a2 Milk – growth stocks and downgrades don’t mix well

A case study in understanding how downgrades impact growth stocks, by Castle Point's Stephen Bennie.

Friday, October 23rd 2020, 6:00AM 1 Comment

by Castle Point Funds Management

Stephen Bennie

Back in early August, we contributed an article that highlighted some potential headwinds that a2 Milk could be facing in the near, medium and long-term.

In it, we stated that we would be assessing the upcoming full year result to identify any of those emerging issues.

As expected, the financials for the year to June 2020, announced on August 19, were very strong.

This is attributed to the regional lockdowns which created significant online demand as people stocked up hence increasing sales.

Some of the financial metrics were extremely impressive as a result. Net profit after tax was a record $386 million, up 34% on the previous year, which increased cash in the bank to a whopping $854 million.

Despite this great result, what really matters to the share price of a growth company is its future prospects. In that regard, the company was clearly upbeat, with ongoing growth opportunities in existing and new markets and products.

While there was no comment regarding trading since the end of June, the company reiterated their guidance for continued strong growth in revenue in the 2021 financial year.

The near-term items of concern that we had written about did not materialise.

However, a combination of three factors saw the share price fall 5% on the day of the result.

Firstly, the shares had traded to all-time highs, $21.74 the day before, presumably on the expectation of upgraded guidance on the next day’s result announcement. That has been a winning strategy for investors for the past four years, as result after result saw increased guidance.

Secondly, there was no increased guidance at this result, so yesterday’s buyer became today’s seller.

Thirdly, there was no indication of a capital return. The company was keeping the $854 million and was assessing merger and acquisition opportunities.

This was a disappointment. Investors have learned over time that for every Trade Me acquisition there are three Clint’s Crazy Bargains.

Just ask Fletcher Building shareholders how corporate acquisitions can ruin shareholder’s value.

So, because of those three factors, the share price fell even though a2 Milk carded a record result.

On August 21, two days after announcing its results, a2 Milk announced that it had made a non-binding offer of $270 million for 75% of Mataura Valley Milk.

Securing supply of infant milk formula by owning production is fine but it makes the business model more capital intensive.

The signalling here is that the business is shifting from a phase of rapid growth to that of a more mature business.

This is not a bad development, but it can signal that future growth expectations might be on the high side which may not be great for the share price. Investors mulled over this news and the shares traded sideways.

On August 27, a2 Milk reported that members of the board and senior executive team had sold over 1.8 million shares since the release of the result.

At Castle Point, we believe that insider buying generally occurs when a business’s share price is undervaluing its intrinsic value. Insider selling, though, can occur for many reasons and is not a clear indicator of whether the shares will go up or down.

Given the number of insiders selling and the percentage of existing holdings that were sold, we do understand why investors were unimpressed.

As a result of this, over the course of the next two days the share price fell another 7.5%

A mere five weeks after the result briefing, our near term concerns that pantry destocking will hit revenues, had materialised.

The first half of the year’s revenue is now expected to drop by around 7%, versus the same period in 2019.

The company however expects a very strong rebound in the second half of the year’s revenue at 24% higher than the now expected first half of the year’s revenue.

Even so, the new guidance for 2021 represented a 10% downgrade to consensus forecasts.

Now this is where growth companies can become problematic.

Forecasts quickly become difficult to reach where high growth rates are baked into forecasts for next year and the year after that.

For example, if a2 Milk were to have a solid recovery in FY21, but of a level similar to last year, where the second half was up 14% on the first half not the 24% that management were guiding for then full year revenues will be down over 20% on 2020.

If that is how it plays out, a2 Milk will have to increase revenue by over 50% in the following 12 months to reach what forecasters thought could be achieved in 2022.

A lower growth trajectory can rapidly lead to blow-out versus the previous higher growth rate. This often leads to very large downgrades, or lots of small ones, to make future forecasts more realistic for the lower growth rate.

This is at the core of the cockroach theory, which dictates that when you see one downgrade you will generally get others.

The other issue with a lowering growth trajectory is that the premium in share price to the average company has to be close.

Essentially, a higher growth company trades at a higher price-to-earnings multiple than the average company.

It stands to reason then, that as the growth rate of a higher growth company slows and moves closer to the growth rate of an average company, its price-to-earnings multiple starts dropping and it moves closer to the average price-to-earnings multiple.

In industry parlance this is referred to as multiple contraction.

Therefore, when you can see a company’s share price drop 17% when it downgrades earnings by 10%; the extra 7% is essentially multiple contraction.

This is exactly what happened the week following a2 Milk’s 10% downgrade to earnings.

This may prove to be a one-off bump in the road for a2 Milk but, whatever happens from here, this has been an excellent case study regarding investors' reaction to an in-favour growth company that delivers a surprise profit downgrade.

Tags: a2 Milk Castle Point Funds Management investment manager Stephen Bennie