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Stock:The A2 Milk Company (A2M)
Investment view:Add and A$12.35 price target (underreview)

1H19 result result -A2Mreported a strong 1H19 result:

• Underlying NPAT rose 55.1% to NZ$152.7m, which was a 11.7% beat compared to our forecast of NZ$136.7m.
• Underlying EBITDA (+52.7% to NZ$218.4m) was also 10.5% ahead of our forecast (NZ$197.6m).
• The significant earnings growth reflected the benefit of strong revenue growth (+41% to NZ$613.1m), particularly in infant formula (+45.3% and 80.8% of group sales). Revenue growth was driven by strong product demand, increased points of distribution and market share gains. China label revenue was NZ$74.7m (+82.6%) and 12.2% of total sales.
• The gross profit margin rose 580bps to 55.6% (was 50.3% in FY18) and the EBITDA margin was 270bps higher to 35.6% (was 30.7% in FY18), highlighting its operating leverage to increased scale and favourable product mix (higher IF skew). Margin also benefited from IF price rises. Both the GP and EBITDA margin were materially better than expected. Marketing costs rose 75% to NZ$45.5m (7.4% of sales).
• Operating cashflow (-3.6% to NZ$112.3m) was slightly softer than expected. A2M paid materially more tax (NZ$79.9m vs. NZ$46.5m the pcp), while receivables, prepayments and inventories were all higher. A2M noted the inventories balance included NZ$35.3m of goods in transit.

Divisional summary:

• ANZ reported strong IF led revenue (+37.5% to NZ$418.4m) and earnings growth (EBITDA +64.9% to NZ$192.0) and its a2 Platinum market share increased to 35.7% (was 32% at FY18). Fresh milk sales rose 11.7% and a record market share of 10.8% was achieved.
• China and other Asia also posted a strong set of numbers. Revenue rose 50.1% to NZ$171.7m and EBITDA was up 41.6% to NZ$68.4m. As expected, margins fell slightly (down 240bp to 39.9%) due to increased investment across the business. A2M said its market value share of the China's IF market across Tier 1 and Key A cities increased to 5.7% from 5.1% at 30 June 2018 and its market value share of Tier 1, Key A, B, C & D cities rose to 5.4% from 4.7% at 30 June 2018. A2M is now in approx. 12,250 Mother & Baby stores (vs. 12,000 in October and 6,700 at 1H18).
• US/UK revenue rose 43.1% to NZ$23.0m, underpinned by strong marketing spend in the US which also caused the EBITDA loss to increase to NZ$14.6m (vs. NZ$8.4m in the pcp). At the end of January 2019, A2M is now in ~12,400 stores in the US (vs. ~9,000 in October). It continues to grow new key accounts, such Costco and Walmart and its brand awareness is increasing following national advertising campaigns. A2M has increased its expectation for the US loss in FY19 from US$22m to US$27m. The US is still expected to be breakeven (on a monthly basis) in FY21.
• Corporate costs rose to NZ$27.4m from NZ$13.3m the pcp.

FY19 guidance -A2M'sFY19 outlook commentary has been upgraded:

• A2M expects the group revenue growth rate in the 2H19 to be broadly in line with growth achieved in the 1H19 (41%). We currently forecast revenue growth of 40% in FY19.
• The FY19 EBITDA margin is now expected to be in the range of 31-32%. This is higher than management's previous guidance for the margin to be "broadly consistent" with FY18 at 30.7%. We currently forecast a group FY19 EBITDA margin of 30.0% which appears slightly too low.
• 2H19 marketing investment will double on 1H19. This implies FY19 marketing spend of NZ$136.5m (vs. NZ$73.6m the pcp and up over 85%) or ~10.5% of our revenue forecast.

Forecast implications -Wewill review our forecasts in a report to follow. FY19 guidance implies 4.2-7.5%EBITDA upgrades to our FY19 forecasts.