The a2 Milk Company Limited (ATM) Earnings Call Transcript & Summary

Hi, everyone. Thanks for joining the call today. On the call today, we have our Managing Director and Chief Executive Officer, David Bortolussi; our Chief Financial Officer, Race Strauss; Peter Nathan, our Chief Executive for Asia Pacific. David, Race and Peter will present our half year results, and there will be time for questions at the end. And with that, let me hand over to David.

Thanks, David. Good morning, everyone. I'm very pleased to have finally joined The a2 Milk Company after a long transition period. It really is a remarkable business. Notwithstanding some of the challenges that we'll cover today, I'm confident in the fundamentals of the business, and I'm excited about the future. It's been a big couple of weeks settling in, relocating to Sydney, meeting as many of our team as possible around the world in-person and virtually, being introduced to our strategic partners and developing a better understanding of the business. I've only been in the business for a short time, so for the intro, I just wanted to make a few comments on the half and cover why I think the fundamentals remain strong. The first half was challenging for a2. Like most businesses, it's been impacted by various dynamics related to COVID-19, which has caused a lot of demand and supply volatility that has impacted the business significantly. We won't gloss over the fact that performance for the half was challenging and disappointing relative to the company's initial plans and market expectations. Revenue and earnings were down significantly mainly due to disruption in our English label business, which Peter will cover later. But there were some real positives in our results, too, in the China label business, Australian liquid milk and a material improvement in the profitability of our U.S. business. Notwithstanding these challenges and results, the fundamentals of the business give me confidence that we have plenty of opportunities to grow the business over time. I've reviewed our brand health metrics across our categories and markets, and they're strong, which we'll continue to have to invest in. We have a compelling consumer product with first-mover advantage and lots of innovation potential over time. We have a significant further growth potential in our core markets, particularly in the China label IMF market. We have a strong balance sheet with the flexibility to invest in growth opportunities. And lastly, the team has been investing heavily in improving our execution capability. Lastly, I want to acknowledge the efforts put in by the a2 team and all of our strategic partners. It's clear they've been working hard to address the challenges head on and get the business back into growth. I'll now hand over to Race to take you through the financials, and then Peter and Race to take you through the regional performance. I'll come back at the end to cover our plans and outlook for the second half.

Thanks, David. Hi, everybody, and I hope everybody is safe and well. There are a number of highlights in our result despite the challenges. We are especially pleased with the strong growth in our China label business. We're achieving a growing share in the largest IMF channel with strong brand health metrics. However, the shape of the result has been impacted by our performance in our English label channel. Here on Slide 7, we've presented a summary income statement for the half year. Group revenue was down 16%, and EBITDA was down 32%. I'll explain some of the key movements on the next few slides. On Slide 8, we show our segment revenue. China and Other Asia segment was flat half-on-half, where the growth in China label was offset by the decline in CBEC. In Australia and New Zealand, as we flagged previously, we were impacted by challenges in the daigou and reseller channel. And in the U.S.A., the changes we made to our execution approach have had a positive impact. Moving to Slide 9. A few things to call out here. Our lower gross margin percentage reflects the impact of a number of temporary factors. Most relevant is the stock provision that we recognized in the half and the adverse product mix shift with a higher proportion of liquid milk to infant nutrition sales. Another important point here is that historically, the gross margins we have achieved for infant nutrition sales between channels has been broadly similar. However, some variance in gross margin percentages between the channels has now emerged. This is due to the different channel pricing pressures; cost of goods sold differences, in particular things like ingredients and packaging innovation; and foreign exchange movements. China label infant nutrition has a lower gross margin percentage than our English label but has a higher absolute gross margin per unit in a higher cost-to-serve channel. Moving to Slide 10. Our balance sheet remains in a strong position, with closing cash position of $775 million. Cash was $80 million lower than June, and this was due to negative operating cash flow, primarily due to an increase in working capital reflecting higher inventory and a decrease in accounts payable; our participation in the recent Synlait capital raising; and our acquisition of the Kyvalley processing facility. With that, I'll hand over to Peter to go through the Asia Pacific performance.

