It has been a while since I have written or spoken about a2 Milk. I know that a lot of people either own the stock or at least have an interest in it. a2 for those that do not know, trades on the NZX under the ticker code ATM and on the ASX under the code A2M. They have a market cap of somewhere in the region of $10 to $11 billion NZ, they are one of the most significant companies on the NZX. They have recently released their annual report for the 2019 financial year. Now there are a lot of people that will know a lot more about a2 than what I do so I will not dive too deep into the qualitative aspects but I will just highlight some things that stuck out for me from the report and presentations.
Obviously there are the things that the company has pointed out on the first page as highlights, 6.4% infant nutrition value share in China and leading brand in Australia, infant nutrition value share sounds like a bit of a mouthful to me, maybe a company invented metric? Number one premium milk brand in Australia with an 11.2% market share. I guess the question is how large can the market share get? In this sort of business, you are taking market share from someone else, so one would expect it to get harder as the percentages get higher, although I do acknowledge that the market for infant formula is growing and there might just be enough to go around. They also had a 64% increase in the number of stores in China to a total of 16,000 stores. Revenue in the US revenue increased 161% with 13,000 stores, so those are big numbers.
The chairman and CEO letter was a bit boring, same old stuff that you normally see. In fact, let’s just skip the letters and the qualitative stuff and get right to the nitty-gritty of the financial statements. Revenue came in at $1.3 billion, a substantial 41% increase on the $900 odd million the year before. Gross margins were 54.7% compared to 50.3% in 2018. So nice to see an expansion of gross margins, so not only are they selling more, as in they are growing, but it is more profitable growth, which is obviously exactly what you want to see. It will be interesting to see if this trend can continue. This combination of revenue and margin expansion is rarer than you might think!!
This margin expansion flowed down to operating profit, with a 31.5% operating margin, compared to 30.5% the year before, you have operating profits of $411 million for a market capitalisation of around $10.5 billion. So an earnings yield of around 4%. Which is not too bad considering how much of a darling and a following the stock has been and considering that your expectations would be that the operating profit will grow from here. It just shows how undervalued the stock was a few years ago.
Moving to the balance sheet. There are no current issues there. They have $464 million in the bank in cash, no debt. $675 million in current assets and only $205 million in current liabilities. They also own 17 odd per cent of Synlait Milk, interesting that they carry this on the balance sheet as a non-current asset, which suggests that they consider it a long term investment.
During the year they generated $289 million in cash, which wasn’t a massive increase from the prior year. The thing I love about a2 is that there is virtually no capital expenditure. So that net cash from operating activities is virtually just free cash flow. So they are able to grow just through marketing and advertising as opposed to more capital investments. It is quite impressive. It is almost how you would expect the cash flow statement from a successful software company to look. It is quite impressive. Looking cash flow, I wouldn’t be surprised if they started paying a dividend or buying back shares at some point. That is if they cannot find anything better to do with the money.
So they are a great company doing some great things. It truly is quite impressive. So why did the stock fall after earnings? I think it was down 12% or so after the update. And this can be quite confusing for both old and new investors. If a company puts out such a wonderful update why would the stock fall? It is often a head-scratcher. Now, this happens for reasons related to valuation. Other market participants had placed a higher valuation on a2 prior to the earnings with the expectations of better earnings. So the market was expecting more. I think when you consider a2s historical performance this is not unsurprising. I believe that a lot of people have invested in the company are invested because of its historical performance, both in terms of its business performance and the share price appreciation. That would be my warning to anyone buying the company, due to the law of large numbers, on a percentage basis a2 will not be able to deliver the per share appreciation that it has in the past. If they do they will be one of the largest companies in the world by market cap. As I say all the time it is a lot easier, I should clarify, I do not mean easy, it is easier to go from a market cap of $1 billion to $10 billion than from $10 billion to a $100 billion.
So what of the valuation? I think it is about right at the moment, they are priced with a cash flow yield of about what you can get in the bank. The difference compared to the bank is that you would have to expect that cash flow to grow. I do not think that you would consider the stock cheap. But it is not ridiculously expensive either. For me, it will be interesting to see what they start doing with their cash flow. I do not think they need more cash than what they currently have on the balance sheet, so that will be the one to watch for me.