A2 Milk's margin boost gets stock moving

Thomson, James.The Australian Financial Review

Any parent will tell you it's unwise to give in to a toddler chucking a tantrum.

But while there's no doubt that the chief executive of infant formula giant The a2 Milk Company, Jayne Hrdlicka, has appeased investors by finding a way to lift short-term margins against her earlier forecast, she insists she hasn't changed her long-term strategy to chase growth.

It's always fascinating - and occasionally confusing - to watch how the market balances long-term and short-term growth. New Zealand-born a2 Milk has long been a great case study, and fresh details on its outlook released at its annual general meeting yesterday reinforce just how difficult this juggle is.

While a2 has emerged as a darling of investors in the past five years, with its shares soaring 34-fold between November 2014 and July 31 this year, the release of the company's full-year results for fiscal 2019 crystallised concerns about its outlook.

Despite reporting a 41.4 per cent jump in revenue and a 47 per cent rise in net profit, Hrdlicka watched a2 stock plunge 12.6 per cent on the day of the result after guiding for EBITDA margins to fall from 31.7 per cent in 2019 to about 28 per cent in 2020.

But this was hardly the sign of a business taking its eye off the ball.

The margin fall reflected the need for increased investment to respond to market changes, particularly in the Chinese market, where growth in the daigou market (essentially personal shoppers buying tins of infant formula in Australia and selling them back into China) is slowing.

As Hrdlicka explained again in her AGM speech, a2 is moving to counter those market changes by stepping up its investment in its sales channels in China, such as mother and baby retail stores and the giant websites that facilitate cross-border sales, such as JD.com and Tmall.

The prize here is clearly large, but there is a cost to this strategy, too.

Back at the full-year results, Hrdlicka said a2 would spend about 12 per cent of sales - about $212 million, based on the market outlook for financial 2020 revenue - on marketing. That would have represented a sharp rise from the $135 million a2 spent on marketing in the year ended June 30.

But, however worthy Hrdlicka's marketing plan might have been, the market was not impressed that this spend would hit margins.From the eve of those full-year results on August 20 to yesterday morning, the stock fell almost 25 per cent to $12.02.

Hrdlicka has clearly listened to the market's drumbeat.Yesterday she announced that EBITDA margins would now sit between 29 per cent and 30 per cent for the full year, and between 31 per cent and 32 per cent in the six months to the end of December.

The stock soared 16.6 per cent yesterday morning in response, and settled up about 10.4 per cent at $13.28.

Hrdlicka said yesterday that marketing spending would be about $200 million, which, on the numbers of some analysts at least, looks slightly lower than the original forecast back in August, which was for spending of about 12 per cent of revenue.

But Hrdlicka bristles at suggestions that she's taken her foot off the investment pedal. She says there has been no change to the company's marketing plan and, if anything, she's keen to keep capitalising on a2's growth in the early stages of the 2020 financial year.

The message from her AGM address and outlook statement is that investors can have the milk and the cream - that is, investment and growth.

First-half revenue is expected to total between $780 million and $800 million, which at the midpoint would represent growth of 29 per cent on the first half of 2019.

While that's slower than the 41 per cent growth rate that investors saw in the first half of 2019, a2 does appear to be gaining momentum in China. It is guiding for 84 per cent growth in China label infant nutrition sales and 54 per cent rise in Chinese web sales; in the December half in 2019, total Chinese sales rose 51 per cent.

Hrdlicka said this deluge of data was a recognition from a2 that investors are coming to terms with the strategy changes in the business as it approaches a tipping point in China.As the importance of the daigou market falls, those in-market channels will be crucial.

For all its recent success, a2 is still talking about driving trials of its products and consumer engagement through in-market testing in China, so further investment is crucial."We're listening with the desire to . . . have more information that demonstrates that the strategy is delivering," Hrdlicka said. "We understand that the market is re-calibrating and we're trying to provide as much information as we can."
CREDIT: James Thomson