Thank you, Race. So looking at Slide 12, and look, this is a slide we have presented a number of times before. And what it does is summarizes our infant nutrition revenue across both ANZ and China. And you can see that the proportion of our revenue has evolved over time, and we're growing very well in our China label business, which is the largest by a long stretch of the infant nutritional channel within China. Looking at Slide 13, we show that in China label, we grew revenue by 45% on the prior -- versus the prior corresponding period. We also grew share and furthermore expanded our footprint. We've invested very heavily in our brand by in-store activation, with greater engagement with consumers through increased mama classes and also our promotional people as one of the key activation points. We do believe that there continues to be an opportunity for us to gain market share, given our very strong brand resonance with our consumers. We're very pleased by our performance here, given the incredible -- the strong strategic importance and size of the MBS channel. Looking at Slide #14. What this slide does is highlight some of the key activities during the half in terms of our social media campaigns as well as investments in road shows, in mama classes, in promotional people and other various activities, which we use to engage our consumers with. If we look at Slide 15, what this shows is that the very strong growth we delivered in distribution and also growth in our MBS market value share, which was up to 2.4% from 2% at the end of the December half. In Slide 16, our performance in English label was impacted by Australian retailers and daigou/reseller channels as well as in cross-border e-commerce. In our ANZ business, we have previously explained the challenges initially resulting from the disruptions of COVID-19. The pantry stocking in 3Q 2020 and then the unwind in Q4 and into this fiscal year was also compounded by the challenges in the daigou/reseller channel, which we did begin to observe from September. These events, combined with subdued online pricing and channel inventory unwind, have resulted in daigou/resellers being slower to fully reenter the market to promote our brand than we initially expected. In CBEC, our sales were down 35%. Having said that, our market share was 22.3% on an MAT basis, which was up from the previous share number that we took to the market of 21.5%. The revenue decline for this period, therefore, was due to a lower level of sales to informal social e-commerce channels and traders, which are not measured by Smartpath. And also on top of that, there was some inventory -- further inventory unwound in these channels. And in addition, we have temporarily ceased sales of our Hong Kong label. While our performance in the competitive 11/11 online sales event showed strong year-on-year growth with higher promotional activity, sales in the month preceding that or just after that, we're a little bit below our expectation, with some pricing issues compounding back there. Looking at Slide 17. We do have a solid plan in place to reactivate the English label channels. We are focusing on reactivating the daigou/reseller channels and are confident that it does still remain a very attractive and strategically important channel for distribution penetration and also for new user recruitment. We are aiming to continue to reactivate the channel by further rebalancing inventory levels and improving, very importantly, traceability through the channel. Furthermore, we will continue to provide temporary support to corporate daigou. And lastly, we will be continuing to look at some very innovative opportunities within corporate daigou to further grow distribution. In CBEC, we'll continue to rebalance inventory in the channel and also continue to refine and optimize our promotional approach. Turning to Slide 18. Liquid milk, it's fair to say, does continue to be an absolute critical pillar of our business. And we're pleased to announce that we have achieved double-digit growth as we've increased our market share again, and we now have a market share of 11.7% in value in Australian grocery. Assuming the COVID-19 situation improves in Australia, however, we would expect out-of-home consumption to increase or to decrease a little bit, which could impact us slightly in the second half. And New Zealand licensing fees increased by 33% during the period, along with China revenue which increased in liquid milk at 107% to $3.7 million. On Slide 19, it demonstrates that the other nutritional products segment, mainly our whole milk and skim milk powders, and we have seen additional products here, such as Smart Nutrition, Nutrition for mothers and then also Manuka honey powder. Unfortunately, all of these product categories were impacted by the disruption we've experienced in the daigou/reseller channel, but we are confident in our plan to reactivate the channel. And we do definitely see further opportunity in all of these other nutritional products moving forward. And now I'd like to hand back to Race.

