It’s not only about what you buy…but what you pay when you buy it

Daniel Moore

When looking at all stocks over a period of time, even the best quality ones, it becomes clear that companies often fall into or out of favour with investors based on short-term factors. These short-term factors can greatly impact the perception and the PE rating of the company’s stock price and will often impact investors’ perception as to what constitutes a company with bright prospects (a ‘growth’ stock) as opposed to a company with poorer prospects.

Further to Anton Tagliaferro’s wire ‘Market dynamics – the case for value remains’, we compare two ASX top 100 stocks – A2 Milk (market cap $8 billion) which falls firmly into the ‘growth’ stock category and Brambles (market cap $14 billion), which is perceived by many in the market as having earnings issues and is thus seen as a much less exciting prospect, thereby now very much falling into the ‘value’ category.

A2 Milk

A2 Milk is a New Zealand milk products company listed in Australia and the stock has been a star performer over the last few years as Chinese consumers that can afford it have swapped their buying preferences to overseas infant formula brands after melamine was found in infant formula of Chinese local brands in 2008. Thanks to this scare, demand for A2’s products have benefited greatly from its clean, green NZ image.

As a result of this, A2’s profits have risen rapidly from effectively zero a few years ago to a forecast NPAT of NZ$188 million in FY18 and its share price has risen from under $2 a share to over $10 a share (see chart below) valuing the company at $8 billion – this valuation now equates to a not insignificant PE of 44 times the company’s FY18 forecast earnings.

Source: FactSet Date: 18 June 15 – 18 June 18

A2’s recent past success is now obvious to all – the question is whether A2’s Milk shares on a PE of 44 times represent good buying today or is A2 too risky an investment for the prudent long-term investor?

There are many things to consider when answering this question. Crucial factors for investors to assess are how sustainable A2 Milk’s current EBIT margins of 30%, and its cash-adjusted return on equity of close to 100% will be going forward.

In reality, it will only be possible for the company to continue to generate these exceptional returns going forward if the company’s product and competitive position are extremely strong.

The key questions then become:

  • Is an investment in A2 shares still an attractive proposition given the high expectations implied in its lofty valuation?
  • Has the company got a strong enough competitive advantage through its brands and products to enable A2 to continue to produce and grow its recent returns in the longer term?

One of the major issues for A2 is that its product has been successful in China through the unregulated and opaque so-called Chinese ‘daigou’ or suitcase market and not through any exclusive distribution agreement. The company has managed to achieve an estimated 5% share of the market in China through word of mouth and A2 has managed to achieve this share through limited marketing spend.

A2’s success is now drawing attention from many milk producers and competitors in the sector – recently global giant Nestle, with all its scale and marketing clout launched “Atwo” into China to directly compete in A2’s market. And only in the last fortnight, Bubs Australia, another NZ infant formula company, announced it was increasing its milking herd by over 5-fold and raising capital to take advantage of the opportunities in the infant formula market in China.

While it is true that A2 has grown rapidly and has a cashed-up balance sheet, in our opinion, those investors who are extrapolating A2’s current margins and returns well into the future are likely to be disappointed. We believe that the market appears to be overly optimistic on A2’s outlook as the high returns the company currently enjoys are unlikely to be sustainable over the long term as competition increases, and on a PE of 44 times forecast earnings,

A2 is a very risky investment in our opinion.

Brambles

This leads us to Brambles, a stock which we have been recently adding to in IML’s portfolios.

Brambles first listed in Australia in 1954, as W E Bramble & Sons Limited and entered the pallet pooling business in 1958 through the purchase of the Commonwealth Handling Equipment Pool (CHEP), from the Australian Government. Through a series of acquisitions, joint ventures and green field expansion into different countries and the investment of billions of dollars in pallet pools, warehouses and distribution centres Brambles has grown to be the largest supplier of pallets in the world over its 64-year history. Today, from its humble beginnings in Australia, Brambles has over 300 million CHEP pallets throughout the US, Europe and Australasia.

Chart 2: Brambles’ pallets growth over time

Source: Brambles and IML. Date: July-95 to June-17

Brambles has very strong competitive advantage in the markets it operates in thanks to its scale, unique network and reach. In recent times Brambles share price has weakened significantly as investors are concerned over the impact on margins from elevated transport costs (driven by higher oil prices), increased labour costs in the US as well as higher timber prices.

We believe Brambles, which is now trading on around 16 times earnings appears reasonable value on a 3 to 5-year view for a number of reasons:

  1. Input price concerns are short-term - we believe that Brambles will be able to recover its higher input prices and restore margins through price rises in the years ahead. Many of its customers are totally reliant on Brambles’ unrivalled scale and network density for their operations.
  2. Cost-outs will improve margins - Brambles has embarked on a significant cost-out programme to introduce automation across a number of depots which will also improve margins over time and increase its profitability.
  3. Earnings throughout the cycle - the majority of Brambles’ earnings are derived from the renting of pallets to facilitate the movement of food and consumables from manufacturers to their supermarket customers such as Walmart in the US. As such Brambles earnings have proven to be very resilient throughout economic cycles.

