Intelligent investor:
The milk business with no cows
· Money Magazine Australia
· 1 Mar 2020
· STORY GAURAV SODHI
Over the past five years, A2 Milk’s revenue has grown almost tenfold and operating profits have risen 200-fold. The business has gone from making a net loss in 2015 to generating $275 million last year. And that’s just the start of it.
Over the same period, operating margins have gone from 2% to 32% while return on assets has increased from 1.5% to more than 30%. A2 now generates a higher net profit margin than Apple.
We have long argued that A2’s high margins would be competed away. This is, we reasoned, a commodity producer and high margins would invite competition. Returns would eventually fall. Only they haven’t.
There’s a reason for that, deeply embedded in the company’s business model. About a third of the solid content in milk comes from a protein called beta-casein, which comes in two forms: A1 and A2.
A1 is a mutation originating thousands of years ago, spread around the world by farming, agriculture and breeding. Most cows carry the A1 strain. The A2 protein can only be produced by cows that are free of A1, which requires them to have specific breeding histories.
The scientists that formed A2 argued that the A1 protein was linked to heart disease and diabetes. Proponents also claim that the A2 strain is easier to digest and acceptable for lactose-intolerant guts.
None of the health claims for the A2 strain are proven. A2 milk ought to sit alongside “organic” as a marketing label rather than a scientific one. But despite the lack of scientific efficacy, surging sales have turned A2 into the most profitable milk business in the world.
The table (below) compares the profitability metrics of A2 with those of key global competitors. No matter where you look, how large or small the competitor, no one comes close to A2’s margins.
In theory, the holder of the scarce resource should capture the bulk of the value in the A2 production chain. The scarce resource in this case is the A2 milk herd.
So why don’t A2’s suppliers sell more milk to competitors or establish their own brand, the way Dairy Farmers has done?
A2 is an easy business to replicate. Access to third-party milk is plentiful – A2 itself is supplied by Synlait, which supplies others, too. And legacy producers should be able to use existing distribution networks to replicate A2’s sales channels. The moat appears narrow and easy to breach.
So how has A2 sustained margins so high for so long?
It helps that A2 has captured 10% of the Australian fresh milk market. A2 outsells all organic, lactose-free and vegan milk brands combined. Returns really exploded after the introduction of its infant formula products. A2 has taken 30% of the domestic infant formula market and it now claims a 6% share of the $37 billion Chinese market. Formula now accounts for 80% of profits.
This is one explanation for the stunning returns: formula delivers greater margins. Yet the larger truth about A2 is on the balance sheet.
Almost all of A2’s assets are counted by its huge cash pile, strategic investments and
inventory. Noticeably absent from the balance sheet are any cows, milking machinery or processing plants. The business generated more than $1 billion of sales supported by just $10 million of tangible assets.
That’s because A2 isn’t really in the milk business. It’s in the marketing business. Its margins appear absurdly high when measured against those of milk producers. The better comparison, though, is with brand-led businesses as shown in the table (below).
In terms of profitability, A2 is a match for some of the most successful brands in the world and, like those brands, it spends huge sums on marketing. Last year, more than 10% of its revenue went on marketing. This is the ongoing capital expenditure needed to maintain the brand. And the A2 Milk brand is now large enough and established enough to fight off challengers.
Competitors may even be a benefit. As they sink cash to educate consumers, the market for A2-strain products expands and likely aids the business that invented the segment – A2 itself.
The big risk investors face from here is buying after a fantastic spurt of growth and extrapolating that growth into the future. At around 40 times earnings, A2 carries heady expectations. Can it meet them?
There does appear to be ample opportunity for growth. A2 has fattened its distribution channels into China to raise its formula market share.
In 2016, almost 80% of formula sales came from daigous (direct private exports from Australia and New Zealand); this is now more than 60% of volume. E-commerce sites and Chinese-labelled supply are supplanting daigous as the main growth channel. This is important because these channels are less exposed to flighty regulation.
On singles day last year – China’s largest shopping day – an A2 product was the top-selling formula on JD.com and A2 was the second highest selling brand; on Tmall, a large retail platform run by Alibaba, A2 is the third highest selling formula brand and ranked as the number one store on the platform. The brand is now established and popular in China.
Yet the Chinese opportunity is well understood, which is why the stock appears dear. We think investors may be more dismissive of an equally lucrative US expansion.
A2 has already built over 13,000 points of distribution in the US, including Wal Mart, Costco, Whole Foods and Sam’s Club. It plans to fill those channels with formula and fresh milk.
Although currently a capital sink – A2 is losing tens of millions of dollars there now – the US market is 10 times larger than Australia’s and shares many of the same consumption trends.
US growth may not come with margins as fat as those for Chinese formula sales, but options for growth are enormous. Other dairy products – cheese, yoghurt, ice-cream – can easily be added to an existing distribution network.
From tiny revenues today, it’s not hard to imagine a $1 billion of revenue from the US within a few years.
A2 generates plenty of cash and boasts a pristine balance sheet with $450 million in net cash and a $275 million holding in key supplier Synlait. Backing out the cash and investments, A2 still trades around 35 times earnings with lingering risks,including the durability of the product.
Brands that grow as quickly as this have either struck a chord with consumers or are riding a fad. It’s impossible to know which of those is true for A2.
The other risk is internal: three senior executives, including the CEO, have departed abruptly. There is little insider ownership among directors or management, although swift growth is bound to cause some operating hiccups.
A2 boasts sensational economics, an established brand and a clear growth path. Yet this could just as easily be a fad that disappears in a few years. Does anyone remember Space Food or Yowie?
It’s impossible to know whether A2 will endure, but we do know the market is assigning a decent probability to that outcome.
We think A2 is more likely to succeed than to fail but would prefer to take that bet with more attractive odds. This is a business to add to your watchlist.
Gaurav Sodhi is a senior analyst at Intelligent Investor. Disclaimer: The Intelligent Investor Model Ethical Portfolio and Intelligent Investor Ethical Fund (ASX: INES) own stock in A2 Milk.
Options for growth in the US are enormous ... cheese, yoghurt and ice-cream can easily be added
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