Thanks, Peter. In the U.S.A., I'm now talking on Slide 20, we delivered 22.3% revenue growth. During 2020, we did observe that consumers were becoming more value conscious given the economic uncertainties, and retailers were prioritizing conventional and private label brands. Consequently, we have redirected a significant portion of our marketing investment towards account-specific activity to position our pricing at a more affordable premium level. The aim was to increase shelf presence as well as investing in additional in-store activation to further build velocity. Our average velocities have grown within our key accounts, and distribution grew to 22,300 stores. And we have strong brand health metrics. For the second half, as we further increase our trade spend, we are expecting net revenue to be lower than the first half. On Slide 21, we show some images of the in-store activities, and Slide 22 has the growth in our store footprint. So turning to Slide 24 to talk about some group updates. The proposed Mataura Valley acquisition will provide the opportunity for us to participate in nutritional product manufacturing. It provides supplier and geographic diversification and strengthens our relationship with key strategic partners in China. Over time, it will also offer access to manufacturing margins, and the ability to provide more flexibility for product supply, including the potential to pursue an additional China label registration and additional innovation opportunities. During a transitional period, MVM will operate as a manufacturer of commodity powders and some base powders for nutritional products, prior to manufacturing predominantly consumer packaged nutritional products for The a2 Milk Company. We've previously announced that during this transitional period from FY '22 to '24, the business will operate at approximately EBITDA breakeven, with the business returning a positive EBITDA from FY '25. However, due to the revised volume assumptions, we now expect an EBITDA loss of up to $10 million per annum during the transition period. We still expect EBITDA to be positive from FY '25. Prior to any further investment in a blending and canning facility and the associated infrastructure with that, it is expected that depreciation and amortization during the transitional period will be approximately $15 million. We are continuing to explore business development opportunities to improve the financial performance during this transition period. On sustainability, we made progress in a number of areas in the first half. In particular, we established The a2 Impact Fund as a vehicle to fund and manage our investments in pursuit of our sustainability and decarbonization goals. The team is making progress in several areas, including on-farm activities, such as farm environmental plans and animal welfare as well as across various people and community initiatives. We are also working through the process of target setting, and we'll look to update you later in the year. And with that, I'll hand back to David.

Thanks, Race and Peter. Turning to Slide 27. I thought it would be useful to summarize on the slide here the key actions we are taking in the second half, which we've already covered in the presentation. Just to reiterate, we're pleased with our performance in China label and liquid milk in Australia and the U.S., and we'll keep executing against those plans. And we have a good plan for reactivating the daigou channel and optimizing our growth in CBEC. As you would expect, I will also be reviewing our growth strategy and execution plans with our leadership team and Board to consider what adjustments we may need to make to maximize the long-term growth potential of the business. Turning to the outlook on the next slide. Globally, there continues to be unprecedented levels of uncertainty and volatility due to COVID-19. The company remains confident in the underlying fundamentals of the business, and we will continue to invest behind the brand and in its capability to drive long-term growth. However, the pace of recovery in the daigou channel and in the CBEC channel has been slower than previously anticipated, and the company now expects revenue to be at the lower end of the previous guidance range. A lower EBITDA margin range is now expected due to lower revenue, higher brand investment, longer daigou support, movements in foreign currency and adverse channel mix relative to what was anticipated in December. Accordingly, the company's FY '21 outlook is now as follows: group revenue for FY '21 in the order of $1.4 billion; group EBITDA margin for FY '21 of 24% to 26%, excluding MVM acquisition costs. The outlook for F '21 assumes the actions being taken to reactivate the daigou channel deliver a significant improvement in quarter-on-quarter growth from the third quarter to the fourth quarter. And with that, we'll open up the call for Q&A. Back to you, David.

Thanks, David. Operator, if you can please help us facilitate the Q&A session.

[Operator Instructions] First question comes from Shaun Cousins of JPMorgan.

I just want to ask a little question about inventory. The company is now discussing rebalancing inventory in the daigou and CBEC channel. Is this the company confirming there is excess inventory in the daigou channel? And if so, when did this start, as we've been asking a bit about this issue for some time and a2 has been indicating there hasn't been an inventory issue with the business, please?

Sure, it's David. From my point of view, it seems to be rebalancing, but I think Peter is really best placed to answer this.

Yes. So we're not talking about inventory which we are aware of. So the key point being is that the inventory within customers that we ship to, we've been confident for, for some time. It's more about inventory, which is very hard to trace, which falls into third parties, which typically fall into the trader-type definition. That is inventory which is more difficult to get a handle on that, and that's what we're still trying to make sure that we bottom out. But again, that is -- and that's where the traceability system that we are putting in place is so critical, in ensuring that, that is achieved going forward.

