It's All About the Milk

Last month the New Zealand share market witnessed an extraordinary event. The a2Milk Company (whose NZX code is ATM) announced their first-half result which, alongside a deal with Fonterra, resulted in their share price rallying almost 44%. Across financial markets this type of price performance in itself is not unprecedented, but what is almost unique with this situation is that this jump in price occurred, outside a takeover event, to our largest listed company. From its humble beginnings where, for example, ATM could be purchased for only 10 cents-per-share in early 2011 to today where it now trades at close to $13 per share, this is a story that at the very least, captures the imagination.  It now has a market capitalisation of $9.4bn and is much larger than all our traditional listed businesses such as Auckland International Airport, Fletcher Building and Contact Energy.

The impact that ATM has had on the performance of the S&P/NZX50 Index (NZX50) and the outcomes for those responsible for investing money in this part of the world has been considerable. If we look back to February, the NZX50 finished the month down 0.81% but within this negative return was a positive contribution of 3.4% from ATM. What this means is that if ATM were excluded, our stock market would have in fact finished down over 4.2% for the month. A similar exercise completed on the past 12-months of performance shows that although the NZX50 rallied 18.3% over that period, almost 9.6% (or 52%) of it came from ATM. ATM is up 461% over the last 12 months. As highlighted earlier, this type of influence is almost unseen in capital market history. For professional investment managers the position they have had in this stock over the past year has largely defined their overall performance. For Devon, unfortunately, we have been underweight and the effect from this single portfolio position has been marked.

An enormous amount of credit is deserved by ATM. Their 1H18 result demonstrated that they have successfully leveraged off their very strong market share in Australian fresh milk (they now have 9.5% market share in Australia and are the only brand being distributed through all six grocery channels in that market) to achieve the type of success in China that most global consumer businesses can only dream of. As at 31 December 2017 the ATM Infant Formula business, a2 Platinum, has grown its market share in China to 5.4%. This represents significant growth from their share level of 3.6% in June last year and potentially suggests that the company is on track to achieve its long-term goal of a 10% share in this market. This recent lift in China sales has been supported by the business successfully growing their direct sales channel. Over the past two years the number of stores selling Chinese labelled a2 infant formula has risen from 1,450 in FY16 to over 6,700 stores in the latest result. This growth appears to have been executed without affecting the current bulk of sales which occur through the Dàigòu or grey channel (typically unregulated sales that occur when people in Australia buy a2 infant formula off the shelves of supermarkets and chemists and ship them up to China to be on sold through internet sites such as WeChat and Weibo). The financial results of this strategy have been significant with 1H18 Revenue reported at $434m and Operating Profit coming in at $143m. The market was surprised by these numbers and analysts were forced to upgrade their expected results for the coming years by a large margin.

This type of volatility in the operating outcomes for any business should give investors cause for caution. Although we applaud the success that Managing Director Geoff Babidge has enjoyed with this business, there are strong fundamental reasons why Devon maintained an underweight position in this stock over the past few years. After failing to replicate the success of Australia in other jurisdictions such as the UK, the US and China (their initial attempts to execute in this market failed) we have been reluctant to capitalise the rapidly growing earnings that ATM have generated through the Chinese Dàigòu or grey channel. This sales network is unregulated and provides the company with little transparency into who their end customers are. Also the recent volatile experiences of other Australasian businesses such as Bellamy’s and Blackmores that have utilised this channel, have highlighted to us that sales strategies which are dependent on Dàigòu agents expose both the companies and their investors to a high level of uncertainty.

The other important aspect of the ATM result was the announcement of a partnership with Fonterra. This strategic relationship provides a range of benefits to ATM including diversification of their supply and production requirements, access to Fonterra’s distribution capabilities in new markets such as South East Asia, and the granting of a New Zealand fresh milk license. This deal looks very good for ATM but it does highlight, again, the shortcomings in the performance of Fonterra. This business has simply failed to execute on the opportunities that have been afforded it. By being our largest agricultural business, Fonterra should have done better at a time when the New Zealand brand has been as strong as it has and the demand for fresh produce by our major trading partners has been growing beyond expectations. Against this backdrop Fonterra has been unable to develop an infant formula strategy in China and until recently were dismissive of any business whose success was tied to the grey channel. In the major about-face that this deal between ATM and Fonterra represents therefore, it is worth noting that ATM now essentially has the same equity value as Fonterra despite its sales value being only a fraction of its new partner.

As we have highlighted throughout this article, the ATM story has been remarkable tale of risk and reward. The management and board of this business deserve all the accolades they have received in recent weeks and from a New Zealand perspective, it is always great to see one of our own corporate underdogs beating the odds. Despite these sentiments it is important for investors to conduct themselves with caution. The ATM share price is now trading on an FY18 price-to-earnings multiple of almost 50-times. This makes it the most expensive stock on the NZX50 and this valuation is based on financial forecasts which require the company’s recent success in China to continue unabated. Such expectations, when they are currently dependent on sales from a channel as unpredictable as the Dàigòu channel, could be considered optimistic. When we look across our market and see recent evidence of gross mismanagement from businesses such as CBL (a stock that Devon has never owned) we are reminded of just how important it is to properly price risk. As part of this process Devon has two of its analysts in China this month specifically researching the Dàigòu channel.