Is there a crueller mistress in the market than Miss(ed) Expectations?

Maybe not, given shares in A2 Milk Company Ltd (Australia) (ASX: A2M) fell 7% today after reporting a 127% increase in revenue and huge uplift in profits.

Here’s what you need to know (all figures are in NZ$):

  • Revenues rose 127% to $353 million
  • Net Profit After Tax rose to $30 million, from a loss of $2 million in the prior year
  • Earnings per share of 4.31 cents per share
  • Baby formula carried the day, with a 414% increase in sales to $214 million
  • Modest increase in fresh milk sales, renegotiated supply contract to support future demand
  • Increased expansion in Research and Development (R&D) to support advantages of A2 Milk
  • Outlook for ‘continued growth’ from infant formula and milk powder in 2017, and improved momentum in US business
  • UK business expected to breakeven in 2017
  • Expect an update on financial performance at the Annual General Meeting in November 2016

So What?

A2 shares at first appear to be highly overvalued. They’re trading on 50 times full year earnings, and as a result have a significant amount of future growth already factored into them. It doesn’t take much for such highly priced shares to wobble and news that the US expansion was going slower than expected might have been the cause.

However, shareholders have no cause for complaint about performance in the Australian or Chinese segments, which grew rapidly, or the UK segment which hit break-even in the fourth quarter. Baby formula was the obvious standout, accounting for well over half of A2’s total sales, while performance in the milk part of the portfolio was far more subdued.

I was hoping for a better performance in the fresh milk part of the portfolio but, considering the relatively high prices of A2’s products and the ‘staple’ (read: boring and highly competitive) segment it operates in then a stable Australian market share and revenue growth of 4% wasn’t bad.

Similar to the gluten-free industry?

This part of the portfolio will likely be a slow burn and it reminds me distinctly of the gluten-free food market and the success of Freedom Foods Group Ltd (ASX: FNP). Ten years ago, the gluten free market was tiny and the quality was appalling – I’m speaking from unpleasant experience here. Now the range of products is massive (and tasty), public awareness is huge, and first-mover Freedom Foods won the lion’s share of the benefits, up 900% in the past decade.

I’m not suggesting A2 will turn out like that – especially since competition is mounting – but a relatively tiny part of the population requires gluten free food and catering to them is now a $1 billion dollar industry. That’s why A2 is investing in research to properly evaluate the effects of milk that contains only A2 proteins and validation here could lead to substantial upside.

Making waves already

Doing some market research at my local supermarket a few weeks ago I was interested to note one competitor claiming that their milk ‘contains A2 protein!‘, I was surprised but encouraged as I figured this implied that A2’s unique selling point (A2 proteins/ healthier milk) was already having an effect – and a closer look at this competitor’s bottle suggested that its milk did contain A2 proteinsright alongside the undesirable A1 proteins. A2 reported today it has taken that competitor to court for alleged misleading conduct.

What does the future hold?

Back on the topic of baby formula, this is clearly the company’s flagship product and biggest growth avenue going forwards. With a new supply agreement, management is in a better position to meet demand, and they state the company is also well placed to meet potential new regulatory demands in China – allaying one of the market’s major risks.

However, a significant amount of growth – in the US, UK, China, and elsewhere – is already priced into A2 and investors should be sure to have a closer look at the company and its products to be sure today’s price is justified before investing. I continue to hold my shares.

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Motley Fool contributor Sean O'Neill owns shares of A2 Milk. The Motley Fool Australia owns shares of A2 Milk. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.