Okay. I mean, we've sort of been concerned about trade or distributor inventory being an issue as well. Is this something where you just can't get a hold of it and that's the...

It's not distributor -- they are 2 very different definitions. In distributor inventory, we have got a good hand on. All of the customers that we ship to, we have a very good handle on inventory. It's the noncustomers which get leakage, which is more difficult to trace, and we want to absolutely make sure that, that's bottomed out. And on top of that, as I said, the traceability system is a key in that, but that we want to make sure that distinction is clearly understood.

Okay. And does the company reiterate the 30% EBITDA margin target in the medium term? I couldn't -- it may be in your release, I might have missed it. But could you confirm if that's still being reiterated? Or has that been removed, please?

Shaun, we've -- I've taken that out for the time being. It's -- we're in a very different context. It's not that, that is necessarily inappropriate. It's just that I haven't had time to think about our plans going forward with the team. And we may give some more color on that in the future.

The next question comes from David Errington of Bank of America.

David, it's been a long time. It's been a while, so welcome aboard and good luck.

Thank you.

First question I've got is on the inventory. And Peter, I'm sorry, I just don't accept your explanation on that. You've been saying now you haven't got an inventory problem, but now you're saying you may have an inventory problem with customers but you don't know who they are. And then the company takes a $23 million inventory provision out of the blue, and the inventory this half has increased by $50 million on your balance sheet. So can you explain what is going on in your inventory? Because I know the question has been asked last 12 months, and you have steadfast denied that there's an inventory issue, but clearly, there is. Your inventory has increased by $50 million. You've taken an inventory provision by $23 million, and now you're saying that there's inventory with customers that you don't even know who they are, and you have to do a tracing system to try to track it down. If that's not an inventory problem, I don't know what is. So can you give a bit more clarity, so that we can have a bit more comfort that you are in control of your inventory?

David, it's Race. Let me start on our inventory, and then Peter can comment on the trade inventory. We had previously said that back when COVID started, we did take contingency steps working with our strategic partner in Synlait to build up our inventory. Because when COVID first started, there was issues of supply, there was risks of not being able to get materials, and you'd appreciate there was risks globally about the global supply chain. So we took a deliberate step, which we did talk previously about building up our inventory. Unfortunately, post that, as the daigou and English label channels started to contract, the demand offtake -- our demand offtake of that started to decline. Hence, we have to go through the downgrade process, and that inventory that we had built up was not being reduced as quickly as we wanted. We -- as part of our December downgrade, which we delivered to the numbers that we did communicate back in December, incorporated that we would take a provision, which we now have done of 20-odd -- $23 million into our results for the half. So that is, as I said, the deliberate contingency we took for COVID. The demand fell off. We were left with a lot of inventory. And what's really important, as you'd appreciate, is we need to ensure that, that inventory does not end up in the trade that could potentially be discounted, and we protect the quality to ensure as it gets older. We ensure that it doesn't get to the trade, and we will potentially destroy it, hence the provision. That's our inventory. But I'll throw it to Peter to talk about the inventory throughout the supply chain.

Let me be clear that I'm not saying that we have a trade inventory issue at all at a2 Milk. That's not what we're saying. What we are saying is that there's always a potential for a product to get into their own process, and that will always be the case. And therefore, look, a traceability system enables us to identify precisely where that product originally came from and, therefore, deal with it. So that will help us going forward. So that is a clear point to make. The other point to make is that the extent to which pricing is uplifted is a consequence of reduced inventory. And therefore, what we're saying is that the inventory that we need going forward will be lower than what it has been in the past in order to uplift the daigou pricing. So we're not saying -- just so we're very clear, we're not saying that we do have a trade inventory problem at this point in time.

