A2 Milk offers the best risk-reward profile of any stock out of the 150+ stocks that I’ve covered on the market today, let’s see why.
A2 Milk has three geographies (Australia-New Zealand, China, and the US) – let’s break them down. Note that because A2 is a NZ-based company, all their numbers are in NZ dollars (NZD).
ANZ is A2’s original core market, and it’s most mature and longest-serving market. You’d expect that it has saturated this geography by now, what with it’s presence in every ANZ supermarket and widespread brand value for years. Despite all that, the ANZ grew 16% in the most recent results. Last year the ANZ segment had FCF of NZ$320m – that’s on sales of NZ$966m, leading to FCF margins of a whopping 33%. So let’s use our most conservative FCF multiples approach – the growth multiple.
ANZ Value = 16 x $320m = NZ$5.1billion
Now let’s throw in their approx. $1billion of cash and investments into the mix and we get a total value of NZ$6.1b. Since A2 is primarily listed on the Australian Stock Exchange (ASX), let’s figure out the stock price value of just the ANZ segment. Note here that the multiple of 16x is unbelievably conservative, especially when you consider that the big banks trade at multiples of 15-20x despite growing in the low-single digits and facing low interest rates for years to come. We also have to factor in that the NZD is worth 0.93 AUD.
Stock Price Value of ANZ = NZ$6.1b = AU$5.7b = $5.7b/740m shares = AU$7.67
With the A2 stock price currently sitting at $8.50, we’re essentially getting China and the US for almost-free. Now let’s dive into those geographies.
Last year China had growth of 65%, produced sales of $700m, and had FCF of $168m. That implies a FCF margin of 24%. Considering that they sell products at higher prices in China than they do in ANZ, why is it that the margin is lower than that of ANZ? Growth. Growth comes at a cost. In order to grow 65% you need to invest in sales, advertising, stores, etc. A2 Milk is pursuing growth in China because it currently only has 2.3% market share – meaning that there’s still a lot of potential to be tapped. But let’s be conservative here – let’s assume that China-Australia politics go into worst-case scenario (even though China hasn’t attacked milk and baby formula imports – probably because they know how much they need it). In this worst-case let’s assume that A2 stops growing entirely, and slumps from a 65% growth with a huge potential market still ahead of it, to just 3% growth from here on out. If that were to occur, A2 would shift focus to maximising profits and FCF – meaning a 33% FCF margin on sales of $700m – producing $231m in FCF. We’ll use our conservative low-growth formula here and arrive at a value of;
China Value = $231m/(10%-3%) = $3.3b = $3.3b/740m shares = $4.46 in stock price terms
Let’s now take a look-see at the US. Huge, huge market. They had sales of $66m last year – 89% growth. Now the US segment lost $51m in FCF last year because again, they’re investing for growth. That’s another reason why the superficial investors looking at A2’s posted profits are freaking out about the declines – because they simply haven’t done their research into the business. Considering that A2 produced FCF overall of $381m last year – a $51m loss is a size-able 14% drag on overall FCF which isn’t being seen for what it truly is – a valuable investment. So let’s assume again in a worst-case scenario that A2’s US business goes absolutely nowhere and suddenly drops from 89% growth to just 3% indefinitely. If that were to happen, the A2 management team would be wise enough to shift focus onto profits and chase that 33% FCF margin that they have in ANZ. However, the US corporate tax rate stands at 21% compared to ANZ’s 30%. So the FCF margin will actually land at 37% – giving a FCF of $24.7m. Now we plug it into our eternally conservative low-growth formula and get;
US Value = $24.7m/(10%-3%) = $350m = $350m/740m shares = $0.47 stock price
Now let’s look at the upside valuation scenario. Oatly is an organic oat milk company that plans to go public sometime soon. They had sales of around $300m in 2020 – 50% growth year-on-year. The valuation they’re looking for? $10billion. So let’s look at the sales multiple here;
Sales Multiple for Oatly = $10b/$300m = 33x
Considering that A2 Milk is also an organic milk play, and that there aren’t too many pure-play public milk companies out there – what do you think will happen when Oatly goes public? Well all the US investors will start to have this newfound interest in the milk industry, and will start hunting for other public milk companies on the market. Considering that investors are loving growth, and that A2’s US business posted 89% growth last year, it’s very plausible that they assign at least a similar sales multiple to A2’s US business. With $66m of sales, a 33x sales multiple implies a value of;
US Value = $66m x 33 = $2.2b = $2.2b/740m shares = $2.90 stock price
Now let’s bring it all together by looking at a few scenarios:
- Worst-Case Scenario – ANZ segment flatlines at 3% growth, China and Aus have such a fall-out that China bans A2 milk products altogether, and US segment flatlines at 3% growth. This terrible scenario gives a stock value of A2 at; Stock = $7.67+$0.47 = $8.14. Considering that A2 closed at $8.50 today, you’re essentially buying A2 at a worst-worst case scenario valuation.
- Conservative Scenario – ANZ segment flatlines at 3% growth, China and Aus make amends but China still flatlines in growth at 3%, and the US also flatlines at 3%. This still very conservative scenario gives A2 a stock value of; Stock = $7.67+$4.46+$0.47 = $12.60.
- Conservative Scenario but with US Catalyst – ANZ and China both flatline at 3% growth, but A2 gets valued like it’s most similar peer Oatly. This gives; Stock = $7.67+$4.46+$2.90 = $15.03
So you can see from all these situations, that even if China were to disappear, the stock is still a compelling buy. Even if A2’s two biggest markets (ANZ and China) flatline for no apparent reason, the stock is actually undervalued. When you bring it all together you get an exceptionally compelling value proposition with a lot of upside and near-zero downside risk left. That also gives you safety if there was to be another collapse in markets and tech stocks – A2 is at a basement level price, it just can’t sink much lower than this. This is a company with; huge FCF margins (tick), no debt (tick), a huge return on invested capital (ROIC = 91%), and a long-term record of growth (tick). You couldn’t ask for much more.
DISCLAIMER: these are my ideas and I’m not a licensed investment management and so this shouldn’t be taken as investment advice. Please seek a professional.
