In the space of just one month, a2 Milk added more than $1bn of additional market capitalisation, Wisetech Global not far short of $1bn, and Blackmores more than $500m. In the case of a2 Milk and Wisetech these amounts are substantially more than their reported revenues for the 2017 year, and in the case of Blackmores very close.
Price momentum and financial market asset value creation often make wealth creation seem easy; making the profits to support the paper wealth is hard. We remain somewhat sceptical in the ability of many of the Powerpoint slides and persuasive sales pitches which are currently being translated into extremely optimistic valuations, often in turn used to fund aggressive acquisition strategies, to deliver long run earnings and match the hype. As the old idiom goes: “Money talks, bulls...t walks.”
a2 Milk: Aphrodisiacs for analysts
Effervescent market environments and vertical share price charts incite emotional responses. Whilst a business may remain well managed, the analysis of it has a tendency to the cursory. From our perspective, a2 Milk is probably a case in point. Booming demand, significant price escalation and minimal required reinvestment are the equivalent of aphrodisiacs for analysts.
More likely long-term scenarios and the potential for prices and demand to fall as well as rise, are ignored. In reality, most food manufacturing and consumer goods businesses make margins of closer to 10% than the 25% which a2 are currently reporting . Good ones may get to 20%, but staying there is incredibly difficult.
If the $5.5bn valuation of the business is to be justified, we are going to need at least $400m or so in operating profit. At a 15% profit margin on a $30 tin of infant formula we’ll need to sell around 100m tins. Using some crude assumptions we might conclude that some 5% of the population in an average country might be under 3. In Australia, we might reasonably conclude we have a market of some 1m people buying perhaps 1 tin per week. $1500 per annum is no small investment for an average parent, however, this would still only leave a profit pool of $225m at our 15% margin. Our very rough assumptions therefore leave us needing a2 Milk to earn the entire profit pool (100% market share) of nearly 2 Australias to justify the current market valuation.
Countries the size of China, at 50 times the Australian population, offer potential for weaving even wilder optimism around prospects (ignoring the small detail that the $1500 annual bill excludes a large element of the population).
Be realistic about probabilities
Our point is hopefully clear; valuing a business requires a realistic assessment around the prospects for making profits over the long term, and even when the future is highly uncertain, placing realistic probabilities around the prospects for success or failure. We do not deny the potential for a2 Milk to justify its current valuation, management have done an amazing job to date, however, we would suggest there is a far greater probability it will not.
If the $5.5bn was your money and you could make only one investment, your investigations would be likely to run more deeply than an observation that there are a lot of babies in China, the stuff is flying off the shelves in Coles and Woolies (for resale in China) and recent sales through Chinese daigous have been solid.
Conditions change and popularity sometimes fades. Sensible valuation also needs to think about the other side.
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Martin is the Head of Australian Equities, and leads the portfolio construction process for Australian Equity portfolios, while also retaining analytical responsibilities for a variety of sectors including Diversified Financials, Gaming and Insurance
Great article, thanks for sharing Martin. Love the example you give of needing 2 Australias.
Perhaps Aussie investors are too insular in their thinking regarding the Asian food boom. A2M has a 3.5% market share of the infant formula market in China. China is having 17 million babies per annum and has one of the lowest breast feeding rates in the world. A recent positive profit report from HK based Ausnutria suggests that infant formula sales continue to grow strongly. A2M is using the strong growth in infant sales to expand its milk offering in the UK and the US and are building an envious global brand in the process (even they know this infant formula growth can't go on forever). BKL sales have stalled in Australia, but sales growth in Asia are up 36% and China direct sales growth is 71%. BKL recorded sales of $372 million in Australia & NZ while they are now doing $216 million in sales to Asia. Forget what is happening in Australia and consider the global growth opportunity of strong Australian brands, particularly in Asia (and the 4.4 billion people that live there).