Okay. Okay, I'll leave that one there. If I could go on to my second question, which is on the recovery of the corporate daigou. The first part of it is, well, how are you going to actively manage this? Because your stating that you're expecting the fourth quarter to be a significant improvement on the third quarter. That really concerns me because that means that there's potentially further risk to the downside here, if what you're actually doing doesn't work or is delayed further. So can I ask the question, either to you, Peter, or -- it's too early for you, David, because I'm not -- you've just come on board. But probably, Peter, you're the best. What are you actively doing with the corporate daigou to actually deliver fourth quarter significant improvement on the third quarter? What are you actually doing to ensure that? So as that -- because that's a big statement to make to the market. You have to be held to account on that because if it comes again that you come for another downgrade, I mean, we've had 3 strikes now. How many more downgrades do you want to come to the market with? And you've got that big statement out there that fourth quarter is going to be significant on third quarter. So what are you going to do to ensure that you don't come to the market again with another significant downgrade? What are you doing to ensure that?

Sure. No. It's an excellent question. Yes. So we're doing 3 things. Firstly, there is a positive trend for corporate daigou, so let's be clear about that. So the trend is up. So yes, the bottom has been -- is behind us, and we've seen positive trend upwards. That's on the basis of 2 initiatives. One is the corporate daigou margin support program, which is rebuilding confidence in the channel. In addition to that, we have some innovative promotion activity which has been effective. And thirdly, which is in front of us, there's some innovation within the corporate daigou channel itself, which is building momentum, particularly in the O2O space in China. And also the O2O channel, let me say, David, is showing some very significant growth for us in China. That gives us confidence that we're going to end the quarter or end the half very strongly.

The next question comes from Chelsea Leadbetter of Forsyth Barr.

I guess, maybe extending a couple of those questions a little further. So you talk about the inventory traceability, Peter. Can you give us a time line of when that will actually be in place?

Yes. Yes, Chelsea, we're looking to get that implemented by the end of the month. So the reason -- and I think I might have mentioned this in previous calls, there's been a significant delay on the basis of COVID in terms of technicians being able to implement. But given the -- now COVID is freeing up, we're very confident that -- or the process has already started, but we're very confident by the end of this month, very, very soon, that will be up and running.

Okay. And I guess, coming back to the question before around the statement on significant improvement quarter-on-quarter. Can you kind of cycle back and sort of -- I don't know if you can but give us some sort of quantification around what that third quarter last year looks like versus the fourth quarter last year? You talked a lot about pantry stocking in the third quarter of '20 and some of that unwinding in the fourth quarter. I'm just trying to understand, I guess, what the comps are like that you are cycling for that daigou channel in particular, but also, I guess, how the third quarter has started versus the second quarter. And ultimately, what gives you the confidence for that, that statement around significant improvement? And maybe if you can provide some quantification around what significant improvement actually means.

Sure, look, I mean, I -- we're not going to give the absolute specifics of that, but you could probably do the maths on that in terms of looking at the guidance number relative to the results. But what we would say is, again, we have seen some very strong momentum and offtake within the corporate daigou channel. We've seen very strong momentum in the O2O channel. So that gives us confidence on top of what we did indicate and going back to David Errington's question around further tightening. So it's not about the fact that we've got inventory, a further tightening, which is implicit in the numbers to further uplift pricing on top of the innovation, on top of the margin support, which hopefully will fall away once the pricing starts to move upwards. And then you couple that with the momentum that we're already seeing, that gives us confidence in that forecast.

Okay. And any context on the pantry stocking in terms of how to think about that for what you're cycling in the prior period?

Yes. Look, the pantry stocking, the numbers that we indicate, clearly, that's behind us. But clearly, that upset or unsettled some of the flow of numbers in terms of ex-factory. But we're confident that, that's no longer an issue, which is implicit in the -- obviously, in the, as I said, in the numbers that we've delivered, which [ managed to go ] in terms of ex-factory being, as we indicated in previous announcements, not as high as we thought going back 6 months.

The next question comes from Richard Barwick of CLSA.

I was just going to just try and get a bit more clarity, if I can. When you talk about the pace of recovery in the daigou and reseller channel basically recovering more slowly than previously anticipated, why is that? And do you understand why or what's caused that now? And then sort of married up with that is, how does your new daigou channel reactivation plans compare to the plans you had in place back of the last downgrade just before Christmas?

