The a2 Milk Company: Easy to stomach

Background and investment view: The a2 Milk Company (A2M) is in the business of producing, marketing and selling branded dairy and infant milk formula (IMF) products in Australia, New Zealand, China, US and UK. A2M branded milk contains only A2 Protein rather than both A1 and A2 proteins which are found in Regular Cows’ Milk. The business model of A2M is to focus on consumer facing products with a target on the functional food markets where a premium can be generated. We initiate on A2M with a Buy rating and a $1.81ps price target. Our favourable view on A2M is supported by: (1) a favourable margin shift as sales evolve in IMF; (2) exposure to growing demand for imported IMF products in China; (3) transition of the US and UK businesses from losses to profits; (4) a change in the NZ business model post 2017 to the advantage of A2M; (5) the potential expansion of the product portfolio into new products across all regions; and (6) undemanding valuation metrics relative to other FMCG companies with functional properties or leverage to infant nutrition markets.

Offshore growth options: In the last three years A2M has entered the fast growing Chinese IMF market, restructured its UK operations and re-entered the US market. The size of these market opportunities is large with; (1) the Chinese IMF market worth US$17.8Bn in 2014 (vs. Australia at A$780m) and growing (+18% pa FY14-19e); and (2) the UK and US fresh milk markets worth US$48Bn with a premium segment worth $4Bn annually, rivalling the size of the entire Australian market (worth ~A$4.6Bn). The earnings upside to A2M from gaining relatively modest market share in these markets is material in our view.

Investment view: Initiate coverage with a Buy rating: A2M looks a business operating within its competitive advantage period, benefiting from being a first mover in a new functional food category with a degree of IP and brand protection. In our view A2M is at the infancy of its earnings growth profile, generating an exceptional ROIC (~44% in FY16e) and strong operating cashflows (from FY17e) and we initiate coverage on A2M with a Buy rating and a $1.81ps target price.[A2M070616.pdf]