 4.0 UK and USA 0.9 1.0 1.9 Corporate and other 0.0 0.0 0.0 EBITDA ANZ 4.9 25.1 30.0 China and other Asia -0.6 -2.5 -3.1 UK and USA -1.9 -10.1 -12.1 Corporate and other 0.9 -11.0 -10.0 EBITDA margin ANZ 6.7% 32.9% 10.1% China and other Asia -56.7% -84.0% -76.7%

1H16 127.9 8.4 2.9 0.0

2H16 168.4 29.8 15.4 0.0

FY16 296.3 38.2 18.3 0.0

1H17 206.6 37.7 11.8 0.0

2H17 232.9 51.2 9.2 0.1

FY17 439.6 88.9 21.0 0.1

1H18 304.3 114.4 16.1 0.0

1H18 vs 1H17 47% 204% 36% 0%

34.5 1.2 -8.1 -9.0

50.2 7.9 -12.4 -9.8

84.7 9.2 -20.5 -18.8

70.4 13.7 -7.7 -12.3

85.0 19.0 -14.8 -12.1

155.3 32.7 -22.5 -24.4

116.4 48.3 -8.4 -13.4

65% 252% 9% 8%

27.0% 14.6%

29.8% 26.7%

28.6% 24.0%

34.1% 36.5%

36.5% 37.1%

35.3% 36.8%

38.3% 42.3%

FY17 vs FY16 48% 133% 15% 30%

2H17 1H17 vs vs 2H16 1H16 38% 62% 72% 348% -40% 310% 300% -100%

FY16 2H16 vs vs FY15 2H15 99% 121% 844% 903% 846% 1382% 10% -13%

83% 258% 10% 30%

69% 104% 140% 1021% 19% 5% 23% -38%

182% 395% 70% 87%

1H16 vs 1H15 76% 681% 224% 26%

100% 608% 418% 301% 22% 323% -10% -1075%

SOURCES: COMPANY REPORTS, MORGANS

18


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