Conclusion

IML has always focused on buying companies with the criteria of strong competitive advantage, capable management, recurring earnings that can grow at a reasonable price.

To a long term, prudent investor like IML, buying a well-established, quality company like Brambles and being patient makes sense, especially when the company is out of favour with most investors and its shares are trading on depressed multiples due to short-term issues. We believe that doing this is a much more sensible investment than investing in many exciting relatively new ‘growth’ stocks like A2 Milk, on multiples of over 40 times earnings, when there are valid doubts as to the sustainability of the company’s earnings in the longer term.

Further insights

We believe that markets are not fully efficient and there will be times that a company’s share price will not reflect what we believe to be that company’s true underlying value. Find out more here


Daniel Moore

Since joining IML, Daniel has been part of the team which won Large Cap Fund Manager of the year in 2012 & 2015. In 2013 he was given Portfolio Management responsibilities within the firm, managing a portion of the IML Australian Share Fund.

Expertise

ASX:BXB ASX:A2M

Comments

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jonathan hall

Daniel Moore's comments about A2 are inaccurate. The facts are: 1. Iluma aTWO does not have Chinese CCC certification and cannot be sold on the ground in China only through websites. 2. IIuma aTWO is priced at over 400 yuan a tin almost 80% higher than a2 because Iluma cannot competitively price for fear of cannabalising its existing non A2 existing formula product lines 3. Iluma aTWO is produced by just a few herds in Ireland Iluma has neither the depth of herds or the capacity to change them over rapidly to be any substantial competition to A2 3. To develop the volume of herds and the necessary testing and verification infrastructure to compete with A2 will cost a competitor much more than A2's market cap. Look for a takeover offer as A2 grows to a global brand.

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Peter Brown

Jonathan, thank you for your summation of Iluma aTWO. I found it enlightening. if you read this I would be interested in your perspective regarding a new A2 product in Australia. Freedom Foods has recently released the only A2 ultra high temperature (UHT) treated packs people can buy in Australia. The price in my local Coles seemed competitive and not greatly dearer compared to other UHT milks. Freedom Foods is planning to sell the UHT A2 range in Asian countries as well.

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Peter Brown

I agree with your overall assessment Daniel. Growth companies can get ahead of themselves in terms of valuation and value companies by definition can become good value when their intrinsic value falls below their market price. However, I note that Brambles is currently trading at $9.20. If your thesis is correct you believe its intrinsic value is more than this. If you look at the last 15 years of share prices for Brambles you will see quite quickly that there have only been two periods when its share price has exceeded its current share price. The first was in 2006-2007 and the second was in 2014-2017. I also note that while its earnings may be resilient over cycles (although it did announce 4 profit downgrades in 2002/2003) share prices aren't that resilient over cycles. In the GFC its shares dropped to $4, when it arguably was a screaming value buy. Brambles has all the hallmarks of being a steady, relatively reliable, low-growth company that is tied very closely to the overall state of the economy. Its share prices correlate closely with that of the All Ordinaries Index. In other words, over the last 15 years, the time to have bought Brambles as a conviction value buy (and to have profited well) was at the start of bull markets not at the end.

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Stephen James

The problem with BXB is that management lacks credibility. Some years ago, they lost a truckload of pallets; then a few years ago, they had too many; and last year, the CEO sold a pallet load of shares just before he "retired". Apparently, BXB has a wide economic moat, is some sort of growth stock, yet pays 3+% partly unfranked yield. If BXB really had any pricing power, it would show up by now, and it wouldn't be sitting on a forcast PE of 16-14x. The simmering issue is whether the present trade wars are affecting volumes. Yet again, BXB management are conspicuous by their silence......

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tim lake

Daniel, thanks for the note. It's all about growth expectations. Paying 30x PE for A2 Milk one would expect 'lots' of growth and paying 16x PE for Brambles one would expect 'reasonable' growth. Here's the rub, over the last three years A2M has grown earnings (astronomically) while BXB's earnings has slightly gone backwards. I'm glad you display BXB's pallet growth over time because it highlights something troubling about the business model. Since 2014, total number of pallets has increased by 20% but earnings has fallen. This doesn't look like a company with pricing power. In fact, if they continue to grow the pallet pool and experience flat or declining profits they are destroying shareholders capital! Don't get lured into BXB's high returns on capital because its return on incremental capital is low. This is like buying Telstra (a high return on capital but low return on incremental capital business) on 16x PE justifying that its a high quality company only to find out that the business cannot grow.

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