Fund Mgr notes, page-2

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We exited long-term portfolio holding, The A2 Milk Company (A2M, -12.2%), during the quarter largely due to concerns about the medium-term profitability of the company, with consensus estimates looking too high to us. In FY20, A2M management has declared it will spend almost NZ$200m in marketing the A2 brand in the world’s two largest consumer markets (being the US and China) with an eye to future growth opportunities. While we view this as a sensible strategy, given the quantum of the opportunity in these markets, it is likely that ongoing brand investment beyond 2020 will limit operating leverage over the coming years, a fact we believe is yet to be captured in consensus estimates. A2M’s traditional growth engine in China, the Daigou (individual reseller) channel, is facing increasing regulatory scrutiny in China, including through greater tax imposts, more stringent registration requirements and increasing customs inspections. A2M management is doing a credible job building the infrastructure of the offline channel, including in the physical mother and baby stores, which will continue the growth of the A2 brand in China. Indeed, A2M has already secured shelf space in over 16,000 physical stores in China as at the end of June 2019. This offline channel will become increasingly important for the future growth of A2M in China as the Daigou channel moderates, and perhaps even shrinks, due to regulatory pressures. The offline channel will require considerable investment to build out distribution and increase brand awareness including investment in relationships, shelf space and employing “push girls” in-store to promote the A2 brand. At its FY19 result, A2M management announced that its FY20 margin would flatline, largely as a result of increased marketing investment and this has now been factored into analyst consensus. What is less clear, is whether operating leverage will return to the business beyond FY20 and we view analyst consensus as being overly ambitious on this front given the huge marketing investment that the management is flagging over the next few years in both China and the US.We also note that the management team has announced it will change its long-term incentive scheme from one based on EPS and EBITDA growth to one more focused on revenue growth. This suggests to us that profitability over the next few years is likely to be sacrificed to build market share in the US and China. Longer term this may prove to be wise, but it is unlikely to drive the share price in the short to medium term as analysts are forced to rebase their profit forecasts. We appreciate that exiting our A2M position is a major pivot from the investment team in a stock that had been a significant holding for the Fund over a long period of time and a lucrative investment. The stock price has continued to fall post our exit and several analysts have recently revised down their future year earnings forecasts. We continue to believe that A2M is solid long-term growth story and will revisit the stock should the share price fall to an attractive re-entry point.