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Why I think a2 Milk shares are a buy today

First of all I must admit that after gloating after the relatively short lived rise of the a2 Milk Company Ltd (ASX: A2M) share price in July 2019 it has since come back down to earth. S

ince trading as high $17 on July 30 it’s retreated to $12.02 this morning as investors reassess its profit growth trajectory on the back of greater-than-expected investment over FY 2020.

This morning the a2-only-protein supermarket milk and infant formula business updated the market on its China strategy where it now generates around one third of sales and EBITDA or operating income. Over FY 2019 China and other Asia operating income came in at NZ$123.9 million on group operating income of NZ$413.6 million. 

a2 Milk is also investing heavily on growing its supermarket milk sales in the U.S. a region that posted an EBITDA loss of NZ$44 million on sales of NZ$36 million over FY 2019.

However, I remain bullish on this opportunity and further investment is part of the reason why the group is forecasting flat EBITDA margins at 28.2% over FY 2020.

It’s also fair to expect another strong year of revenue growth to translate into more strong profit growth.

The company has no debt and a cash balance of NZ$464.8 million as at June 30, 2019. Return on equity landed at an impressive 36.8% to suggest this is a profitable business. 

Should you buy?

The only caveat is the valuation on around 32x trailing FX-adjusted earnings of NZ$0.39 cents per share is reasonably high.

If we aggressively assume the company can grow earnings at a 20% compound growth rate over the next 7 years as its operating leverage kicks in and use a conservative 0% terminal growth rate on a discount rate of 11% the stock is worth around A$9.89.

The U.S. market is also something of an unknown for now, but boasts potentially big profit growth opportunity over 3-5 years. 

Given the robust cash balance of NZ$464.8 million provides room for dividends or buy backs down the line the stock is likely to receive more support in my opinion.

As such I’d happily buy a2 Milk shares today, although only as a small part of a balanced investment portfolio.

Others looking to cash in on rising Chinese demand for its products include Bellamy’s Australia Ltd (ASX: BAL), Bubs Australia Ltd (ASX: BUB) and Blackmores Limited (ASX: BKL).

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Motley Fool contributor Tom Richardson owns shares of A2 Milk.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia owns shares of and has recommended Blackmores Limited. The Motley Fool Australia owns shares of A2 Milk. The Motley Fool Australia has recommended BUBS AUST FPO. 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 Scott Phillips.

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