Yes. Look, that's an excellent question. The key issue for us has really been about market pricing. So market pricing, we expect it to recover more quickly than it has. Now outside of market pricing, we've still seen growth. Had we had market pricing where we thought it would be on top of what we've run with initiatives, we would have been at the numbers that we thought in previous announcements. That's really those -- the combination of those 2 factors.

So do you think that means, Peter, if the market pricing has been weaker, i.e. hasn't recovered to the extent that you thought, is that a sign that there is more inventory washing around, so there's sort of stuff that you don't have the visibility on, there's actively more there than you had appreciated?

Well, there was a bit of disruption from Pinduoduo, which we're confident now there is less access. As I said, the traceability gives the capacity to really deal with that, the more [ of that ] instrument. That is certainly the case.

Okay. And I'm pleased you raised it, Peter, because that's my next question. So circling back in August and September, the sort of the color we got from you guys then, you're pretty dismissive of that as a channel and saying that it wasn't compatible for the a2 brand or is a place you didn't want to be. Has your views towards PDD changed at all? I mean, my observations would be, it's seemingly like a more credible channel today than what it was even 6 months ago. So just wanted to know if it's going to play a bigger role or -- going forward for a2. Or are you still intent on sort of getting your product out of there?

No. Look, our view has not changed, so we believe that they're not the sort of customer that we want to be encouraging or doing business with, so another customer but a platform. So in that regard, no, our view has not changed. It remains consistent.

The next question Sam Teeger of Citi.

Maybe one for Peter. Peter, just in terms of the limits around the recovery in market pricing. There's been a lot of talk around supply on this call. But what about the demand side? It just seems to me that the formula is not as advanced as a few of your competitors in terms of the ingredients, and the resurgence of Chinese brands continues.

So I would say, I'm not sure about -- so you said about the formula. Sorry, what was your -- if you can just repeat that or rephrase that question, please?

Yes. So just in terms of the market pricing recovery comments you made earlier, it feels that a lot of the comments is around supply. But can you talk maybe a bit more around the demand side? I mean, from my perspective, it seems that your formula is not as advanced as a few of your competitors have launched into the space in recent times, and also, we've got this resurgence of Chinese brands which continues.

Yes. With the -- I think you talked -- with the formula, are you referring to a competitive product? Or is that -- was that your question? When you said the formula, what are you emphasizing?

I mean, all the ingredients, and a lot of your competitors abide to the process, yes.

Right. Look, I think on that point, the reality is, Sam, it's always been a brand play. So we've been pleased with the success we've had relative to new entrants. Yes, you could argue some new entrants may or may not have relatively strong ingredients panels, but that hasn't meant that they had consumer traction. So it's been no -- at this point in time, there's been no A1-free product, which is how consumer traction. It doesn't mean that they won't. But just clearly, it's been, as first-mover advantages service, particularly well. In terms of the supply side, what I would reiterate is that, again, we're getting traction in terms of offtake with a daigou channel post the COVID disruption. So we're seeing our way clear of that, as I indicated or reemphasizing the point that upside beyond what we've indicated would be dependent on pricing, which we, therefore, were determined to try to leverage or to try to encourage into commentary around inventory. So that really probably answers that question that there is some -- pricing dependency will provide further variation.

Got it. And then the lower China label margins that you're talking about, in your view, is this something temporary that's going to pass? Or is this some new normal?

Sam, it's Race. I'm going to just take that one. Look, the China label margins, the innovation we put in the lid, the additional lactoferrin does make that a more expensive product. That, of course, will continue. The impact that it comes through because that is transacted for us through RMB into U.S. dollars back to New Zealand dollars, I think that part will be particularly temporary. And we have, of course -- well, that's more from the CBEC side taken part of the obsolete stock. So at the China label, I would say that the FX is potentially temporary, but the actual ingredient cost and the lid is a permanent fixture.

And the channel pricing pressures that [ the release submitted ] to?

Sorry, the channel pricing pressures for?

China label.

For China label? Well, China label pricing, we don't see a lot of pressure, so we've maintained our pricing through the period.

Got it. And then in terms of the reduction in corporate costs, what proportion of these reductions do you feel you can bank permanently post-COVID?