A2M - Extrapolating Perfection May Leave A Sour Taste First off,...

A2M - Extrapolating Perfection May Leave A Sour Taste

First off, I want to say that I have not done extensive research on A2M's addressable market other than what I have read in the media. (Yes I know there is China, US, UK and the whole World to conquer and I am looking forward to those who address this in response.) This is simply my opinion on what I believe are the current market expectations for the business over the next decade. These expectations may be achieved by A2M, even beyond, and it is important to take this into consideration, just as the possibility these expectations are not met. I am not writing this without any ulterior motives other than to make my thoughts public to promote a discussion on them.

Thanks.

A2M - Extrapolating Perfection

It is no secret that A2M is the hottest stock on the ASX right now, and likely has been for some time. For this reason, I wanted to peel back what the current share price and multiples suggested in terms on the real world profitability A2M must achieve in the coming decade.

I estimate, in my very humble opinion, that to justify it's current multiple A2M will need to grow earnings at 25% per year, compounded for the next 10 years, starting from the FY18 estimate I see on Commsec which is currently about 26c EPS.


I have attached a compound growth table from a website which illustrates the EPS growth year by year. From 33c after year 1, to $2.42 at year 10.

	Column 1	Column 2	Column 3	Column 4	Column 5	Column 6
0	Year	Year Deposits	Year Interest	Total Deposits	Total Interest	Balance
1
2	1	$0.00	$0.07	$0.26	$0.07	$0.33
3	2	$0.00	$0.08	$0.26	$0.15	$0.41
4	3	$0.00	$0.10	$0.26	$0.25	$0.51
5	4	$0.00	$0.13	$0.26	$0.37	$0.63
6	5	$0.00	$0.16	$0.26	$0.53	$0.79
7	6	$0.00	$0.20	$0.26	$0.73	$0.99
8	7	$0.00	$0.25	$0.26	$0.98	$1.24
9	8	$0.00	$0.31	$0.26	$1.29	$1.55
10	9	$0.00	$0.39	$0.26	$1.68	$1.94
11	10	$0.00	$0.48	$0.26	$2.16	$2.42

As you can see by year 10, or FY28, A2M will be earning $2.42 per share and that is nearly ten times the projected earnings of FY18. This is truly staggering growth and if achieved would be remarkable, to say the least.

Lets look at in terms of the overall profitability. Currently, A2M has 727 million shares on issue which would equate to a group profit of $1.759 billion in FY2028. To compare this to a company of similar profitability today, look no further than Woolworths. That's right, A2M will have a similar profitability as Woolworths, a $36 billion supermarket and pokies giant in just ten years from now.

Worried yet? I think we all should be.

A2M - The Woolworths of Milk Powder

So, now that we have established the size and scope of the current market expectations on A2M, what is it worth in 2028 after achieving all this glory?

This is where it gets tricky because we have no idea what the market conditions, and more importantly interest rates will be in the year 2028. However, I will make some assumptions to illustrate some possible valuations for A2M when it reaches this level of profitability.

First off, I will assume a growth rate of 5% PA for the next 10 years compounded, following FY28. I have chosen this number as by then A2M will be a very, very large and mature company in the diary space, and unlikely to be growing a lot more than the broader economy. After all, Woolworths has only managed to grow at about 3% PA over the last 10 years. I will also assume A2M has the same number of shares on issue, 727 million, which is unlikely to the case 10 years down the track. Additionally, I will assume interest rates are 0, 1 and 2 per cent higher in each case, the later is more likely than the first two.

Proposed valuations in FY28:

At 15 times earnings: (a long term average of the ASX)
Market Cap $1.759B x 15 = $26.39B
Share Price $26.39B / 727m = $36.30

At current interest rates:
Share price = $39.93

1% Higher:
Share Price = $31.94

2% Higher:
Share price = $26.62

As you can see interest rates have a significant impact on valuations and it is important to consider that they are likely to be higher in the future. However, simply 15 times earnings for a still growing, yet mature business has been listed to illustrate that to you. I used a valuation formula for the valuations that concerned interest rates.

A2M - Actual Returns May Leave A Sour Taste

Here is the fun part, let's look at the compound annual returns an investor will receive on their capital if A2M achieves this level of profitability, and then matures gracefully in the following decade from FY28.

Share price used is $13 as if you had purchased A2M today, and also the expected return of holding from today.

At 15 times earnings valuation $36.30 in FY28 = 10.81% CAGR

At current interest rates valuation $39.93 in FY28 = 11.88% CAGR

At 1% higher interest rates valuation $31.94 in FY28 = 9.41% CAGR

At 2% higher interest rates valuation $26.62 in FY28 = 7.43% CAGR

Now, this is before tax and excluding dividends to be clear. Though, if you like, you add up 50% of the EPS from all the years listed in the table above to illustrate that as well. I presume any more than a 50% pay out ratio would hamper A2M's growth of ten times FY18 earnings in ten years, so I wouldn't count on more than that.

A2M - Directors Taking Fresh Profits and So Should You

It's clear how the directors feel about the current valuation of A2M, they are selling to the cows come home! One in particular sells every option he gets his hands on, not a bad move your probably thinking after reading this! I would be cashing in as well. Naturally, this is all for tax reasons and/or 'personal reasons'. Don't worry I'm sure all the directors think A2M will be a 30 billion dollar business in 10 years time making 1.75b+ a year.

Though seriously, it is clear that the current share price and expectations do not offer a margin of safety. It is clear that the market expectations are enormous, and the size and scope of A2M will have to become just as big, and in the real World not just in investor's minds.

More importantly, as I have illustrated, the reality that the returns on offer 10 years down the track, looking back, are not hugely attractive. In fact, similar returns can be found in a general market ETF, and without all the risk of missed expectations.

I believe that the holders, and those looking to buy should avoid it, should take note of the directors and sell/reduce into the euphoria surrounding the business. I firmly believe that looking back 10 years from now the compound return, including dividends, will be mediocre taking into account the current risk/reward offered by the price, and the outlandish expectations potentially missed in future years.

STRONG SELL

Cheers, and I'm Looking forward to the hate!!